Lisa Stark, Business Law Today editor-in-chief: Judge Montgomery-Reeves, you have been hailed as a trailblazer—the first-ever African American to serve as a Vice Chancellor of the Delaware Court of Chancery as well as the first African American associate justice and the youngest jurist to sit on the Delaware Supreme Court. You recently started a new position as a federal judge on the Third Circuit Court of Appeals, having been nominated by President Biden, in June 2022.
What have been the key drivers of these tremendous accomplishments?
Judge Tamika Montgomery-Reeves: The two main reasons for my career accomplishments are sponsorship and timing. As I have said before, no one gets very far alone in life. I am here because I stand on the shoulders of giants. Many people came before me, in Delaware and on the federal bench, and those people paved the way for me to follow. I also have been extremely fortunate to have people, like former Chancellor William B. Chandler III, who not only mentored me but sponsored me during my career. Finally, I think it is important to put your name in the hat and to take chances on yourself, even if the timing and circumstances are not exactly what you had planned.
Lisa: Did you always want to be a judge?
Judge Montgomery-Reeves: I knew I wanted to be a lawyer in elementary school. I first developed an interest in the law from my grandmother. She grew up in Mississippi, and while she was not highly educated, she talked to me all the time about the importance of the law and knowing your rights. She talked to me about the inequities she witnessed growing up in Mississippi in the 1930s and 1940s, and she influenced me to pursue the study of law.
Lisa: What do you most enjoy about your job?
Judge Montgomery-Reeves: Finding the right answer. My role as a judicial officer is to study the record before me and the applicable law and come to the correct outcome based on that.
Lisa: Who have been the biggest influencers in your career trajectory?
Judge Montgomery-Reeves: My judicial mentor is Chancellor Chandler. He is very smart, and he works very hard. When I worked with him, he was in early, and he stayed late. He was constantly studying all things corporate law. He was a titan in corporate law, but you would never know that from the way he treated people. Every litigant, lawyer, law clerk, really anyone he encountered, he treated with the utmost respect. He is a person who cares deeply about other people, about making sure that everyone feels heard and is treated fairly, and you can see that in every interaction he has.
Lisa: You have worked to improve diversity in the judiciary. Is that something that you feel passionate about?
Judge Montgomery-Reeves: I think the judiciary should reflect the population it serves. And I think this for two reasons. First, having the judiciary reflect the whole population fosters trust in the judicial system, which is essential. Second, it allows children to see themselves in the people on the bench and start to think, “Hey, maybe I can do that too.”
Lisa: Studies have shown that more men than woman argue cases before the country’s high courts. What can we do to increase opportunities for women in the courtroom?
Judge Montgomery-Reeves: It is important that each of us recognizes that we all have the power to influence positive change whatever our position. For example, I make sure to treat every person before me, regardless of gender, with the same levels of engagement and respect. And I would encourage attorneys to consider who is arguing motions or presenting oral argument. If an associate drafted the motion, knows the entire record, and is going to prep the partner for argument, perhaps she should be the one arguing the motion instead.
Lisa: What are your favorite things to do when you are not on the bench?
Judge Montgomery-Reeves: I love to travel, eat good food, and spend time with my family and friends.
Typical business planning transactions often can trigger fraudulent transfer law. Evidence of intent with respect to transactions involving an entity can be gleaned from direct evidence,[1] but, like transactions involving individuals, is often gleaned from facts and circumstances. Resorting to the use of a business entity to hinder or delay creditors may result in avoidance under fraudulent transfer law.
In 1932, the Supreme Court decided a case involving a Pennsylvania lumber dealer who was unable to pay his debts as they came due and whose creditors were seeking payment. The dealer believed he could retain assets if a receiver was appointed. However, Pennsylvania did not permit the appointment of a receiver for a business conducted by an individual as distinguished from one conducted by a corporation. Consequently, the Pennsylvania dealer formed a Delaware corporation, then transferred all his assets in exchange for all the stock. The new corporation also assumed all the dealer’s debts. The dealer then sued in conjunction with a creditor against the new corporation.
Justice Cardozo noted the transfer to the corporation was fraudulent as well as the resulting receivership because it was part and parcel of a scheme whereby the form of a judicial remedy was to supply a protective cover for a fraudulent design. “A conveyance is illegal if made with an intent to defraud the creditors of the grantor, but equally it is illegal if made with an intent to hinder and delay them. Many an embarrassed debtor holds the genuine belief that, if suits can be staved off for a season, he will weather a financial storm, and pay his debts in full. Means v. Dowd, 128 U.S. 273, 281, 9 S.Ct. 65, 32 L.Ed. 429. The belief even though well founded, does not clothe him with a privilege to build up obstructions that will hold his creditors at bay.”[2]
Limited liability companies
Because the asset protection trust is laced with evidence of intent to hinder creditors ab initio, the use of a limited liability company is tempting because it enjoys a disguise as a valid business entity unrelated to the owner’s personal creditor issues. However, if a creditor can show a debtor fraudulently transferred assets to an LLC (e.g., through a contribution of capital), the transfer to the LLC may be voided, just as a fraudulent transfer to a trustee of a trust may be voided.[3] To the surprise of some planners, a contribution of capital in exchange for membership interests does not necessarily equate to “reasonably equivalent value.”[4]
The limited liability company, and its charging order protection preventing creditors from reaching a member’s distribution until the LLC makes a distribution, is expressly permitted by most state laws. In a minority of states, an LLC need not have more than one member but still provide charging order protection. With an LLC, a veil of protection is created so that a business owner’s individual assets are protected from the claims of creditors of the business (inside creditors).[5] This protection helps promote entrepreneurial spirit and is long recognized by the courts. “After all, there is nothing fraudulent or against public policy in limiting one’s liability by the appropriate use of corporate insulation.”[6] But where the LLC is used as a trust substitute to protect assets from a member’s personal creditors, the member’s concern is not creditors of the business, but rather, the debtor’s personal creditors (outside creditors.)
LLCs as Trust Substitutes
Conceptually, the LLC is developing into a variant of the self-settled trust, where the rights of members and creditors are handled primarily by statutes, which in turn, permit the parties to do as they please under an operating agreement. This contrasts with centuries of developed case law and modern statutes adopting the case law as it applies to the use of trusts. With trust law, certain safeguards developed over time to protect creditors, the most obvious being the centuries old rule against self-settled trusts, which essentially provides one cannot use a trust to have his cake and eat it, too. The LLC and the law of contract, coupled with the benefit of not having to account to beneficiaries, are options for some to sidestep centuries of trust law and its protections for creditors and beneficiaries alike.
Today, some may attempt to enjoy the benefits of a self-settled trust in the form of an LLC. Managers can make decisions instead of trustees. The tax treatment can be replicated as well. A self-settled trust is usually treated as a so-called grantor trust in tax parlance, meaning the settlor pays the income tax on trust income. The LLC achieves the same result where it has a single member. This is because the default classification of a single-member LLC, for federal tax purposes, is to treat the LLC as disregarded (meaning all the tax consequences flow through to the member.)
The concept of a charging order has roots in trust law. At its core, a charging order is a lien on a debtor’s interest where a creditor has to wait for distributions to be made from a third party to the debtor before seizing the distributed property.[7] In the trust setting, generally a court does not refer to this lien as a “charging order” but instead enters an order permitting a creditor to attach present and future mandatory distributions due to a trust beneficiary. If the trust is discretionary, a court may enter an order permitting garnishment of distributions when made in the discretion of a trustee.[8]
According to section 736.0504(2), a former spouse may not compel a distribution that is subject to the trustee’s discretion or attach or otherwise reach the interest, if any, which the beneficiary may have. The section does not expressly prohibit a former spouse from obtaining a writ of garnishment against discretionary disbursements made by a trustee exercising its discretion. As a result, it makes no difference that the instant trusts are discretionary. Casselberry is not seeking an order compelling a distribution that is subject to the trustee’s discretion or attaching the beneficiary’s interest. Instead, she obtained an order granting writs of garnishment against discretionary disbursements made by a trustee exercising its discretion.[9]
Where the trust is self-settled, generally, a creditor may reach the maximum amount that could be distributed to the settlor. Where a debtor does not contribute assets to a trustee but is merely a discretionary beneficiary of the trust (referred to as a third-party trust), the beneficiary’s interest generally is protected from creditors, at least until distributions are made.[10]
Contrast with the LLC, which essentially takes a best of both worlds approach; the debtor-member may contribute assets to the LLC much like the debtor would a self-settled trust, however, the debtor-member is essentially treated as a beneficiary of a third-party trust because the LLC charging order statutes permit a creditor to reach distributions only if made by the LLC.[11] If the LLC was treated like the self-settled trust, a creditor could, like a creditor of a beneficiary of a self-settled trust, take the maximum amount distributable to the member. With an LLC, this would mean foreclosing on the member’s interest, voting the member’s interest, etc.
But the LLC is not a trust; the LLC is a business entity. The charging order for purposes of trust law was meant to ensure a beneficiary could not thwart a creditor by enjoying the benefits of a trust despite an obligation to creditors. For LLCs (and partnerships), the charging order is justified on the grounds that a creditor should not step into the debtor’s shoes as a member of the LLC. Instead, the creditor may receive the same economic benefits the debtor member enjoyed. The goal with the LLC charging order is to prevent the creditor from interrupting other members of the LLC in conducting LLC business. But if there is no business other than dodging creditors, the public policy supporting the charging order weakens.
The law in some jurisdictions is written in a way that makes it difficult to disregard public policy. Like choice of law disputes in the trust context, debtors also attempt to hardwire the governing law of an operating agreement to force creditors to play by the rules of debtor-friendly states or countries.
In sum, the LLC is increasingly being used as a quasi-trust with the goal of protecting a member’s assets from the member’s personal creditors. Consequently, creditors who engage in discovery will look for evidence of the LLC serving as a personal use vehicle. This may lead to a court viewing the LLC as an alter ego or sham, permitting the creditor to reach the assets. Not only can general creditors rely on personal use evidence to reach assets, but the lack of a true business purpose can have negative consequences for federal tax law purposes.
Capital Contributions
In some cases, the contribution of an asset to a business entity is not meant to assist with business operations but instead intended to help the owner insulate the transferred asset from the claims of the owner’s creditors. Fraudulent transfer law provides a creditor with an opportunity to challenge the transfer of assets to a business entity.
In Firmani v. Firmani, the court reviewed debtor’s argument that the transfers to an LLC were made not to hinder a creditor, but for estate planning purposes. The court did not buy the excuse and found the transfer to the LLC to be fraudulent under an actual fraud analysis.
Defendants failed to present any substantial evidence to counter the strong inference of fraudulent intent established by these badges of fraud. Firmani submitted a certification which asserted that he established the Family Partnership and conveyed the Haddonfield property to this entity for “estate planning purposes.” However, we are unable to discern from Firmani’s certification how the transaction could have served any estate planning purposes, except by increasing the total amount of his estate by the $25,000 he seeks to avoid paying plaintiff and by the amounts of the judgments that certain casinos have against him. In any event, N.J.S.A. 25:2–25(a) does not require that an intent to hinder, delay, or defraud a creditor be the exclusive motivation behind a transfer in order for the transfer to be deemed fraudulent.[12]
If more than one person transfers assets to an LLC, but only one person is a debtor, such that his transfer is voidable by a creditor, it should not matter if the transaction involved a non-debtor; one cannot insulate a fraudulent transfer by arguing the avoidance would complicate matters or affect another person’s interest. Such was the case in First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, where the debtor transferred his 50 percent interest in real property, together with the other 50 percent owner (Whiteman), to PDC, LLC. It should be noted that debtor offered evidence of his intent, which included legitimate business planning, to no avail.[13] Despite the complications of unwinding a transfer to an LLC where some members do not have fraudulent intent, the court ruled in favor of the creditor:
Accordingly, we find the conveyances of Whiteman’s 50 percent interest and Clifton’s 50 percent interest to PDC were each distinct transfers that Whiteman and Clifton merely chose to accomplish in a single deed. The fact they utilized one instrument to transfer their separate interests does not negate the distinct ownership interest each person possessed in the Property. As mutually exclusive conveyances, we also find that the invalidity of one does not necessarily invalidate the other. To that end, Whiteman’s intent in transferring her share of the Property to PDC is irrelevant to the circuit court’s finding of fraudulent intent as to Clifton. Clifton’s proportional interest is subject to the claims of his creditors, and he cannot legitimize the fraudulent transfer of his interest by lumping it together with Whiteman’s presumably valid transfer of her interest. Regardless of the parties’ choice of instrument to convey the Property, we find the circuit court properly set aside the conveyance pursuant to the Statute of Elizabeth.[14]
The transfer of assets to an LLC may be viewed as a badge of fraud where the debtor removed assets by transferring to an LLC to enjoy charging order protection.[15] The Official Comments to the UVTA also address the intersection between charging order protection and fraudulent transfer law.[16]
In Interpool, the debtor, Cuneo, transferred non-exempt assets to an LLC (RMC). The RMC interests were then transferred to a trust (RAC). The court examined the transfers under both New York and Florida fraudulent transfer law, finding their holding would have been the same, regardless of the applicable law because there was no conflict between the state laws. As is typical in wealth transfer transactions challenged under fraudulent transfer law, the debtor argued he was motivated by non-creditor reasons. This did not persuade the court to find in the debtor’s favor.
Cuneo was deposed in March 1995 in connection with the proceedings to enforce the judgment. His explanation for the challenged transfers was un-illuminating. He was unable, or chose not, to explain how he and his wife determined what property to transfer into RMC and RAC or why the transfers were made other than to say that he “picked stuff that [he] thought had a worth to it” and that he did so on the advice of counsel for “estate planning” reasons. He testified that he did what [Attorney] suggested and that he “assume[d] that it had to do with tax purposes if [he] die[d].” But he did not articulate any specific reasons why he believed the transfers to be advantageous.[17]
As to whether the membership interests received in exchange for non-exempt assets constituted reasonably equivalent value, the court did not focus on the LLC’s value, and thus, the potential value of the LLC interests Cuneo received in exchange for his assets. Instead, the court focused on a creditor’s rights to the property that was transferred. In other words, the court examined a creditor’s rights before and after the transaction in determining the value of the debtor’s asset from the creditor’s perspective.
The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited *266 partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.
Interpool can be contrasted with United States v. Holland, where the debtor transferred assets to a limited liability company but remained the sole member. The transfer of assets to a single-member LLC, where the governing law does not provide single-member charging order protection, is akin to the transfer of assets to a revocable trust.
The US contests this characterization, contending that, when compared to the prospect of garnishing the Royalty Assets, the 1998 Transaction left Holland’s creditors with “the far less appealing recourse of seizing [Holland’s] partnership interest (which is subject to major partnership-level debts).” (Doc. 310, p. 7). In this connection, the US asserts that “a conveyance is not an exchange for equivalent value when it makes the debtor ‘execution proof.’” (Id.). In support, the US cites Interpool Ltd. v. Patterson, 890 F.Supp. 259 (S.D.N.Y. 1995), in which a debtor-husband transferred assets to a partnership jointly owned by his wife, and Dunn v. Minnema, 323 Mich. 687, 36 N.W.2d 182, 184 (1949), in which a debtor-husband “invest [ed] of $9,600 of his personal assets in property to which he and his wife held title by the entireties.”
Under the particular facts of this case, the transfer to EHLP did not make Holland “execution proof” because, unlike the debtors at issue in Interpool and Dunn, Holland was the sole owner of the assignee entity, EHLP. Accordingly, seizing Holland’s partnership shares would, apparently, enable a creditor to reach the Royalty Assets. The US is correct that, under this scenario, the Royalty Assets would be subject to “partnership-level debts.” However, because Holland received the benefit of such partnership-level debts in the form of the Note proceeds, this factor is of no avail to the US. If Holland had simply left the Note proceeds in his bank account, his creditors would have been no worse off—they could garnish the cash and recover the remaining value of the Royalty Assets upon repayment of the Notes.
In view of these factors, the 1998 Transaction and 2005 Transaction did not significantly hinder Holland’s creditors. Accordingly, the transfer did not result in the type of “wrong” that would support a finding that (i) that EHLP held title to the Royalty Assets as Holland’s nominee, (ii) that Holland fraudulently conveyed the Royalty Assets to EHLP, or (iii) that EHLP is the alter ego of Holland. Because the US demonstrates no basis for attaching property held by EHLP, the Court must deny its motion for summary judgment.[18]
United States v. Holland illustrates why some states have enacted statutes providing charging order protection for a single-member limited liability company. The LLC becomes a quasi-exemption debtors may use to avoid paying their personal creditors. Like the asset protection trust, the single-member LLC offering charging order protection presents public policy issues relevant to fraudulent transfer law and choice of law for debtors attempting to import protections into their own state against their personal creditors.
Although avoiding a transfer to a business entity has an impact on the business and its owners, this is of no consequence if the transfer is fraudulent. As previously addressed, some have argued that it is unfair to other business entity owners if a creditor may void a transfer to the business entity by a debtor. This argument has also been used in the trust context, where some maintain it is not fair to void a transfer to a trust if the debtor created rights in third parties (via beneficial interest.) Like the choice of law in a trust agreement, or avoidance of a transfer to a self-settled trust, a creditor who has been injured and seeks relief under fraudulent transfer law is not always held subject to rules created in advance by a debtor. Stated differently, a debtor cannot transfer assets to an entity or trustee, muddy the ownership rights to such property by creating rights in third parties (often insiders), and then expect these third-party interests will automatically defeat a creditor.
If business entities are utilized to effectuate a fraudulent transfer, there is a risk that the court will disregard the business entity. This could have the effect of rendering the individual who controls the business entity liable as transferee. For example, In re Pace featured an attorney who helped his client (the debtor) transfer assets to an LLC controlled by the attorney. This was done to avoid the debtor’s creditors. The court held the LLC was the initial transferee, and further found that the attorney, due to his participation, was jointly liable and might have been considered the person for whose benefit the transfer was made.[19] As discussed in the civil liability section of this book, lawyers must be careful as to their degree of involvement in fraudulent transfers.
Fish v. East, 114 F.2d 177, 182 (10th Cir. 1940). (“The court found that an additional object of making that lease and organizing the Placers Company to receive the grant or demise as lessee was ‘to hinder and delay creditors’ of the Mines Company, direct evidence of such fact being found in the minutes of the meeting of the board of directors of the bankrupt held November 2, 1932, at which a resolution was adopted to the effect that the stock of the Placers Company should be issued to Edward Cunningham, Erland F. Fish, and John A. Traylor, as trustees for the Mines Company, and the president of the Placers Company, stating that one of the reasons for this arrangement was that it was desired to have the stock ‘out of the name of Mines Company, so it could not be attached.’ In re Holbrook Shoe & Leather Co., D.C., 165 F. 973; In re Looschen Piano Case Co., D.C., 261 F. 93; Shapiro v. Wilgus, 287 U.S. 348, 53 S.Ct. 142, 77 L.Ed. 355, 85 A.L.R. 128.”) ↑
Shapiro v. Wilgus, 287 U.S. 348, 354, 53 S. Ct. 142, 144, 77 L. Ed. 355 (1932). ↑
See SE Prop. Holdings, LLC v. McElheney, No. 5:12CV164-MW/EMT, 2016 WL 7494300, at *11 (N.D. Fla. May 7, 2016). (“For Crestmark, it appears at this point that there is nothing to garnish—there is no debt owed to McElheney individually by the LLC. But SE Property may be able to garnish assets of Crestmark if it can show that McElheney transferred those assets to Crestmark fraudulently.”) ↑
See, e.g., Interpool Ltd. v. Patterson, 890 F. Supp. 259, 265-66 (S.D.N.Y. 1995) (“The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.”) ↑
See generally, Thomas O. Wells & Jordi Guso, Asset Protection Proofing Your Limited Partnership or LLC for the Bankruptcy of A Partner or Member, Fla. B.J., January 2007, at 34. (“An FLP has two types of creditors — inside creditors and outside creditors. Inside creditor claims arise from alleged actions or omissions of the FLP. Inside creditors may levy against the assets of an FLP, but generally cannot levy against the individual assets of limited partners or members of the FLP. Outside creditor claims arise from alleged actions or omissions by a debtor partner of the FLP. This article’s focus is on the rights of outside creditors to the debtor partner’s interest in the FLP.”) ↑
See Miller v. Honda Motor Co., 779 F.2d 769, 773 (1st Cir. 1985). ↑
See Loring and Rounds, Section 5.3.3.3(a). (“A creditor is then left with little recourse other than perhaps to attempt to obtain a judicial charging order that, if granted, might snare any discretionary distributions actually made to the beneficiary.” citing Hamilton v. Drogo, 241 N.Y. 401, 401, 150 N.E. 496 (1926) (“By the enactment of section 684 of the Civil Practice Act, providing that an execution may issue against a certain proportion of income from trust funds due and owing, or thereafter to become due and owing to a judgment debtor, it was the intention of the Legislature to extend the scope and effect of an execution as it had theretofore existed. There is no requirement that the income be due at the time the order is made and the execution served. It is enough either that it will become due in the future from the trustee to the cestui que trust, or that it may become so due. If ever the day of payment arrives the lien of the execution attaches.”) ↑
Historically, a beneficiary has a “reachable” interest in a trust when the interest has vested. This may occur when an event occurs such as the death of a lifetime beneficiary where the debtor-beneficiary receives the trust corpus outright, or when a trustee has decided to make a distribution in favor of the debtor-beneficiary. An interest may vest in a debtor-beneficiary but be non-possessory; in this situation, a creditor may reach the property unless state law provides otherwise. (See Ariz. Rev. Stat. Ann. §14-10506. “Whether or not a trust contains a spendthrift provision, a creditor or assignee of a beneficiary may reach a mandatory distribution of income or principal if the trustee has not made the distribution to the beneficiary within a reasonable period after the mandated distribution date unless the terms of the trust expressly authorize the trustee to delay the distribution to protect the beneficiary’s interest in the distribution.”) ↑
Berlinger v. Casselberry, 133 So. 3d 961, 965–66 (Fla. Dist. Ct. App. 2013). ↑
See, e.g., Hamilton v. Drogo, 241 N.Y. 401, 150 N.E. 496 (1926). (“In the present case no income may ever become due to the judgment debtor. We may not interfere with the discretion which the testatrix has vested in the trustee any more than her son may do so. Its judgment is final. But at least annually this judgment must be exercised. And if it is exercised in favor of the duke then there is due him the whole or such part of the income as the trustee may allot to him. After such allotment he may compel its payment. At least for some appreciable time, however brief, the award must precede the delivery of the income he is to receive and during that time the lien of the execution attaches.”) ↑
Transfers to an LLC are subject to avoidance under fraudulent transfer law. Florida’s charging order statute also expressly refers to fraudulent transfer relief. See Florida Statute Section 605.0503(7)(b). (“This section does not limit any of the following: *** The principles of law and equity which affect fraudulent transfers.”) ↑
See First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 342, 797 S.E.2d 409, 414 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (“At trial, Clifton asserted he transferred the Property to PDC at the insistence of Whiteman. Clifton testified that Whiteman was ‘hammering’ him every day to place the Property into an LLC based on her fear of the liability associated with the Property being used for recreational hunting. Renee Gilreath, Clifton’s daughter, also testified they transferred the Property to PDC based on Whiteman’s liability concerns as well as for legitimate business purposes.”) ↑
First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 344, 797 S.E.2d 409, 415 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (Emphasis added.) ↑
Firmani v. Firmani, 332 N.J. Super. 118, 122–23, 752 A.2d 854, 857 (App. Div. 2000). (Firmani’s conveyance of the Haddonfield property to the Family Partnership manifested at least five of the “badges of fraud: set forth in N.J.S.A. 25:2–26. Defendant was the sole general partner and primary limited partner of the Family Partnership prior to the conveyance, and therefore the conveyance was made to an insider. N.J.S.A. 25:2–26(a); see Gilchinsky, supra, 159 N.J. at 478–79, 732 A.2d 482. By continuing to use the Haddonfield property as a residence and place of business, and as the sole general partner with a total ninety-five percent interest in the Family Partnership, defendant clearly retained possession or control of the property after the conveyance. N.J.S.A. 25:2–26(b). Firmani does not dispute that he was aware that the $25,000 had become due to plaintiff, and therefore he knew or should have known that absent voluntary payment, an enforcement action *123 probably would be brought. N.J.S.A. 25:2–26(d). By putting plaintiff in a position where she could only recover the money owed through the Limited Partnership charging process, defendant “remove . . . assets.” N.J.S.A. 25:2–26(g); see Gilchinsky, supra, 159 N.J. at 479, 732 A.2d 482 (“[I]n transferring assets from New York to New Jersey [where more debtor-protective IRA laws exist], defendant effectively prevented them from being attached by [her creditor].”). ↑
See Comment 8 to UVTA Section 4. (“Likewise, it is voidable for a debtor intentionally to hinder creditors by transferring assets to a wholly-owned corporation or other organization, as may be the case if the equity interest in the organization is more difficult to realize upon than the assets (either because the equity interest is less liquid, or because the applicable procedural rules are more demanding). See, e.g., Addison v. Tessier, 335 P.2d 554, 557 (N.M. 1959); First Nat’l Bank. v. F. C. Trebein Co., 52 N.E. 834, 837-38 (Ohio 1898); Anno., 85 A.L.R. 133 (1933).”) ↑
Interpool Ltd. v. Patterson, 890 F. Supp. 259, 263 (S.D.N.Y. 1995). ↑
United States v. Holland, No. 213CV10082MOBMKM, 2017 WL 4676607, at *5 (E.D. Mich. Sept. 12, 2017). ↑
In re Pace, 456 B.R. 253, 278 (Bankr. W.D. Tex. 2011). (“The court’s previous findings and conclusion that Hensley [the attorney] did not act in good faith in connection with the transfer of the condo underscores the conclusion here that Hensley used CFM to help Pace [the debtor] carry out a fraudulent transfer. That evidence is sufficient to justify piercing the corporate veil and to thus recover the condo from both Hensley and CFM under the theory of joint and several liability. See Resource Dev. Int’l, LLC, 487 F.3d at 303 (affirming district court’s conclusion that defendant shareholder had ‘utilized his control over defendant corporation’ to perpetuate the debtor’s fraudulent conduct where defendant had agreed with debtor to pay debtor’s legal fees in exchange for a wire transfer to defendant’s corporation, and holding defendant and defendant’s corporation jointly and severally liable under section 550).”) ↑
In today’s digital world and especially as businesses move toward building large brands, companies are building and accumulating significant intellectual property portfolios, whether it be trademarks in branding assets, copyrights to website pages, patents to artificial intelligence processing applications and modules, or trade secrets to a highly valuable recipe or a client list. As businesses combine, divide, and engage in mergers and acquisition activities, many businesses are finding that their value may be partly grounded in their intellectual property and that evaluating their intellectual property assets makes up a core portion of the diligence behind such a transaction.
A major part of intellectual property due diligence today also includes issues relating to technology (aka information technology due diligence). The goal of any intellectual property due diligence in a potential transaction will include determining what intellectual property (if any) the target holds and its value. It will also include understanding the target company’s policies and practices regarding document retention; its various intellectual property registrations across jurisdictions; past, ongoing or anticipated disputes; intellectual property enforcement; intellectual property protection measures; and the location of any intellectual property owned or licensed by the target company, as well as the local practices and IP compliance environment.
In cross-border deals or deals that involve target companies with foreign subsidiaries or affiliates, where the buyer company is looking at intellectual property assets abroad, the goal of such intellectual property due diligence will also be to understand the relevant jurisdictions’ intellectual property laws. For example, in Canada, there is no “work for hire” concept, and moral rights in intellectual property not only exist, but stay with the inventor or creator. And in India, for example, intellectual property in software is handled only by copyright and cannot be patented.
Assessing the quality and integrity of the intellectual property assets helps the acquirer, whether domestic or abroad, not just determine the risks associated with them, but also their value and therefore the overall value of the business. For example, the integrity of the chain of development, acquisition, and transfer of intellectual property from the creator to the eventual beneficial “owner” often surfaces as the biggest risk in transactions involving companies based in India.
To illustrate: the way India handles IP in software (being only eligible for copyright and not patent rights) may be the reason why a strict movement of IP is not documented or easily done. There may also be issues that arise when intellectual property is owned by a third party or jointly owned with a third party. In carve-out transactions, it is important to inquire whether the intellectual property is owned or used by the target or an affiliate that is not being acquired. Often, the seller assumes that even after the intellectual property is transferred, it will continue to be used by third parties or affiliates! Not all such inconsistencies are deal breakers, but they definitely are red flags.
As a buyer’s counsel providing a due diligence request list to the seller’s counsel, it is critical to understand that the disclosures and agreements provided by the seller, while useful, often do not paint the full picture of the target’s intellectual property portfolio, assets, and liabilities. It is, therefore, important to understand the proposed deal and the parties’ motivations for exploring and entering into the deal, and to seek more context from each party when necessary. In addition to the context of the deal, market standards and practices are important to bear in mind while conducting an intellectual property due diligence, both domestically and abroad. It is only then that one can articulate any issues that need to be remedied pre- or post-closing to solidify the buyer’s rights and ability to protect the intellectual property being purchased in the M&A transaction. For example, while in the West it is common for due diligence to be separated based on category or portion of the deal (like a separate intellectual property team or a separate security or privacy team), in India, due diligence teams typically report into the same partner to take a more holistic view, reviewing many elements, such as the findings on accounting and financials of the company, as well as the intellectual property due diligence report.
As the world continues to digitize, moving to a more digital standard with an increasing number of companies in IT, data, and online spaces and with fewer brick-and-mortar operations, often there is proprietary software (i.e., the software is the primary product of the target company) at stake. So it is not just a reliance on representations and warranties that is needed, but a deeper knowledge of the primary software itself, the intellectual property being purchased.
As such, the intellectual property due diligence must involve review of invention assignment agreements to confirm they contain present-tense assignment language or meet other assignment criteria in the relevant jurisdictions. The due diligence should also include review of employment agreements, licensing agreements, service agreements, etc. These should be taken in light of the relevant jurisdiction of the target, the intellectual property, and any applicable subsidiaries or affiliates.
For example, since India doesn’t have any trade secret laws, one needs to review confidentiality obligations, use restrictions, and other protections of trade secrets. Open source is a concern while reviewing software licenses and other documents related to use of such software. In addition to the above, there are other pieces of standard information typically reviewed and/or requested, including:
Patents and patent applications;
Trademarks;
Copyrights;
Trade secrets (usually protected by contract);
Corporate names;
Domain names;
Tag lines, by-lines, slogans, and brand hashtags;
Publicity rights;
Written works;
Brand assets;
Websites, online publications, and social media;
Software; and
Databases (data, particularly personal data, is the new asset class requiring scrutinous review).
Privacy and data security diligence often raises data and intellectual property issues. This particularly happens with trade secrets, as maintaining their value and status as a trade secret largely falls on confidentiality, security, and privacy measures taken by the holder. It also arises today because of the digital nature of how businesses are run; many (if not most) intellectual property assets are captured in, stored in, transmitted by, used in, and/or concern a digital medium, which inevitably and with any reasonable care requires data and security activity.
This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.
Two companion statutes, Sections 204 and 205 of the Delaware General Corporation Law, permit Delaware corporations to fix defective transactions. For example, sometimes—perhaps all too often—a Delaware company may accidentally issue more stock than its charter or stock plan permits. The company can “fix” the error using these statutes, by “ratifying” the issuance of the stock and retroactively changing the corporate charter to increase the permitted number of shares. Doing so, however, has always required the company to first admit that it made a mistake.
That might no longer be true. The Delaware Court of Chancery’s recent decision in In re Lordstown Motors Corp.[1] suggests that Delaware companies can “ratify” corporate transactions which they merely believe may be bungled. Is Lordstown just an anomaly? Or is it the beginning of a broad expansion of Sections 204 and 205 that would allow companies to seek the Delaware Court of Chancery’s[2] blessing of transactions that they merely think might be defective?
Basic Background on Sections 204 and 205
In 2014, Delaware’s General Assembly enacted Sections 204 and 205 to enable Delaware companies to retroactively “fix” a company transaction that suffers from a mistake or defect. The statutes call such a mistake or defect a “defective corporate act.” Under Section 204, a Delaware company may “fix” defective corporate acts on its own, without the Chancery Court’s assistance, simply by passing appropriate board resolutions and following certain other processes. Section 205, though, allows a Delaware company to commence a proceeding to ask the Court of Chancery to “validate” the defective corporate act.
Until now, both of these sections required that the company acknowledge there was a defect—otherwise there was nothing to ratify or validate. In re Numoda Corp.[3] is a good example. That was an early Section 205 case in which the Chancery Court held:
the Chancery Court is not free to exercise equitable powers under the statutes unless there was a “defective corporate act”;
the Court’s equitable power under the statutes is designed only to “remedy the technical validity of the act or transaction”; and
the Court’s equitable power under the statutes does not supersede “traditional fiduciary and equitable review.”
The Numoda opinion goes on to explain, “The Court does not now draw a specific limiting bound on its powers under Section 205, but it looks for evidence of a bona fide effort bearing resemblance to a corporate act but for some defect that made it void or voidable”, for “it is the legislation, not broad equitable theories, that instructs interested parties of the steps and requirements for ratification and validation of defective corporate acts and putative stock.”[4]
In a subsequent case, In re Genelux Corp.,[5] the Chancery Court concluded that Section 205 is a “remedial statute” that was designed only to “cure otherwise incurable defective corporate acts, not a statute to be used to launch a challenge to stock issuances on grounds already available through the assertion of plenary-type claims based on alleged fiduciary duty or common law fraud or a Section 225 action, if the stock had been voted.”[6]
In an unpublished (and often overlooked) decision, In re Baxter International, Inc., [7] the Chancery Court held that the purpose of Section 205 is to enable Delaware companies to seek judicial validity of “defective corporate acts” or corporate acts that suffered from “procedural defects.” There, Vice Chancellor Bouchard observed:
Section 204 and 205 of the Delaware General Corporation Law were recently enacted to provide certain avenues for the ratification or validation of defective corporate acts. Under Section 205, a corporation or a member of its board may submit an application to the Court of Chancery for a determination of the validity and effectiveness of defective corporate acts ratified under the related Section 204. The Court is also empowered by Section 205(a)(4), the provision that applies here, to “determine the validity of any corporate act or transaction.” The Court has used this power to validate, for example, an issuance of stock that suffered from procedural defects.[8]
In sum, Chancery Court cases before Lordstown consistently made clear that a Delaware company had to show that a transaction suffered from a defect that needed to be “fixed” before it could ask the Chancery Court to “validate” the transaction. But this might be changing. Recent case law appears to permit using Section 205 even when there is mere uncertainty about whether a corporation action was valid.
The Chancery Court Issues Its Decision in Lordstown To Resolve “Uncertainty”
On December 27, 2022, the Chancery Court decided Garfield v. Boxed, Inc.[9] In that case, the Chancery Court held that if a company had multiple series of common stock outstanding and wanted to issue more shares in order to accomplish a going-public merger with a special purpose acquisition company (SPAC), Section 242(b)(2) of the Delaware General Corporate Law requires each class of shares to vote separately to approve the new stock issuance.[10]
In the wake of Boxed, dozens of companies with multiple series of common stock that had issued new shares of common stock without following the voting procedure the Chancery Court required in Boxed filed Section 205 petitions to remedy potentially defective votes. Although some of these involved SPAC transactions, many did not. On February 20, 2023, Vice Chancellor Will held hearings on several of these petitions and approved each in rulings from the bench, including the first one, which was filed by Lordstown Motors Corporation in In re Lordstown Motors Corp.[11]
Lordstown Motors, a Delaware corporation, had filed a Section 205 petition seeking to validate under Section 205 an amendment to its corporate charter that increased the number of authorized Class A common shares, but which had not been approved by “a separate Class A vote” under Section 242(b)(2).[12] In granting the application, Vice Chancellor Will observed that “post-de-SPAC companies are experiencing uncertainty over their capital structures and the validity of their stock” and “a contrary ruling [i.e, to deny validation under Section 205] would invite untold chaos.”[13] Without a Section 205 validation of the potentially defective votes, Vice Chancellor Will held, similarly situated companies might be unable to satisfy auditors, complete periodic filings with the US Securities and Exchange Commission (SEC), obtain financing, or remain listed on a national securities exchange.[14]
Vice Chancellor Will added that in Lordstown, the Chancery Court could not “conceive of any legitimate harm that would result from validating” the amendment, and that “absent validation, a number of parties would face widespread harm.”[15] Consequently, Vice Chancellor Will determined that relief under Section 205 was “the most efficient and conclusive—and perhaps the only—recourse available.”[16] Vice Chancellor Will has scheduled hearings to handle waves of similar Section 205 petitions in the near future.
The key here is that Vice Chancellor Will approved using Section 205 to validate a corporate act, as long as there is “uncertainty” as to whether the corporate act is “void or voidable”—that is, so long as there is uncertainty as to whether a “defective corporate act” (as opposed to a corporate act that is legally valid and does not suffer from any defects) occurred:
Regardless of whether these acts are technically void or voidable due to a failure of authorization, the Company has encountered sudden and pervasive uncertainty as to its capitalization. Section 205 provides the court “with a mechanism to eliminate equitably any uncertainty” where questions of validity persist. The statute confers “substantial discretion on the court and, absent obvious procedural requirements, does not set a rigid outer boundary on the Court’s power.” The Delaware General Assembly intended Section 205 to provide an “adaptable, practical framework” for correcting blemished corporate acts “without disproportionately disruptive consequences.[17]
This decision—i.e., that Section 205 validation may be granted regardless of whether or not the company can show that an actual “void or voidable act” constituting a “failure of authorization” occurs—is directly at odds with prior decisions of the Chancery Court. As discussed above, those decisions held that Section 205 review can be granted only if the Section 205 applicant who seeks validation of a corporate act sufficiently shows that the corporate act in question is a “defective corporate act” or one which, at a minimum, suffers from a procedural defect.[18] The Lordstown decision also does not seem to fit within the language of the statute.[19] The statute on its face does not contemplate that it can be used to remedy uncertainty, only that it can used to fix what is undoubtedly a technical defect.
But Lordstown departs from this precedent: it requires Delaware companies to show the Chancery Court only that such a transaction might be defective.
Lordstown’s Potential Impacts
Because Lordstown appears to broaden Section 205 to cover corporate acts that merely might be defective, under Lordstown virtually any corporate act can be ratified that is within a Delaware corporation’s power to do, but for an uncertain defect. Thus, if the Chancery Court follows Lordstown going forward, Delaware companies and their boards will undoubtedly turn to Section 205 more frequently as a “belt-and-suspenders” approach to protecting corporate acts from attack by any shareholders who may, in the present or in the future, become disgruntled.
This strategy could turn out to be a mixed blessing. One the one hand, boards may take advantage of this looser standard by acting preemptively. In other words, they may file applications under Section 205 to ask the Chancery Court to “validate” corporate acts just to make sure that a possibly questionable corporate step they took is legally in order, with a view to achieving certainty and foreclosing future litigation. This could have the salutary effect of enabling companies to run their businesses without having to look over their shoulders for possible legal challenges.
But on the other hand, this more relaxed standard could embolden some bad actors. By definition, company insiders know more about the company’s inner workings and future prospects than any court possibly can. Indeed, the company chooses which facts to disclose to the court—so even without outright deception, this situation appears to be ripe for possible abuse. For example, a board intent on enriching itself might undertake acts of questionable or borderline legality that they might not otherwise have undertaken, knowing that they could seek judicial “validation” of such acts, long before the effects of their action become clear to the company’s shareholders, and without having to admit there is anything “wrong” (i.e., defective) with what the company did.
Conclusion
The Chancery Court’s recent decision in Lordstown departs from prior Chancery Court precedent which requires a Section 205 applicant to show that a company transaction suffers from a defect before asking the Court to validate the transaction. It remains to be seen if Lordstown is merely an outlier, or if it marks the beginning of a new and much more expansive Section 205 landscape.
Scott Watnik and Stuart Riback are litigation partners at Wilk Auslander, LLP in New York City.
The opinions expressed above are those of the authors and do not necessarily reflect the views of Wilk Auslander LLP, it clients or its respective affiliates. This article is for general information purposes and is not intended to be, and should not be taken as legal advice.
See, e.g., In re Numoda, 2015 WL 402265 (Del. Ch. Jan. 30, 2015); In re Genelux, 126 A.3d 644 (Del. Ch. 2015), vacated, in part, on other grounds, 143 A.3d 20 (Del. Sup. 2016); and In re Baxter International, Inc., (Del. Ch. C.A. No. 11609-CB May 17, 2012). ↑
See, e.g,. 8 Del. C. § 204, subd. (h)(1) and (h)(2) (defining “defective corporate act” and “failure of authorization”). ↑
If a purchase agreement has a fee-shifting provision and the prevailing party hires counsel on a contingency fee basis, does the losing party have to pay the contingency fee? The answer is yes, based on the Delaware Chancery Court’s ruling in Williams Cos., Inc. v. Energy Transfer LP.[1] We look at the court’s ruling and suggest a modification to the fee-shifting provision to alter this result. We also offer a drafting tip regarding the calculation of interest.
Background
The Williams case is based on a dispute over the merger agreement between The Williams Companies, Inc. (Williams) and Energy Transfer LP (ETE). The deal fell through, and the court found that Williams was entitled to a $410 million judgment as liquidated damages, as specified in the merger agreement. Normally, courts follow the American Rule—each litigant pay its own attorneys’ fees—but, in this case, the parties had altered that default rule. The merger agreement provided that if Williams prevailed in the recovery of the breakup fee, Williams was entitled to recover its reasonable attorneys’ fees and expenses related to such recovery from ETE.
Williams hired its counsel under a contingency fee structure, and the main dispute in this last opinion of the Williams v. ETE saga was whether the contingency fee was reasonable.
Contingency Fee
The Chancery Court concluded that the contingency fee was reasonable in this case. Consequently, ETE had to pay the 15 percent contingency fee that Williams had agreed to pay to its counsel Cravath, Swaine & Moore LLP (Cravath). Two of ETE’s failed arguments merit a close review.
First, ETE argued that it was unreasonable for Williams to switch from an hourly arrangement to a contingency fee arrangement mid-litigation. However, the Chancery Court found this was reasonable because the change occurred when the nature of the case shifted from one seeking injunctive relief (which called for a noncontingent representation) to one seeking recovery of the breakup fee (for which contingent representation was a business option). However, the Chancery Court cautioned that a change to a contingency fee arrangement may be unreasonable in some circumstances. For example, if the litigation had progressed significantly or the uncertainty of the outcome had diminished, switching to a contingency fee in an attempt to penalize the other side would be unreasonable.
Second, ETE argued that Cravath’s fee under the contingency fee arrangement ($74.8 million) was unreasonable because it was 1.7 times what Cravath would have received based on a traditional hourly rate ($47.1 million). This disclosure came out because Williams had to provide a “lodestar”—calculated as the number of hours Cravath expended multiplied by its hourly rate—to support the contingency fee.[2] Additionally, ETE complained that the number of hours and the billing rate of Cravath was higher than the number of hours that ETE’s counsel billed to the matter and the billing rate of ETE’s counsel. However, the Chancery Court held that the 1.7 lodestar multiple was within the range of reasonableness. The Chancery Court also found that the number of hours Cravath expended (which involved Williams having to produce approximately ten times more documents than ETE) and its billing rates (which reflected a discount and rate freeze and were at a level the market would bear for its services) were both reasonable.
Interest
This opinion also addressed two issues regarding interest.
First, how is interest computed (simple or compound) if the merger agreement is silent? The Chancery Court concluded that when parties are silent, they manifest an intent to leave that determination to the Court. The Chancery Court decided that prejudgment interest should be compounded because compounding more accurately reflects the standard form of interest in the financial market.
Second, ETE argued that prejudgment interest should be tolled because there was a delay caused by an inadvertent error by Williams’s discovery vendor. And then, because of that delay, the trial was further delayed by the COVID-19 pandemic. Although the Chancery Court has discretion to reduce prejudgment interest, the Chancery Court declined to toll the interest. The discovery error was inadvertent, and Williams didn’t cause the pandemic. Additionally, the purpose of interest is to address the lost time value of money, and here ETE had the use of the $410 million judgment during the litigation.
Conclusion
If your purchase agreement has a fee-shifting clause and the other side hires counsel on a contingency fee basis, your client would most likely be liable for the other side’s contingency fee (absent a contrary provision) under Delaware law. Thus, if your client has potential liability for a contingency fee (e.g., a buyer agreeing to a reverse termination fee or a seller agreeing to an indemnity—in each case, with a fee-shifting clause), you might want an express provision to the contrary. One approach is to provide that the contingency fee will be reduced to the fee payable had the prevailing party hired counsel on an hourly basis:
. . . provided, however, that if costs and expenses include a fee determined on a contingency or similar basis, then the contingency or similar fee must be reduced to a reasonable fee computed on the basis of an hourly rate or similar basis.
No one likes to lose in litigation. Adding insult to injury, losers that are subject to a fee-shifting provision have to pay the prevailing party’s attorneys’ fees. Don’t make it worse by allowing that fee to be a percentage of recovery due to a contingency fee arrangement. And while you are at it, consider specifying how interest will be calculated.
The views expressed in this article are exclusively those of the authors and do not necessarily reflect the views of Sidley Austin LLP and its partners. This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.
The fiduciary duty of oversight has been one of the hottest topics of discussion among practitioners and boards of directors since it was thrust back into the limelight by the Delaware Supreme Court’s decision in Marchand v. Barnhill.[1] In Marchand, the Delaware Supreme Court reversed a decision by the Delaware Court of Chancery to dismiss, among other things, a claim for breach of the duty of oversight—known as a Caremark claim—against the directors of Blue Bell Creameries, reasoning that a successfully pled oversight claim should not be “a chimera.”[2] Since Marchand in 2019, multiple plaintiffs have successfully overcome motions to dismiss filed by directors pursuant to oversight theories.
On January 25, 2023, in In re McDonald’s Corporation Stockholder Derivative Litigation,[3] the Court of Chancery settled the open question of whether officers, like directors, owe a fiduciary duty of oversight. The Court explained that most officers “have particular areas of responsibility,” and that officers have a duty to make a good faith effort to ensure information systems are in place and to address and report upward red flags within their areas. The Court noted, however, that “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.”
Denying defendants’ motion to dismiss, the Court in McDonald’s found that an officer’s duty of oversight is “an essential link in the corporate oversight structure,” as critical parts of an officer’s job are (i) “to identify red flags, report upward, and address them if they fall within the officer’s area of responsibility,” and (ii) “to gather information and provide timely reports to the board about the officer’s area of responsibility.” Like directors, officers will only be held liable for violations of the duty of oversight if a plaintiff can prove such officers acted in bad faith. On March 1, 2023, the Court dismissed the claim against the officer under Rule 23.1 for failure to plead demand futility, after finding that the complaint failed to plead a claim against the director defendants for breach of fiduciary duty.
Even before the Court’s ruling in McDonald’s made clear that officers owe a fiduciary duty of oversight, stockholder plaintiffs were focused on the role of technology professionals in cybersecurity incidents. In Construction Industry Laborers Pension Fund v. Bingle,[4] and Firemen’s Retirement System of St. Louis v. Sorenson,[5]the plaintiffs alleged that the board and certain officers had breached their oversight duties in relation to cybersecurity matters. The Court in both cases dismissed the claims after determining the companies’ boards were sufficiently independent and disinterested to determine for each corporation whether to bring the claims and therefore did not reach the issue addressed in McDonald’s. Now that McDonald’s has clarified that officers have a duty of oversight as well, the question is whether and when officers might be on the hook for overseeing data privacy and security.
In Firemen’s Retirement System of St. Louis v. Sorenson, plaintiff brought Caremark claims against the board of directors of Marriott International, Inc. following a data security breach that exposed the personal information of up to 500 million guests. In dismissing the claims under Rule 23.1 for failure to plead demand futility, the Court credited the Marriott board’s systems to assess cybersecurity risks. The board and audit committee were “routinely apprised on cybersecurity risks and mitigation, provided with annual reports … that specifically evaluated cyber risks, and engaged outside consultants to improve cybersecurity practices.” Notably, the Court further found that when management discovered “red flags” related to cybersecurity, relevant reports were delivered to the board. The Court found that cybersecurity “is an area of consequential risk that spans modern business sectors” and that the “corporate harms presented by non-compliance with cybersecurity safeguards increasingly call upon directors to ensure that companies have appropriate oversight systems in place.” Following the holding in McDonald’s, it is probable that Delaware courts will equally call upon the appropriate officers to focus on reporting red flags to the board and how such red flags are addressed.
Almost one year later, in Construction Industry Laborers Pension Fund v. Bingle, a plaintiff brought Caremark claims against SolarWinds’ board of directors following a major cyberattack on the company’s software system, through which Russian hackers were able to insert malware that gained access to up to 18,000 of SolarWinds’ clients’ systems. The directors were alleged to have failed to monitor corporate efforts in a way that prevented cybercrimes. The Court dismissed these claims under Rule 23.1 and, in so doing, found that the SolarWinds board (i) did not utterly fail to implement a reporting system for cybersecurity risks, since both the nominating and corporate governance committee and the audit committee were charged with oversight responsibility for cybersecurity, and (ii) did not ignore any red flags related to cybersecurity risks. Notably, in its analysis, the Court described the reporting systems SolarWinds had in place as “subpar” because, among other reasons, the board did not receive any reports from either committee with respect to cybersecurity for over two years.
The Bingle Court held that “a subpar reporting system between a Board subcommittee and the fuller Board[, however,] is not equivalent to an ‘utter failure to attempt to assure’ that a reporting system exists.” Accordingly, the Court continued “[w]ithout a pleading about the Committees’ awareness of a particular threat, or understanding of actions the Board should take, the passage of time alone under these particular facts does not implicate bad faith.” The Court was not required to address, however, whether SolarWinds’ officers had adequately complied with their oversight duties in reporting to the board or had received information amounting to a red flag.
Given these prior attempts by plaintiffs to plead cybersecurity-related Caremark claims, what should companies be focused on in the wake of the McDonald’s holding? The Court in McDonald’s observed that, unlike directors, “nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.” Furthermore, the Court found that “[a]s the day-to-day managers of the entity, the officers are optimally positioned to identify red flags and either address them or report upward to more senior officers or to the board. The officers are far more able to spot problems than part-time directors who meet a handful of times a year.” Accordingly, companies should focus on determining which officers’ “areas of responsibility” could be viewed to encompass data privacy or cybersecurity, as the cybersecurity-specific oversight by such officers will likely now face greater scrutiny. This analysis, unfortunately, may not be as straightforward as one would hope, particularly since there exists no single comprehensive data privacy law in the United States to provide guidance. Instead, companies must consider the various state laws to which they might be subject—such as the recently adopted and fairly comprehensive California Privacy Rights Act (“CPRA”)—and federal laws and regulations enforced by federal agencies, like the Federal Trade Commission.
If a company has a Chief Technology Officer, Chief Privacy Officer, and/or Data Protection Officer—which is required under the European Union’s data privacy law, the General Data Protection Regulation—it seems likely a court would find that data protection and cybersecurity fall within that officer’s area of responsibility, and therefore that each officer has a fiduciary duty to oversee data management and protection. But who else might be responsible for overseeing those matters? Would a company’s Chief Human Resources Officer be potentially liable for breach of fiduciary duty if there is a cybersecurity breach or if employee data is compromised? One could imagine a scenario in which a court might find that a human resources professional is responsible for oversight of employee information received pursuant to the Americans with Disabilities Act or Fair Credit Reporting Act, and therefore owes a fiduciary duty of oversight with respect to the protection of such data.
Furthermore, to what extent would a Chief Executive Officer, especially a technology-oriented one, a Chief Compliance Officer, or even a Chief Legal Officer be liable for cybersecurity oversight, given that the Court in McDonald’s found such officers “likely will have company-wide oversight portfolios”? Given that the CEO, CCO, and CLO are charged with broader oversight responsibilities, a court’s analysis of the exercise of fiduciary duties might more closely resemble the board-level duty of oversight analyses conducted in Sorenson and Bingle.
Recent Delaware caselaw suggests that fiduciaries of many companies may owe a duty of oversight encompassing the protection of consumer data and cybersecurity. The Court’s ruling in McDonald’s makes clear that such duty would be owed not only by a company’s directors, but also by those officers whose areas of responsibility include consumer data and cybersecurity. For some companies, it may be clear who should be responsible for cybersecurity oversight; for others, it may be advisable to delineate the roles and responsibilities of executive officers and board committees such that it is clear which officers are charged with oversight responsibility over specific functions. Companies should, at a minimum, make an effort to determine which of the officers are principally responsible for the establishment and monitoring of the company’s data and information protection systems. Such efforts could potentially prevent confusion regarding responsibilities, increase the likelihood that cybersecurity-related issues are identified and addressed in a timely manner, and help directors establish the reporting system required by Delaware law. The law recognizes that no system is foolproof. Fiduciary liability is not premised on the occurrence of the underlying event but rather the failure of officers and directors to make a good faith effort to attempt to establish systems of controls or the failure to report clear red flags when they emerge.
This area of Delaware law is rapidly developing. Similarly, data privacy law in the United States is continually evolving, and a handful of states have enacted comprehensive legislation specific to data privacy, including the CPRA, the Virginia Consumer Data Protection Act, and the Colorado Privacy Act, and many others have similar legislation under consideration or pending. Companies should therefore stay apprised of potentially relevant data privacy legislation, as well as future cases resolving cybersecurity-related and/or officer-level Caremark claims.
The views expressed in this article are those of the authors and not necessarily those of Richards, Layton & Finger or its clients.
The ABA Business Law Section is pleased to announce publication of the fifth edition of Ken Adams’s A Manual of Style for Contract Drafting. One of the most popular titles of ABA Publishing, this book is always in the Top Five for best-selling titles among all ABA books.
You can buy print and e-book versions only from the ABA. (ABA members and members of the Business Law Section, remember your discount!)
With each new edition of MSCD, we have wondered, what more can Ken offer? Each time, the answer has been, “a lot of substantive changes”—and this holds true for the fifth edition. In the preface, Ken describes what’s entirely new and what has been revised. Cumulatively, the updates amount to more than seventy pages of additional material.
In the nineteen years since it was first published, MSCD has grown from a small-format paperback of fewer than 300 pages to a bigger-format hardback that weighs in at 667 pages, with no padding.
One result of this evolution is that MSCD is somewhat intimidating. It contains within its covers some mind-bending complexity. And Ken will tell you that even he can’t remember everything it covers—often enough he consults MSCD as if he were an ordinary reader. On the other hand, that complexity is offset by Ken’s clear and no-nonsense prose.
The sheer size of the book is valued by those who work with contracts and need guidance on all issues relating to how to clearly say whatever you want to say in a contract. Readers have come to rely on Ken’s wisdom, his eye for detail, and most important, his clear writing.
For a taste of the breadth of the book and its new material, here is the new section from chapter 13 (“Selected Usages”) on the phrase public domain.
***
PUBLIC DOMAIN
13.706 The phrase in the public domain is used in contracts in two ways.
Used in the Exception to the Definition of Confidential Information
13.707 It’s standard to state exceptions to the contract definition of what constitutes confidential information, and one exception covers information that’s public or becomes public other than as a result of breach of an obligation under the contract. Information falling within that exception can be described in different ways, besides public. For example, publicly available, available to the public, and publicly known. Another of those variants is in the public domain.
13.708 Public domain originally referred to land belonging to the public, but it has also come to refer to anything, including information, that is available to all. Hence use of the phrase in that exception to what constitutes confidential information. But using in the public domain to mean simply public is wordy and primarily British. Furthermore, it’s confusing, as in the public domain has another meaning that is more entrenched in legal circles; that meaning is discussed in the following section. So don’t use in the public domain to refer to information being public.
Used Regarding Intellectual Property
13.709 The phrase in the public domain is also used to refer to the copyright status of a work of authorship that is no longer subject to copyright protection. And formerly patented inventions and unpatentable inventions are also sometimes said to be in the public domain.
13.710 The Oxford English Dictionary gives as a definition of public domain (besides the one pertaining to land) “The state or condition of belonging or being generally available to all, esp. through not being subject to copyright.” That suggests that the copyright meaning of public domain is more prevalent than using it to say that information is public (see 13.707).
13.711 But you can’t count on readers outside of intellectual-property circles knowing the intellectual-property meaning of public domain, so if you use the phrase in the public domain, consider explaining what it means. That would give you the speed of messaging offered by a term of art while letting everyone else in on the secret. But it would be even simpler to omit public domain and say what you mean instead of using a confusing term of art:
Except for portions in the public domain (that is, not subject to copyright protection), the Acme Products and related documentation are the property of Acme and are protected by law, including U.S. copyright laws and international treaties.
A recent decision of the Ontario Superior Court of Justice represents a rare victory for activists in overturning a target board’s proposed timing for setting a requisitioned meeting. While Canada is generally viewed as an activist-friendly jurisdiction, due in part to the relative ease with which a shareholder may demand that a special shareholder meeting be called, the ultimate timing of that meeting is in the discretion of the board. Canadian courts have rarely interfered with a board’s exercise of that discretion, even when the meeting date was set several months after the requisition. The decision includes important guidance for boards and shareholders seeking to bring their case for change before their fellow shareholders, particularly if they can demonstrate that the requisitioned meeting is urgent. The decision emphasizes that the right to requisition a meeting is “fundamental” and that a board’s decision in scheduling the meeting is deserving of careful scrutiny, both in the process undertaken to reach that decision and the substantive reasons advanced by the board to justify it.
Background
In Sandpiper Real Estate Fund 4 Limited Partnership v First Capital Real Estate Investment Trust, 2023 ONSC 794, two activist investors, the Sandpiper Group and Artis Real Estate Investment Trust (together, the Shareholder Group), submitted a meeting requisition with the goal of replacing four of nine of the issuer’s trustees who were to oversee the implementation of the issuer’s recently announced capital allocation plan (the Plan), which included the sale of certain assets by the real estate investment trust. The requisition asked the Board to call a unitholder meeting no later than March 1, 2023, some two-and-a-half months after the requisition. On December 30, 2022, the issuer announced a combined annual and special meeting of unitholders to be held on May 16, 2023, five months after the requisition.
The Shareholder Group applied to the Ontario Superior Court of Justice (Commercial List) to compel the issuer to hold a special meeting on March 1, 2023, or as soon as practical thereafter, citing concern over the possibility of assets being sold under the Plan before the meeting is held.
The Decision
The court noted that although there is no specific timeframe for holding a requisitioned meeting, unitholders have a “fundamental right” to have the meeting held expeditiously. While this does not imply a right to have a meeting held immediately or at the soonest available date, it does imply an obligation to hold the meeting “without unreasonable or unjustifiable delay.” Still, boards generally enjoy deference under the business judgment rule in determining the appropriate timing for a meeting.
The court looked to the Board’s process and whether it applied an appropriate level of prudence and diligence in its decision to schedule the meeting. The court took issue with the process undertaken by the Board, namely that the Board had only held a single two-hour meeting at which the requisition was only one item on the agenda, and that the trustees targeted by the Shareholder Group participated in the deliberations. The court found that this process failed to demonstrate the required independence and objective process that would warrant deference under the business judgment rule. As a result, the court proceeded to examine whether the special meeting was called within a reasonable timeframe.
The factors cited by the Board included:
the costs and distractions of holding two meetings;
the desire to give time for the issuer’s strategy to unfold and for financial results to be available for unitholders and proxy advisory firms to appropriately assess the strategy; and
the desire for unitholders to have more time to consider the issues to be raised at the special meeting.
While the court recognized that concerns regarding the cost and distraction of holding two meetings are frequently cited by target boards, these concerns had more relevance for a smaller company facing financial challenges. For the issuer, the cost was relatively small considering its size, and the issuer had previously held unitholder meetings in close succession.
Similarly, the purpose of the special meeting was, in part, to refresh the Board in order to supervise the execution of the issuer’s Plan. Delaying the meeting to allow the Plan to unfold would thwart the very purpose of the meeting, which was to allow unitholders to consider whether they wanted the existing Board to continue with their plans. Moreover, the Board cited unspecified events that, if they transpired, would be reflected in the first quarter results, and should be considered by shareholders. The court concluded that this was too vague and speculative a reason, given that the issuer could not point to any specific transaction or event that could justify the Board’s decision to delay the meeting. Further, the Shareholder Group was willing to agree to the May meeting so long as the Board would provide an undertaking not to dispose of any further assets under the Plan in the interim.
Ultimately the court ordered the issuer to hold the requisitioned meeting as soon as practicable after March 1, 2023.
Key Takeaways
A board’s decision in a contested situation will be heavily scrutinized, with a focus on management of conflicts. In its evaluation of the Board’s decision-making process, the court cited similar cases in which boards made use of special committees and met frequently prior to making key decisions that would warrant the protection of the business judgment rule in the context of proxy contests. The decision suggests that boards should carefully evaluate whether directors specifically targeted for removal may be viewed by a court as being conflicted and, if necessary, consider conducting deliberations in the absence of those directors. In addition, the fact that the Board formally considered the requisition only once and as part of a board meeting with unrelated agenda items was viewed as insufficient. This finding highlights the need for boards to demonstrate that they devoted sufficient time and focus to decisions, especially when responding to the exercise of one of a shareholder’s fundamental rights.
A board’s response must be tailored to the specific circumstances. The Shareholder Group primarily sought to prevent the issuer from following through on its Plan, which included selling assets and increasing distributions. In its reasoning for setting the meeting in May, the Board focused on the costs and distraction of holding two separate meetings and on the fact that it was preferable to wait an additional quarter so that the Plan would have more time to play out. Although the argument of saving costs by combining meetings is frequently used, it appears this will no longer justify the deferral of a requisitioned meeting in cases where the cost savings are nominal relative to the resources of the company, particularly where the company has a history of holding multiple meetings in short succession. Boards should instead consider the specific circumstances of the company, including its size and potential near-term material developments, in setting the timing of a meeting. On the second consideration, the court found that by delaying the meeting by five months, the Shareholder Group’s goal of checking the Board’s oversight of the optimization Plan was undermined.
Parties to a contested situation can benefit from demonstrating responsive engagement. Activists are well served by trying to show that they are accommodating the board’s concerns. The Shareholder Group was prepared to accede to the May meeting date, provided that the Board did not proceed with any further asset dispositions under the Plan prior to the May meeting. The court discussed this decision in its reasons and referred to the Wells v Bioniche case in which the company at issue had also determined to hold a meeting later than was requested by the activist, but unlike the issuer in this case, also provided a commitment not to take certain actions prior to the requisitioned meeting. The commitment in the Wells case allayed concerns surrounding the timing of the meeting. In the case of the issuer, the court found that the very purpose of the requisition was being frustrated by pushing out the meeting to allow the Plan to unfold.
The relationship between borrower and lender is not unlike many others in that both participants enter with the intent and expectation that the future will unfold smoothly—along with the cognizance that, whether the chance is realistic or remote, it may not. Savvy borrowers, going in, should have an understanding of their rights in the event that they are unable to fulfill their obligations to the lender (due to inability to pay or other reasons). Likewise, sophisticated lenders will take steps at the outset, before dollars change hands, to ensure that their interests are maximally protected. One way lenders accomplish this is through the taking of security interests in collateral under Article 9 of the Uniform Commercial Code (“UCC”). (Although the UCC has been adopted in some form by all fifty states, references to the UCC herein are to the North Carolina statute, codified in chapter 25 of the General Statutes of North Carolina, unless otherwise stated.) If the “debtor” has granted a security interest in collateral and the security interest has been properly perfected under Article 9 of the UCC,[1] then upon a default under the applicable security agreement the “secured party”[2] may enforce its rights and exercise its remedies (in accordance, in each case, with Article 9 and the terms of the agreement itself) by taking action against the collateral. This article discusses some of those rights and remedies.
Default and Part 6
Default itself is not defined in Article 9 of the UCC; rather, Article 9 leaves to the parties the task of determining—typically in the security agreement or other related document—the situations in which the debtor’s failure to live up to its end of the bargain may entitle the secured party to exercise remedies against the collateral.[3]
After a default has occurred, a secured party has the rights provided in Part 6 of Article 9 of the UCC (titled “Default”) and, except with respect to certain nonwaivable provisions set forth in section 25-9-602, those provided by agreement of the parties.[4] Part 6 contains rules pertaining to the rights of the parties following a default, collection and enforcement, disposition of collateral, and accounting for surpluses and/or deficiencies. Additional rules establish process-oriented requirements, such as the notices that must be given to defaulting debtors and secondary obligors (e.g., guarantors) before collateral may be disposed of. Although some of the rules set forth in Part 6 can be waived or varied by agreement of the parties, certain rules, to the extent they give rights to a debtor or obligor and impose duties on a secured party, may not be waived. These rules are stated with specificity in section 25-9-602, and where applicable certain of these are referenced in the discussion below.
Remedies and the Nature of the Collateral
Just as there are various types and categories of collateral under Article 9, there exist different remedies that may be pursued by the secured party depending on the nature of the collateral. Broadly speaking, in exercising remedies, a secured party may notify account debtors to make payment directly to the secured party if the collateral consists of accounts or certain other rights to payment, may apply funds on deposit in deposit accounts, may repossess collateral, may accept collateral in full or partial satisfaction of the obligations, and/or may dispose of collateral via judicial or nonjudicial sale (whether on the debtor’s premises or at another location).
Accounts and Deposit Accounts
Accounts
In cases where the collateral consists of an account or other specified right to payment, a perfected secured party’s essential remedy is to enforce the debtor’s rights against the account debtor,[5] including requiring the account debtor to make payment directly to the secured party and realizing on any collateral securing the payment obligation. Section 25-9-607(a) provides that a secured party
if so agreed and in any event after default . . . (1) [m]ay notify an account debtor or other person obligated on collateral to make payment or otherwise render performance to or for the benefit of the secured party; (2) [m]ay take any proceeds to which the secured party is entitled under [section] 25-9-315; and (3) [m]ay enforce the obligations of an account debtor or other person obligated on collateral and exercise the rights of the debtor with respect to the obligation of the account debtor or other person obligated on collateral to make payment or otherwise render performance to the debtor, and with respect to any property that secures the obligations to the account debtor or other person obligated on the collateral.[6]
Clause (3) of the foregoing makes clear that a secured party may step into the shoes of the debtor in proceeding against collateral securing an account debtor’s obligation to the debtor. This would include, for example, foreclosing on personal property under the UCC and/or real property under applicable foreclosure statutes. In this regard, if it is necessary to enable a secured party to exercise the right of a debtor under clause (3) to enforce a mortgage nonjudicially,
the secured party may record in the office in which a record of the mortgage is recorded: (1) [a] copy of the security agreement that creates or provides for a security interest in the obligation secured by the mortgage; and (2) [t]he secured party’s sworn affidavit in recordable form stating that (a) [a] default has occurred . . . ; and (b) [t]he secured party is entitled to enforce the mortgage nonjudicially.[7]
Of note, a secured party must “proceed in a commercially reasonable manner” if it undertakes to collect from or enforce an obligation of an account debtor or other person obligated on collateral.[8] The secured party may deduct from any amounts collected the “reasonable expenses of collection and enforcement, including reasonable attorney’s fees and legal expenses incurred by the secured party.”[9]
Deposit Accounts
A secured party with a perfected security interest in a deposit account may realize upon the funds in the account as provided in section 25-9-607. Where collateral consists of a deposit account over which the secured party has control under section 25-9-104(a)(1) (i.e., the secured party is the bank with which the deposit account is maintained), if so agreed and in any event after default, the secured party may apply the balance of the deposit account to the obligation secured by the deposit account.[10] Where collateral consists instead of a deposit account over which the secured party has control under section 25-9-104(a)(2) (i.e., the debtor, the secured party, and the bank are parties to an authenticated record providing for the secured party’s control over the account) or section 25-9-104(a)(3) (i.e., the secured party becomes the bank’s customer with respect to the deposit account), if so agreed and in any event after default, the secured party “may instruct the bank to pay the balance of the deposit account to or for the benefit of the secured party.”[11]
Application of Collection/Enforcement Proceeds
Application by a secured party of the proceeds of a collection or enforcement under section 25-9-607 is governed by section 25-9-608. Under this section,
(1) A secured party shall apply or pay over for application the cash proceeds of collection or enforcement . . . in the following order to:
The reasonable expenses of collection and enforcement and, to the extent provided for by agreement and not prohibited by law, reasonable attorney’s fees and legal expenses incurred by the secured party;
The satisfaction of obligations secured by the security interest or agricultural lien under which the collection or enforcement is made; and
The satisfaction of obligations secured by any subordinate security interest in or other lien on the collateral subject to the security interest or agricultural lien under which the collection or enforcement is made if the secured party receives an authenticated demand for proceeds before distribution of the proceeds is completed.[12]
If requested by a secured party, the holder of a subordinate security interest or other lien must “furnish reasonable proof of the interest or lien within a reasonable time”; and if it fails to do so, the secured party “need not comply with the holder’s demand.”[13] A secured party “need not apply or pay over for application any noncash proceeds of collection or enforcement unless the failure to do so would be commercially unreasonable”; however, if the secured party does apply or pay over for application noncash proceeds, it must “do so in a commercially reasonable manner.”[14] A secured party must also account to and pay a debtor for any surplus, and the obligor remains liable for any deficiency.[15] However, if the underlying transaction is a sale of accounts, chattel paper, payment intangibles, or promissory notes, the debtor is not entitled to any surplus, and the obligor is not liable for any deficiency.[16] To the extent that section 25-9-608(a) gives rights to a debtor or obligor and imposes duties on a secured party, with respect to the application or payment of noncash proceeds of collection or enforcement, or the accounting for or payment of surplus proceeds of collateral, such provisions may not be waived or varied by the debtor or obligor.[17]
Repossession and Breach of the Peace
Repossession
With respect to tangible collateral, a secured party has the right to seize and/or require the debtor to make the collateral available to the secured party. Section 25-9-609(a) provides that “after default a secured party: (1) [m]ay take possession of the collateral; and (2) [w]ithout removal, may render equipment unusable and dispose of collateral on a debtor’s premises under [section] 25-9-610.”[18] A secured party may take such action pursuant to judicial process or, if it does so “without breach of the peace,” without judicial process.[19] In addition, “if so agreed and in any event after default, a secured party may require the debtor to assemble the collateral and make it available to the secured party at a place to be designated by the secured party that is reasonably convenient to both parties.”[20]
Breach of the Peace
What would constitute a “breach of the peace” is left unaddressed in the statute and, rather, is “left to continuing development by the courts.”[21] Despite this omission, courts regularly describe breach of the peace as tending to cause violence or similar responses.[22] In North Carolina, case law also indicates that whether breach of the peace occurs may hinge on whether the repossessor has any face-to-face interaction with the debtor. It is well-established that “if there is confrontation at the time of [an attempted] repossession, the secured party must cease the repossession” or risk breaching the peace.[23] In contrast, where there is no confrontation, the North Carolina Court of Appeals has adopted a five-part balancing test to determine whether a breach of the peace occurred: “(1) where the repossession took place, (2) the debtor’s express or constructive consent, (3) the reactions of third parties, (4) the type of premises entered, and (5) the creditor’s use of deception.”[24] In Giles v. First Virginia Credit Services, Inc., the court emphasized that the repossession occurred when it was unlikely anyone would be outside, the repossessor did not enter the debtor’s home or any enclosed area, and there was no deception involved.[25] Interestingly, in some sister states, a would-be breach of the peace may need to be incident to the repossession itself, rather than the result of actions taken later, to be actionable.[26] Presumably, the North Carolina five-part test would also consider and evaluate the timing of the reaction in similar circumstances.
Section 25-9-609 does not authorize a secured party who repossesses without judicial process to utilize the assistance of a law enforcement officer.[27] Additionally, in considering whether a breach of the peace has occurred, courts “should hold the secured party responsible for the actions of others taken on the secured party’s behalf, including independent contractors engaged by the secured party to take possession of collateral.”[28] To the extent that section 25-9-609 gives rights to a debtor or obligor and imposes duties on a secured party, neither the debtor nor the obligor may waive or vary the duty of a secured party that takes possession of collateral without judicial process to do so without a breach of the peace.[29]
Disposition and Commercial Reasonableness
Disposition
Disposition of collateral after default is governed by section 25-9-610, which provides that “[a]fter default, a secured party may sell, lease, license, or otherwise dispose of any or all of the collateral in its present condition or following any commercially reasonable preparation or processing.”[30] Every aspect of a disposition—including the method, manner, time, place, and other terms—must be commercially reasonable.[31] If commercially reasonable, disposition may be “by public or private [sale], by one or more contracts, as a unit or in parcels, and at any time and place and on any terms.”[32]
Commercial Reasonableness: Guidelines and Interpretations
The UCC does not define the term commercially reasonable with precision. However, it does provide certain guidelines and interpretations of what constitutes a commercially reasonable disposition. For example, the official commentary to UCC Article 9 offers the following:
Although the term is not defined, as used in this article, a “public disposition” is one at which the price is determined after the public has had a meaningful opportunity for competitive bidding. “Meaningful opportunity” is meant to imply that some form of advertisement or public notice must precede the sale (or other disposition) and that the public must have access to the sale (disposition).[33]
By implication, the failure to provide a “meaningful opportunity” for competitive bidding through public advertising and access could render a public disposition commercially unreasonable.
Section 25-9-627 also offers guidance regarding commercially reasonable dispositions. Under this section, a disposition of collateral is made in a commercially reasonable manner if it is made “(1) [i]n the usual manner on any recognized market;[34] (2) [a]t the price current in any recognized market at the time of the disposition; or (3) [o]therwise in conformity with reasonable commercial practices among dealers in the type of property that was the subject of the disposition.”[35]
[The] fact that a greater amount could have been obtained by a collection, enforcement, disposition, or acceptance at a different time or in a different method from that selected by the secured party is not of itself sufficient to preclude the secured party from establishing that the collection, enforcement, disposition or acceptance was made in a commercially reasonable manner.[36]
However, it may indicate to the court that it should carefully scrutinize all aspects of the disposition.[37]
Courts analyzing commercial reasonableness frequently weigh factors such as whether the lender gave the borrower reasonable notice of the foreclosure sale, provided potential bidders adequate time and access for due diligence, advertised the sale in suitable news outlets, and hired a broker or auctioneer to conduct the sale.[38] A prime example of factors weighed in determining commercial reasonableness comes from Commercial Credit Group, Inc. v. Barber, where the defendant lender erred in several respects, with the court ultimately concluding that a foreclosure sale was not commercially reasonable.[39] This was in part because (1) the lender failed to provide ten full days’ notice of the sale; (2) the newspaper advertisements, while in appropriate publications, limited a bidder’s opportunity to conduct due diligence because the ads circulated only on the two days before and after the Christmas holiday; and (3) the advertised terms misstated the parties’ agreement.[40]
Commercial Reasonableness and Safe Harbor Provisions
Pursuant to section 25-9-603(a), the parties may determine by agreement the standards of commercial reasonableness applicable in a foreclosure scenario, as long as the standards agreed upon are not “manifestly unreasonable.”[41] Indeed, it is not uncommon for security or pledge agreements to contain “safe harbor” provisions whereby the parties agree at the outset on what will be deemed “commercially reasonable” in the event of a foreclosure or other exercise of the secured party’s remedies.
However, recent proceedings in a case pending in the Commercial Division of the New York Supreme Court suggest that courts may require a secured lender to exceed the parameters of a preexisting agreement defining commercial reasonableness, or at least fulfill certain obligations regardless of their exclusion from safe harbor provisions.[42] In WC Braker Portfolio, LLC v. ATX Braker, LLC, the judge granted first a temporary restraining order (“TRO”) and then a preliminary injunction halting the sale of real property in Austin, Texas, even though the lender complied with the safe harbor requirements to which the parties mutually agreed.[43]
In granting a TRO, the court first acknowledged that the parties’ agreement defining commercial reasonableness “does not require” sharing the terms of the sale.[44] Ultimately, though, it was not persuasive to the court that the borrower could have exercised its right of redemption up until the beginning of the public auction, that thousands of potential bidders were contacted with hundreds conducting due diligence, or that multiple third-party purchasers were expected to bid.[45] Instead, the court concluded that it could not “evaluate the commercial reasonableness of [the] sale without having the terms of the sale” and ordered the defendant to share that information even though the safe harbor agreement was silent on that requirement.[46] In due course, the court also ordered the defendant lender to grant the borrower access to the data room and the intercreditor agreement to assist in the reasonableness evaluation.[47]
Later, the court granted a preliminary injunction on the grounds that the borrower should have had a greater opportunity to participate in the sale by either bidding or having complete knowledge of the terms, and that there were apparent restrictions on the bidder pool.[48] More specifically, the court heard that the requirements for bidders were so stringent as to possibly discourage participation in the auction (which the court previously acknowledged at the TRO stage), and especially excluded the borrower.[49] For example, the lender reserved the rights to set a minimum reserve price (in addition to its preexisting right to credit bid), reject all bids, and even accept a lower bid or cancel the sale.[50] The plaintiff also argued that the parties’ pledge agreement was merely a “procedural safe harbor” that failed to reach the level of “a comprehensive statement of commercial reasonableness” under which compliance would show that the sale was commercially reasonable as a whole under the UCC.[51]
Interestingly, the court did not completely disregard the safe harbor provisions and was thus unmoved by the borrowers’ complaints that there was insufficient notice of the sale. It noted that the “very sophisticated” parties had agreed to notice between five and ten days prior to the sale, stating, “That may be [commercially unreasonable] but that’s what you agreed to. I can’t help you with you that.”[52] Thus, lenders can still expect some degree of protection from prearranged safe harbor requirements but should be prepared to distribute the terms of sale and related documents to the borrower in advance of a public sale, and plan to avoid sales terms that appear to limit the pool of potential bidders.
Commercial Reasonableness and Mandatory Provisions
In any event, section 25-9-603(a) does not permit the parties to an agreement defining commercial reasonableness to vary the duty of the secured party to refrain from breaching the peace under section 25-9-609.[53] In addition, the commercial reasonableness requirements set forth in sections 25-9-607(c) and 25-9-610(b) with respect to a secured party’s collection, enforcement, or disposition of collateral may not be waived or varied by the debtor or obligor.[54]
Further, a secured party may not dispose of collateral without first following specified notification procedures. This is in part because proper notice is an important component of commercial reasonableness, allowing an interested party to protect its interests by paying the debt, locating potential buyers, or attending the sale.[55] Before a disposition of collateral under section 25-9-610, a secured party must (except with respect to perishable collateral or collateral that is of a type customarily sold on a recognized market) provide a reasonable authenticated notification of disposition to
[t]he debtor;
[a]ny secondary obligor [such as a guarantor (unless waived)]; and
[i]f the collateral is other than consumer goods:
[a]ny other person from which the secured party has received, before the notification date,[56] an authenticated notification of a claim of an interest in the collateral;
[a]ny other secured party or lienholder that, 10 days before the notification date, held a security interest in or other lien on the collateral perfected by the filing of a financing statement that:
[i]dentified the collateral;
[w]as indexed under the debtor’s name as of that date; and
[w]as filed in the [correct] office . . . as of that date; and
[a]ny other secured party that, 10 days before the notification date, held a security interest in the collateral perfected by compliance with a statute, regulation, or treaty described in [section] 25-9-311(a).[57]
A secured party complies with the notification requirement to other lienholders if, “[n]ot later than 20 days or earlier than 30 days before the notification date, the secured party requests, in a commercially reasonable manner, information concerning financing statements indexed under the debtor’s name in the [proper filing] office”; and, before the notification date, the secured party either does not receive a response or receives a response and sends proper notification to the parties named therein.[58] The contents and form of the notification are prescribed for nonconsumer transactions in section 25-9-613, and for consumer transactions in section 25-9-614. In a nonconsumer transaction, a notice of disposition that is sent after default and ten or more days before the earliest disposition date set forth in the notice is presumptively sent within a reasonable time.[59]
Commercial Reasonableness and Application of Proceeds of a Disposition
Rules governing the application of proceeds of a disposition under section 25-9-610 are set forth in section 25-9-615. In particular, cash proceeds are applied in the following order (and in pertinent part):
(1) The reasonable expenses of retaking, holding, preparing for disposition, processing, and disposing and, to the extent provided for by agreement and not prohibited by law, reasonable attorney’s fees, and legal expenses incurred by the secured party;
(2) The satisfaction of obligations secured by the security interest or agricultural lien under which the collection or enforcement is made;
(3) The satisfaction of obligations secured by any subordinate security interest in or other lien on the collateral if:
The secured party receives from the holder of the subordinate security interest or other lien an authenticated demand for proceeds before distribution of the proceeds is completed; and
In a case where a consignor has an interest in the collateral, the subordinate security interest or other lien is senior to the interest of the consignor; and
(4) A secured party that is a consignor of the collateral if the secured party receives from the consignor an authenticated demand for proceeds before distribution of the proceeds is completed.[60]
The secured party may demand from the holder of a subordinate security interest reasonable proof of such interest. The secured party need not apply noncash proceeds unless the failure to do so would be commercially unreasonable. Any surplus must be paid to the debtor, and the obligor remains liable for any deficiency. However, different rules apply for calculating a surplus or deficiency where the purchaser at a disposition is the secured party, a person related to the secured party, or a secondary obligor and the amount of the proceeds “is significantly below the range of proceeds” that a disposition complying with the terms of Part 6, to a noninterested party, would have brought.[61] In such cases, the surplus or deficiency is calculated based on the amount of proceeds that would have been realized in a Part 6–compliant disposition to a noninterested purchaser.[62] To the extent that sections 25-9-615(c) and 25-9-615(d) give rights to a debtor or obligor and impose duties on a secured party, with respect to the application or payment of noncash proceeds of disposition, or the accounting for or payment of surplus proceeds of collateral, such provisions may not be waived or varied by the debtor or obligor.[63]
In an action arising from a transaction (other than a consumer transaction)[64] in which the amount of a deficiency or surplus is in issue, a secured party is presumed to have complied with the provisions of Part 6 unless “the debtor or a secondary obligor places the secured party’s compliance in issue.”[65] In such a case, “the secured party has the burden” of proving compliance.[66] If the secured party cannot do so, the liability of a debtor for a deficiency “is limited to an amount by which the sum of the secured obligation, expenses, and attorney’s fees exceeds the greater of” (i) the proceeds actually realized or (ii) “the amount of proceeds that would have been realized” had the noncomplying secured party complied with the provisions of Part 6.[67] The amount of proceeds that “would have been realized” if the secured party had complied with Part 6 is presumed to be the sum of the secured obligation, expenses, and attorney fees unless the secured party proves that the amount is less than such sum.[68] The foregoing rule codifies the previously recognized “rebuttable presumption rule” and expressly rejects the “absolute bar rule” adopted by some courts, which would bar a secured party from recovering any deficiency in the case of noncompliance with the default rules of Article 9.[69]
Acceptance of Collateral in Full or Partial Satisfaction
In addition, Article 9 of the UCC allows a secured party to accept collateral in full or partial satisfaction of an obligation (i.e., strict foreclosure). Strict foreclosure requires (1) a proposal by the secured party to retain collateral in full or partial satisfaction of an obligation, which must be sent to the debtor, any secondary obligor, and other lienholders or secured parties of record; and (2) an acceptance of the proposal (or failure to object within a specified time) by such parties.[70] A secured party’s acceptance of collateral in full or partial satisfaction of a secured obligation
(1) discharges the obligation to the extent consented to by the debtor; (2) transfers to the secured party all of the debtor’s rights in the collateral; (3) discharges the security interest or agricultural lien that is the subject of the debtor’s consent and any subordinate security interest or lien; and (4) terminates any other subordinate interest.[71]
A debtor, any secondary obligor, or any other secured party or lienholder may redeem collateral by fulfilling “all obligations secured by the collateral” and paying the “reasonable expenses and attorney’s fees” incurred by the secured party as permitted in section 25-9-615(a)(1).[72] To satisfy this requirement, it is not enough that the redeeming party simply give a new promise to pay; rather, this section requires “payment in full of all monetary obligations then due and performance in full of all other obligations then matured.”[73] Any unmatured obligations will remain subject to the security interest.[74] If the entire balance of the secured obligation has been accelerated, the redeeming party must tender the entire balance.[75] A redemption may occur at any time before a secured party has (i) collected collateral under section 25-9-607; (ii) disposed of, or entered into a contract for the disposition of, collateral under section 25-9-610; or (iii) “accepted collateral in full or partial satisfaction” of the secured obligation under section 25-9-622.[76] Except in a consumer goods transaction, the right of redemption may be waived only by an agreement to that effect entered into and authenticated after default.[77]
Conclusion
The rules that a secured party must follow in exercising remedies and enforcing a security interest under Part 6 of UCC Article 9 are complex and will differ depending on the type of collateral involved. At the same time, the rules offer secured parties flexibility by providing alternatives such as disposing of collateral at a public versus a private sale, or retaining collateral in full (or partial) satisfaction of the obligation.
In any event, the secured party must proceed with an understanding of its duties under Part 6, especially with respect to commercial reasonableness. This includes the important prerequisite of providing sufficient advance notice to the debtor, as well as avoiding breaching the peace. Secured parties should also keep in mind that agreements with the borrower defining a commercially reasonable sale are generally enforceable, but they should be prepared to share the terms of sale with the obligor in advance of any sale.
Likewise, debtors and obligors need to be cognizant of their rights—and which rights may and may not be waived—in order to maximize the fairness of a secured party’s enforcement actions.
This article assumes that the security interest has been properly created (i.e., has “attached”) and perfected prior to the default and exercise of remedies. Perfection of a security interest in most types of personal property is addressed in Article 9 and, with respect to certain securities and other “investment property,” Article 8 of the UCC. ↑
The terms debtor, obligor, and secured party are used herein with the meanings given in UCC Article 9. A “debtor” is “(a) [a] person having an interest, other than a security interest or other lien, in the collateral, whether or not the person is an obligor; (b) [a] seller of accounts, chattel paper, payment intangibles or promissory notes; or (c) [a] consignee.” A “secured party” means, in relevant part, “[a] person in whose favor a security interest is created or provided for under a security agreement, whether or not any obligation to be secured is outstanding.” An “obligor” means “a person that, with respect to an obligation secured by a security interest in or an agricultural lien on the collateral, (i) owes payment or other performance on the obligation, (ii) has provided property other than the collateral to secure payment or other performance of the obligation, or (iii) is otherwise accountable in whole or in part for payment or other performance of the obligation.” N.C. Gen. Stat. § 25-9-102. A “debtor” may, but is not required to, be the “obligor” with respect to a secured obligation. ↑
An “account debtor” is “a person obligated on an account, chattel paper, or general intangible.” The term does not include persons obligated to pay a negotiable instrument, even if the instrument constitutes part of chattel paper. Id. § 25-9-102(a)(3). ↑
See, e.g., Donegal Assocs., LLC v. Christie-Scott, LLC, 241 A.3d 1011, 1026 (Md. Ct. Spec. App. 2020) (determining no breach of peace where a reasonably conducted repossession was unlikely to incite “immediate public turbulence”); Giles v. First Va. Credit Servs., Inc., 560 S.E.2d 557, 564–65 (N.C. Ct. App. 2002) (collecting cases requiring incitement of violence). ↑
Pruitt v. Pernell, 360 F. Supp. 2d 738, 747 (E.D.N.C. 2005) (quoting Everett v. U.S. Life Credit Corp., 327 S.E.2d 269, 270 (N.C. Ct. App. 1985)). ↑
Giles, 560 S.E.2d at 565–66 (concluding that no breach of the peace occurred where a 4:00 a.m. vehicle repossession awakened and alarmed a neighbor, who immediately alerted the debtor). ↑
See, e.g., Jordan v. Citizens & S. Nat’l Bank of S.C., 298 S.E.2d 213, 213–14 (S.C. 1982) (concluding no breach of the peace existed despite an extensive, reckless highway pursuit of a recently repossessed vehicle because the confrontation occurred only after the repossession); Wallace v. Chrysler Credit Corp., 743 F. Supp. 1228, 1233 (W.D. Va. 1990) (determining no breach of the peace in part because any “disturbance of the public tranquility” occurred only after repossession was complete). ↑
The concept of a “recognized market” is intended to be limited and “applies only to markets in which there are standardized price quotations for property that is essentially fungible, such as stock exchanges.” Seeid. § 25-9-627 cmt. 4. ↑
See, e.g., Vornado PS, LLC v. Primestone Inv. Partners, LP, 821 A.2d 296, 306–07 (Del. Ch. 2002) (noting that the seller provided ample notice of the public auction, hired a licensed auctioneer, marketed the sale in both the New York Times and Chicago Tribune, and took other steps to better market the collateral); In re Zsa Zsa Ltd., 352 F. Supp. 665, 668–70 (S.D.N.Y. 1972) (affirming a sale as reasonable despite a low sale price compared to the collateral value where an experienced auctioneer was hired, the sale was advertised in the New York Times, eight days’ notice was provided, and bidders had ample time to inspect the collateral); Com. Credit Grp., Inc. v. Falcon Equip., LLC, No. 3:09cv376-DSC, 2010 WL 144101, at *9 (W.D.N.C. Jan. 8, 2010) (discussing that the borrower received authenticated notifications of disposition within a reasonable time after default and before the auction, and that a detailed notice of public auction was published multiple times in an appropriate regional newspaper). ↑
WC Braker Portfolio, LLC v. ATX Braker, LLC, No. 651792/2022 (N.Y. Sup. Ct. filed Apr. 12, 2022). At the time of publishing, this case is currently stayed pending the outcome of parallel bankruptcy proceedings in Texas. ↑
See Order to Show Cause at 2, Braker, No. 651792/2022 (Doc. No. 25); Decision & Order on Motion at 1, Braker, No. 651792/2022 (Doc. No. 40). ↑
Transcript of TRO Hearing at 24, 33, 39–40, Braker, No. 651792/2022 (Doc. No. 41). ↑
Gregory Poole Equip. Co. v. Murray, 414 S.E.2d 563, 566–67 (N.C. Ct. App. 1992). ↑
The “notification date” is the earlier of the date on which “(1) [a] secured party sends to the debtor and any secondary obligor an authenticated notification of disposition, or (2) [t]he debtor and any secondary obligor waive the right to notification.” N.C. Gen. Stat. § 25-9-611(a). A debtor or secondary obligor may waive the right to notification of disposition of collateral under section 25-9-620(e) only by an agreement to that effect entered into and authenticated after default. ↑
For the ABA’s Business Law Section (BLS), the appointment of Mike Flowers as chair of the Section (1999–2000) was significant in many ways: Not only was he a talented lawyer who excelled in advising clients on business matters, but he was also the first African American attorney to lead the Section.
Flowers attended his first BLS meeting in 1985 and, for him, it was an exciting and opportune time to become involved in the ABA. “Many initiatives were about to be launched by the ABA that would begin to open doors and remove barriers to participation for women, people of color, and other underrepresented groups,” said Flowers. “The first of these initiatives began in 1986 when the ABA created the Commission on Opportunities for Minorites in the Profession.”
Now known as the Commission on Racial and Ethnic Diversity in the Profession, this Commission was initially led by Dennis Archer, who was mayor of Detroit from 1994 to 2001 and would become the first African American president of the ABA.
According to Flowers, another groundbreaking initiative occurred the next year in 1987 when the ABA launched the Commission on Women in the Profession under the leadership of its first chair, Hillary Rodham Clinton.
“The work of these two Commissions has been at the forefront of making the ABA more diverse and inclusive,” said Flowers. “These two Commissions were the initial and primary advocates for creating more opportunities for women, people of color, and other underrepresented groups to have representation on the Board of Governors of the ABA and as members of the Nominating Committee of the ABA House of Delegates, which is the Committee that for all practical purposes selects the officers of the ABA.
“I attribute my past service as a member of the ABA Board of Governors and my present service as a member of the ABA Nominating Committee to the governance reforms championed by these two Commissions. I am pleased that many of the processes and methods used by the ABA to achieve greater diversity and inclusion have been made available to the larger profession and are helping to create more diversity and inclusion within law firms, in-house legal departments, and in the judiciary.”
Michael E. Flowers, ABA Business Law Section Chair 1999–2000.
Year as BLS Chair
Flowers was chair of the Section during the 1999–2000 bar year. And as the year 2000 approached— “Y2K” as it was commonly called in the media—there was a great amount of anxiety, as well as dire predictions, that computers would fail on a widespread scale causing havoc in the business world. “Happily, as we now know, the world did not stop, and the year 2000 arrived without any significant glitches,” said Flowers. “I navigated the Y2K waters for the Section but, on a more long-lasting note, my year as chair we were able to expand the pool of lawyers participating in the Section’s highly successful Business Law Fellows program to intentionally include lawyers of color and lawyers from the LGBTQ community.”
This was a significant accomplishment that still resonates in the Section today; the continued diversity of BLS fellows can be credited to Flowers and his initiative back in 2000.
In addition, during Flowers’s year as chair, William G. Paul, president of the ABA at that time, established the ABA Legal Opportunity Scholarship Fund. The mission of the Legal Opportunity Scholarship Fund is to encourage racial and ethnic minority students to apply to law school and to provide financial assistance to attend and complete law school. During Flower’s year as chair, the Business Law Section made the largest gift to the Legal Opportunity Scholarship Fund of any ABA Section, Division, or Forum at that time.
Significant Contributions Beyond BLS
Flowers’s appointments to various civic and charitable organizations are particularly impressive:
Member and Chair, Minority Development Financing Advisory Board (Appointed by Ohio Governor 2019–2026);
Board of Trustees, Columbus State Community College (2005–2017);
Member, Board of Trustees, Bucknell University (2007–2022) (Chair, Audit & Risk Management Committee);
Member, Board of Trustees, National Church Residences (2012–2020) (Chair, Housing Subsidiary Committee);
Member, Ohio Small Business Advisory Council (Appointed by Ohio Lt. Governor 2010–2018);
Leadership Council, UNCF (Central Ohio Region);
President’s Advisory Council, Elon University, Elon, NC (2011–2015); and
Board of Trustees, Mount Carmel Health System (2002–2010).
“Lawyers are frequently invited to serve on the boards of civic and charitable organizations,” said Flowers. “My service on these boards has hopefully allowed me to add value to these organizations through the use my knowledge and experience around the issues of corporate governance, enterprise risk management, and ESG (environmental, social, and governance).”
Legacy – and Continued Service in the Profession
At Steptoe & Johnson PLLC, Flowers’s focus on diversity issues led to him being named the Director of Diversity & Inclusion for the firm. In that role, Flowers works with the Diversity & Inclusion Committee and firm leadership to develop, implement, and execute the firm’s aggressive initiatives around diversity and inclusion. Flowers champions policies that impact attorney and staff recruiting, increase attorney retention and engagement, and create an inclusive and welcoming culture.
“The legal profession is becoming more diverse,” said Flowers. “This diversity is producing a fresh re-evaluation of how lawyers can best discharge our responsibility to defend liberty and pursue justice. Leadership opportunities will expand when you are ready to use your voice to speak up about the things that you feel are important to our society that derive from the existence of the just rule of law.”
Flowers’s career, indeed, is marked by his incredible leadership to the legal profession as well as to the community at large. His legacy is inspiring to generation after generation of new lawyers, and his efforts have created a more diverse and welcoming legal culture.
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