Following the regional bank crisis in March of 2023,^[1] many businesses started to review their treasury-management procedures for cash deposits out of safety concerns in the event of an insolvency of their depository bank. The reviews brought new attention to deposit programs designed to maximize access to insurance coverage provided by the Federal Deposit Insurance Corporation (“FDIC”) for deposits larger than the current $250,000 standard maximum deposit insurance limit per account at a depository bank. This article focuses on the IntraFi Cash Service of IntraFi LLC (“IntraFi”) as an example of such a program. The article will respond to frequently asked questions about how the IntraFi program works and how the depositors and their lenders are protected in the program.

How Does the IntraFi Program Work?

When placing funds on behalf of a customer through the IntraFi program, the customer’s relationship institution, which may be a bank, broker-dealer, or other eligible financial institution (“Relationship Institution”), and the customer enter into a deposit placement agreement (“DPA”) and a custodial agreement with the Relationship Institution as the custodian. The DPA states that the Relationship Institution will act as the customer’s agent in placing deposits. The custodial agreement further authorizes the Relationship Institution to maintain a custodial account^[2] for the customer for the purpose of crediting the deposits placed through the program.

The Relationship Institution, in turn, will have entered into a Participating Institution Agreement with IntraFi and a sub-custody agreement (“Sub-Custody Agreement”) with a large money-center bank as a sub-custodian (“Sub-Custodian”) for the IntraFi program. The funds the Relationship Institution places for the customer are then, as described below, deposited with various FDIC-insured deposit-taking financial institutions (“Destination Institutions”) that enter into Participating Institution Agreements with IntraFi and are eligible to receive funds through the IntraFi program.

The placements are in amounts and pursuant to arrangements that make the funds eligible for deposit insurance provided by the FDIC ($250,000 per owner, per Destination Institution for each account ownership category). Specifically, the benefits of that insurance for the deposits at the Destination Institutions may be passed on to the customer under the “pass-through” rules established by the FDIC, which enable funds deposited by a custodian on behalf of the customer to be insured as if the customer had made the deposit with the Destination Institution itself.^[3] Notably, customers can instruct the Relationship Institution not to deposit funds with certain Destination Institutions where the customer already maintains accounts, so as not to exceed coverage limits at that insured bank. The IntraFi program allows depositors to access millions in aggregate FDIC insurance across network banks.

The Sub-Custodian acts under the Sub-Custody Agreement as an intermediary to have the funds deposited with the Destination Institutions. The funds are then placed into deposit accounts at each Destination Institution, with the deposit accounts being in the name of the Sub-Custodian at the Destination Institution.

The Relationship Institution, the Destination Institutions, and the Sub-Custodian maintain appropriate books and records. These books and records, when considered together, reflect that the customer is the ultimate beneficiary of the funds placed in a deposit account at the relevant Destination Institution. Each deposit is recorded (a) on the records of the Destination Institution, in the name of the Sub-Custodian as the Relationship Institution’s sub-custodian; (b) on the records of the Sub-Custodian, in the Relationship Institution’s name as the customer’s custodian (showing that the Sub-Custodian is holding any claims with respect to the funds against the Destination Institution for the benefit of the Relationship Institution); and (c) on the records of the Relationship Institution, in the customer’s name (showing that the Relationship Institution is holding its claims with respect to the funds against the Sub-Custodian for the benefit of the customer).

In addition, under the DPA, the Relationship Institution agrees with the customer that it is acting as a “securities intermediary” under Article 8 of the UCC with respect to the custodial account established for the customer and that it will treat as “financial assets” under Article 8 of the UCC all of the Relationship Institution’s rights against the Sub-Custodian with respect to the deposit accounts placed by the Sub-Custodian. Financial asset means, among other things, “any property that is held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under [Article 8].”^[4] The custodial account is a “securities account” under the UCC. Once the rights to payment with respect to the deposit accounts are financial assets credited to the custodial account, the customer acquires a security entitlement to them, which is a combination of contractual rights against the Relationship Institution, as securities intermediary, and a property interest in the financial assets. The customer’s rights include obtaining payments and distributions on the financial assets, exercising rights with respect to those financial assets, changing the form of holding of those financial assets, and causing the Relationship Institution to comply with entitlement orders to transfer or redeem those financial assets.^[5]

How Is the Customer Protected in the Event of Insolvency of the Relationship Institution?

As noted above, the claims against the Sub-Custodian are credited to the customer’s account and treated as financial assets, giving the customer security entitlements against the Relationship Institution. Under Article 8, financial assets so credited, with exceptions not relevant here, are not property of the Relationship Institution and are not subject to the claims of the Relationship Institution’s creditors. As a result, the financial assets—the claims of the Relationship Institution against the Sub-Custodian—would not be included in the insolvency estate of the Relationship Institution. Practically, in most cases when a Relationship Institution has failed, its deposits and the custodial account have been assumed by another Relationship Institution, and business has continued as usual.

How Is the Customer Protected in the Event of Insolvency of the Sub-Custodian?

Similarly, under the Sub-Custody Agreement, the parties agree that the Sub-Custodian is acting as a securities intermediary and that the claims of the Sub-Custodian against the Destination Institutions are treated as financial assets under Article 8. Accordingly, such claims against the Destination Institutions are treated as security entitlements of the Relationship Institution against the Sub-Custodian. As with the Relationship Institution, financial assets, with exceptions not relevant here, are not property of the Sub-Custodian, are not subject to the claims of the Sub-Custodian’s creditors, and would not be included in the insolvency estate of the Sub-Custodian.

How Is the Customer Protected against the Exercise of Setoff by the Sub-Custodian in Case the Sub-Custodian Has an Unrelated Claim against the Relationship Institution?

The only contractual right of setoff that the Sub-Custodian has under the Sub-Custody Agreement against the Relationship Institution is for certain limited charges due to the Sub-Custodian as compensation in the Sub-Custody Agreement.

The Sub-Custodian would likely not have a noncontractual common-law right of setoff against the funds placed with it under the IntraFi program for amounts owed to the Sub-Custodian unrelated to the IntraFi program. Under the common law of most states, noncontractual common-law setoff is permitted only when the debts owed are “mutual.”^[6] Mutuality requires that both parties be acting in the same capacity. Under the Sub-Custody Agreement, though, the Sub-Custodian is acting as a securities intermediary under Article 8 for the ultimate benefit of customers of the Relationship Institution. The Sub-Custodian would likely be acting in a different capacity as a creditor of the Relationship Institution for amounts owed unrelated to the IntraFi program. (The analysis would be similar if the Destination Institution were to consider exercising a setoff right for unrelated claims against the Sub-Custodian.)

How Does a Lender to the Customer Obtain a Perfected Security Interest in the Customer’s Rights to Payment under the IntraFi Program with the Desired Priority?

The lender’s security agreement needs to reasonably identify the collateral. The collateral description in a security agreement may refer to security entitlements or investment property, which is the generic UCC Article 9 category into which security entitlements fall. Alternatively, the collateral description could be even more specific while using one of those terms, such as “all of the debtor’s right, title, or interest in security entitlements to financial assets consisting of rights to payment under the IntraFi program maintained by [the Relationship Institution] for the benefit of the debtor, and the proceeds thereof.”

The security interest may be perfected by the lender filing in the appropriate UCC filing office a properly completed UCC financing statement against the customer and indicating as the collateral the security entitlement or investment property or a more specific description of the security entitlement or investment property using those terms, and the proceeds thereof.

The security interest granted by the customer may also be perfected by the Relationship Institution obtaining “control” of the security entitlements. If the lender is also the Relationship Institution, the lender obtains control automatically because the Relationship Institution is the customer’s securities intermediary. If the lender is not the Relationship Institution, the lender should enter into a securities account control agreement with the Relationship Institution and the customer, which will require the Relationship Institution to follow, without further consent of the customer, the entitlement orders of the lender, rather than the customer, under certain circumstances. If the lender perfects the security interest by control, there is no need for the lender to file a financing statement against the customer to perfect the lender’s security interest in the customer’s rights to payment under the IntraFi program.

Perfection of the lender’s security interest by control is the preferable method of perfection for the lender.^[7] A security interest in a security entitlement or investment property perfected by control will have priority over a security interest in the same collateral perfected by the filing of a financing statement. This is the case even if the perfection of the security interest by control occurred after the filing of the financing statement and even if the secured party perfected by control knew of the financing statement filing.

Additional Considerations

Notably, the DPA provides that the customer has the right to dismiss the Relationship Institution as custodian and request that any of the funds placed for the benefit of the customer with a Destination Institution be retitled by the Destination Institution in the name of the customer directly. This process has the effect of unwinding the securities account held by the Relationship Institution and the Relationship Institution ceasing its role as a securities intermediary with respect to the funds.

If the customer exercises this right and the funds are so retitled, (a) there would no longer be a security entitlement with respect to the customer’s right to payment of the funds, and (b) the Relationship Institution’s security interest with respect to the right to the funds would no longer be perfected by control or may not be entitled to the priority afforded by control. The Relationship Institution may then need to take any additional steps necessary to preserve the perfection and priority of the security interest. As a result, a Relationship Institution that is also a lender may wish to include a provision in its credit documents providing that the customer shall postpone the exercise of its rights under the DPA while any obligations under the credit documents are outstanding or while the Relationship Institution has any obligation to extend credit under the credit documents. A third-party lender will want to address this issue in its account control agreement with the customer and the Relationship Institution.

Concluding Comments

This article provides only a brief summary of the IntraFi program and does so as an example of similar programs. It does not respond to all questions that may arise under these types of FDIC insurance maximization programs and is not a substitute for a careful review of the documentation for each program.

1. Tobias Adrian et al., Int’l Monetary Fund, Global Financial Stability Notes: The US Banking Sector Since the March 2023 Turmoil: Navigating the Aftermath (Mar. 2024). ↑

2. The custodial account will be a securities account for purposes of Article 8 of the Uniform Commercial Code (“UCC”), which is an account to which securities or other financial assets may be credited. The crediting of the deposit to the custodial account does not in and of itself render the deposit a security for purposes of federal securities laws. ↑

3. Pass-Through Deposit Insurance Coverage (12 C.F.R. § 330.5; 12 C.F.R. § 330.7), Fed. Deposit Ins. Corp. (last updated May 29, 2024). ↑

4. UCC § 8-102(a)(9) (Am. L. Inst. & Unif. L. Comm’n 2023). ↑

5. See id. §§ 8-504(a), 8-505(a), 8-506(a), 8-507, 8-508. ↑

6. U.S. Dep’t of Just., Justice Manual: Civil Resource Manual ch. 65, § IIA (updated June 1998). ↑

7. UCC § 9-328 (Am. L. Inst. & Unif. L. Comm’n 2023). ↑

This article is Part IV in the Many Splendors of Fraud Claims series by Glenn D. West, which explores recent cases that affect drafting practices for avoiding fraud claims in private company M&A.

In Delaware, as in most states,

any person or entity that is alleged to have knowingly participated in the making of a fraudulent misrepresentation can be liable for that misrepresentation to the same extent as the person or entity that actually makes the misrepresentation; and the persons or entities potentially liable can include affiliates of the entity making the representation, as well as the human officers and owners of that entity or its affiliates, to the extent they knowingly cause or permit that entity to make a fraudulent misrepresentation.^[1]

This concept applies to both intra-contractual and extra-contractual fraud claims.

Importantly, however, ABRY Partners V, L.P. v. F & W Acquisition LLC^[2] and its progeny permit (1) extra-contractual fraud to be taken off the table for both parties and nonparties to an agreement, through a properly worded disclaimer-of-reliance provision (to which the nonparties are made third-party beneficiaries); (2) liability for intra-contractual fraud to be limited to deliberate or knowing falsehoods stated in the express representations and warranties contained in the written agreement only, through an exclusive remedy provision (to which the nonparties are made third-party beneficiaries); and (3) the elimination of liability, through an exclusive remedy and nonrecourse provision, for parties and nonparties from “reckless, grossly negligent, negligent, or innocent misrepresentations of fact”^[3] in a purchase agreement (all of which are potential states of mind supporting tort-based claims, including, potentially, common-law or equitable fraud).

What no contractual provision can accomplish, however, whether it is an exclusive remedy provision or a nonrecourse provision, is the elimination of liability of either a party or a nonparty for knowingly making or causing another person to make a deliberately false statement in a purchase agreement. I have written about this several times,^[4] but it appears that deal lawyers continue to negotiate fraud definitions and nonrecourse provisions as if nonparties could avoid liability for deliberate and knowing participation in the conveyance of falsehoods in the express representations in a purchase agreement.

Matrix Parent: Deficient Fraud Definition

Fraud is frequently defined with the aim of purportedly limiting liability for fraud to only the party that is actually making the representations and warranties in the purchase agreement. An example of this approach is the following definition of Fraud from the recent Delaware Superior Court decision Matrix Parent, Inc. v. Audax Management Company, LLC:^[5]

[“Fraud” means] intentional and knowing common law fraud under Delaware law in the representations and warranties set forth in this Agreement, any Contribution Agreement and the certificates delivered pursuant to Section 2.02(f)(i) and Section 2.03(d)(i). A claim for Fraud may only be made against the Party committing such Fraud. “Fraud” does not include equitable fraud, constructive fraud, promissory fraud, unfair dealings fraud, unjust enrichment, or any torts (including fraud) or other claim based on negligence or recklessness (including based on constructive knowledge or negligent misrepresentation) or any other equitable claim.^[6]

But as noted by Aveanna Healthcare, LLC v. Epic/Freedom, LLC,^[7] one of ABRY Partners’ many progeny, “if a seller ‘knew that the company’s contractual representations were false,’ the seller cannot ‘insulate’ itself from contractual fraud by hiding behind the company’s representations.”^[8] In other words, it does not matter who technically made the representations—it matters who participated in their making or in causing them to be made.

And just as nonparties cannot hide behind the party that technically made the contractual representations, you cannot use a nonrecourse provision to exonerate nonparties from their participation in the conveyance of intentional lies in a written purchase agreement either. Nonrecourse provisions are not permitted to go so far—any attempt to do so is famously considered “too much dynamite.”^[9]

Matrix Parent not only rejected the effort of defendants to limit Fraud, as it was defined, to just the parties to the purchase agreement, but also rejected the reliance upon a very broadly worded nonrecourse clause to exonerate nonparties who were alleged to have knowingly participated in intentional intra-contractual fraud. The court further rejected a very explicit provision that actually had the parties waiving “any claim against any Non-Recourse Party for conspiracy, aiding or abetting or other theory of liability.”^[10] According to the court, “under Delaware law, the terms of a fraudulently procured contract [even though limited to claims based ‘solely on the falsity of express contractual representations’] cannot exempt from liability entities that were knowingly complicit in the fraud, including entities that aided, abetted, or conspired to commit such fraud.”^[11] And, similar to the holding in Online Healthnow, Inc. v. CIP OCL Investments, LLC,^[12] “[b]ecause Plaintiff has well pled that [a non-recourse party] did, in fact, know of and facilitate the fraudulent misrepresentations in the SPA . . . [the non-recourse party] cannot invoke the non-recourse provision to avoid liability under ABRY Partners and its progeny.”^[13]

Crafting an Agreement with the Matrix Parent Decision in Mind

So, knowing this, you can easily agree as a seller to carve out intentional inter-contractual fraud from the nonrecourse clause, and define Fraud by reference to “Persons” rather than “Parties.”

The July 15, 2024, Merger Agreement governing Perdoceo Education Corporation’s $135 million acquisition of University of St. Augustine for Health Sciences, LLC, contains an example of a Fraud definition that appears to understand that you cannot limit intentional intra-contractual common-law fraud to just the party actually making those representations:

“Fraud” means actual and intentional common law fraud under Delaware law with respect to the representations and warranties set forth in this Agreement (including Article V or Article VI), any of the Related Documents, or any certificate delivered pursuant to this Agreement or any of the Related Documents. For the avoidance of doubt, (a) the term “Fraud” does not include any claim for equitable fraud, promissory fraud, or unfair dealings fraud, or any claim for fraud or misrepresentation based on negligence or recklessness and (b) only a Person who had actual knowledge of or knowingly and intentionally participated in such Fraud shall be responsible for such Fraud and only to a Person who actually relied on such representations and warranties and was actually damaged or harmed by such Fraud.^[14]

Keep in mind that clause (b) does not actually do anything that the law of Delaware doesn’t already do, but sometimes saying it out loud helps the other side—and it’s sleeves off the seller’s vest to acknowledge that nonparties can be liable for the knowing participation in the conveyance of falsehoods in the express representations and warranties set forth in an acquisition agreement.

1. Glenn D. West, New Cases Shed Further Light on the Limits of Non-Recourse Provisions, Weil’s Glob. Priv. Equity Watch (Nov. 21, 2022). ↑

2. 891 A.2d 1032 (Del. Ch. 2006). ↑

3. Id. at 1063. ↑

4. West, supra note 1; Glenn D. West, Too Much Dynamite—The Non-Recourse and Survival Clauses Are Both Subject to Delaware’s Built-In Fraud Carve-Out for Intentional Intra-Contractual Fraud, Weil’s Glob. Priv. Equity Watch (Aug. 24, 2021); Glenn D. West, The Limits of Liability Limitation Provisions: Nonrecourse Clause, Like Exclusive Remedies Provision, May Be Subject to Delaware Public Policy Exception, Weil’s Glob. Priv. Equity Watch (Jan. 25, 2021). ↑

5. 319 A.3d 909 (Del. Super. Ct. 2024). ↑

6. Id. at 924 (emphasis added). ↑

7. 2021 WL 3235739 (Del. Super. Ct. July 29, 2021). ↑

8. Id. at *17. ↑

9. Online Healthnow, Inc. v. CIP OCL Invs., LLC, 2021 WL 3557857 (Del Ch. Aug. 12, 2021). ↑

10. 319 A.3d at 923. ↑

11. Id. at 922, 939. ↑

12. 2021 WL 3557857. ↑

13. 319 A.3d at 940. ↑

14. Emphasis added. ↑

Section 5 of the Securities Act of 1933 (“Securities Act”) prohibits the offer or sale of unregistered securities, absent an exemption. However, Section 4(a)(1) of the Securities Act explicitly states that the prohibition in Section 5 only applies to transactions by an issuer, underwriter, or dealer.^[1]

The Securities and Exchange Commission (“SEC”) has been relatively undaunted by that limitation. Through a long series of SEC enforcement actions, appellate courts have expanded the plain language of Section 4(a)(1) by developing the “necessary participant” doctrine, widening the scope of the “issuer, underwriter, or dealer” language to hold defendants liable when they have been a “necessary participant” in the offer and sale of alleged unregistered securities. In an SEC enforcement action dating back to 1941, SEC v. Chinese Consolidated Benevolent Ass’n, the U.S. Court of Appeals for the Second Circuit found that a person not directly engaged in transferring title of the security nevertheless can be held liable under Section 5 if that person “engaged in steps necessary to the distribution of [unregistered] security issues.”^[2] The Second Circuit’s interpretation is judge-made law that departs from the plain language of the statute.

This article explores the advent and evolution of the “necessary participant” doctrine and discusses some of the dangers of expanding the plain language of Section 4(a)(1).

Section 4(a)(1): The “Ordinary Trading” Exemption

Section 5 of the Securities Act makes it unlawful, directly or indirectly, to publicly offer or sell unregistered securities, unless the offering is covered by an exemption.^[3] Several potential exemptions are available to market participants, depending upon the nature of the transaction, amount of the offering, and participants involved. One of those exemptions is codified under Section 4(a)(1),^[4] sometimes known as the “ordinary trading” exemption, which states that Section 5 does not apply to transactions by any person other than an issuer, underwriter, or dealer.^[5]

Underwriter is statutorily defined in Section 2(a)(11) of the Securities Act as

any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.^[6]

For example, an investment bank that has an arrangement with a securities issuer to facilitate the public sale of its securities is typically considered an “underwriter.”

On its face, Section 2(a)(11) defines underwriter broadly enough such that, theoretically, it could be construed to encompass persons other than the traditional investment bank that underwrites a registered securities offering. However, “while the definition is indeed broad, ‘[u]nderwriter’ is not . . . a term of unlimited applicability that includes anyone associated with a given transaction.”^[7] Courts have found that “[i]t is crucial to the definition of ‘underwriter’ that any underwriter must participate in the distribution of a security.”^[8] This participation notion was expressly contemplated by Congress, which “ma[de] clear that a person merely furnishing an underwriter money to enable him to enter into an underwriting agreement is not an underwriter. . . . The test is one of participation in the underwriting undertaking rather than that of a mere interest in it.”^[9] The rationale for subjecting underwriters to potential liability is “because they hold themselves out as professionals who are able to evaluate the financial condition of the issuer,” and “[t]he public relies on their expertise and reasonably expects that they have investigated the offering with which they are involved.”^[10]

If a holder of securities is not an issuer, underwriter, or dealer, they may sell their existing securities without registration pursuant to Section 4(a)(1).^[11] Section 4(a)(1) was “designed to exempt routine trading transactions with respect to securities already issued”—not necessarily to exempt initial distributions by issuers.^[12] Importantly, Section 4(a)(1) exempts transactions, not persons.^[13]

SEC v. Chinese Consolidated Benevolent Ass’n

In 1941, the Second Circuit seemingly expanded the statutory limitations of Section 4(a)(1), not only by construing the Section 2(a)(11) definition of underwriter broadly, but by holding that even if a defendant was not an issuer, dealer, or underwriter itself, the Section 4(a)(1) exemption would not apply if the defendant was engaged in “steps necessary” to the distribution of unregistered securities.

In Chinese Consolidated, the SEC sued a New York corporation to enjoin it from using any instruments of interstate commerce or of the mails in attempting or offering to sell or dispose of Chinese government bonds.^[14] The defendant was a benevolent association with a membership of 25,000 Chinese individuals. Without any official or contractual relationship with the Chinese government, this New York corporation urged members of Chinese communities in New York, New Jersey, and Connecticut to purchase Chinese government bonds, and offered to accept funds from prospective purchasers and deliver those funds to the Bank of China in New York. Neither the defendant nor its members were ever charged for their activities, and they did not receive any compensation. The SEC sought to enjoin the defendant from disposing of, or attempting to dispose of, these Chinese government bonds, which it alleged were unregistered securities.

The defendant was concededly neither the issuer of the Chinese government bonds nor a dealer. Accordingly, under Section 4(a)(1) of the Securities Act, the defendant would be exempt from registration requirements if it was also not an underwriter, as defined in Section 2(a)(11). The district court indeed found that the defendant was not an underwriter and was therefore exempt because the defendant did not sell or solicit offers to buy the Chinese government bonds for an issuer, as the Section 2(a)(11) definition of underwriter specifies. The district court found that the defendant’s actions in attempting to dispose of the bonds were not for the Chinese government; indeed, there was no contractual arrangement or even understanding with the Chinese government.

The Second Circuit reversed, pointing to the facts that the “defendant solicited the orders, obtained the cash from the purchasers and caused both to be forwarded so as to procure the bonds.”^[15] The court noted that “the aim of the Securities Act is to have information available for investors[,] [and] [t]his objective will be defeated if buying orders can be solicited which result in uninformed and improvident purchases.”^[16] Ultimately, the court, noting the aim of the Securities Act to furnish the public with adequate information, and the purported aim of the issuer (here, the Chinese government) to promote the distribution of the securities, broadly interpreted the plain language of the definition of underwriter. The court held that “[a]ccordingly the words ‘(sell) for an issuer in connection with the distribution of any security’ ought to be read as covering continual solicitations.”^[17] The court ultimately found that the defendant acted as an underwriter in the distribution of unregistered securities.^[18]

Crucially, the court went on to find a “further reason” for holding that the defendant’s activity was prohibited.^[19] The court noted that Section 4(a)(1) was not intended to exempt distributions by issuers, and that here,

[t]he complete transaction included not only solicitation by the defendant of offers to buy, but the offers themselves, the transmission of the offers and the purchase money through the banks to the Chinese government, the acceptance by that government of the offers and the delivery of the bonds to the purchaser or the defendant as his agent.^[20]

The court held that “[e]ven if the defendant is not itself ‘an issuer, underwriter, or dealer’ it was participating in a transaction with an issuer, to wit, the Chinese Government.”^[21] The court explained that the Section 4(a)(1) exemption does not “protect those who are engaged in steps necessary to the distribution of security issues.”^[22]

In sum, the court found that the defendant’s actions fell under the definition of underwriter under Section 2(a)(11) such that the defendant was liable for its attempts to dispose of the Chinese government bonds without registration; and, significantly, that even if the defendant was not an underwriter, it “engaged in steps necessary to the distribution” of the unregistered securities such that it did not qualify for the Section 4(a)(1) exemption. Thus, the “necessary participant” doctrine was born, making it possible for a defendant to be liable under Section 2(a)(11) even if it is not an issuer, underwriter, or dealer.

The Second Circuit’s Expansion of Necessary Participant

Stemming from Chinese Consolidated in 1941, courts have adopted and expanded the necessary participant language from that case to create myriad other tests that purportedly help explain what a “necessary participant” is—and when a person who is not an issuer, underwriter, or dealer can nevertheless be liable under Section 5.^[23]

Perhaps realizing that Chinese Consolidated was unmoored from the statute, the Second Circuit later tried to put the genie back in the bottle, but without actually overturning Chinese Consolidated. In SEC v. Kern, the Second Circuit cited the “steps necessary” language from Chinese Consolidated to hold that “underwriters . . . include any person who is ‘engaged in steps necessary to the distribution of security issues.’”^[24] But later, in SEC v. Sourlis, with somewhat cursory analysis, the Second Circuit held that Section 5 liability extends to “those who have ‘engaged in steps necessary to the distribution of [unregistered] security issues’”—quoting and relying on Chinese Consolidated without even mentioning the word underwriter.^[25]

District courts within the Second Circuit, springboarding from Chinese Consolidated’s departure from the statutory text, developed the “necessary participant” doctrine by introducing additional considerations beyond the plain language of Section 4(a)(1). Under these cases, defendants may be liable for violating Section 5 even if they do not offer or sell a security, provided that they were a “necessary participant” in the unregistered distribution.^[26]

But then how is a court to determine who is a “necessary participant”? As one court frames it, “[t]he ‘necessary participant test . . . essentially asks whether, but for the defendant’s participation, the sale transaction would not have taken place.’”^[27] This “but for” formulation significantly expands the range of whom the SEC can sue for Section 5 liability to include anyone or any entity that the SEC asserts had a necessary role in the unregistered securities transaction.

In other words, in an attempt to define limitations on what a “necessary participant” is, courts have articulated a “substantial factor” test—that is, “whether the defendants’ acts were a ‘substantial factor in the sales transaction.’”^[28] However, the concept of a “substantial factor” in a securities transaction is as ill-defined as other terms within this discussion.^[29]

And as the SEC v. Genovese court pointed out, the “but-for” test raises its own problems. It “would require finding innumerable necessary participants to every unregistered securities offering—everyone who played an intermediate role, no matter how small, in the chain of causation leading to the sale.”^[30] Indeed, “[a] strict ‘but-for’ test also is at odds with the Commission’s guidance, which provides that not every individual in the causal chain is a necessary participant.”^[31]

Ultimately, in Genovese, the court organized the defendant’s activities into two categories: (1) those showing “direct involvement” in the sale and (2) those “activities ancillary” to the sale.^[32] Examples of direct involvement, which implicate substantial participation, include where defendants “directly prepared . . . corporate resolutions and documentation”;^[33] “formed entities for use in sale, solicited investments, provided subscription agreements, communicated with buyers and sellers, and directed broker action”;^[34] and “found private parties as clients for deals, filed paperwork with regulators, served as president, CEO and director of transfer agency and handled promotion of stock.”^[35] In contrast, the Genovese court ultimately found that “activities ancillary” were “too remote from the actual sale to rise to the level of necessary or substantial participation”—creating yet another criterion for considering what “necessary participation” is.^[36]

Thus, in the Second Circuit alone, the new category of “necessary participant” created by Chinese Consolidated—explicitly described as being separate from the definition of underwriter in Section 2(a)(11)—has spawned a slew of tests, some of which appear to be attempting to shoehorn the classification back into the underwriter definition, and some of which follow Chinese Consolidated more strictly (and thus follow the statute far more loosely).

Other Circuit Courts’ Interpretation of Necessary Participant

In the wake of Chinese Consolidated, other circuit courts, including the U.S. Courts of Appeals for the Seventh and Ninth Circuits, also adopted a new, atextual “necessary participant” doctrine, often tempered by the “substantial factor” doctrine, to hold that defendants need not be issuers, underwriters, or dealers to be held liable for a Section 5 violation.^[37] These courts often recognize the risk that a party whose minimal acts assisted in the unregistered securities distribution could be held liable for registration violations, but they have found that, “in practice, the standards differ little, for no court using the ‘necessary participant’ test has found liable a defendant whose acts were not a substantial factor in the sales transaction.”^[38]

In SEC v. Holschuh, the Seventh Circuit formulated the test differently, explicitly finding that persons who were not underwriters may nevertheless be liable on the grounds that the statute refers to the transactions by people, not the people themselves.^[39] Holschuh found that the defendant “was a ‘necessary participant’ and ‘substantial factor’ in the unlawful sales transactions,” and thus liable even though not an underwriter.^[40] Thus, other circuits have used this “substantial factor” test as well—sometimes articulated somewhat differently from the Second Circuit, but still addressing the concept of a “necessary participant” rather than strictly an issuer, underwriter, or dealer.

Back to the Second Circuit: In re Lehman Brothers

After the adoption of the “but-for” test and “substantial factor” test, which both provided gloss on the “necessary participant” doctrine, the Second Circuit provided further guidance in a 2011 case, In re Lehman Brothers Mortgage-Backed Securities Litigation.^[41] There, investors brought putative class actions to hold credit ratings agencies liable under the Securities Act, in part as underwriters. The plaintiffs attempted to argue that Second Circuit precedent construed the term underwriter broadly to include any person who is “engaged in steps necessary to the distribution of security issues.”^[42] According to the plaintiffs’ logic, “any persons playing an essential role in a public offering . . . may be liable as underwriters.”^[43] The court disagreed, stating that its “prior cases do not hold that anyone taking steps that facilitate the eventual sale of a registered security fits the statutory definition of underwriter.”^[44] Rather, the court “stated that ‘underwriter’ references those who take ‘steps necessary to the distribution’ of securities.”^[45]

Further elaborating on Chinese Consolidated, Kern, and other Second Circuit progeny, the court clarified that “this precedent cannot be read to expand the definition of underwriter to those who participate only in non-distributional activities that may facilitate securities’ offering by others.”^[46] Rather,

the participation must be in the statutorily enumerated distributional activities, not in non-distributional activities that may facilitate the eventual distribution by others. This approach avoids the implausible result of transforming every lawyer, accountant, and other professional whose work is theoretically “necessary” to bringing a security to market into an “underwriter” . . . , a dramatic outcome that Congress provided no sign of intending.^[47]

In its elaboration, the court corrected a common misinterpretation of Chinese Consolidated, remarking that “we note that the ‘steps necessary to the distribution’ language relied on by plaintiffs was originally employed by this court [in Chinese Consolidated] to explain a registration exemption, not the underwriter definition.”^[48] The court noted, “[W]e stated [in Chinese Consolidated] that ‘[i]t,’ meaning the [4(a)(1)] exemption, ‘does not . . . protect those who are engaged in steps necessary to the distribution of’ securities because it is limited to transactions between individual investors.”^[49]

On the one hand, Lehman Brothers clarified that Chinese Consolidated first employed the “steps necessary” language to carve out “necessary participants” from the Section 4(a)(1) exemption. On the other, Lehman Brothers clarified that underwriter references those who take “steps necessary to the distribution” of securities, despite that language not existing in the Section 2(a)(11) statutory definition of underwriter. In doing so, Lehman Brothers reconfirmed the departure from the text first set out in Chinese Consolidated: under these cases, a “necessary participant” is not just a type of underwriter; it’s a new category entirely—one that does not exist in the text of the 1933 Securities Act.^[50]

Where to, from Here?

The rationale of the Securities Act was to provide the public accurate and complete information by the people or entities responsible for distributing securities to the public.^[51] Yet, despite Congress’s circumscribed application of registration requirements to issuers, dealers, and underwriters, the Second Circuit expanded the group responsible for registration requirements to include “necessary participants” to the distribution of securities, even if they are not underwriters.

That expansion, initiated in a few lines in Chinese Consolidated in 1941 and expounded on over a period of decades by multiple circuit and district courts, stretches the plain language of Section 4(a)(1). Not only can the Section 2(a)(11) definition of underwriter include those who indirectly participate in the distribution of securities (already, arguably, at the outer reaches of Section 2(a)(11)), but even those who are not underwriters may not fall under the Section 4(a)(1) exemption if they are “necessary participants” and take “steps necessary” to the distribution of unregistered securities.

Chinese Consolidated opened the door for a nebulous “necessary participant” to include myriad individuals or entities other than issuers, underwriters, or dealers in the chain of a securities distribution. The Ninth Circuit’s discussion in Murphy raised the concern that “this broader standard could encompass a party whose acts in furtherance of the distribution were de minimis and who should not be held liable for registration violations.”^[52]

In the era of digital assets trading over complex and interconnected computer networks, it might be a struggle to draw the appropriate limiting principle on who could be deemed a “necessary participant,” and an expansive interpretation could apply to innumerable persons and entities. No longer are we only concerned with a single newspaper editorial, as Judge Swan pointed to in his Chinese Consolidated dissent, but courts will be asked to consider: Websites that host front ends? Participants in a blockchain network, such as validators, stakers, or decentralized exchanges? Noncustodial wallet providers? Blockchains themselves?

For many (and perhaps all) of these categories, it would make no sense to hold the persons or entities creating or operating these technologies responsible for issuances of unregistered securities—not from a policy point of view, and certainly not under the plain language of the Securities Act. Indeed, given the free-flowing and permissionless nature of the internet and Web 3.0, participants may not even be aware of the role they play in the distribution chain—perhaps they simply publish software on the internet that could be used to ultimately purchase an alleged unregistered security.

Eighty years of case law has developed to suggest that a “necessary participant” is its own category, apart from issuers, underwriters, and dealers. That alone is a departure from the plain text of the Securities Act. Worse, as explained above, district courts have struggled to interpret the “necessary participant” language from Chinese Consolidated to apply some limiting principle, such that underwriter is not too broadly construed to include any person who is engaged in “steps necessary” to the distribution of securities.

Without the “necessary participant” doctrine’s advent in Chinese Consolidated, district courts would merely have to interpret the plain language of Section 4(a)(1) that applies to issuers, underwriters, and dealers—and perhaps Section 2(a)(11)—to determine who would be considered an underwriter. While some of the same analytical tools might be useful, such tools would be used within the context of Section 2(a)(11) and the rest of the underwriter definition, which—in context—might serve to limit some of the more expansive interpretations of which parties may be liable.

Ultimately, the “necessary participant” doctrine as first stated in Chinese Consolidated would be unlikely to survive a strict textualist Supreme Court review. Chinese Consolidated created a new category for liability, even if a person was not an underwriter. A textualist review would likely limit Section 4(a)(1)’s application to its plain language of only issuers, dealers, or underwriters (as defined in Section 2(a)(11)), not issuers, dealers, underwriters, or those who have engaged in “steps necessary” to the distribution of securities, as in Chinese Consolidated.

Further, a textualist review, grounded in the remainder of Section 2(a)(11) (and taking into account the context of that language), would be narrower. For example, such a review would not eliminate the words “for an issuer” from the Section 2(a)(11) definition of underwriter, meaning that an entity with no contractual arrangement or understanding with the issuer likely would not be considered an underwriter. Deeming an individual or entity integral to distributing an alleged security, and thus liable under Section 5, simply because it provides information about or access to that security, despite no relationship or understanding with the issuer, is unmoored from the plain language of Section 5.

Unless the Supreme Court, other courts of appeal not bound by prior circuit law, or Congress weighs in and ends this eighty-year-long (and counting) detour away from the plain statutory language of the Securities Act, the definition of necessary participant, and the myriad considerations that influence what a “necessary participant” is, will remain unclear for individuals and entities operating in the securities industry and beyond.

1. See 15 U.S.C. § 77d(a)(1). ↑

2. 120 F.2d 738, 741 (2d Cir. 1941). ↑

3. See 15 U.S.C. § 77e. ↑

4. Section 4(a)(1) was formerly Section 4(1) but was redesignated as Section 4(a)(1) by the JOBS Act. ↑

5. See 15 U.S.C. § 77d(a)(1). ↑

6. 15 U.S.C. § 77b(a)(11); see Fed. Deposit Ins. Corp. v. Credit Suisse First Bos. Mortg. Sec. Corp., 414 F. Supp. 3d 407, 413 (S.D.N.Y. 2019). ↑

7. In re Refco, Inc. Sec. Litig., No. 05-cv-8626, 2008 WL 3843343, at *4 (S.D.N.Y. Aug. 14, 2008) (citing Ackerberg v. Johnson, 892 F.2d 1328, 1335 (8th Cir. 1989)). ↑

8. McFarland v. Memorex Corp., 493 F. Supp. 631, 644 (N.D. Cal. 1980). ↑

9. Id. at 645 (citing Conf. Rep. No. 152, 73d Cong., 1st Sess. 24 (1933)). ↑

10. Id. at 646. ↑

11. See SEC v. Genovese, No. 17-cv-5821, 2021 WL 1164654, at *3 (S.D.N.Y. Mar. 26, 2021). ↑

12. SEC v. Murphy, 626 F.2d 633, 648 (9th Cir. 1980) (citing Preliminary Note to Rule 144, 17 C.F.R. § 230.144 (1979)). ↑

13. See id. ↑

14. 120 F.2d 738 (2d Cir. 1941). ↑

15. Id. at 740. ↑

16. Id. at 740–41. ↑

17. Id. at 741. ↑

18. Circuit Judge Swan dissented, pointing out that “the majority opinion has construed the statute more broadly than its language will permit.” Id. at 742. In his interpretation, including the defendant within the definition of an underwriter “gives no meaning to the words ‘for an issuer.’” Id. He pointed out that under the majority’s construction, “a single newspaper editorial, published without instigation by the Chinese Government and merely urging the purchase of the bonds in the name of patriotism, would make the newspaper an ‘underwriter,’” and that he “cannot believe the statute should be so interpreted.” Id. ↑

19. Id. at 741. ↑

20. Id. ↑

21. Id. (emphasis added). ↑

22. Id. (emphasis added). ↑

23. See SEC v. N. Am. Rsch. & Dev. Corp., 424 F.2d 63, 82 (2d Cir. 1970) (noting that Chinese Consolidated “make[s] it clear that being an underwriter is not a prerequisite to a finding of violation of Section 5”); SEC v. Culpepper, 270 F.2d 241, 246 (2d Cir. 1959) (“In [Chinese Consolidated] we noted the underlying policy of the [Securities] Act, that of protecting the investing public through the disclosure of adequate information, would be seriously impaired if we held that a dealer must have conventional or contractual privity with the issuer in order to be an ‘underwriter.’”). ↑

24. 425 F.3d 143, 152 (2d Cir. 2005) (citing Chinese Consolidated). Ironically, the citation of Chinese Consolidated’s “steps necessary” language to define underwriter in Kern “was arguably dictum because the transaction in that case unquestionably ‘involved underwriters,’ rendering [Section 4(a)(1)] inapplicable.” In re Lehman Brothers Mortg.-Backed Sec. Litig., 650 F.3d 167, n.7 (2d Cir. 2011). ↑

25. 851 F.3d 139, 143–44 (2d Cir. 2016). ↑

26. See SEC v. Mattera, No. 11-cv-8323, 2013 WL 6485949, at *10 (S.D.N.Y. Dec. 9, 2013) (holding that “necessary participants” in unregistered distributions may be liable under Section 5); SEC v. Sason, 433 F. Supp. 3d 496, 513 (S.D.N.Y. 2020). ↑

27. SEC v. Universal Express, Inc., 475 F. Supp. 2d 412, 422 (S.D.N.Y. 2007) (quoting SEC v. Murphy, 626 F.2d 633, 651–52 (9th Cir. 1980)). ↑

28. Id. (quoting Murphy, 626 F.2d at 651–52); see also SEC v. Genovese, No. 17-cv-5821, 2021 WL 1164654 (S.D.N.Y. Mar. 26, 2021) (noting that Sason and Mattera qualify the “necessary participant” test “with statements that the defendants’ acts must be a ‘substantial factor in the sales transactions’”). ↑

29. See SEC v. Elliott, No. 09-cv-7594, 2011 WL 3586454, at *7 (S.D.N.Y. Aug. 11, 2011) (“As for substantial participation, to be sure it is a concept without precise bounds. . . .”). ↑

30. Genovese, 2021 WL 1164654, at *6. ↑

31. Id. (quoting In re Owen v. Kane, Exchange Act Release No. 23827, 1986 WL 626043, at *3 (1986) (reinforcing that “not everyone in the chain of intermediaries between a seller of securities and the ultimate buyer is sufficiently involved in the process to make him responsible for an unlawful distribution”). ↑

32. Genovese, 2021 WL 1164654, at *5. ↑

33. Id. at *4 (citing SEC v. Carrillo Huettel LLP, No. 13-cv-1735, 2017 WL 213067, at *5 (S.D.N.Y. Jan. 17, 2017), report & recommendation adopted, No. 13-cv-1735, 2017 WL 1162199 (S.D.N.Y. Mar. 28, 2017)). ↑

34. Id. (citing SEC v. Mattera, No. 11-cv-8323, 2013 WL 6485949, at *3–5 (S.D.N.Y. Dec. 9, 2013)). ↑

35. Id. (citing SEC v. Boock, No. 09-cv-8261, 2011 WL 3792819, at *16 (S.D.N.Y. Aug. 25, 2011)). ↑

36. Id. at *2. ↑

37. See, e.g., SEC v. Murphy, 626 F.2d 633, 648 (9th Cir. 1980) (“Although we have rejected Murphy’s exemption argument because he need not be an issuer, underwriter or dealer to be held liable for a § 5 violation, we recognize that Murphy’s role in the transaction must be a significant one before liability will attach.”). ↑

38. Id.; see also SEC v. CMKM Diamonds, Inc., 729 F.3d 1248, 1255 (9th Cir. 2013) (“Prior to the issuance of a security, numerous persons perform mechanical acts without which there could be no sale. . . . [B]ut these acts nonetheless do not render the defendants sellers” because their “acts must also be a substantial factor in bringing about the transaction.”). ↑

39. 694 F.2d 130, 139–40 (7th Cir. 1982). ↑

40. Id. at 140. ↑

41. 650 F.3d 167 (2d Cir. 2011). ↑

42. Id. at 177 (internal citations omitted). ↑

43. Id. ↑

44. Id. ↑

45. Id. (citing Kern). ↑

46. Id. ↑

47. Id. at 181. ↑

48. Id. at n.7. ↑

49. Id. (emphasis in original) (citations omitted). ↑

50. As noted above, in Sourlis, the Second Circuit—after Lehman Brothers—sidestepped the whole morass, simply quoting and relying on Chinese Consolidated without even mentioning the word underwriter. 851 F.3d 139, 143–44 (2d Cir. 2016). ↑

51. See H.R. Rep. No. 73-85, at 5 (1933) (noting that the Securities Act imposes fiduciary-like responsibilities on “all those responsible for statements upon the face of which the public is solicited to invest its money,” namely, “directors of the issues, its experts, and the underwriters who sponsor the issue”). ↑

52. SEC v. Murphy, 626 F.2d 633, 651–52 (9th Cir. 1980). ↑

Directors and officers of Delaware corporations often benefit from a robust suite of liability protections that generally include exculpation rights, indemnification rights, rights to recoup expenses incurred while defending a proceeding in advance of its final disposition (or “advancement” rights), and rights under director and officer (D&O) liability insurance policies. While each aspect of this so-called three-legged stool^[1] of executive protection—exculpation, indemnification/advancement, and insurance—often has different exclusions and exceptions, personal, monetary liability of individual directors and officers is exceedingly rare. For example, even if a company becomes insolvent or is prohibited from or unwilling to indemnify or advance legal fees on behalf of the executive, the executive may nonetheless be entitled to D&O insurance coverage for nonindemnified losses, protecting the individual from personal exposure.

But as the Delaware Court of Chancery’s recent post-trial opinion in InterMune v. Harkonen^[2] illustrates, these protections are not bulletproof. There, the Court of Chancery ordered the CEO and director of InterMune, Inc. to repay almost $6 million of advanced funds where the executive had been convicted of wire fraud and exhausted all appeals. As such, Harkonen serves as a reminder that, while only possible under an increasingly uncommon set of facts, “advanced sums sometimes must be repaid.”

Background

The proceedings central to the Harkonen dispute were criminal and administrative fraud disputes waged for over twenty years. In 2002, Dr. Scott Harkonen, InterMune’s CEO and board member, issued a press release that (per the opinion) “misrepresented . . . clinical study results” for an InterMune drug product candidate. The U.S. Department of Justice launched an investigation into the press release in 2004, which led to criminal indictments for felony misbranding and felony wire fraud. In 2009, a federal jury found Harkonen guilty of wire fraud but not misbranding.

Harkonen challenged that finding through an extensive series of motions, petitions, and appeals at the U.S. district court, U.S. circuit court, and U.S. Supreme Court levels. His campaign in the courts ultimately proved unsuccessful and the verdict stood. All the while, Harkonen retained a “sophisticated and well-resourced” defense team and accrued expenses—advanced on his behalf by both the company and its D&O insurers—that exhausted the applicable D&O policy’s $10 million primary policy, $5 million first excess policy, and $5 million second excess policy.

Several ancillary proceedings unfolded in parallel. Between 2011 and 2015, Harkonen defended himself in professional misconduct proceedings brought by the Medical Board of California, which culminated in a finding of cause for discipline and resultant punishments. And perhaps more relevant for Harkonen’s future recoupment battles, two of InterMune’s D&O insurance carriers filed an arbitration action to recover the $10 million advanced to Harkonen under the two $5 million excess policies.

The insurers succeeded in those efforts, demanding repayment in arbitration proceedings based on the D&O policies’ so-called fraud exclusion—common in most modern D&O policies—barring coverage for loss arising out of deliberate criminal or fraudulent acts if established by a final adjudication. The arbitration panel concluded on dispositive motions that the insurers could recoup millions of dollars in defense costs advanced to defend the wire fraud count and fees and costs incurred to defend against allegations relating to the offending press release. Eventually, the D&O insurance claims were settled, with InterMune repaying all excluded loss, subject to a reservation of rights against Harkonen.

After advancing the full settlement amount, InterMune sued Harkonen to claw it back. As is common, InterMune’s bylaws and indemnification agreements required all executives seeking advancement to undertake to repay any funds ultimately determined not indemnifiable. And while both instruments guaranteed Harkonen indemnification to the fullest extent permitted by law, Section 145 of the Delaware General Corporation Law only empowers corporations to indemnify directors and officers if the indemnitee “acted in good faith and in a manner the person reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe the person’s conduct was unlawful.” Failure to satisfy that standard of conduct—by, for example, acting in bad faith—forecloses indemnification and can trigger an obligation to repay advanced funds.

The Court of Chancery’s Post-Trial Opinion

So it was in Harkonen. At the summary judgment stage, the Court of Chancery had held that Harkonen’s felony fraud conviction foreclosed his ability to satisfy Section 145’s standard of conduct requirement because bad faith was a subsidiary element of the crime. That meant that the only issue left to decide in the follow-on advancement clawback trial was whether the roughly $6 million that InterMune had advanced to settle the insurance arbitration arose in connection with Harkonen’s fraud conviction.

The Court of Chancery concluded that it did, as the settlement (which, the court highlighted, Harkonen himself agreed to) had been tailored to reflect only sums attributable to the wire fraud count. As such, indemnification was unavailable, and the court ordered Harkonen to repay the full amount advanced for the settlement.

Takeaways

In one sense, Harkonen is a reminder that “fullest extent permitted by law” indemnification protection does indeed have limits. In another sense, though, Harkonen is perhaps better understood as an exception that proves the rule. That is, proceedings against directors and officers in their corporate capacities rarely result in personal liability, a result only reached in Harkonen under extreme facts: (i) adjudicated criminal misconduct involving a specific finding that the executive acted in bad faith and (ii) a complete exhaustion of appeals.

Notwithstanding the uncommon set of facts giving rise to Harkonen’s approximately $6 million repayment obligation, the result shows that D&O insurers can and will enforce available policy exclusions to support recoupment claims following an adverse, final adjudication. InterMune’s D&O policies had strong final-adjudication exceptions to the standard conduct exclusion, but not all insurers and forms are created equal, and they require careful analysis at the time of placement or renewal, not after a claim arises. Negotiating robust limitations on exclusionary provisions, especially those based on fraudulent and criminal conduct, can help mitigate the risk of insurer recoupment in all but the most dire circumstances where fraud is actually and finally adjudicated.

The authors are co-chairs of the ABA Business Law Section Director and Officer Liability Committee. The views expressed in this article are those of the authors and not necessarily those of Richards, Layton & Finger, Hunton Andrews Kurth, or their respective clients.

1. For more information on the issues presented in preparing and maintaining a comprehensive D&O liability protection program, see James Wing, Geoffrey B. Fehling & Brian T.M. Mammarella, Training for Tomorrow: 2021 Checklist for Entity Counsel Supervising the Creation or Renewal of an Executive Protection Program in the Age of ‘Cooperation,’ Bus. L. Today (Nov. 1, 2021). ↑

2. No. 2021-0694-NAC, 2024 WL 3619692 (Del. Ch. Aug. 1, 2024). ↑

After what one commissioner described as “intense negotiations” among the commissioners, the Federal Trade Commission (FTC) has unanimously approved a substantial overhaul to the rules governing the documents and information that must be submitted as part of parties’ premerger notification filings under the Hart-Scott-Rodino Antitrust Improvements (HSR) Act. The FTC asserts that the changes are necessary to allow it and the Antitrust Division of the Department of Justice to “keep pace” with “the realities of how businesses compete today” and provide them with the information needed to detect transactions that may harm competition.

Although the HSR Final Rule dropped or modified a number of the items sought in the June 2023 proposed rule, it will still require a great deal more time, effort, and information than the current rules. Indeed, the FTC itself found:

[T]he average number of additional hours required to prepare an HSR filing with the changes outlined in the final rule is 68 hours, . . . with an average high of 121 hours for [purchaser] filings . . . in a transaction with overlaps or supply relationships.

Based on our experience, these estimates appear low. The lead time necessary to prepare a filing will increase dramatically to two or more weeks. Many filers, particularly large companies with a wide array of products or services, and private equity groups, will face a significant burden under the new filing rules.

The FTC also announced that after the Final Rule becomes effective (ninety days from publication in the Federal Register), it will lift its categorical suspension on early termination of filings made under the HSR Act. The agencies anticipate that the additional documents and information provided by the Final Rule will facilitate their antitrust assessments and help inform the processes and procedures used to grant early termination.

Summary of Key Aspects of the Final Rule

• For HSR filings made based on an executed letter of intent or term sheet, instead of a definitive agreement, parties must submit:
  • A document that includes “some combination of the following terms: the identity of the parties; the structure of the transaction; the scope of what is being acquired; calculation of the purchase price; an estimated closing timeline; employee retention policies, including with respect to key personnel; post-closing governance; and transaction expenses or other material terms.”
  • An affidavit accompanying the filing “attest[ing] that a dated document that provides sufficient detail about the scope of the entire transaction that the parties intend to consummate has also been submitted.”
• Filers must provide their regularly prepared ordinary course plans and reports that “analyze market shares, competition, competitors, or markets pertaining to any product or service of the acquiring person also produced, sold, or known to be under development by the target” that were “prepared or modified within one year of the date of filing” and, regardless of the regularity of their preparation, any similar plans provided to the board of directors (or its equivalent).
• Parties must describe their “principal categories of products and services,” including any “current or known planned product or service” that competes with one of the other party. The parties are instructed not to “exchange information for the purpose of answering this item.” But for any self-reported overlapping product or service—so-called overlap filings—the parties must provide:
  • top ten customers overall and by product or service category;
  • sales revenue, “projected revenue, estimates of the volume of products to be sold, time spent using the service, or any other metric” used to measure performance;
  • description of all categories of customers of the product or service; and
  • if the product or service is still in development, “the date that development of the product or service began; a description of the current stage in development, including any testing and regulatory approvals and any planned improvements or modifications; the date that development (including testing and regulatory approvals) was or will be completed” and the anticipated launch date.

  This information is not required for executive compensation transactions and open market purchases or equity purchases from holders other than the target that will not confer control of the target or board representation rights (“select 801.30 transactions”).

• Parties must describe all transaction rationales, including cross-referencing them with the transaction-related documents submitted with the filing (with the exception of select 801.30 transactions).
• In addition to transaction-related documents prepared by or for officers and directors, the parties must submit all studies, surveys, analyses, and reports evaluating the proposed transaction regarding market shares, competition, competitors, markets, potential for sales growth or expansion into product or geographic markets, and prepared by or for the “supervisory deal team lead.”
  • The Final Rule defines supervisory deal team lead as the “individual who has primary responsibility for supervising the strategic assessment of the deal, and who would not otherwise qualify as a director or officer.”
• Parties will be required to submit accurate and complete verbatim translation of foreign-language documents.
• Submission of all documents governing the transaction, “including, but not limited to, exhibits, schedules, side letters, agreements not to compete or solicit, and other agreements negotiated in conjunction with the transaction that the parties intend to consummate, and excluding clean team agreements.”
• Parties must describe any supply relationships between the purchaser and target, including the amount of revenue involved and the top ten customers other than the transaction counterparty, and note if the purchaser and target have any nonsolicitation agreements, noncompete agreements, leases, licensing agreements, master service agreements, operating agreements, or supply agreements.
• Reporting of defense or intelligence contacts with a value equal to or greater than $100 million for (1) pending proposals submitted to the U.S. Department of Defense or any member of the U.S. intelligence community and (2) awarded procurement contracts with the U.S. Department of Defense or any member of the U.S. intelligence community.
• Parties must report if they have “received any subsidy (or a commitment to provide a subsidy in the future) from any foreign entity or government of concern,” meaning China, Russia, Iran, North Korea, any foreign terrorist organization designated by the Secretary of State, or any Office of Foreign Assets Control specially designated national.

The new burdens imposed by the Final Rule are substantial. It is worth noting, however, some of the most significant changes from the 2023 proposed rule were not carried over to the Final Rule. These are set forth below.

Final Rule’s Key Changes Compared to the 2023 Proposed Rule

• Eliminates the requirement that merging parties provide all drafts of transaction-related “document[s] that were sent to an officer, director, or supervisory deal team lead(s).”
• Abandons mandates that merging parties (1) classify their employees by job category codes from the U.S. Bureau of Labor Statistics, (2) classify their employees by the U.S. Department of Agriculture’s Economic Research Service commuting zones, and (3) identify any penalties or findings issued against the filing person by the U.S. Department of Labor’s Wage and Hour Division, the National Labor Relations Board, or the Occupational Safety and Health Administration.
• Revises the definition of “supervisory deal team lead” to limit it to a single individual, eliminating the need to review multiple employees’ files for transaction-related or Item 4 documents.
• Limits disclosure requirements for limited partners without management rights.
• Removes demands for filers to create some new documents, such as deal timelines and organization charts, though still seeks such information to the extent it exists in the ordinary course of the filer’s business.
• Shortens lookback periods for certain requests, including identification of directors and prior acquisitions.
• Eliminates requirement that filers identify and list all communications systems or messaging applications on any device used by the filing person that could be used to store or transmit information or documents related to its business operations.

The impact of the Final Rule will become clearer as HSR filings are made under the new regime and the FTC’s Premerger Notification Office starts to engage with the new format and the substantial volume of additional documents and information provided.

This article is Part III in the Many Splendors of Fraud Claims series by Glenn D. West, which explores recent cases that affect drafting practices for avoiding fraud claims in private company M&A.

In a recent order denying a motion for reargument in Surf’s Up Legacy Partners, LLC v. Virgin Fest LLC, the Delaware Superior Court was faced with a claim that the “Fraud” carved out from an Asset Purchase Agreement’s (“APA”) indemnification caps did not require proof of reliance.^[1]

A Fraud Definition without a Mention of Reliance

Fraud was defined in the APA as “any false representation, misrepresentation, deceit, or concealment of a fact with the intention to deceive, conceal or otherwise cause injury.”^[2] The definition then went further to state that “‘Fraud’ shall not include constructive fraud or other claims based on constructive knowledge or merely negligent misrepresentation or similar theories.”^[3] The defined term Fraud was then used in the indemnification provision to eliminate all of the contractual limitations and caps on losses “in the event of any breach of a representation or warranty by any Party hereto that results from or constitutes Fraud.”^[4]

The buyer argued that this definition of Fraud “clearly obviates the normal (or common law) requirement of reliance, because reliance is not mentioned in the provision.”^[5] While the court noted that the parties could have eliminated reliance as an element of the fraud claim, the court refused to find that this particular definition did so. It helped that the definition stated that a “false representation [or] misrepresentation” had to be “with the intention to deceive, conceal or otherwise cause injury.”^[6] Moreover, the disclaimers all related to lesser states of mind applicable to fraud. Therefore, the court concluded that all this definition did was incorporate the common-law concept of fraud while eliminating “fraud claims with a state of mind less than intentional knowledge.”^[7] What the definition did not do, according to the court, was constitute “a waiver of reliance.”^[8]

Less Versus More

That is great, but this case did make me pause and consider that we sometimes say both less and more than we need to—and we leave things out in the process.

It is not uncommon to see definitions of Fraud that do not actually use the word fraud in them; instead, they simply refer to intentional or deliberate misrepresentations or breaches of the express representations and warranties. In that context, would the buyer have to prove reliance?

And there are those definitions of Fraud that, while not using the term fraud in the definition, nevertheless include all of the elements of common-law fraud, including reliance. A good example can be found in the August 13, 2024, Stock Purchase Agreement governing the $2.095 billion Performance Food Group Company’s acquisition of the stock of Cheney Bros., Inc.:

“Actual Fraud” means the making by a Party,^[9] to another Party, of a representation or warranty contained in Article 3, Article 4 or Article 5; provided that at the time such representation or warranty was made by such Party (a) such representation or warranty was inaccurate, (b) such Party had actual knowledge (and not imputed or constructive knowledge), without any duty of inquiry or investigation, of the inaccuracy of such representation or warranty, (c) in making such representation or warranty such Party had the intent to deceive such other Party and to induce such other Party to enter into this Agreement or consummate any transaction contemplated hereby and (d) such other Party acted in reasonable reliance on such representation or warranty; provided that for the purposes of this definition, the Party making the representations and warranties of the Company in Article 3 shall be limited to the Persons listed in the definition of Knowledge. For the avoidance of doubt, “Actual Fraud” does not include equitable fraud, promissory fraud, unfair dealings fraud, or any torts (including fraud) based on negligence or recklessness.

Note that the term fraud is not used in the above definition, except in the “avoidance of doubt” clause at the end. If clause (d) had been left out of this definition, could an argument be made that reliance is not required to prove “Actual Fraud” for the purposes of this agreement? Would your answer change if the “avoidance of doubt” clause had been left out too? Not sure? Why take the chance?

All we are trying to do from the sell side, and sometimes from the buy side (particularly if there is an earnout), is to limit fraud claims to those that cannot be eliminated in any event in Delaware—i.e., “intentional and knowing common law fraud claims respecting the express representations and warranties in the agreement.” Using the term intentional and knowing common law fraud should mean that the elements of common-law fraud (including reliance) have to be satisfied but that the scienter requirement excludes recklessness. In addition, equitable fraud is off the table, too, because it is not common-law fraud.

Accordingly, the following definition from the July 18, 2024, Purchase Agreement governing Amphenol Corporation’s $2.1 billion acquisition of certain assets of CommScope Holding Company, Inc., might provide less risk of getting it wrong:

“Fraud” means actual,^[10] intentional and knowing common law fraud under Delaware law in the making of the representations and warranties set forth in Article 4 or Article 5 (each as qualified by the Schedules to the Disclosure Letter), or in any certificate delivered pursuant to Section 7.2(d) or Section 7.3(g), and specifically excluding equitable fraud or constructive fraud of any kind (including based on constructive knowledge or negligent misrepresentation).

I certainly do not have a problem with the more elaborate definitions, particularly those that disclaim lesser scienter requirements specifically, as well as all the other types of fraud. However, try not to open the door to arguments that you were defining Fraud in a manner that did not include all of its common-law elements.

1. No. N19C-11-092 PRW CCLD, 2024 WL 3273427 (Del. Super. Ct. July 2, 2024) (order denying motion for reargument). ↑

2. Id. at 4 (quoting APA, annex II at 3). ↑

3. Id. (quoting APA, annex II at 3). ↑

4. Id. at 4 n.11 (quoting APA § 6.04). ↑

5. Id. at 4. ↑

6. Id. ↑

7. Id. at 5. ↑

8. Id. ↑

9. In the next article in this series, we will discuss the fact that the common practice of limiting fraud to the party making the representations does not work the way that many deal lawyers apparently think it does. So, stayed tuned on that one. ↑

10. I actually prefer leaving the term actual out. It seems like all common-law fraud types are actual (or “real”) fraud—we just like to think that anything other than the intentional variety is not “actual,” but constructive, fraud. Probably not fatal, but I certainly do not think the term actual adds anything to intentional and knowing. In addition, please do not use just the term actual alone, assuming that it means an intentional or knowing misrepresentation. There is case law defining actual fraud as not necessarily involving a representation at all—just some kind of deceitful activity that has been given the moniker unfair dealings fraud; and there is certainly case law that would implicitly include recklessness (not just intentionality) in the concept of “actual fraud,” even if it was confined to a misrepresentation. See Glenn D. West, That Pesky Little Thing Called Fraud: An Examination of Buyers’ Insistence upon (and Sellers’ Too Ready Acceptance of) Undefined “Fraud Carve-Outs” in Acquisition Agreements, 69 Bus. Law. 1049, 1063–64 (2014); see also Husky Int’l Elecs., Inc. v. Ritz, 578 U.S. 355, 362 (2016) (noting that “a false representation has never been a required element of ‘actual fraud’”). ↑

Millions of working Americans (approximately one in five) are subject to noncompetes—that is, legal agreements that restrict employees from activities that increase competition for their employers.^[1] In June 2024, just months after the Federal Trade Commission (“FTC”) voted to implement a nationwide ban on the use of noncompete agreements,^[2] the U.S. Supreme Court issued a landmark ruling that overturned Chevron deference—a forty-year-old doctrine that had previously required courts to defer to federal agencies’ interpretations of ambiguous statutes.^[3] In August 2024, a district court ruled that the FTC could not implement its proposed ban; the FTC is considering appealing this decision.^[4]

Despite the rulings against the FTC’s authority, a key economic question for both sides of the emerging legal dispute concerns the potential consequences of a nationwide noncompete ban. The FTC’s proposed rule comes in the wake of research and speculations regarding the intended and unintended consequences of noncompetes.^[5] Some have postulated that a nationwide ban on noncompetes would lead to an increased number of trade secret disputes because, as proponents of noncompetes argue, such agreements are used to safeguard a company’s sensitive information, including trade secrets.^[6]

Whether a nationwide ban on noncompetes would have a quantifiable impact on the volume of trade secret cases is ultimately an empirical question—one that the authors of this article examined in a previous publication.^[7] In that article, we identified and examined state-level variations in noncompete regulations over time alongside annual federal trade secret caseloads to empirically explore any potential relationship between these two factors. We summarize our main findings here and conclude with some related considerations regarding how companies may approach intellectual property (“IP”) policies in light of the expected regulatory developments in noncompetes.

Impact of Noncompete Regulations on Trade Secret Caseloads

Over the last two decades, states have varied in their approach to whether and how noncompetes are enforced. Using a variety of publicly available sources, we assigned states to one of three categories: (1) states that have already banned noncompetes, (2) states that have introduced various forms of restrictions on the enforcement of noncompetes, and (3) states that enforce noncompetes without restrictions.

When analyzing the average annual trade secret caseloads across the three categories, we observed that states with a ban on noncompetes experience the highest levels of trade secret cases. Specifically, as presented below in figure 1, beginning around 2006, the average number of trade secret cases was highest among states with a ban on noncompetes (on average, thirty-one annual cases between 2006 and 2023), followed by states that have imposed some form of restriction on noncompete enforcement (on average, eighteen annual cases), and, finally, states that enforce noncompetes without any restrictions (on average, thirteen annual cases). These findings are consistent with the hypothesis that a nationwide ban on noncompetes could lead to more trade secret disputes.

Figure 1. Average number of trade secret cases filed per state, 2000–2023.

Data obtained from Lex Machina, district court cases database. For each year, the total number of cases filed across states in each of the three categories was divided by the number of states in those categories. In the year of transition, each state was assigned to its post-change category.

However, subsequent analyses indicated that once we factored in state populations, the results no longer supported the previously implied relationship between noncompetes and trade secrets. In figure 2 below, we reproduce the trends for the three categories of states. This time, instead of plotting the total annual number of trade secret cases divided by the number of states in each category, we plot the volume of trade secret cases per one million residents. The resulting trends across the three categories differ substantially from those in figure 1. Specifically, in figure 2, we do not observe the same ordering of the categories. In fact, the ordering of the categories appears to vary at different points in time. While the trends in figure 1 support the hypothesis that a nationwide ban on noncompetes would increase trade secret cases, the patterns in figure 2, or lack thereof, indicate no evidence of such a relationship. Said differently, observed differences in the volume of trade secret cases across the three categories of states are influenced by state characteristics such as population size rather than solely by their enforcement of noncompetes.

Figure 2. Average number of trade secret cases filed per million population, 2000–2023.

Data on trade secret case counts obtained from Lex Machina, district court cases database. For each year, the total number of cases filed across states in each of the three categories was divided by the total population across those states. In the year of transition, each state was assigned to its post-change category. Population data for the fifty states and Washington, D.C., were sourced from Release Tables: Resident Population by State, Annual, FRED (2000–2023).

When we abstracted from aggregate analyses and instead analyzed individual state-level data, our findings were once again mixed. For some states, including Illinois, Louisiana, and Washington, implementing some form of restriction on the enforcement of noncompetes was followed by a decline in per capita trade secret cases. This implies that doing away with noncompetes may not lead to more trade secret cases. On the other hand, in states like Nevada, Oregon, Utah, and Virginia, implementing some form of restriction on the enforcement of noncompetes was followed by an increase in per capita trade secret cases. The experience in these states implies that doing away with noncompetes may lead to more trade secret cases.

Considerations Regarding How Companies May Approach IP Policy

When the aggregate analysis of the different categories of states and the before-and-after experiences of select individual states are taken together, our findings lead us to conclude that a nationwide ban on noncompetes is unlikely to lead to any immediate surge in trade secret cases. At the same time, however, we recognize that any impact of a nationwide ban on the volume of trade secret cases may not be immediate. Moreover, we do not claim our estimated effects or lack thereof to be causal. We interpret our findings as preliminary and as motivation for state-level analyses that control for additional confounding factors that may impact both the enforcement of noncompetes and the volume of trade secret cases.

Our findings highlight some important considerations regarding how companies may approach their IP policies. When evaluating both existing and new IP strategies, it may be prudent to consider the potential short-term and long-term impacts. This can ensure the retention of valuable IP developed within a company, particularly before any employee departure.

To this end, an initial consideration is determining the most suitable IP protection for the technology being developed. Specifically, companies can prioritize assessing whether patent protection is more appropriate than trade secret protection. A ban on noncompetes could change how companies assess their IP strategy. In particular, when employees and the knowledge they gain from their employers become more portable, it may become harder to keep proprietary, inventive knowledge a secret. If this knowledge offers a competitive advantage, companies may place greater emphasis on securing patent protection. At the same time, as other studies have suggested, trade secrets and patents don’t need to be viewed as mutually exclusive. A viable IP strategy could involve patenting certain aspects of a technology while maintaining trade secret status for others.^[8]

Regardless, this highlights an essential task companies should undertake in the light of the potential noncompete ban—revisiting and redefining clear trade secret policies. While trade secret policies may vary across companies due to budget constraints and the nature of the business, having a strong chance of enforcing trade secret protection in litigation requires clear policies. Companies must define what constitutes a trade secret and specify the protective measures in place to maintain its secrecy. This includes establishing protocols for the development, marking, and accessing of the information both physically and electronically. Additionally, in light of the potential ban on noncompetes, trade secret protocols should include oversight of individuals with access to sensitive information. In the absence of noncompete agreements, measures like assignment and confidentiality agreements can help alleviate concerns about the portability of a company’s trade secrets or confidential information.

1. Noncompetition Agreement, Cornell L. Sch. Legal Info. Inst. (updated July 2023); see also Press Release, Fed. Trade Comm’n, FTC Announces Rule Banning Noncompetes (Apr. 23, 2024). ↑

2. Press Release, supra note 1; see also Press Release, Fed. Trade Comm’n, FTC Proposes Rule to Ban Noncompete Clauses, Which Hurt Workers and Harm Competition (Jan. 5, 2023). ↑

3. Chevron Deference, Cornell L. Sch. Legal Info. Inst. (updated July 2024). This shift in power from federal agencies to the judiciary may, among other things, limit the FTC’s ability to enforce a federal ban on noncompetes based on its interpretation of its statutory mandate to protect competition. ↑

4. See Paul A. Ainsworth & Jonathan Tuminaro, Update: FTC’s Ban on Non-Compete Agreements Set Aside, Sterne Kessler (Aug. 27, 2024). ↑

5. For example, existing studies on noncompetes have focused on their impact on wages and employee mobility, highlighting differences in enforcement and outcomes in various states or industries. Studies have also explored the broader economic impacts of noncompetes, examining their influence on firm behavior, such as investments in training or research and development, as well as their overall effects on market competition and consumers. Gabriella Monahova & Kate Foreman, A Review of the Economic Evidence on Noncompete Agreements, Competition Pol’y Int’l (May 31, 2023); see also Evan Starr, Noncompete Clauses: A Policymaker’s Guide Through the Key Questions and Evidence, Econ. Innovation Grp. (Oct. 31, 2023). ↑

6. Rosemary Scott, FTC’s Non-Compete Law Could Propel Rise in Trade Secrets Lawsuits, BioSpace (Feb. 8, 2023); see also Steve Carey, Sarah Hutchins & Tory Summey, FTC’s Noncompete Ban Leaves Room to Prevent Trade Secret Theft, Bloomberg L. (Jan. 24, 2023). ↑

7. Animesh Giri, April Dang & Marie McKiernan, Noncompetes and Their Potential Impact on Trade Secret Cases, 17 Landslide (Sept./Oct. 2024). ↑

8. See, e.g., Steven R. Daniels & Sharae’ L. Williams, So You Want to Take a Trade Secret to a Patent Fight? Managing the Conflicts between Patents and Trade Secret Rights, 11 Landslide (Jul./Aug. 2019). ↑

On June 27, 2024, the U.S. Supreme Court issued its decision in Securities & Exchange Commission v. Jarkesy, addressing the circumstances in which a party subject to an administrative enforcement action is entitled, under Article III of the Constitution, to have that action determined by a jury.^[1] In reaching its decision, the majority applied a two-step framework to outline whether an administrative agency can lawfully subject a party to an enforcement action using internal adjudication processes or whether the Seventh Amendment entitles a party subject to the enforcement action to a jury trial.^[2]

Although the majority opinion focused on the Securities and Exchange Commission’s authority to impose civil penalties for a securities fraud claim via its internal administrative apparatus,^[3] the breadth of some of the Court’s reasoning naturally calls into question the enforcement powers of other administrative agencies.^[4]

This article will consider this issue with specific focus on the National Labor Relations Board (“NLRB”). By outlining NLRB enforcement options and applying them to the Jarkesy reasoning, the authors hope to provide practitioners and courts with some useful thoughts to help as these cases inevitably arise.

NLRB Enforcement Authority

Jarkesy is most relevant to administrative agencies with internal adjudicative processes, rather than those that must resort to the courts to enforce policy. Even within the field of labor and employment law, though, different agencies have different enforcement powers.

For example, the Equal Employment Opportunity Commission (“EEOC”) is empowered “to prevent any person from engaging in any unlawful employment practice,”^[5] but its internal processes include only investigations and informal resolution methods.^[6] The EEOC must bring an action in U.S. district court to otherwise enforce its prerogatives,^[7] including when it seeks compensatory or punitive damages for intentional unlawful acts.^[8]

Section 10 of the National Labor Relations Act (“Act”) grants the NLRB powers “to prevent any person from engaging in any unfair labor practice.”^[9] But in contrast to the EEOC approach, the NLRB can adjudicate violations of labor law. Specifically, the Act authorizes the NLRB to issue and serve complaints alleging unfair labor practices,^[10] to conduct fact-finding hearings, to issue orders requiring violators to cease and desist from such practices, and “to take such affirmative action including reinstatement of employees with or without back pay, as will effectuate the policies of [the Act].”^[11] Federal courts are not involved in an NLRB adjudication unless the subject of the enforcement action appeals the NLRB’s decision,^[12] or unless the NLRB seeks court assistance in the enforcement of its order.^[13]

The NLRB’s authority under section 10(c) to craft appropriate remedies is “a broad discretionary one, subject to limited judicial review.”^[14] Even under judicial review, NLRB orders stand “unless it can be shown that the order is a patent attempt to achieve ends other than those which can fairly be said to effectuate the policies of the Act.”^[15] Furthermore, the NLRB’s findings of fact are conclusive unless the reviewing court is convinced that additional evidence should be considered.^[16] However, the court does not take evidence; instead, the NLRB reopens its fact-finding process and may modify its findings or make new findings.^[17]

The principal objective for the NLRB in fashioning remedies is to make the victim of an unfair labor practice whole, as though the violation had never occurred.^[18] The remedies expressly authorized by the Act—orders for reinstatement of employees and to cease and desist unfair labor practices—further this purpose.^[19] Likewise, an order for back pay is also largely remedial.^[20] But the NLRB has construed this make-whole objective broadly, at times ordering monetary relief for harms directly and indirectly stemming from an unfair labor practice.^[21]

Jarkesy Framework, Part 1: The Nature of the Remedy

The Seventh Amendment to the U.S. Constitution provides that “[i]n suits at common law, where the value in controversy shall exceed twenty dollars, the right of trial by jury shall be preserved. . . .”^[22] As explained in Jarkesy, the initial question is whether an internal administrative adjudication falls within the Seventh Amendment as a “suit at common law.” According to the Court, despite the amendment’s phrasing, the right to a jury is not strictly limited to claims arising under common law: a statutory claim is subject to the amendment if the claim is “legal in nature”—that is, not arising under equity, admiralty, or maritime jurisprudence.^[23]

According to the Court, in making such an assessment, the nature of the remedy is the most important consideration. Monetary damages, especially when imposed to punish or deter wrongful conduct, are within the scope of legal remedies. In contrast, remedies designed to restore the status quo are more likely to be considered equitable in nature.^[24]

As discussed above, the relief typically imposed by the NLRB is equitable in nature, with remediation of harm the primary objective. In the 1937 case of National Labor Relations Board v. Jones & Laughlin Steel Corp., the Court held that NLRB awards of money damages incident to equitable relief (such as back pay) are not subject to the Seventh Amendment.^[25] But awards of back pay serve not merely a remedial purpose—they also act as a deterrent against wrongful conduct.^[26] Jarkesy’s emphasis on the purpose of the remedy calls into question whether Jones & Laughlin Steel should be revisited to determine whether the dual purposes of such relief render back pay damages subject to the Seventh Amendment.^[27]

Jarkesy Framework, Part 2: The Public Rights Exception

Even if the NLRB’s monetary awards are legal in nature, the agency may nevertheless be able to claim an exception to the Seventh Amendment’s jury requirement. As the Jarkesy majority recognized, under the so-called public rights exception, if a cause of action has historically been determined by the executive or legislative branches, the judicial branch does not have exclusive jurisdiction over the claim.^[28] This exception typically extends to various types of administrative actions including revenue collection, immigration, relations with Indian tribes, administration of public lands, and the granting of public benefits.^[29]

In looking at the claim in Jarkesy—fraud—the majority considered whether the cause of action was substantially the same as one that might have arisen under traditional English common-law customs circa the late eighteenth century. The Court had little difficulty determining that the exception did not apply, as fraud was well-known in traditional common-law courts.^[30]

However, the majority distinguished the fraud claim at issue from an earlier decision, Atlas Roofing Co. v. Occupational Safety & Health Review Commission,^[31] involving workplace safety regulations. Since the regulations at issue in Atlas Roofing were not founded in common law, the Jarkesy majority found the case inapplicable to its consideration.^[32]

Therefore, determining whether unfair labor practice claims are within the public rights exception requires a review of the history of labor rights and whether the unfair labor practices policed by the NLRB have historical common-law analogs or are creations of modern legislative and executive functions.

There is at least one example of an English court in the 1700s relying on common-law criminal conspiracy principles to restrict the collective rights of organized workers.^[33] However, scholars debate whether the decision was truly based on common-law doctrines or a statute passed the preceding year.^[34] The leading early American case considering the question expressly rejected the English precedent as a common-law rule because of the existence of statutory prohibition.^[35] Essentially, in the absence of a statute making the collective action unlawful, a conspiracy to engage in the action cannot be considered criminal under the common law.

Thus, there is a historical American legal tradition of looking to statute to define lawful and unlawful collective bargaining rights and duties. The Act does just that, assigning the adjudication of such rights and duties to the NLRB as permitted by the public rights exception.^[36] But the Jarkesy majority cautioned that the public rights exception is an exception,^[37] with Article III courts presumptively the appropriate forum even where an argument can be made in support of the exception’s application.^[38]

Thus, while we believe the stronger argument is that the public rights exception applies to NLRB actions, there is insufficient certainty in existing case law to make a definitive determination. The Court in Jarkesy cautioned that its jurisprudence on the public rights exception is an “area of frequently arcane distinctions and confusing precedents,” with no definitive distinction between public and private rights.^[39] While Jones & Laughlin Steel is precedent holding that NLRB-imposed remedies are not subject to the Seventh Amendment,^[40] the Court has shown its willingness to cast aside long-standing precedent to rein in administrative authority.^[41]

1. Sec. & Exch. Comm’n v. Jarkesy, 144 S. Ct. 2117 (2024). ↑

2. Id. ↑

3. Id. at 2126–31. ↑

4. See Kai Ryssdal & Sofia Terenzio, What the Supreme Court’s SEC Decision Means for the Administrative State, Marketplace.org (June 27, 2024); Meghan E. Flinn et al., Jarkesy’s Impact on Agency Enforcement Proceedings: Potential Implications for the SEC and Beyond, K&L Gates Hub (July 3, 2024). ↑

5. 42 U.S.C. § 2000e-5(a) (2024). ↑

6. 42 U.S.C. § 2000e-5(b) (“If the Commission determines after such investigation that there is reasonable cause to believe that the charge is true, the Commission shall endeavor to eliminate any such alleged unlawful employment practice by informal methods of conference, conciliation, and persuasion.”). ↑

7. 42 U.S.C. § 2000e-5(f). ↑

8. 42 U.S.C. § 1981a. ↑

9. 29 U.S.C. § 160. ↑

10. 29 U.S.C. § 160(b). ↑

11. 29 U.S.C. § 160(c). ↑

12. 29 U.S.C. § 160(f). ↑

13. 29 U.S.C. § 160(e), (j). ↑

14. Nat’l Lab. Rels. Bd. v. J. H. Rutter-Rex Mfg., 396 U.S. 258, 262–63 (1969) (quoting Fiberboard Paper Prods. v. Nat’l Lab. Rels. Bd., 379 U.S. 203, 216 (1964)). ↑

15. Va. Elec. & Power Co. v. Nat’l Lab. Rels. Bd., 319 U.S. 533, 540 (1943). ↑

16. 29 U.S.C. § 160(e), (f). ↑

17. 29 U.S.C. § 160(e). ↑

18. Nat’l Lab. Rels. Bd. v. Strong, 393 U.S. 357, 359 (1969) (quoting Phelps Dodge Corp. v. Nat’l Lab. Rels. Bd., 313 U.S. 177, 197 (1941)). ↑

19. Larry M. Parsons, Title VII Remedies: Reinstatement and the Innocent Incumbent Employee, 42 Vanderbilt L. Rev. 1441, 1443 (1989) (discussing reinstatement as an equitable remedy in the context of unlawful employment discrimination violations). ↑

20. Strong, 393 U.S. at 359. ↑

21. See 372 NLRB No. 22, at 7–10 (Dec. 13, 2022). Notably, the NLRB attempted to style the damage awards as something other than “consequential damages” awarded for common-law tort and contract claims, after previously describing these expanded remedies as such. Id. at 8–9. Post-Jarkesy, it may be more difficult for the NLRB to unring the bell. ↑

22. U.S. Const. amend VII. ↑

23. Sec. & Exch. Comm’n v. Jarkesy, 144 S. Ct. 2117, 2128 (2024). ↑

24. Id. at 2129. ↑

25. Nat’l Lab. Rels. Bd. v. Jones & Laughlin Steel Corp., 301 U.S. 1, 48 (1937). ↑

26. See Nat’l Lab. Rels. Bd. v. J. H. Rutter-Rex Mfg., 396 U.S. 258, 265 (1969); see also Hoffman Plastic Compounds, Inc. v. Nat’l Lab. Rels. Bd., 535 U.S. 137, 153 (2002) (Breyer, J., dissenting). ↑

27. Jarkesy, 144 S. Ct. at 2129 (“As we have previously explained, ‘a civil sanction that cannot fairly be said solely to serve a remedial purpose, but rather can only be explained as also serving either retributive or deterrent purposes, is punishment.’” (quoting Austin v. United States, 509 U.S. 602, 610 (1993)). ↑

28. Id. at 2123. ↑

29. Id. ↑

30. Id. at 2135; see also Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989). ↑

31. 430 U.S. 442 (1977). ↑

32. Jarkesy, 144 S. Ct. at 2138 (“Atlas Roofing concluded that Congress could assign the OSH Act adjudications to an agency because the claims were ‘unknown to the common law.’ The case therefore does not control here, where the statutory claim is ‘in the nature of’ a common law suit.” (internal citations omitted)). ↑

33. Rex v. Journeymen Tailors, 88 Eng. Rep. 9, 8 Mod. 10 (1721). ↑

34. Francis B. Sayre, Criminal Conspiracy, 35 Harv. L. Rev. 393, 403–04 (1921–1922). ↑

35. Commonwealth v. Hunt, 45 Mass. (4 Met.) 111, 122 (1842). ↑

36. Jarkesy, 144 S. Ct. at 2132 (“Such matters ‘historically could have been determined exclusively by [the executive and legislative] branches,’ even when they were ‘presented in such form that the judicial power [wa]s capable of acting on them.’” (internal citations omitted)). ↑

37. Id. at 2134. ↑

38. Id. (“‘[E]ven with respect to matters that arguably fall within the scope of the ‘public rights’ doctrine, the presumption is in favor of Article III courts.’” (citing N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 69, n.23 (1982) (plurality opinion))). ↑

39. Id. at 2133 (internal citations omitted). ↑

40. Nat’l Lab. Rels. Bd. v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937) (see supra note 25 and accompanying text). ↑

41. See Loper Bright Enters. v. Raimondo, 144 S. Ct. 2224 (2024). ↑

A sharply divided Supreme Court in Harrington v. Purdue Pharma L.P. has barred the issuance of nonconsensual third-party releases in Chapter 11 bankruptcy plans.^[1] In a 5–4 decision, the Court held that “the bankruptcy code does not authorize a release and injunction that, as part of a plan of reorganization under Chapter 11, effectively seeks to discharge claims against a nondebtor without the consent of affected claimants.”

Purdue Pharma L.P. (“Purdue” or the “company”) was a manufacturer of the opioid OxyContin. Purdue was a “family company” owned and controlled by the Sacklers. Sales of OxyContin soared as it became the most prescribed brand-name narcotic medication. However, Purdue ultimately became a defendant in thousands of lawsuits claiming injuries resulting from deceptive marking practices. During this time period, the Sacklers received distributions from the company of approximately $11 billion, about $4.6 billion of which was designated to pay taxes.

Faced with mounting liabilities related to litigation claims, Purdue filed for relief under Chapter 11 of the United States Bankruptcy Code. It proposed a Chapter 11 plan that included payment by the Sacklers in the amount of $4.325 billion in return for a release of any and all claims of the debtors and from third parties. Specifically, the Sacklers sought to end the growing number of lawsuits brought against them by claimants with damages resulting from the company’s products (particularly OxyContin), referred to in the Supreme Court opinion as “opioid victims.” The proposed plan would have provided recoveries for the individuals harmed by the company’s products ranging from $3,500 to $48,000, depending upon the severity of the injuries.

The United States Trustee opposed the plan, as did certain government entities. The bankruptcy court overruled these objections and confirmed the plan.^[2] On appeal, the district court vacated confirmation. It held that the bankruptcy code did not allow the release of third-party claims without consent of the claimants. Thereafter, the plan proponents (i) appealed the decision to the Second Circuit; and (ii) increased the proposed Sackler payment in exchange for the withdrawal of certain objections. While the additional payment was sufficient to cause certain states to withdraw their objections, the U.S. Trustee, Canadian creditors, and other individuals continued their opposition to the plan.

A divided panel of the Second Circuit reversed the district court and approved the plan as modified by the additional proposed payment.^[3] The U.S. Trustee sought a stay of confirmation, which was granted by the Supreme Court and treated as a petition for writ of certiorari to address the issue of whether the bankruptcy code authorized nonconsensual releases of third-party claims.

Writing for the majority, Justice Gorsuch focused the Purdue opinion on Section 1123(b) of the bankruptcy code, which addresses permissible components of a Chapter 11 plan. Among these provisions, the only one that could allow for third-party releases was Section 1123(b)(6), which authorizes a plan to “include any other appropriate provision not inconsistent with the applicable provisions of this title.” Gorsuch first rejected the argument that paragraph 6 authorizes any provision not expressly prohibited as long as the judge deems it appropriate. Rather, the Court interpreted this catch-all paragraph in light of its surrounding context so as to “‘embrace only objects similar in nature’ to the specific examples preceding it.”^[4] Finding that all the preceding provisions concern the debtor and its relationship with creditors, the Court concluded that the paragraph “cannot be fairly read to endow a bankruptcy court with the ‘radically different’ power to discharge the debts of a nondebtor without the consent of affected nondebtor claimants.”^[5] In doing so, the Court noted that the text could have permitted anything not expressly prohibited, but it does not.

It next addressed the purpose of bankruptcy plans. While acknowledging that bankruptcy law serves to address some collective-action problems, it rejected the argument that this would allow a bankruptcy court to resolve all such problems to extinguish claims of third parties without their consent. The Court then looked at other provisions of the bankruptcy code, including the discharge, that applies only to debtors, and found no other provision of the code that would allow for the third-party releases. Finally, the Court looked to the history of bankruptcy law and concluded that such history provided no support for third-party releases.

The Court declined to address the policy and ramifications of unwinding the plan, including the possibilities that the opioid victims in this case may have no viable path to recovery anytime soon. However, according to the Court, Congress is the appropriate forum to address those concerns.

In his dissent, Justice Kavanaugh (joined by Chief Justice Roberts, Justice Sotomayor, and Justice Kagan) focused on the practical ramifications of the decision, stating that it “makes little legal, practical, or economic sense” to find such releases categorically outside the ambit of an “appropriate” Chapter 11 plan.^[6] The dissent focused on the history of utilizing the bankruptcy process to solve collective-action problems in mass tort cases and similar situations. It criticizes the majority for “jettison[ing] a carefully circumscribed and critically important tool that bankruptcy courts have long used and continue to need to handle mass-tort bankruptcies going forward.”^[7]

The decision is framed as narrow and addresses only nonconsensual third-party releases. The Court expressly does not address or call into question consensual third-party releases or what would qualify as consent to a third-party release under a plan. It also does not address the impact this decision will have on plans that include such releases that have already been substantially consummated. The Court held “only that the bankruptcy code does not authorize a release and injunction that, as part of a plan of reorganization under Chapter 11, effectively seeks to discharge claims against a nondebtor without the consent of affected claimants.”^[8]

While it is clear that nonconsensual third-party releases are not permissible, how the Purdue decision impacts consensual third-party releases is less clear. Consensual third-party releases are presumed to be valid. But exactly what constitutes “consent” is far from apparent. Some courts have concluded that a creditor that votes in favor of a plan has consented to a release. Other courts have held that even where a creditor does not vote in favor of the plan (either by voting “no” or by failing to return the ballot) but fails to affirmatively opt out of the release, they may be deemed to have consented to such release. The area of consensual releases is likely to continue to divide courts post-Purdue.

The Purdue decision also did not address exculpation provisions that are often included in bankruptcy plans. These provisions are generally more limited and protect professionals, committee members, and employees who were involved in the bankruptcy case. While exculpation provisions may be distinguishable on some bases, the rationale of Purdue may call those provisions into question and result in future litigation.

In addition, the Supreme Court was clear that the Purdue decision did not address plans that were confirmed long ago that include nonconsensual third-party releases. It seems that such releases are likely to be enforceable under principles of res judicata. However, some parties may seek relief from nonconsensual third-party releases, particularly in fairly recent plans.

Moreover, the Purdue decision is likely to influence motions or complaints seeking to extend the automatic stay to third parties. Chapter 11 debtors sometimes seek to extend the automatic stay to their officers and directors in order to allow them to focus on reorganizing the company. Recently, the United States Bankruptcy Court for the Northern District of Illinois granted a motion to enjoin creditors from pursuing a debtor’s officers but noted that such an injunction can no longer be premised on the likelihood of a third-party release under a confirmed plan.^[9]

Finally, the reasoning of the Purdue decision is likely to influence courts as they make rulings under other provisions of the Bankruptcy Code that include broad language. For example, the Third Circuit recently cited Purdue in a decision regarding what constitutes “other cause” under Section 350(b) of the bankruptcy code, noting Purdue’s statement that “pre-code practice may sometimes inform our interpretation of the code’s more ‘ambiguous’ provisions.”^[10]

1. Harrington v. Purdue Pharma L.P., 603 U.S. ___ (2024). ↑

2. In re Purdue Pharma, 635 B.R. 26 (S.D.N.Y. 2021). ↑

3. In re Purdue Pharma LP, 69 F. 4^th 45 (2^nd Cir. May 30, 2023). ↑

4. Harrington v. Purdue Pharma L.P., 603 U.S. at 2. ↑

5. Id. ↑

6. Harrington v. Purdue Pharma L.P., 603 U.S. (Kavanaugh, J., dissenting) at 3. ↑

7. Id. at 54. ↑

8. Harrington v. Purdue Pharma L.P., 603 U.S. at 4, 19. ↑

9. See In re Coast to Coast Leasing, LLC, 2024 WL 3454805 (Bankr. N.D. Ill. July 17, 2024). ↑

10. In re Congoleum Corp., 2024 WL 3684376 (3^rd Cir. August 1, 2024). ↑

The move by the Food and Drug Administration (FDA) to regulate Laboratory Developed Tests (LDTs) as medical devices presents new obligations for an industry historically shielded from regulatory enforcement. Stemming from a small change to the FDA’s regulation defining in vitro diagnostic products (IVDs), the FDA’s May 6 final rule detailed the agency’s four-year, stage-based approach to ending blanket enforcement discretion over LDTs. Although the final rule spares many existing LDTs from compliance with some of the more burdensome medical device regulations, and significant legal challenges to the final rule swirl in the background, as of right now, most laboratories offering LDTs are less than one year away from facing regulatory obligations previously foreign in a laboratory setting. Notably, while some laboratories may be inclined to wait to see how recent legal challenges, including those filed by the American Clinical Laboratory Association (ACLA) and HealthTrackRX, and the Association for Molecular Pathology, play out, laboratories would be wise to take preliminary steps, including determining how much time they realistically need in advance of the final rule’s Stage One deadline of May 6, 2025, to set up and effectuate infrastructure to meet these requirements.

While diagnostic tests may seem like a highly specialized product, the FDA’s vast regulatory reach, and compliance with exacting quality assurance regulations, is an often-overlooked but consequential consideration in various life science deals. The FDA’s move to regulate LDTs thus may have a significant impact on assessing healthcare and regulatory compliance activities in the laboratory space. This article will briefly address which entities face this shifting regulatory tide and how to comply with the FDA’s initial compliance expectations.

How Did We Get Here?

Diagnostic products, including IVDs, generally provide information about a patient’s health. The FDA considers LDTs to be a subcategory of IVDs designed, manufactured, and clinically used within a single laboratory with Clinical Laboratory Improvement Amendments (CLIA) certification to perform high-complexity testing—although the industry has construed the category a bit more broadly to include tests manufactured and offered beyond the single laboratory in which a test was designed.

For decades the FDA maintained a policy of enforcement discretion for LDTs because they were low risk, used relatively simple manual techniques, were performed in small volumes, and were used for specialized needs of a local patient population. The industry, however, has long challenged the FDA’s authority to regulate LDTs, pointing to the regulation of laboratories as a whole under CLIA as a clear Congressional mandate for the Centers for Medicare and Medicaid Services, rather than the FDA, to regulate this space. Nonetheless, citing advancements in technology that make many modern LDTs much more complex, the broad marketing and sale of modern LDTs, and consequential healthcare treatment decisions made in reliance on the results of LDTs, the FDA’s final rule amended the regulatory definition of IVDs to clarify that all IVDs, even if manufactured in a laboratory, are medical devices, and ended its historic enforcement discretion policy regarding LDTs. As a result, laboratories that offer LDTs must comply with the FDA’s medical device regulations absent an exception.

The FDA intends to end its enforcement discretion policy over many LDTs in stages, requiring laboratories to first comply with various reporting, complaint, and correction and removal regulations in Stage One; comply with registration, listing, labeling, and other requirements in Stage Two; and comply with quality system reporting in Stage Three; before eventually complying with premarket review and approval requirements for high-risk devices in Stage Four, and all devices in Stage Five. For laboratories, it could be a long, and expensive, road ahead.

But Does My Laboratory Have to Comply?

By May 6, 2025, the FDA expects most laboratories offering LDTs to comply with medical device reporting (MDR) requirements, correction and removal reporting requirements, and the Quality System (QS) requirement to maintain and review records of complaints. The only laboratories that are exempt from complying with these Stage One requirements (and all other Stages, too) are those that solely manufacture the following four categories of tests:

• 1976-Type Tests: LDTs that have characteristics common to LDTs offered in 1976—including relying on manual techniques (without automation) performed by laboratory personnel with specialized expertise using components legally marketed for clinical use—and are otherwise designed, manufactured, and used within a single CLIA-certified high-complexity laboratory.
• Human Leukocyte Antigen (HLA) Tests: LDTs designed, manufactured, and used within a single CLIA-certified high-complexity histocompatibility testing laboratory when used in connection with certain organ, stem cell, and tissue transplantation activities.
• Forensic Tests: Tests intended solely for forensic (law enforcement) purposes.
• Military Tests: LDTs manufactured and performed within the Department of Defense or the Veterans Health Administration.

All other clinical laboratories that offer any LDTs—even those that are exempt from later stage compliance (e.g., LDTs approved by the New York Clinical Laboratory Evaluation Program, which are exempt from premarket review requirements that take effect in Stage Four and Five)—must comply with the Stage One requirements that take effect on May 6, 2025. Additionally, if a laboratory manufactures both exempt and nonexempt tests, it will be exempt from complying with Stage One only with respect to its exempt tests.

How Do I Prepare for Stage One?

Any laboratory that offers an LDT that does not fall into one of the above exempt categories should prepare to be in compliance with the FDA’s MDR, correction and removal reporting, and QS complaint requirements by May 6, 2025. Fortunately, of all the requirements the FDA will eventually impose over the four-year phaseout, the Stage One requirements are the least burdensome. Nonetheless, there is still work that needs to be done in preparation.

Medical Device Reporting Requirements (21 C.F.R. Part 803)

At Stage One, the FDA wants to be able to systematically monitor significant adverse events to identify “problematic” LDTs in the market. To help accomplish this goal, the FDA is requiring compliance with MDR requirements obligating a manufacturer, such as a laboratory, to report to the FDA reportable events of which it becomes aware.

A reportable event is an event that reasonably suggests an LDT has or may have caused or contributed to a death or serious injury, or has malfunctioned such that the LDT or a similar device marketed by the laboratory would be likely to cause or contribute to a death or serious injury if the malfunction were to recur. Importantly, a laboratory is required to report an event even if the laboratory is only able to determine the LDT may have caused or contributed to a death or serious injury. For example, user errors, issues with materials or components, design issues, labeling issues, issues resulting from off-label use, or other malfunctions may be reportable events—even if the error or issue only may have caused or contributed to the death or serious injury. Notably, reporting an event to the FDA does not constitute an admission that the LDT caused or contributed to the harm.

If a laboratory becomes aware of a reportable event, it must submit a report no later than thirty calendar days after the date the laboratory becomes aware of the event. Additionally, if the event requires remedial action to prevent unreasonable risk or substantial harm to the public health (or the FDA requests a report in writing), the laboratory must submit its report within five working days after it becomes aware of the event. The laboratory must also submit supplemental reports if it obtains more information after submitting the initial report. These reports must be submitted to the FDA through the Electronic Submissions Gateway (ESG) on Form 3500A.

To comply with these requirements, laboratories will need to establish procedures to timely and effectively identify and evaluate adverse events; establish a standardized review process for determining when reporting is required and how long the laboratory has to report the event; timely submit reports and supplemental reports to the FDA; and maintain documentation of all related information, reports, and evaluation materials. The purpose of these procedures is to allow a laboratory to comprehensively track all adverse events that may result from use of its LDTs and to provide the FDA with sufficient information necessary to inspect the laboratory’s activities with respect to an adverse event.

Correction and Removal Requirements (21 C.F.R. Part 806)

Furthering its goal to systematically monitor and identify “problematic” LDTs, the FDA is also requiring laboratories offering nonexempt LDTs to comply with its correction and removal requirements effective May 6, 2025. These requirements obligate laboratories to promptly report actions concerning some LDT corrections and removals and to maintain records of all corrections and removals even when not otherwise reportable.

A laboratory will be required to submit a written report to the FDA of any correction or removal of an LDT if the correction or removal is done (1) to reduce a risk to health posed by the LDT or (2) to remedy any unlawful activity resulting from the LDT’s use—for example, any unlawful labeling on the LDT. The FDA defines correction as the repair, modification, adjustment, relabeling, destruction, or inspection (including patient monitoring) of a device without its physical removal from its point of use to some other location. Removal means the physical removal of a device from its point of use to some other location for repair, modification, adjustment, relabeling, destruction, or inspection.

Not every correction or removal of a device is a reportable event. For example, actions taken by a laboratory to improve performance or quality of an LDT or profitability-based decisions to remove an LDT should not trigger reporting as long as those actions do not relate to reducing a risk to health or remedying any unlawful activity. Additionally, if the laboratory has already reported the event under the MDR requirements, no additional report is required. If, however, a laboratory corrects or removes an LDT in order to reduce a risk to health posed by the device or for a reason related to the LDT’s legal compliance, it must submit a report to the FDA within ten working days of initiating any correction or removal. This report can be emailed to the agency or submitted via the agency’s electronic submission software (eSubmitter) through the ESG.

To comply with these requirements, laboratories will need to maintain records of all reported and unreported corrections and removals. These reports should include all of the information the FDA otherwise requests if reporting is required, a narrative description of the events, any justification for not reporting if no report was made, and copies of all communication related to the LDT’s correction or removal. The FDA is authorized to access, copy, and verify all of these records and reports; thus, accuracy and completeness in recordkeeping is essential.

Quality System Complaint Files (21 C.F.R. § 820.198)

The final requirement of Stage One is compliance with the FDA’s QS complaint file requirements. This requirement obligates a laboratory offering nonexempt LDTs to establish a formally designated compliance unit and maintain procedures for receiving, reviewing, and evaluating all complaints.

This formally designated unit, staffed by one or more appropriately trained individuals, must establish written procedures to ensure that all complaints are processed in a uniform and timely manner, that oral complaints are documented upon receipt, and that complaints are evaluated to determine if additional adverse event reporting is required. The FDA suggests keeping all complaint files related to an LDT in a common file to allow for trend analyses. Although a formally designated complaint unit may be located at a site separate from the laboratory, information related to a complaint and its investigation must be reasonably accessible to the laboratory.

A laboratory’s complaint handling system is expected not only to allow it to identify trends that may need additional study or action but also to allow the FDA to assess its complaint processes during inspections. Again, clearly established processes and adequate documentation are key. Should a complaint be determined to not require investigation or subsequent reporting, a laboratory should include a narrative description in the complaint file explaining why an investigation was not required and identifying a specific individual responsible for that decision. Alternatively, should an investigation be required, the laboratory must maintain a record that includes specific information related to the complaint, including the LDT at issue; any unique device identifier or universal product code; the date; contact information for the complainant; the nature of the complaint and details around the complaint and investigation; whatever corrective action was required; and a reply to the complainant.

What’s Next?

Because of ongoing litigation and potential congressional action, it is unclear whether the FDA’s final rule on LDTs will come to fruition. The VALID Act, which would establish within the FDA a separate regulatory pathway for LDTs, currently sits stuck in committee with little chance to make further headway than it has in the last several years. Further, at least two complaints have been filed in federal court challenging the FDA’s authority to regulate LDTs on constitutional and procedural grounds. The lawsuit filed by the ACLA and HealthTrackRX was filed on May 29, 2024, and plaintiffs recently moved for summary judgement, arguing largely that an LDT is not a device under the Food, Drug, and Cosmetic Act and thus the final rule should be vacated. The Association for Molecular Pathology filed its complaint on August 19, 2024, alleging among other arguments that the major questions doctrine requires Congress to have clearly granted the FDA authority to regulate LDTs. Both cases contest the scope of the agency’s regulatory authority under the Food, Drug, and Cosmetic Act, and are poised to allow the consequences of Loper Bright Enterprises v. Raimondo, 144 S. Ct. 2244 (2024), to play out at the district level.

At the end of the day, unless and until the agency further amends its phaseout plan, Congress passes an alternative law, or a federal court speaks on the issue, the law remains what it is. It is unclear whether a ruling in either of the above cases will come before laboratories need to start taking meaningful steps toward complying with Stage One. As a result, it is prudent for laboratories to watch closely as these lawsuits unfold and evaluate how much time they need to ensure that they are well positioned to comply with the FDA’s MDR, correction and removal, and QS complaint file requirements by May 6, 2025.