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.
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.
No. N19C-11-092 PRW CCLD, 2024 WL 3273427 (Del. Super. Ct. July 2, 2024) (order denying motion for reargument). ↑
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. ↑
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.
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. ↑
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). ↑
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]
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.”). ↑
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)). ↑
Va. Elec. & Power Co. v. Nat’l Lab. Rels. Bd., 319 U.S. 533, 540 (1943). ↑
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)). ↑
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). ↑
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. ↑
Nat’l Lab. Rels. Bd. v. Jones & Laughlin Steel Corp., 301 U.S. 1, 48 (1937). ↑
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). ↑
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)). ↑
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)). ↑
Rex v. Journeymen Tailors, 88 Eng. Rep. 9, 8 Mod. 10 (1721). ↑
Francis B. Sayre, Criminal Conspiracy, 35 Harv. L. Rev. 393, 403–04 (1921–1922). ↑
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)). ↑
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))). ↑
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]
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 reportedand 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.
A significant question pending under the recently effective Corporate Transparency Act (“CTA”) is whether a limited liability partnership (“LLP”) is a “reporting company” as defined in the CTA and the related “Reporting Regulations.” Classification as a reporting company has the effect of ab initio subjecting the firm to the beneficial ownership information reporting obligations of the CTA and the Reporting Regulations absent, on a firm-by-firm basis, an exemption from those burdens.
As detailed below, in considering the definition of a CTA reporting company with the law addressing how an LLP comes into being, it is clear that an LLP is not a reporting company.
This article begins with a review of the genesis of the LLP from the midst of the savings and loan crisis of the late 1980s and the subsequent progression of the form from bespoke supplements to state adoptions of the Uniform Partnership Act (1914) and the Uniform Partnership Act (1994), and then to the detailed provisions for LLPs set forth in the Revised Uniform Partnership Act (1997). We then turn to the CTA and the Reporting Regulations to review their respective definitions of what is a reporting company, including informal guidance from the Financial Crimes Enforcement Network (“FinCEN”) office of the Department of the Treasury as to the application of the regulatory definition. Turning then to the crux, we review why the LLP does not fall within the scope of either definition of what is a reporting company.
The Rise of the LLP
The venerable general partnership has existed for millennia;[1] aside from the sole proprietorship, likely it is the oldest organizational form. In the U.S. the common law of partnerships was reduced to statutory form in the Uniform Partnership Act (1914) (“UPA”), shortly thereafter supplemented with the Uniform Limited Partnership Act (1916), the latter providing rules applicable to those partners categorized as “limited partners.” The Uniform Partnership Act (1914) was superseded by the (Revised) Uniform Partnership Act (1994), but Texas’s adoption of the nation’s first LLP provisions in 1992 (which accompanied its initial adoption of an LLC statute) caused the Uniform Law Commissioners to revise the statute again to include LLP provisions as the Revised Uniform Partnership Act (1997) (“RUPA”). This statute has since been renamed the Uniform Partnership Act (1997) (last amended 2013) and Uniform Partnership Act (2024). While all states save Louisiana had adopted the 1914 Act, not all have to date adopted a permutation of the 1997 Act. But by the end of the twentieth century,[2] all states had engrafted LLP provisions onto whatever general partnership statute the state had.
The most commonly understood characteristic of the general partnership is the rule that each partner is vicariously personally liable for partnership obligations; in popular parlance, partners do not enjoy “limited liability” but rather bear personal exposure to the extent of their assets for the partnership’s debts and obligations.[3] While today some may look askance at this rule, because the absence of vicarious personal liability for organizational liabilities is the universal rule for other forms of organization, in fact it had important benefits. In a firm in which each owner is liable for the consequences of another’s negligence, there is incentive to oversee tasks and to require cooperative action. “Lone wolf” unilateral actions that could put the firm’s capital (including its reputational assets) and that of its partners’ at risk will not be tolerated, and there is an incentive to train employees and newer partners as a method of risk mitigation. “All for one and one for all” became a successful modus operandi. Well, it was until who the “all” was became unknown.[4] As professional firms grew to have offices distributed throughout the country with varying levels of sophistication and resultant different risk profiles, the “one” in “one for all” was reduced to this office, or my practice group, or even just me.
The fallout of the Savings and Loan Crisis of the 1980s and early 1990s demonstrated that exposing partners across the country and across practices to personal liability for claims often arising in a distant office[5] was no longer a viable structure.[6] Generically, the CPA in Lincoln, Nebraska, who performed scrupulous audit work for local farmers and farm equipment distributors found himself facing bankruptcy when his “partner” in Texas was found to have provided spotty if not actually fraudulent assurance services to a savings and loan. Public institutions including the courts asked, Where were the attorneys and accountants who (with 20/20 hindsight?) should have intervened to protect the public from the scourge of unprincipled lending? Accounting firms paid nine-figure fines[7] or were outright destroyed,[8] as were storied law firms.[9]
Okay, but if not general partnerships, then what? And here there arose the narrow gap between a rock and a hard place. On one side were the regulatory rules that limited professional firms to general partnerships (already rejected due to the personal liability rule) and in some instances professional service corporations (“PSCs”).[10] While the PSC option afforded limited liability, larger firms could not use the PSC form because of the functional size limitation imposed for S-corporation treatment.[11] Further, the conversion of an existing partnership into an entity taxed under either Subchapter C or Subchapter S resulted in phantom income because of the (for tax purposes) realization of accounts receivable.[12] Additional transactional costs would have been incurred in the real costs of drafting and negotiating a shareholder agreement, as well as the intangible costs of referring to copractitioners as “shareholders” and in some cases “directors” rather than the previously employed “partners.” What was needed was a partnership that satisfied the professional regulatory rules as to forms of practice and maintained the preferred tax classification while limiting or abolishing the venerable partnership rules as to partner liability. The LLP arose out of that tension.
The limited liability partnership (“LLP”), which in some states is labeled a “registered limited liability partnership,” is a construct in which a general partnership may via a state notice filing elect to be governed by a different rule as to the vicarious liability of the partners for the partnership’s debts and obligations.[13] In a classic general partnership, each partner is jointly and severally liable with the partnership and each other partner for the partnership’s debts and obligations.[14] The LLP is a general partnership that continued the partnership format in that it retained existing management structures and tax treatment as well as the perceived value of identifying the firm’s principals as “partners.” Crucially, because the LLP was a general partnership, it did not run afoul of then-existing rules limiting professional practices to the forms of a general partnership and in certain instances a PSC.
The importance of staying within the confines of a partnership is illustrated by the development of the laws of the Commonwealth of Kentucky governing the permitted forms of an accounting practice. Kentucky’s modern statute governing the accounting practice was adopted in 1946,[15] it providing in part for the structure of partnerships engaged in accounting.[16] Then in 1984 the defined term “firm” was added to that act, namely: “‘Firm’ means a sole proprietorship, partnership or professional service corporation or association engaged in the practice of public accountancy.”[17] The rule remained that an accounting practice could be conducted in the form of a sole proprietorship, a partnership, or a professional service corporation.[18] In 1990 additional detail was added to the rules governing the composition of partnerships and professional corporations through which accounting was practiced, but they, along with sole proprietorships, remained the only available forms.[19] Then, in 1994, coincident with the adoption of LLP amendments to Kentucky’s enactment of UPA,[20] the rules governing accountants were amended. But tellingly, while LLCs were encompassed in the permitted forms, no additional language was added to address LLPs.[21] That was not an omission but rather a recognition that no new authorization was necessary—accountants could practice as partnerships, and partnerships included the new option of electing into LLP status.[22]
What distinguished the LLP from the preexisting partnership model is that it jettisoned the no longer desired rule of joint and several vicarious liability among the partners. While there are a variety of distinctions under various state laws, if a partnership makes this notice filing and satisfies the name requirements, the partners qua partners are to one degree or another (the distinction is between so-called “partial” and “full” shield LLPs) not subject to joint and several liability for the partnership’s obligations, but rather enjoy limited liability akin to that enjoyed by shareholders in a corporation.[23] Some states require that the partnership periodically renew its LLP filing and that in the absence of that renewal it reverts to a traditional general partnership. Nearly all if not all states provide that the partnership that elects LLP status is the same entity that existed before that election was made.[24]
For purposes of this article, it is important to recognize that aside from the elimination of vicarious liability, LLPs are indistinguishable from other general partnerships in all respects: they are formed by association of two or more persons as co-owners of a business for a profit, and, most importantly in this context, they are formed by this association, not by the filing of a charter or certificate with the state. While the characteristic of vicarious liability of the partners may depend upon the filing of a registration, in the parlance of RUPA a “statement of qualification,” the absence of such a filing does not alter the fact that the partnership exists as a business organization under state law. Further, should the registration expire or be withdrawn, the partnership continues as that same partnership; there is no dissolution or other interruption of its ability to transact business as an ongoing organization.
A last point on the substantive law of LLPs; the frame of reference of comparing “general partnerships” with “limited liability partnerships” is false as they are not two sets; essentially all limited liability partnerships are general partnerships.[25] The set is general partnerships, and it may be divided into the subsets of (i) general partnerships that have elected to be limited liability partnerships, and (ii) general partnerships that have not elected to be limited liability partnerships.[26] Graphically, it is not:
but rather:
General Partnerships
General partnerships that have not elected to be LLPs
General partnerships that have elected to be LLPs
The CTA Reporting Company
The “gateway” to the CTA is status as a “reporting company”;[27] a reporting company is obligated to file beneficial ownership information reports (“BOIRs”) with FinCEN’s Beneficial Ownership Secure System (“BOSS”) database through its interface.[28] Conversely, an organization that is not a reporting company never enters into the range of responsibility to file BOIRs.
What is a reporting company is initially defined in the CTA, namely:
(11) Reporting Company.—The term “reporting company”—
(A) means a corporation, limited liability company, or other similar entity that is—
(i) created by the filing of a document with a secretary of state or a similar office under the law of a State or Indian Tribe[.][29]
From that source the Reporting Regulations (unfortunately) modified the definition, defining a “domestic reporting company” as:
The term “domestic reporting company” means any entity that is:
A corporation;
A limited liability company; or
Created by the filing of a document with a secretary of state or any similar office under the law of a State or Indian tribe.[30]
FinCEN/Treasury did itself no favors in modifying the definition of a reporting company in the course of drafting the Reporting Regulations, as it may be read as a reporting company is any of (i) all corporations, (ii) all limited liability companies, and (iii) any other “entity” that is “created” by a secretary of state filing.[31] FinCEN, in an FAQ, clarified that the interpretation of the Reporting Regulation’s definition of a reporting company is limited to those organizations created by a secretary of state filing and does not extend to every corporation or LLC.[32]
No state requires a secretary of state or similar filing in order for a general partnership to come into existence.[33] This rule is elemental in that partnership is a default category; when persons enter into a business relationship that satisfies the terms of what is a partnership, then a partnership comes into being,[34] unless they elect to structure their relationship in another way such as a corporation or LLC.[35] There being no secretary of state or similar filing in order to “create” a general partnership, it necessarily follows that a general partnership is not a CTA reporting company, a conclusion FinCEN/Treasury has recognized.[36]
Against this background is what is apparently only a single statement from FinCEN to the effect that an LLP is a reporting company.[37] On closer analysis that statement, to the extent it addresses LLPs, is incorrect.
LLPs Are Not Created by a Secretary of State Filing and Therefore Are Not “Reporting Companies”
No business organization is “created” by an election by a partnership to be an LLP. Rather, there was a partnership that was not an LLP, and then there is a partnership that is an LLP, and it may come to pass that there is a partnership that once was but is no longer an LLP; throughout all of those conditions there was a single partnership. That the partnership exists and then elects into LLP status is clear from the statutory language. The Revised Uniform Partnership Act (1997) provides: “[a] partnership may become a limited liability partnership pursuant to this section.”[38] The partnership exists by agreement of the partners,[39] and thereafter determines that it will be and makes the filing necessary to be an LLP. Since the partnership existed without the requirement of a state or other filing, and the already existing partnership files a document by which it elects in LLP status, it follows that a partnership is not “created” by the partnership’s filing of that election. This point was addressed in the Official Comments to RUPA § 201 in 1997 when it was observed:
Thus, just as there is no “new” partnership resulting from membership changes, the filing of a statement of qualification does not create a “new” partnership. The filing partnership continues to be the same partnership entity that existed before the filing. Similarly, the amendment or cancellation of a statement of qualification under Section 105(d) or the revocation of a statement of qualification under Section 1003(c) does not terminate the partnership and create a “new” partnership. See Section 1003(d). Accordingly, a partnership remains the same entity regardless of a filing, cancellation, or revocation of a statement of qualification.[40]
Numerous courts have applied these principles to determine that a partnership that has elected to be an LLP is the same partnership that preceded that election.[41]
This appreciation of the nature of the LLP is consistent with its roots. Recall that every organizational form is a construct, a combination of characteristics that satisfies a particular need, and as recounted above the “need” was for a structure that was and is a general partnership but with an altered rule of partner vicarious liability. If it was not a general partnership, the structure would have been outside the scope of permissible forms for the professional practices that needed (or at least wanted) the new rule.[42]
Long before the CTA and the question of its treatment of LLPs, the Permanent Editorial Board for the Uniform Commercial Code (the “PEB”) considered the question of whether the election by a partnership to become an LLP via the filing of a statement of qualification is the formation or organization of an entity, a question of importance in the context of the Uniform Commercial Code because it determines the controlling law.[43] Finding the election to be an LLP is not the organization of a new venture, the PEB wrote:
It follows that the statement of qualification filed with the State and by which a partnership becomes a limited liability partnership under the 1997 UPA is not a “public organic record” under the 2010 amendments to Article 9. The statement of qualification is not a record filed with the State to “form or organize” the partnership. It is the association of the partners that forms the partnership, not any record publicly filed with the State. Both conceptually and legally, a partnership is formed wholly apart from the filing of a statement of qualification with the State. Because a limited liability partnership is not formed or organized by the filing of a public organic record, it cannot be a “registered organization” under the 2010 amendments to Article 9.[44]
So the statutory language governing a partnership’s election of LLP status, the cases interpreting that language, the Official Comment to that provision of the Revised Uniform Partnership Act (1997), the comments of leading experts in the field, and the PEB considering the language have all agreed that an LLP is not a separate organization “created” by the election to be an LLP. Against that there is, well, really nothing except FinCEN’s unsupported assertion that LLPs are reporting companies.
It bears noting that the Department of the Treasury, in its own regulations, acknowledges that an LLP is just a type of partnership, stating: “A partnership form of registration is available for two or more individuals who are doing business as a partnership, including a limited liability partnership.”[45] At the same time other of its regulations, namely those under the customer due diligence requirements, provides that “legal entity customer” means: “a corporation, limited liability company, or other entity that is created by the filing of a public document with a Secretary of State or similar office, a general partnership, and any similar entity formed under the laws of a foreign jurisdiction that opens an account.”[46] If FinCEN is to be taken at its word, and LLPs are not general partnerships, them an LLP is not a “legal entity customer” for which a bank has customer due diligence obligations; conversely if an LLP is but a subset of general partnerships, they are included. Further, clearly FinCEN knows how to write a regulation (and how to influence the drafting of a statute such as the CTA) to include entities created by a secretary of state filing and general partnerships.
FinCEN has estimated that there may be more than 32 million firms existing on January 1, 2024, that will be classified as reporting companies required to file BOIRs into the BOSS database and interface.[47] All else being equal, those totals will not include any general partnerships that have elected to be limited liability partnerships. While some may view this treatment of LLPs as exposing a significant gap in the CTA’s coverage, that viewpoint does not alter the reach of the statutory language.
See, e.g., Robert Francis Harper, Assyrian and Babylonian Literature 263 (reciting the terms of a contract dated to 2000 BCE) (D. Appleton and Company 1901). ↑
It is somewhat disturbing to realize this was already a quarter of a century ago. ↑
See also Susan Saab Fortney, Am I My Partner’s Keeper? Peer Review in Law Firms, 66 U. Colo. L. Rev. 329 (1995). ↑
See also Michael Orey, The Lessons of Kaye, Scholer: Am I My Partner’s Keeper?, Am. Law., May 1992, at 3, 81. ↑
See, e.g., Robert W. Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 U. Colo. L. Rev. 1065, 1069 (1995); Robert R. Keatinge et al., Limited Liability Partnerships: The Next Step in the Evolution of the Unincorporated Business Organization, 51 Bus. Law. 147 (1995). See also Joseph S. Naylor, Is the Limited Liability Partnership Now the Entity of Choice for Delaware Law Firms?, 24 Del. J. Corp. L. 145 (1999). ↑
See supra note 5, discussing $41 million fine paid by Kaye, Scholer, Fierman, Hays & Handler; Law Firm Reaches S&L Settlement, Chi. Trib. (Apr. 20, 1993) (discussing $51 million settlement paid by Jones Day); see also Susan Saab Fortney, OTS vs. the Bar: Must Attorneys Advise Directors that the Directors Owe a Duty to the Depository Fund?, 12 Ann. Rev. Banking L. 373, 375 nn.9–11 (1993); id. at 376–379; Harris Weinstein, Attorney Liability in the Savings and Loan Crisis, 1993 U. Ill. L. Rev. 53, 53 (reporting that some ninety civil cases had been brought in the preceding four years against “lawyers”); James S. Granelli, Two Firms Settle Lincoln S&L Cases, L.A. Times, Mar. 31, 1992, at A1. ↑
Recall that at this point in time LLCs had not yet exploded onto the scene, and even where available, professional regulation likely did not yet sanction the use of that form by professional firms. ↑
This statement presupposes that pass-through taxation is “necessary,” a statement more true at that time than it is today with significant narrowing of differentials between Subchapters C, K, and S, especially as to the availability of tax-favored retirement savings plans. From 1982 through 1997, the time period that includes the Savings and Loan Crisis, and the rise of the LLP, S-corporation status was limited to firms with thirty-five or fewer shareholders, greatly reducing the utility of S-corporation classified PSCs for the organization of professional firms. See Subchapter S Revision Act of 1982, Pub. L. 97–354, § 2, 96 Stat. 1669, 1669 (Oct. 19, 1982) (amending Code 1361(b)(1) to provide: “For purposes of the subchapter, the term ‘small business corporation’ means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 35 shareholders . . . .”). The limit was not raised to seventy-five shareholders until 1997, and then it was raised to one hundred shareholders in 2005. See Small Business Job Protection Act of 1996, Pub. L. 104-188, § 1301, 110 Stat. 1755, 1777 (Aug. 20, 1996); American Jobs Creation Act of 2004, Pub. L. 108–357, § 232, 118 Stat. 1418, 1434 (Oct. 22, 2004). See alsoRichard D. Blau, Bruce N. Lemons & Thomas P. Rohman, S Corporations: Federal Taxation § 3:35 (July 2024 Update) (ebook). ↑
See 26 U.S.C. § 357(c)(1); see also Thomas Arden Roha, The Application of Section 357(c) of the Internal Revenue Code to a Section 351 Transfer of Accounts Receivable and Payable, 24 Cath. U.L. Rev. 243 (1975); Bruce G. Perrone, Incorporating a Cash Basis Business: The Problem of Section 357(c), 34 Wash. & Lee L. Rev. 329 (1977). ↑
In certain states including Colorado and Delaware a limited partnership may also make this filing, but for purposes of simplicity this discussion is in the context of a general partnership. Whether a limited partnership that elects LLP status, sometimes referred to as a limited liability limited partnership or “LLLP,” presents a different set of challenges in determining whether it is a CTA reporting company. ↑
SeeUnif. P’ship Act (1914) § 15; Rev. Unif. P’ship Act (1997) § 306(a); Colo. Rev. Stat. § 7-64-306(1) (“Except as otherwise provided in this section, all partners are liable jointly and severally for all partnership obligations unless otherwise agreed by the claimant or provided by law.”); Del. Code Ann. tit. 6, § 15-306(a); Ky. Rev. Stat. Ann. § 362.2-306(1). ↑
See 1946 Ky. Acts. ch. 210 (S.B. 164); see also id. at § 1 (“This Act may be cited as the ‘Public Accounting Act of 1946.’”). ↑
See id. § 5 (certified public accountants); id. § 7 (public accountants); see also id. § 8 (permits to practice public accounting to be issued to “individuals and partnerships”). ↑
SeeKy. Rev. Stat. Ann. § 325.220(6) as created by 1984 Ky. Acts ch. 117 (H.B. 389). Presumably the “professional service [] association” reference is to partnership associations. ↑
See Ky. Rev. Stat. Ann. § 325.300 (repealed 1994). ↑
See Ky. Rev. Stat. Ann. § 325.300 as amended by 1990 Ky. Acts ch. 285, §1(6) (repealed 1994). ↑
SeeKy. Rev. Stat. Ann. § 362.555. Kentucky would not adopt the Revised Uniform Partnership Act (1997) until 2006. ↑
SeeKy. Rev. Stat. Ann. § 325.220(6) as amended by 1994 Ky. Acts 248 (HB 546) (amended 2018) (new text is underlined and deleted text struck through) (“(6) ‘Firm’ means a sole proprietorship, partnership, professional service corporation, or any other form of business organizationassociation engaged solely in the practice of public accountancy that is not otherwise prohibited from operating by the laws of this Commonwealth and which complies with the provisions of this chapter.”). ↑
Through 1992 the American Institute of Certified Public Accountants provided that CPAs could practice as sole proprietorships, as general partnerships, and as professional service corporations. See Keatinge et al., supra note 6 at 158. It was only in 2000 that the Kentucky Supreme Court expressly permitted attorneys to practice as PSCs and (professional) LLCs. SeeKy. S. Ct. Rule 3.022 (adopted by Order 99-1, effective Feb. 1, 2000). Looking at Delaware and its rules governing attorneys and the manner in which firms could be organized, through 1995 there were particular rules for professional service corporations (Del. S. Ct. Rule 67, amended effective Jan. 1, 1995), that form having been authorized for attorneys in 1969. See id., Comment. While it does not appear there was a rule particularly addressing legal partnerships, it may well be that they were so ubiquitous it was simply understood they could operate. In 1997 Rule 67 was significantly expanded to address and expressly authorize the use of a variety of forms for the organization of law firms; beyond PSCs, all partnership, limited partnership, and LLC organized firms were recognized. See Del. S. Ct. Rule 67, amended effective May 1, 1997. For our purposes the phrase used with respect to partnerships is most telling, namely “general partnerships, including registered limited liability partnerships.” Id. Were partnerships and LLPs distinct categories, we would have expected the rule of practice of the most business law–savvy court in the country to treat them as distinct (just as PSCs are from partnerships, limited partnerships, and LLCs, etc.) from one another. Instead they are treated as members of the same class. Special thanks to Paul Altman (Richards, Layton & Finger) for his assistance in tracking down this history. ↑
See, e.g., Ky. Rev. Stat. Ann. § 362.220(2); id. § 362.555 (a partial shield statute); Rev. Unif. P’ship Act (1997) § 306(c) (full shield); Colo. Rev. Stat. § 7-64-306(3); Del. Code Ann. tit. 6, § 15-306(c); Ala. Code § 10-8A-306(c); Va. Code Ann. § 50-73.96(C). See alsoChristine Hurt & D. Gordon Smith, Bromberg and Ribstein on Limited Liability Partnerships, the Revised Uniform Partnership Act, and the Uniform Limited Partnership Act (2001) (2nd ed.) § 3.03; id. § 3.13[C]. While this description is sufficient for purposes of this discussion, it is worth noting that affording partners in an LLP “limited liability” required more than just altering the rule of UPA § 15. In addition, there needed to be addressed the obligation of the partners each individually to contribute to the partnership to satisfy its obligations and upon liquidation to contribute to satisfy intrapartnership settling up of accounts between partners. SeeUnif. P’ship Act (1914) §§ 18(a), 18(b); see also Robert R. Keatinge, The Floggings Will Continue Until Morale Improves: The Supervising Attorney and His or Her Firm, 39 S. Tex. L. Rev. 279 (1998). This was accomplished in the Revised Uniform Partnership Act (1997) by section 306(c) thereto (“A partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner. This subsection applies notwithstanding anything inconsistent in the partnership agreement that existed immediately before the vote required to become a limited liability partnership under Section 1001(b).”). ↑
See, e.g., Rev. Unif. P’ship Act (1997) § 201(b) (“A limited liability partnership continues to be the same entity that existed before the filing of a statement of qualification under Section 1001.”); Del. Code Ann. tit. 6, § 15-201(b); 805 Ill. Comp. Stat. 206/201(b); Ky. Rev. Stat. Ann. § 362.1-201(2); Va. Code Ann. § 50-73.132(E) (“A partnership that has been registered as a registered limited liability partnership under this chapter is, for all purposes, the same entity that existed before it registered.”). See alsoColo. Rev. Stat. § 7-64-202(1) (“A limited liability partnership is for all purposes a partnership.”). ↑
The qualification recognizes that in some states a limited partnership may elect LLP status. ↑
See alsoRobert Hillman, Donald Weidner & Allan Donn, The Revised Uniform Partnership Act (2023–24 ed.) at § 201, Authors’ Comment 9(b):
Limited liability partnerships are often discussed as if they were a separate form of business organization. To the contrary, a limited liability partnership is not a “new” or “separate” form of business organization. Rather, a limited liability partnership is simply a partnership that qualifies for a special limited liability shield. At bottom, a limited liability partnership is either a general partnership or a limited partnership. When it files a statement of qualification, it remains the same business organization but it gets a new liability shield. If it cancels the statement, it simply sets the shield aside. ↑
Reporting companies come in two flavors: domestic, being those organized in the U.S. including one of its territories, and “foreign,” being those organized outside the U.S. and its territories. Compare 31 C.F.R. § 1010.380(c)(1)(i) with 31 C.F.R. § 1010.380(c)(1)(ii). This discussion is focused upon LLPs organized in the U.S., so any reference to a “reporting company” should be understood to be a reference to a “domestic reporting company.” ↑
For reviews of the Corporate Transparency Act, see, e.g., (i) Allison J. Donovan & Thomas E. Rutledge, The Corporate Transparency Act Is Happening to You and Your Clients: Dealing with the Tsunami, Ky. Bar Ass’n (July 30, 2024), and (ii) Robert R. Keatinge, Anne E. Conaway, Thomas E. Rutledge & Bruce P. Ely, Keatinge and Conaway on Choice of Business Entity, ch. 21 (forthcoming Nov. 2024). ↑
See 31 C.F.R. § 1010.380(c)(1)(i). Note that each of “State” and “Indian tribe” are defined terms. See 31 C.F.R. § 1010.380(f)(4) (definition of “Indian tribe”); id. § 1010.380(f)(9) (definition of “State”). See alsoBeneficial Ownership Information: Frequently Asked Questions, FinCEN.gov (hereinafter “FinCEN FAQ”) at FAQ C.7 (Jan. 12, 2024) (discussing “reporting company” status of companies created in a variety of U.S. territories). Important for this discussion is recognition that “created” is not a defined term. ↑
Domestic entities that are: (1) corporations; (2) limited liability companies; or (3) created by the filing of a document with a secretary of state or any similar office under the law of a state or Indian tribe, and foreign entities that are: (1) corporations, limited liability companies, or other entities; (2) formed under the law of a foreign country; and (3) registered to do business in any state or Tribal jurisdiction by the filing of a document with a secretary of state or any similar office under the laws of a state or Indian tribe.
See FinCEN FAQ C.9 (Apr. 18, 2024); see also Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59538 (“FinCEN . . . notes that the core consideration for the purposes of the CTA’s statutory text and the final rule is whether an ‘entity’ is ‘created’ by the filing of the document with the relevant authority.”); id. (“We emphasize again that the only relevant issue for the purposes of the CTA and the final rule is whether the filing ‘creates’ the entity.”). ↑
Intentionally not addressed herein are the laws of any of the Indian tribes or of any of the U.S. territories. ↑
See, e.g., Unif. P’ship Act (1914) § 6(1); Rev. Unif. P’ship Act (1997) § 202(a); Del. Code Ann. tit. 6, 15-202(a); Ala. Code § 10A-8A-1.01; Colo. Rev. Stat. § 7-64-202(1) (“Except as otherwise provided in subsection (2) of this section, the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”); Ky. Rev. Stat. Ann. § 362.175; id. § 362.1-202(1); Va. Code Ann. § 50-73.88(A). See alsoIn re Copeland, 291 B.R. 740 (Bankr. E.D. Tenn. 2003); Flying Phoenix Corp. v. Sinclair, 2024 WYCH 3, 2024 Wyo. Trial Order LEXIS 4 (Wyo. Ch. Apr. 25, 2024) (“A partnership is formed when ‘two or more persons’ associate ‘to carry on as co-owners a business for profit,’ ‘whether or not the persons intended to form a partnership.’ The determinative intent is not the parties’ subjective intent to be characterized (or not characterized) as partners, but their ‘intent to do things that constitute a partnership.’ This means that absent a partnership agreement, or even when the parties express their subjective intent not to form a partnership, the parties may inadvertently create a partnership through their conduct.”) (citations omitted); 1 William Meade Fletcher, Fletcher Cyclopedia of the Law of Private Corporations § 20 (“A partnership is created by mere agreement between the partners. The approval of the state is not necessary.”); 2 John Bouvier, A Law Dictionary, Partnership, 11-§4, at 294 (“Partnerships are created by mere act of the parties; and in this they differ from corporations which require the sanction of state authority, either express or implied.”) (The Lawbook Exchange 2003) (1856). ↑
SeeUnif. P’ship Act. (1914) § 6(2); Rev. Unif. P’ship Act (1997) § 202(b); Del. Code Ann. tit. 6, § 15-202(b); Colo. Rev. Stat. § 7-64-202(1); Ky. Rev. Stat. Ann. § 362.175; id. § 362.1-202(2); Va. Code Ann. § 50-73.88(B). ↑
See Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59537:
In general, FinCEN believes that sole proprietorships, certain types of trusts, and general partnerships in many, if not most, circumstances are not created through the filing of a document with a secretary of state or similar office. In such cases, the sole proprietorship, trust, or general partnership would not be a reporting company under the final rule. ↑
FinCEN expects that these definitions mean that reporting companies will include (subject to the applicability of specific exemptions) limited liability partnerships, limited liability limited partnerships, business trusts, and most limited partnerships, in addition to corporations and LLCs, because such entities are generally created by a filing with a secretary of state or similar office.
(emphasis added).
In addition, pursuant to section 6502(d) of the Anti-Money Laundering Act of 2020, the U.S. Government Accountability Office is reviewing beneficial ownership requirements for trusts, partnerships, and other legal entities, and has made specific inquiries as to LLPs. Not once, not twice, but thrice in the proposed beneficial ownership information reporting regulations FinCEN referenced LLPs, but it then did not structure a definition of a reporting company that would include LLPs within its scope. SeeBeneficial Ownership Information Reporting Requirements, 86 Fed. Reg. 69920 at 69938–39 (proposed Dec. 8, 2021) (“In general, FinCEN believes the proposed definition of domestic reporting company would likely include limited liability partnerships, limited liability limited partnerships, business trusts (a/k/a statutory trusts or Massachusetts trusts), and most limited partnerships, in addition to corporations and limited liability companies (LLCs), because such entities appear typically to be created by a filing with a secretary of state or similar office.”); id. at 69946–47 (“In general, FinCEN believes the phrase ‘other similar entity created by the filing of a document with a secretary of state or similar office’ in the context of the definition of ‘domestic reporting company’ would likely include limited liability partnerships, limited liability limited partnerships, business trusts (a/k/a statutory trusts or Massachusetts trusts), and most limited partnerships, because such entities appear typically to be created by a filing with a secretary of state or similar office.”); id. at 69957 (“As noted above, the counts for Q6 may include general partnerships for some jurisdictions which may not be considered reporting companies; however, because they are grouped with limited partnerships and limited liability partnerships in this survey, FinCEN is retaining this number as part of its estimate.”). ↑
SeeRev. Unif. P’ship Act (1997) § 901(a) (“a partnership may elect the status of a limited liability partnership [by filing a statement of qualification with the state filing officer]”); see also Cal. Corp. Code § 16953(a) (“To become a registered limited liability partnership, a partnership, other than a limited partnership, shall file with the Secretary of State a registration, executed by one or more partners authorized to execute a registration, stating all of the following: . . . .”); Colo. Rev. Stat. § 7-64-1002(1) (“A domestic partnership governed by this article may register as a limited liability partnership . . . .”); 805 Ill. Comp. Stat. 206/1001(a) (“A partnership may become a limited liability partnership pursuant to this Section.”); Ind. Code § 23-4-1-45(a) (“To qualify as a limited liability partnership, a partnership under this chapter must file a registration with the secretary of state in a form determined by the secretary of state that satisfies the following: . . . .”); Ky. Rev. Stat. Ann. § 362.555(1) (“To become and to continue as a registered limited liability partnership, a partnership that is not a limited partnership shall file . . . .”); id. § 362.1-931(1) (“A partnership may become a limited liability partnership pursuant to this section.”); Md. Code Ann., Corps. & Ass’ns § 9A-1001(a) (“A partnership formed in accordance with an agreement governed by the laws of this State may register as a limited liability partnership by filing with the Department a certificate of limited liability partnership which sets forth: . . . .”); Mont. Code Ann. § 35-10-701(1) (“To become a limited liability partnership, a partnership shall file with the secretary of state an application for registration on a form furnished by the secretary of state that indicates an intention to register as a limited liability partnership under this section.”); Va. Code Ann. § 50-73-132(A) (“To become a registered limited liability partnership, a partnership formed under the laws of the Commonwealth shall file with the Commission a statement of registration as a registered limited liability partnership stating: . . . .”); 11 Vt. Stat. Ann. § 3291(a)(1) (“Any lawful partnership may become a limited liability partnership pursuant to this section.”). ↑
See supra notes 33 through 35 and accompanying text. ↑
See alsoHillman, Weidner & Donn, supra note 26. It bears noting that as it is the same partnership both before and after an election into LLP status is made, the election to be an LLP (and likewise the election to be a partnership that is not an LLP that is made when an LLP election lapses) is not a “conversion” as contemplated by certain business organization statutes including those permitting a partnership, LLP or otherwise, to convert into, for example, LLC form. Compare,e.g., Colo. Rev. Stat. § 7-64-1002 andDel. Code Ann. tit. 6, §15-1001 (dealing with registration of general partnerships to change their status to LLPs) withColo. Rev. Stat. § 7-90-201(a) andDel. Code Ann. tit. 6, § 15-901 (dealing with a conversion of a general partnership into another entity). Thus, FinCEN FAQ C.18 (October 3, 2024), which states, “Where a conversion does result in the creation of a new domestic reporting company, the new domestic reporting company is required to file an initial beneficial ownership information (BOI) report,” does not apply to the change of status whereby a general partnership acquires the status of LLP. ↑
See, e.g., Mudge Rose Guthrie Alexander & Ferdon v. Pickett, 11 F. Supp.2d 449, 452 n. 12 (S.D.N.Y. 1998) (commenting in footnote that the New York LLP statute “clearly enunciates that a general partnership that is registered as a RLLP is for all purposes the same entity that existed before registration and continues to be a general partnership under the laws of New York”) (citation omitted); Howard v. Klynveld Peat Marwick Goerdeler, 977 F. Supp. 654, 657 n.1 (S.D.N.Y. 1997), aff’d 173 F.3d 844 (2d Cir. 1999) (upon a partnership electing to become a limited liability partnership, “The partnership was not dissolved and continued without interruption with the same partners, principals, employees, assets, rights, obligations, liabilities and operations as maintained prior to the change. Thus, Peat Marwick LLP is in all respects the successor in interest to Peat Marwick.”); Sasaki v. McKinnon, 707 N.E.2d 9 (Ohio Ct. App. 1997) (“These two entities, E&Y and E&Y LLP are, but for the corporate change to a limited liability partnership designation, the same entities for all practicable intents and purposes.”); Maupin v. Meadow Park Manor, 125 P.3d 611 (Mont. 2005) (LLP is “same entity that existed before the registration”); Ex parte Haynes Downard Andra & Jones, LLP, 924 So. 2d 687, 699 (Ala. 2005) (an LLP “is for all purposes, except as provided in Section 10-8A-306 [not relevant to our inquiry], the same entity that existed before the registration and continues to be a partnership under the laws of this state . . . .” (citing Ala. Code § 10-8A-1001(i)); Riccardi v. Young & Young, LLP, 74 Misc. 3d 911, 915 (N.Y. Cohoes City Ct. 2022) (“An LLP is a general partnership which acquires limited liability characteristics upon registration with the secretary of state.”) (citation omitted). ↑
See, e.g., Accounting Firms Reorganize to Limit Liability, L.A. Times (Aug. 2, 1994). Of course it was not just accounting and law firms that adopted the LLP format. See, e.g., Jennifer Wong Suzuki, Limited Liability Partnerships for Firms, AIA California (“With the passage of Assembly Bill 469 (Cardoza) in 1998—one [of] the AIACC’s sponsored pieces of legislation—architects can now join accountants and lawyers in forming limited liability partnerships (LLPs).”). ↑
As recounted by the PEB in the first substantive paragraph of the report:
The location of an organization, as “location” is determined under U.C.C. § 9-307, plays an important role in determining the local law that governs perfection, the effect of perfection or nonperfection, and the priority of a security interest. See U.C.C. § 9-301(1). As a general matter, a “registered organization” is located, as determined under U.C.C. § 9-307(e), in the State under whose laws the organization is organized while an organization that is not a registered organization is considered under U.C.C. § 9-307(b)(2) to be located in the State in which the organization has its place of business.
According to the release accompanying the Reporting Regulations, “The number of legal entities already in existence in the United States that may need to report information on themselves, their beneficial owners, and their formation or registration agents pursuant to the CTA is in the tens of millions.” See Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59500 (citation omitted). The footnotes accompanying the quoted language sets forth FinCEN’s estimate “that there will be at least 32.6 million ‘reporting companies’ (entities that meet the core definition of a ‘reporting company’ and are not exempt) in existence when the proposed rule becomes effective.” Id.; see also id. at 59562. That same document goes on to state: “Summing the estimates of both domestic and foreign entities, the total number of existing entities in 2024 that may be subject to the reporting requirements is 36,581,506 and the total number of new companies annually thereafter is 5,616,382.” Id. at 59565 (citation omitted). ↑
This article is Part II 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.
Delaware has made clear that a standard integration provision has no impact on extra-contractual fraud claims based upon false statements of existing fact; instead what is required to defeat such a claim is a clause clearly disclaiming reliance upon any extra-contractual statements. We saw that requirement in action in Part I of this series.[1] But what about extra-contractual promissory fraud—that is, fraud premised upon a promise of future performance? Why shouldn’t an ordinary integration clause defeat any fraud claims premised on that extra-contractual promise? After all, the purpose of an integration clause is to bar parol evidence of alleged prior extra-contractual promises and agreements that are not contained in the written agreement.
In Shareholder Representative Services LLC v. Albertsons Companies, Inc.,[2] the Delaware Court of Chancery held that “[w]hile anti-reliance language is needed to stand as a contractual bar to an extra-contractual fraud claim based on factual misrepresentations, an integration clause alone is sufficient to bar a fraud claim based on expressions of future intent or future promises.”[3] According to the court, “[a]s distinguished from a claim of extra-contractual fraud based on a statement of fact, the fraud claim based on a ‘future promise’ amounts to an improper attempt to introduce ‘parol evidence that would vary the extant terms in the subsequent integrated writing.’”[4]
Recently, however, Vice Chancellor Laster, in Trifecta Multimedia Holdings, Inc. v. WCG Clinical Services LLC,[5] refused to follow the Albertsons decision. While promissory fraud may be based upon extra-contractual promises rather than extra-contractual statements of purported existing fact, it is still an extra-contractual fraud claim, not an effort to introduce an additional covenant into a fully integrated agreement. Indeed, promissory fraud is not a separate species of fraud at all. Promissory fraud actually involves more than a future intention to perform a promise; it involves a false statement of existing fact—the existing fact being the promisor’s existing intention to perform the future promise. Technically, promissory fraud is not based on “future intent” at all; it is based upon the present intent not to perform a future promise.
According to the Restatement (Second) of Torts, “[s]ince a promise necessarily carries with it the implied assertion of an intention to perform[,] it follows that a promise made without such an intention is fraudulent and actionable in deceit.”[6] And, as Lord Bowen famously said, “the state of a man’s mind is as much a fact as the state of his digestion. . . . A misrepresentation as to the state of a man’s mind [i.e., the present intent to perform a future promise] is, therefore, a misstatement of fact.”[7]
In Trifecta Multimedia Holdings, there was no disclaimer-of-reliance provision, only an integration clause. And the court ruled in favor of the sellers, who alleged that the buyers never intended to fulfill certain extra-contractual promises made in order to induce them into agreeing to an earnout.
Even more recently, in Fortis Advisors LLC v. Johnson & Johnson,[8] Vice Chancellor Will also rejected a party’s contention that an integration clause could defeat a promissory fraud claim. While recognizing the existence of prior Delaware authority suggesting otherwise, Vice Chancellor Will held that only “unambiguous anti-reliance language” is effective to defeat any extra-contractual fraud claim.[9] Vice Chancellor Will also noted that, in the prior cases holding otherwise, “the purported oral misrepresentations” about future promises “conflicted with the terms of the contracts.”[10] An anti-reliance clause is less relevant when the alleged extra-contractual misrepresentations conflict with express language in a fully integrated contract because “reliance upon an oral representation that is directly contradicted by the express, unambiguous terms of a written agreement between the parties is not justified as a matter of law.”[11]
Regardless of whether the extra-contractual statements are representations of existing fact or promises of future performance that are alleged to have never been intended to be performed (and therefore constitute representations of existing fact—i.e., the current intention to perform those promises), the only sure way to defeat those claims of extra-contractual fraud based on those statements is through a disclaimer-of-reliance provision.
And just as you cannot simply declare in a fraud definition that extra-contractual fraud is not fraud, the common practice of listing “promissory fraud” as something that is not considered fraud may not actually accomplish the desired result if your disclaimer-of-reliance provision does not affirmatively disclaim reliance on all extra-contractual statements made (whether they purport to be traditional statements of existing fact or future promises that carry with them representations of existing fact).
I frequently advise nonprofit clients on various legal issues that arise when an employer decides to separate an underperforming employee. Several variables impact the legal analysis, but, in all cases, I am interested in whether, and to what extent, the underperforming employee’s poor performance has been documented over time. How a client responds to that inquiry shapes my legal advice, sometimes favorably to the employer, and other times not. Quite simply, when an employer wishes to part ways with an underperforming employee, a robust record of performance deficiencies can significantly reduce—and in some instances, virtually extinguish—legal exposure for the employer.
How Do Performance Evaluations Reduce Risk Exposure?
With the exception of the chief executive, nonprofit employees in the United States tend to be employed “at will,” meaning that the employer can terminate them for any reason or no reason, except for an unlawful reason. To be clear, an employer cannot fire an employee for a discriminatory reason (race, sex, religion, sexual orientation, or another protected classification) or a retaliatory reason (taking protected leave, whistleblowing, or another protected activity), even if the employee is “at will.” With that as the basic guiding principle, how does an employer prove that it is taking an adverse action for a lawful reason, and not for a discriminatory or retaliatory reason? Consider the following illustration.
Let’s imagine that a little over a year ago, you hired Susie Slacker as a project manager. Slacker suffers from a chronic back condition, which for the purposes of this hypothetical scenario qualifies as a disability under federal and state law and necessitates that she schedule protected, intermittent leave. She coordinates the leave with your nonprofit’s HR department, and generally, this arrangement is not particularly disruptive to the nonprofit. What is disruptive to the nonprofit, though, is Slacker’s limited work ethic, nonresponsiveness, and lack of attention to detail. Without regret, Slacker chronically shows up late to work and to meetings (if she shows up at all), and her work product is often sloppy, containing numerous errors. Slacker often doesn’t respond to emails for days, or at all. Her colleagues are starting to complain, and you are concerned about Slacker’s member interactions, the quality of her work products, and the nonprofit’s reputation. After enduring these professional shortcomings for a full year, you decide that it is time to part ways with Slacker, and you call me for legal advice.
One of the first things I am going to ask you is this: “Has Slacker’s supervisor addressed the performance deficiencies with Slacker, and if so, how?” What I am hoping to hear is some variation of the following: “Slacker’s supervisor has consistently addressed the various professional shortcomings in accordance with nonprofit policy, first with two informal meetings, followed by a written warning and a performance improvement plan. Would you like to see documentation of those interactions?” When I hear any approximation of this response, any concerns I might otherwise have about legal exposure diminish significantly. Just as often, though, I learn that the performance concerns have not been documented at all, or even worse, that the only written documentation of the employee’s performance memorializes the employee’s positive contributions to the nonprofit over time, while completely ignoring the shortcomings. You need not be an employment lawyer to intuit that this is problematic.
But why? How does a lax performance evaluation implicate employment law? The answer lies at the intersection of employment law and discrimination law. Recall that an employer can terminate an at-will employee for any reason or no reason, but not for an unlawful reason such as discrimination or retaliation. To successfully prevail in a wrongful termination action that is predicated on claims of unlawful discrimination or retaliation, an aggrieved employee must prove that an unlawful motive prompted the termination. Of course, the employer will offer a legitimate business reason for the adverse decision—here, that Slacker underperformed over time—but the employee then gets another opportunity to prove that the purported legitimate reason was, in fact, pretext for discrimination or retaliation. For Slacker’s situation specifically, if there is no documented history of poor performance, she is well positioned to argue that the employer’s true reason for the termination was to punish her for taking protected leave for a qualifying disability. Even if Slacker is not savvy enough to manufacture this claim, an enterprising plaintiff’s attorney knows exactly how to leverage this fact pattern to negotiate a favorable severance package or settlement. Yet, there is no need to ever be in this scenario. Quite simply, documentation of performance deficiencies disincentivizes aggressive litigants, equips the nonprofit with a great deal of leverage, and serves as a compelling defense to any legal dispute that ultimately materializes.
Practical Advice for Supervisory Staff
Written performance evaluations are one of the best defenses an employer can produce in a wrongful termination situation to reduce legal exposure. With that in mind, here is some practical advice for supervisory staff:
Ensure that performance expectations are tethered to internal policies that have been communicated to the employee. A fundamental concept in employment law is “notice.” As a matter of fundamental fairness, an employee must be apprised of permissible and impermissible behavior. Typically, employers detail these expectations in employee handbooks, and often, as a best practice, these expectations are reinforced throughout the year, whether in staff trainings, in one-on-one supervisory meetings, or through some other medium. If you have not examined your policies and codes of conduct in a while, consider reviewing them to ensure that the policies as written align with your expectations of employee conduct. Also, make sure that each employee acknowledges that they have received and reviewed these documents as part of the employee onboarding experience, and annually thereafter or when the documents are revised, whichever is sooner.
Follow your progressive discipline policy. Most nonprofits describe a progressive discipline policy in an employee handbook (e.g., oral warning, written warning, probation, termination). Follow the policy to a tee. Deviations, no matter how small, may expose the nonprofit to “due process,” contract, tort, or disparate treatment claims.
Address poor performance in real time with underperforming employees. When an employee fails to meet expectations, candidly address professional shortcomings with the employee, along with discussing ways that the employee can either cure a discrete performance issue, or if that is not possible, perform better in the future. This puts the employee on notice of poor performance. Just as importantly, when confronted with clear expectations and a path forward, the employee may course correct, which tends to be a more optimal outcome, both financially and otherwise, than commencing a search and onboarding a new employee.
Document performance discussions in dated communications. After you meet with the employee to discuss performance deficiencies, document a summary of the conversation in a written format. An email suffices for minor infractions; a written warning on nonprofit letterhead or a formal performance improvement plan might be more appropriate for repeated infractions or more egregious violations (of course, in all instances following your internal policies and procedures, as discussed above). These communications should be dated to formally build a performance record over time. This written trail is particularly important to defend against retaliation lawsuits by showing that a pattern of performance deficiencies predated any protected activities.
Be candid. You must be candid in your employee evaluations. Nothing is more frustrating that counseling an employer through an employee separation where all of the underperforming employee’s evaluations specify that the employee “meets expectations.” Favorable evaluations are used as ammunition to show pretext. Using our hypothetical scenario as an example, Slacker’s counsel will address a jury with the following type of argument: “For five years, my client met all company expectations, as evidenced by the five employee evaluations you have as Exhibits A–E. Now, just after my client started taking protected leave, the nonprofit is saying for the very first time that she has not been meeting expectations. Why, then, do the written evaluations speak so favorably of my client? You will need to decide whether this brand-new and undocumented explanation is a cover-up—or what we call a ‘pretext’ for an unlawful action—or whether the nonprofit’s diametrically opposite and undocumented explanation is the truth.” As an employer, you do not want to be in that position (in fact, we would urge you to settle long before ever getting to this point), and there is no reason you ever have to be in this position. A truthful record, built over time and memorialized in writing, can insulate an employer from this kind of exposure.
Treat similarly situated employees similarly. Finally, and importantly, you must treat similarly situated employees similarly. Imagine that you decide to part ways with Slacker, but Larry Lackluster—who holds a similar position as a project manager at the nonprofit and has a performance history similar to Slacker’s—is simply given a written warning. You have just positioned the nonprofit for a sex discrimination lawsuit based on disparate treatment. In other words, two similar employees with similar titles, job functions, and performance deficiencies were treated differently, and the only apparent explanation is that Lackluster is a man and Slacker is a woman. As a matter of nondiscrimination and fundamental fairness, you must treat similarly situated employees similarly.
Conclusion
This article distills a complicated legal framework into a few short pages. Of course, many important considerations should inform an employer’s decision and approach when determining whether to separate an employee. Such considerations include the size of the nonprofit organization; federal, state, and local law; the employee’s protected characteristics, if any; employer policies; custom and practice; and much more. Legal counsel can advise on the technical nuances of any or all of these legal implications. Regardless of unique factual and legal circumstances, when separating with an underperforming employee, your nonprofit will be positioned much more favorably if a well-documented, robust performance history corroborates the rationale underlying the legitimate business decision to terminate an employee.
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