The energy industry is exploring a variety of technological innovations that will make energy cheaper, greener, and more reliable.* For instance, distributed energy resources, microgrids, and battery storage have the potential to fundamentally reshape energy markets. Blockchain is another such innovation that has garnered attention from utilities, energy electricity suppliers, prosumers, FinTechs, and other industry participants. Some of the buzz relates to blockchain’s potential to enable high-volume, peer-to-peer electricity transactions across the distribution grid. Industry participants also recognize blockchain’s advantages within traditional energy market structures, such as the potential efficiency gains from improving data traceability, integrity, and security and automating functions.
Advising clients on the costs and benefits of implementing blockchain solutions and their attendant regulatory challenges requires a basic understanding of the technology. To that end, this article provides a high-level overview of blockchain’s core technical components: cryptography, decentralization and consensus protocols, and distributed ledger.[1]
Baseline Concepts
Three baseline concepts will be helpful to keep in mind. First, blockchain is digital ledger technology. One definition of blockchain is distributed computing architecture through which every network node (or computer) executes and records the same transactions, and new transactions are grouped into blocks that reference prior blocks of transactions. In other words, blockchain is a computing code that groups information into blocks and records the information onto a digitized record in near real time that is accessible by multiple parties.
Second, there is no singular blockchain or application. Rather, blockchains can be developed for a variety of purposes and customized to record various data.
Third, blockchain and cryptocurrencies are not synonymous. Cryptocurrencies are a type of encrypted digital token that are used for payments.[2] Although transactions involving cryptocurrencies are recorded on a blockchain, a blockchain does not necessarily need a cryptocurrency to serve a useful function.
Cryptography: Public and Private Keys
Public key cryptography is a fundamental component of every blockchain. Every user of a particular blockchain has a “private key,” meaning a unique digital signature, and a “public key,” or a digital account identification number. These keys are a unique pair generated by an algorithm. As their names indicate, the public key is publicly disclosed (like a street address) but the private key is not (like a house key). Users verify the transactions they want to initiate over a blockchain by “signing” their transactions with their private key (meaning they combine their private and public keys, but the private key itself is not disclosed). A transaction is valid only if the private key that signs the transaction matches that user’s public key. Once a transaction is signed, the transaction will be broadcast to the blockchain’s decentralized network of nodes, or computer systems, to be verified via the network’s consensus protocol.
Decentralization (Peer-to-Peer) and Consensus Protocols
Blockchains generally are referred to as “decentralized,” or peer-to-peer, because no central entity acts as a trusted intermediary through which information flows and who is responsible for verifying transactions. Rather, a network of unassociated computers confirm transactions according to an agreed-upon verification standard.[3] Given that verification relies on a preset protocol, none of the people who operate a computer in the network need to trust or even know each other; they simply must trust the blockchain consensus mechanism. Once a transaction is initiated, the transaction is broadcast to the network and bundled into “blocks” with other transactions broadcast around the same time. Once a block is full, the block is converted into a unique set of letters known as a hash. Picture a piece of lined paper; each individual transaction takes up one line. Once all the lines are full, the piece of paper is deemed a unique unit, and that unit is given a short name.
One computer that is part of the network will be chosen randomly to apply the rules of the network’s preset verification standard, known as a consensus protocol, to determine whether each transaction has the correct combination of private and public keys. That computer will then relay its work to the network for verification. If the network agrees on which transactions contain appropriately matched key pairings, the blocks containing those transactions are approved. Upon approval, those blocks will be recorded on the blockchain, making them a part of the transaction history of that blockchain. Blockchains are referred to as immutable because all new information must be consistent with all previously confirmed information, which makes manipulating the record by changing past data points a laborious, expensive, and nearly impossible (under most circumstances) proposition.[4]
Entities that operate computers in the network are compensated for their work with either transaction fees paid by the entities initiating the transaction, or by receiving a unit of a digital asset generated by the underlying blockchain’s algorithm. The process of confirming transactions has a different name based on the nature of the consensus protocol. For instance, nodes on the Bitcoin blockchain are called “miners” because they receive newly released Bitcoins in exchange for confirming transactions. The consensus protocol used is called “Proof-of-Work” because each computer must conduct difficult computations to verify blocks. Although there are varieties of consensus protocols and reward structures, the key point is that many computers operated by people who do not need to know or trust each other are able to verify transactions among two or more parties by checking transactions against a preset verification standard.
Distributed Ledger
Finally, blockchains are distributed ledgers. Every computer that is part of a blockchain’s network has access to the entire record of that blockchain.[5] Thus, the blockchain is distributed rather than controlled by a select recordkeeper or group of recordkeepers. Not every computer must have the same level of access to the data, however. For example, settings can be put in place so that certain industry participants, such as purchasers and sellers of electricity, could add information by initiating transactions, whereas others, such as regulators, could review only the information that has already been verified. Given that the same data is shared with multiple unrelated entities, it is difficult for any single entity or group of entities to alter the data without the other participants noticing. By combining these features, blockchains create a shared, immutable record of transactions that is updated and maintained without reliance on any particular third party.
Other Important Concepts: Public Versus Permissioned Blockchains, and Smart Contracts
Two other important concepts to keep in mind are the distinction between public and permissioned blockchains, and smart contracts. Blockchains are decentralized and distributed, but they do not necessarily need to be public records. A public blockchain is a blockchain that allows anyone to join the network and to access its data. The Bitcoin blockchain is the most famous example of a public blockchain. Anyone can download the blockchain and, by doing so, access the full history of its data and help confirm transactions.
On the other hand, many other blockchains, particularly enterprise blockchains, are permissioned. Only entities that are granted access to a permissioned blockchain can access its data and confirm transactions. Permissions can be customized to restrict what data a user can access or whether that user can add data. Data privacy is also handled differently between these types of blockchains. In public blockchains, the parties’ identities are anonymous or pseudonymous, but the details of a transaction are often public. Permissioned blockchains generally adopt the opposite privacy features, with known parties transacting on a private ledger.
Smart contracts are programmable computer code that modify information on a blockchain automatically once specific conditions are met. In essence, they are if-then statements that can be programmed to update a blockchain based on events. For instance, two parties could write a smart contract that would transfer automatically a certain sum of money from one party to another on a certain day or once a claim is settled, and that information would be recorded to the blockchain. Smart contracts can be written with technical code or natural language, depending on their purpose and the underlying blockchain system.
Conclusion
The energy industry has been and will continue to explore various use cases for blockchain, experimenting with different parameters and consensus protocols to capture efficiency gains and adapt to the shifting marketplace. Understanding the fundamentals of the technology will enable lawyers to counsel to clients effectively as they consider whether to integrate blockchain into their day-to-day operations.
* Daniel Cohen is an associate with K&L Gates, LLP, in Washington, D.C. His practice focuses on regulatory compliance counseling and government affairs representation for blockchain-based platforms, payment companies, and financial institutions. He thanks Buck Endemann and Ben Tejblum for their comments and insight.
[1] For an in-depth discussion of blockchain’s technical aspects and its existing and potential use cases, see Buck Endemann, Ben Tejblum, Daniel S. Cohen, et al., Energizing the Future with Blockchain, 39 Energy L. J. 197 (2018). This article will not delve into more advance concepts, such as hashing, or the various types of consensus protocols, among others.
[2] They are also referred to as virtual currencies. Encrypted digital tokens can serve other functions; for instance, they can represent a security, commodity, or act as a prepaid instrument such as a gift certificate. In the energy industry, some companies have created digital tokens to represent available electricity for sale. Regardless of their function, the digital tokens are recorded onto a blockchain.
[3] However, in practice, individuals and companies often join together, forming “pools” in order to share the rewards for confirming transactions. Fundamentally, blockchains are not operated by a centrally controlled entity, unlike bank accounts, for instance.
[4] A public blockchain known as Ethereum Classic was hacked in January 2019 by an attack from entities that controlled a majority of the computing power of the network. Ethereum Classic used the proof-of-work protocol, which requires significant computing power to confirm transactions. To date, significantly larger networks that use proof-of-work, such as Bitcoin, and large blockchains that use other consensus protocols have not been hacked directly.
[5] For some blockchains, nodes have access to only a select portion of the transaction history in order to reduce the amount of data processing required. This feature of a blockchain can be customized to meet the users’ needs.
When one thinks about the dynamics of a trust created by agreement (at its most basic level) and the normal progression of its creation and administration, there typically are several parties that are thought to be integral to the entire structure. Most notably, these are the grantor (or settlor), the trustee, and the beneficiaries. Once the trust is created and funded by the grantor, the trustee is charged with managing the assets of the trust in accordance with the express provisions of the trust agreement for the benefit of the beneficiaries. If the trustee mismanages the trust assets or takes some action that is not in the interests of the beneficiaries, those beneficiaries (or someone acting on their behalves) may bring an action against the trustee to enforce the terms of the trust and seek a remedy. Under this traditional trust framework, a trust without a beneficiary would not be enforceable. As a consequence, courts historically refused to permit such arrangements unless the trustee was willing to carry out the purpose of the trust, thus honoring a trust-like relationship that otherwise would have failed as a traditional trust (this trust-like relationship commonly is referred to as an “honorary trust”).[2]
Given that honorary trusts do not have an identifiable beneficiary, they exist merely to further the purpose for which they were created. Accordingly, honorary trusts are closely related to a traditional charitable purpose trust, which generally is a trust created for the support of religious, educational, scientific, artistic, and similar endeavors. Charitable purpose trusts can be formed for a general charitable purpose or to support a specific beneficiary, which beneficiary could at times be subject to change so long as the charitable purpose of such trust is left intact.[3] Traditionally, the honorary trust and the charitable purpose trust were the only two avenues by which a grantor could advance a cause other than the support of an identifiable beneficiary.
Although the honorary trust doctrine was occasionally applied in England[4] and eventually in the United States,[5] honorary trusts were far less common historically than charitable purpose trusts. Typically, an honorary trust was created for the care of burial plots, the care and maintenance of animals, and the saying of masses.[6] Slowly, as honorary trusts for the pursuit of certain noncharitable purposes became more routine, various jurisdictions around the country, including Delaware, began to pass statutes to specifically allow for their creation as noncharitable purpose trusts.[7] However, it was not until the release by the Uniform Law Commission of the Uniform Trust Code (UTC) in 2000 (and its subsequent adoption in one form or another by 35 states) that a wider array of noncharitable purpose trusts became permissible as a matter of statutory law.
II. The Delaware Purpose Trust Statute
The two fundamental guideposts in Delaware’s law governing the creation and administration of common law trusts (Delaware Trust Law)[8] is that maximum deference will be afforded to the intent of the settlor, and that the settlor has contractual freedom to reflect this intent in the governing documents of the trust. Section 3303(a) of Title 12 of the Delaware Code provides that “[i]t is the policy of this section to give maximum effect to the principle of freedom of disposition and to the enforceability of governing instruments.” Similarly, that section also provides that “a governing instrument may expand, restrict, eliminate, or otherwise vary any laws of general application to fiduciaries, trusts, and trust administration.”
Governed by these two concepts, Delaware has a long history of providing settlors with the tools necessary to create the trusts that suit their needs. To this end, Delaware has adopted a robust noncharitable purpose trust statute. Delaware’s statute, 12 Del. C. § 3556 (the Delaware Purpose Trust Statute), gives greater freedom for settlors to customize their noncharitable purpose trusts. Unlike the more restrictive provisions of the UTC adopted by many states, the Delaware Purpose Trust Statute does not contain a limitation on the duration of noncharitable purpose trusts, and provides that such trusts are valid so long as they contain a declared purpose that is “not impossible of attainment.” By contrast, the noncharitable purpose trust provisions under section 409 of the UTC provide that such trusts are valid only for a period of 21 years. Furthermore, the official comment to section 404 of the UTC, discussing permissible purposes for all types of trusts, provides that a noncharitable purpose trust must have a purpose that is not frivolous or capricious. The Restatement (Third) of Trusts, referenced in the official comment to section 404 of the UTC, implies that a trust may be considered capricious if it does not satisfy “a desire that many (even if not most) people have with respect to the disposition of their property[,]” or if an “unreasonably large” amount of the property is devoted to the trust’ purpose.[9] According to this language, for example, a perfectly reasonable purpose could be invalidated simply for being over funded, or a reasonably funded trust could be invalidated because a purpose important to the settlor could be deemed frivolous by others.
However, given that the focus of Delaware Trust Law is on the subjective intent of the individual settlor with regard to the disposal of his or her property—not the objective standards of “many (even if not most) people”—the Delaware legislature saw these restrictions in the UTC as unnecessarily limiting. The intent behind the Delaware Purpose Trust Statute was to put all purpose trusts, charitable and noncharitable, on equal footing. Settlors of charitable purpose trusts have long enjoyed deference to their stated purposes and unrestricted timeframes in which to apply the assets of their trusts, and the Delaware Purpose Trust Statute affords settlors of noncharitable purpose trusts with these same benefits. An individual has an infinite number of creative ways to dispose of or apply his or her individually owned property, whether for charitable purposes or otherwise, and a settlor’s right to do so is a basic premise of Delaware Trust Law.
In addition, fiduciary responsibilities may be altered under Delaware Trust Law (and in some cases eliminated)[10] if necessary to promote the declared purpose in the trust agreement. The opportunity to divide roles and responsibilities among trustees provides flexibility to allow the trustees to handle the trust assets and carry out the stated purpose of the trust as intended by the settlor. This facet of trust administration, along with many others, can be uniquely tailored to fit the requirements of each situation.
The flexibility of the Delaware Purpose Trust Statute, coupled with the foundation of freedom of contract underlying Delaware Trust Law, provides a powerful platform for settlors to create trusts that may successfully carry out their unique, noncharitable purposes.
III. Facebook Is Utilizing Delaware Law to Support Its Unique Goals
Facebook, Inc. (Facebook), from its inception on the campus of Harvard and throughout its growth into a social media leader, has consistently striven to uphold the values of free speech and freedom of expression. However, Facebook also understands that “there are times when speech can be at odds with authenticity, safety, privacy and dignity.”[11] Realizing the need to balance the rights of all of its users, including users of Instagram, and in an effort to address these competing concerns head on, Facebook is using the Delaware Purpose Trust Statute (in conjunction with the Delaware Limited Liability Company Act (the Delaware LLC Act[12]) to create and operate a social media content review “Oversight Board.” Generally, it is Facebook’s intent that members of the Oversight Board will review appeals regarding user content decisions by Facebook. The decisions of the Oversight Board with respect to such appeals will be binding on Facebook and its users. In addition to conducting this content review, the Oversight Board will also issue policy advisory opinions regarding Facebook’s policies governing content on Facebook and Instagram.[13]
Although Facebook could easily create and operate the Oversight Board within its existing corporate framework, this approach likely would not provide the level of independence necessary to balance the interests of each party involved in a content dispute, including Facebook itself. As a result, Facebook sought an alternative approach that would allow the company to create a truly independent body to “ensure fair decision-making based on standards and values.”[14] Enter the Delaware Purpose Trust Statute.
Specifically, utilizing the Delaware Purpose Trust Statute, Facebook has created and funded a trust, known as the Oversight Board Trust (the Trust), with the following stated purpose:
to facilitate the creation, funding, management, and oversight of a structure that will permit and protect the operation of an Oversight Board for Content Decisions (the “Oversight Board” or “Board”), whose purpose is to protect free expression by making principled, independent decisions about important pieces of content and by issuing policy advisory opinions on Facebook’s content policies.[15]
Facebook’s intent is to create a lasting benefit for those in the worldwide community who engage with one another through Facebook’s platforms. Although there is a broad range of individuals and entities that will be impacted by and benefit from the stated purpose of the Trust, it would be impossible to consider all Facebook users as beneficiaries of the Trust, and a traditional trust structure would therefore not be appropriate. Although Facebook’s overarching goal is to improve social interaction for the collective good of all its users, providing independent review of appealed content for an entity such as Facebook would not be labeled as a traditional “charitable” purpose (i.e., a religious, educational, scientific, artistic, or similar purpose). As a result, a noncharitable purpose trust under the Delaware Purpose Trust Statute is the perfect tool to realize Facebook’s vision.
Before delving more deeply into the details of the creation and operation of the Oversight Board and the Trust, it is important to examine the basic overall structure employed by Facebook. The Trust is a Delaware purpose trust created and funded by Facebook pursuant to the Delaware Purpose Trust Statute, and the Trust will serve as the main source of funds needed to facilitate the operations of the Oversight Board. The Trust is irrevocable and is treated as a grantor trust for federal income tax purposes. Pursuant to the Delaware LLC Act, the trustees of the Trust (the Trustees) have formed and, collectively, on behalf of the Trust, will be the member of a single-member Delaware limited liability company (the LLC) that will be managed by a corporate manager (the Corporate Manager) and one or more individual managers (the Individual Managers, and together with the Corporate Manager, the Managers).
The LLC will enter into a service agreement to provide the above-discussed content review services to Facebook. These services ultimately will be performed by the Oversight Board pursuant to contracts between the LLC and the members of the Oversight Board. The Oversight Board will consist of a diverse set of members with a broad range of knowledge, competencies, diversity, and expertise.[16] In addition, the members of the Oversight Board must not have any actual or perceived conflicts of interest (such as being affiliated with Facebook or any of the Trustees) and should be familiar with “matters relating to digital content and governance, including free expression, civic discourse, safety, privacy and technology.”[17]
With respect to the funding and operation of the LLC, and ultimately the Oversight Board, the Individual Managers will serve as distribution direction advisers of the Trust pursuant to 12 Del C. § 3313 (and Facebook will additionally serve as an adviser pursuant to section 3313 by exercising consent rights in connection with certain actions of the Trustees, including regarding the investment of the Trust’s assets). The Individual Managers are also involved with the retention of the members of the Oversight Board and the facilitation of the Oversight Board’s content review process. As described in greater detail below, the Individual Managers will directly monitor and, when appropriate, replace the Oversight Board members, helping to ensure separation between Facebook and the Oversight Board and promote the independence of the Oversight Board’s decisions.
Currently, the Trustees are composed of a corporate Trustee (the Corporate Trustee) and one initial individual Trustee (the Individual Trustee). Facebook has the ability to appoint additional Individual Trustees, and once there are at least three serving, the number of Individual Trustees shall always be at least three and no more than 11. The Corporate Trustee may serve indefinitely, and each Individual Trustee will generally serve for a five-year term that will automatically be extended for an additional five years if such Trustee does not resign or is not removed. There is no limit to the number of terms an Individual Trustee may serve. The Individual Trustees have the ability to remove the Corporate Trustee by super-majority vote (greater than 66 percent), and the Corporate Trustee has the authority to remove any one or more of the Individual Trustees, provided that the other Individual Trustees consent to such removal by majority vote.
Although the Trustees generally have full authority to administer the Trust and carry out its stated purpose, as mentioned above, the Trust also takes advantage of section 3313 of the Delaware Trust Law, which permits the use of direction and consent advisors in connection with the administration of a Delaware trust.[18] For example, the Corporate Trustee has the responsibility under the Trust to invest the Trust’s assets in a manner that best facilitates the purpose of the Trust, but does so jointly with an investment committee (the Investment Committee) established under the Trust. The Investment Committee is composed of at least three Individual Trustees who are appointed by a majority vote of all of the Individual Trustees. In addition, distributions from the Trust shall be made only upon the direction of certain Managers of the LLC. Distributions that are necessary for the general administration of the LLC (such as to cover insurance premiums, attorney’s fees, accountant’s fees, investment counsel fees, tax payments, service provider fees, etc.) shall be made by the Corporate Trustee as directed by the Corporate Manager of the LLC. Distributions needed to cover expenses directly related to the operations of the Oversight Board, including compensation of Oversight Board members, reimbursement of Oversight Board member expenses, employment of staff to support the Oversight Board, and rent and other office-related expenses, shall be made by the Corporate Trustee as directed by the Individual Managers of the LLC.
In an effort to provide further clarity as to the roles and responsibilities that are allocated among the Trustees, the Trust incorporates the concept of an excluded trustee as permitted under 12 Del. C. § 3313A. Where the settlor of a trust wants to grant certain powers exclusively to only one of multiple co-trustees, the associated fiduciary responsibility rests solely on the trustee who has been exclusively granted the power in question. The nonauthorized excluded trustees are not liable for any loss or other claim stemming from the exercise of such power. Under the terms of the Trust, the Corporate Trustee shall also act as Individual Trustee for a limited period of four months from the effective date of the Trust. However, following the expiration of the four-month period, the Corporate Trustee will be an excluded trustee under 12 Del. C. § 3313A(a)(2) with respect to all matters requiring the action of the Individual Trustees, Investment Committee, Facebook as settlor, or other fiduciaries.
This division of investment and distribution powers among various advisors and fiduciaries is common in modern Delaware trusts for the benefit of individual beneficiaries. However, the unique approach described above utilizes the Managers of the LLC (who are tasked with the role of furthering the purpose of the Trust and are in the best position to determine the capital needs to fund such purpose on a daily basis) to direct contributions from the Trust in a manner similar to a capital call. In order to ensure the availability of assets for continued operations of the LLC, Facebook has included an initial conservative investment mandate regarding the Trust assets. The investments may be changed by the Corporate Trustee and Investment Committee provided that Facebook gives consent. Although a prudent investor rule normally applies to investment decisions by trustees, which may prompt a less conservative approach under other circumstances, this standard is waived under the Trust.[19] The ability to craft these unique provisions derives, in part, from the freedom of contract principle that is integral to both Delaware Trust Law and the Delaware LLC Act.[20]
As mentioned, the LLC (formally known as Oversight Board LLC) is managed by one Corporate Manager and one or more Individual Managers. Each Individual Trustee shall serve as an Individual Manager of the LLC. The Corporate Manager may be the Corporate Trustee but also may be another individual or corporate entity as selected by the Corporate Trustee. In addition, the Corporate Manager may appoint a “Director of LLC Administration” to assist in carrying out its duties. Other positions may be created and filled by the Managers to effectuate the purpose of the LLC as the Managers deem fit.
The Corporate Manager and the Director of LLC Administration shall undertake the following tasks:
Management of Finances. The Corporate Manager shall manage all finances of the LLC.
Payment of Service Providers. The Corporate Manager, or the Director of LLC Administration if one is appointed, may engage the services of accountants, payroll providers, investment counsel, travel service providers, insurance providers, and other professional advisors as necessary to facilitate the ongoing operations of the LLC. Each Manager is also authorized to hire agents, advisors, attorneys, or other counsel to assist the Manager in carrying out the business of the Company or the duties of the Manager, and such costs shall be paid by the LLC as directed by the Corporate Manager.
As discussed above, the main responsibility of the LLC is to support the Oversight Board in furtherance of the purpose of the Trust. The “Director of the Oversight Board” is appointed by the Individual Managers and may be removed, with or without cause, by majority vote of the Individual Managers. This is a required position and must be filled at all times. The Director of the Oversight Board shall have authority to take action on behalf of the Individual Managers as such authority is delegated from the Individual Managers. With respect to the operations of the Oversight Board, the Individual Managers and the Director of the Oversight Board shall undertake the following tasks:
Enter into Oversight Board Member Contracts. After the selection of the individual Oversight Board members, the Director of Oversight Board may enter into a contract with each such individual to provide services as an Oversight Board member according to terms that are suggested by the Individual Managers and the Oversight Board. However, the ultimate contract provisions must be approved by the Director of Oversight Board (subject to the consent of Facebook solely with respect to provisions dealing with Facebook data). These Oversight Board member contracts shall be for a three-year term, with two potential renewals for a maximum term of nine years.
Enter into Service Agreements with Facebook. The Individual Managers may authorize the LLC to enter into agreements with Facebook to provide content review and moderation services, which shall be negotiated and executed by the Director of Oversight Board based on recommendations from the Individual Managers and the Oversight Board.
Annually Certify Oversight Board Member Activities. The Individual Managers shall annually certify to the Corporate Manager that each Oversight Board member has satisfactorily performed the obligations under his or her contract, or proceed with removal if warranted.
Remove Oversight Board Members. The Individual Managers, with the consent of the Individual Trustees, may terminate any contract of an Oversight Board member, or decide not to retain such member, if it is determined that he or she has not satisfactorily performed his or her obligations.
Direct Compensation and Other Payments for Oversight Board Members. As discussed previously, the Individual Managers may direct the Corporate Trustee to make contributions to the LLC for the purpose of compensating the Oversight Board members or reimbursing Oversight Board members for expenses under the terms of their contracts.
Provide for Miscellaneous LLC and Oversight Board Member Expenses. The Individual Managers and the Director of Oversight Board have the authority to direct the Corporate Manager to pay on behalf of the LLC other miscellaneous LLC and Oversight Board member expenses not otherwise covered under a service contract.
Employ Staff. The Director of Oversight Board may employ staff to provide general support to the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover the costs associated with such employees.
Provide for an Office and Office Expenses. The Director of Oversight Board may secure reasonable office space and acquire office supplies and equipment to facilitate the ongoing operations of the LLC and the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover rent and other office-related expenses.
Provide for Research or Related Services. The Director of Oversight Board may engage research and other related services to support the functions of the Oversight Board. The Individual Managers shall direct the Corporate Manager to make payments on behalf of the LLC to cover the costs of such services.
In an effort to create and fund an independent body to weigh the sometimes competing interests inherent in public discourse, Facebook has capitalized on Delaware’s policy of freedom of contract to craft the creative structure described above. The flexibility of Delaware Trust Law and the Delaware LLC Act has allowed Facebook to carry out its purpose to provide additional transparency and clarity to its users with respect to content decisions and policies.
[1] Vincent C. Thomas is a partner, and Justin P. Duda and Travis G. Maurer are associates, with the law firm of Young Conaway Stargatt & Taylor, LLP, in Wilmington, Delaware. The authors are grateful for the insights of Glenn G. Fox, Esq. and Rodney W. Read, Esq., both of the law firm of Baker & McKenzie LLP, as well as Elizabeth King, Aileen C. Denne-Bolton, and Edward Devine of Brown Brothers Harriman & Co.
[2] George G. Bogert et al., The Law of Trusts and Trustees § 166 (3d ed. Supp. 2019).
[3] A change of charitable beneficiary is accomplished through the doctrine of cy pres. For a further discussion of court modification of charitable beneficiaries under the doctrine of cy pres to achieve the settlor’s intent, see Restatement (Third) of Trusts § 67 cmt. e (Am. Law Inst. 2003).
[4] Bogert et al., supra note 2, § 166 (citing In re Dean, 1889, 41 Ch. D. 552 (care of animals); Mussett v. Bingle, W.N. (1876) 170 (building of monuments); Reichenbach v. Quinn, 21 L.R.Ir. 138 (for the saying of religious masses); In re Thompson, (1934) 1 Ch. 342 (to support fox hunting)).
[5]In re Searight’s Estate, 95 N.E.2d 779, 782 (Ohio Ct. App. 1950).
[6] Restatement (First) of Trusts § 124 (Am. Law Inst. 1935).
[7] For example, some states to adopt statutes allowing noncharitable purpose trusts include Wisconsin (Wis. Stat. § 701.11; honorary trusts, enacted in 1969 and repealed in 2014 with passage of UTC provisions), Montana (Mont. Code Ann. § 72-2-1017; honorary trusts and trusts for animals, enacted in 1993), Colorado (Colo. Rev. Stat. § 15-11-901; honorary trusts and trusts for animals, enacted in 1995), New York (N.Y. Est. Powers & Trusts Law § 7-8.1 (formerly § 7-6.1); trusts for pets, enacted in 1996) and Alaska (Ala. Stat. § 13.12.907; honorary trusts and trusts for pets, enacted in 1996).
[8] Generally, this refers to chapters 33 and 35 of title 12 of the Delaware Code and Delaware’s common law regarding the creation and administration of Delaware trusts.
[9] Restatement (Third) of Trusts § 47 cmt. e (Am. Law Inst. 2003).
[10] Although this is particularly helpful in the context of a purpose trust, Delaware Trust Law allows for altered fiduciary responsibilities in all trust instruments. It is possible to completely exclude a trustee from taking certain actions (and from the liability associated with those actions) under 12 Del. C. § 3313A.
[19] Altering the prudent investor rule is specifically authorized under 12 Del. C. § 3302(e).
[20]See 6 Del. C. § 18-1101. The Delaware LLC Act allows the Managers’ duties to be expanded, restricted, or altered as necessary under the LLC’s operating agreement, provided, however, that the covenant of good faith and fair dealing shall not be eliminated.
The Bankruptcy Code[2] contains a number of so-called ipso facto provisions that invalidate contractual provisions triggered by the bankruptcy filing or insolvency of the debtor.[3] Moreover, even where one of the ipso facto provisions is not applicable, courts have long held that it is contrary to federal public policy for a debtor to waive its right to seek relief under, or the protections set forth in, the Bankruptcy Code. Indeed, provisions prohibiting debtors from availing themselves of the bankruptcy laws—laws so seminally important that they were specifically authorized under the Constitution—are almost always deemed unenforceable.[4]
Bankruptcy law is equally clear, however, that state corporate law and corporate formalities govern the process for determining whether a bankruptcy filing was duly authorized. Given that limited liability companies are “primarily creatures of contract,” state law strongly favors enforcement of provisions in operating agreements and other governing documents.[5] As such, and as demonstrated by the cases discussed in this article, provisions contained in limited liability company governing documents that set limitations on the company’s ability to file a bankruptcy case raise challenging issues for judges and practitioners alike.
Seizing on this, lenders in recent years have become more creative in seeking to reduce or eliminate their bankruptcy risk. A common approach is to create what effectively becomes a bankruptcy-remote limited liability company by obtaining, either directly or through a nominee, a so-called golden share or membership interest in their borrower. Contemporaneously, the lender insists that its borrower incorporate various blocking provisions into their operating agreement such that it can utilize a bankruptcy approval requirement to effectively preclude a bankruptcy filing. As described by one bankruptcy court, this strategy was recently “created by the credit community in an attempt to work around the prohibition against an entity contracting away the right to file bankruptcy.”[6]
This is an article in two parts. Part one will discuss the applicable law regarding eligibility to file generally, case law prohibiting advance bankruptcy waivers, and case law where courts have nevertheless held that operating agreement provisions setting limits on the authority of members or managers to file a bankruptcy case are generally enforced. Part two will discuss the recent string of cases dealing with so-called golden share provisions and how courts have dealt with the difficult issue of blocking provisions in favor of creditors set forth in limited liability company operating agreements.
Eligibility to File Generally
Section 109(a) permits any “person” to file a bankruptcy petition,[7] and the statute defines “person” to include individuals, partnerships, and corporations.[8] The term “corporation” is defined in the Bankruptcy Code to include a “partnership association organized under a law that makes only the capital subscribed responsible for the debts of such association” and an “unincorporated company or association.”[9] It is now generally acknowledged that a limited liability company is a “corporation” for bankruptcy eligibility purposes and therefore is a “person” eligible for relief under the Bankruptcy Code.[10]
Advance Bankruptcy Waivers Are Unenforceable as a Matter of Federal Public Policy
Courts almost universally agree that the right to file a petition in bankruptcy is fundamental and cannot be waived. This antiwaiver principle is not found anywhere in the Bankruptcy Code. Rather, it has long been the law that agreements promising not to file for bankruptcy or prospectively waiving substantive bankruptcy rights are unenforceable because of the strong public policy favoring access to bankruptcy relief.
In one early case, In re Weitzen,[11] the District Court for the Southern District of New York held that a contractual agreement to waive the benefit of bankruptcy is unenforceable. “To sustain a contractual obligation of this character,” the court explained, “would frustrate the object of the Bankruptcy Act. . . .” In Fallick v. Kehr,[12] the Second Circuit Court of Appeals noted in dictum that advance agreements to waive the benefits of bankruptcy are void. Similarly, in In re Gulf Beach Dev. Corp.,[13] the Bankruptcy Court for the Middle District of Florida held “the Debtor cannot be precluded from exercising its right to file Bankruptcy and any contractual provision to the contrary is unenforceable as a matter of law.”
Given that the Bankruptcy Code does not have any provisions directly on point, courts frequently rely on public-policy grounds for denying bankruptcy waivers. For example, in In re Huang,[14] the Ninth Circuit Court of Appeals noted: “It is against public policy for a debtor to waive the . . . protection[s] of the Bankruptcy Code.” Similarly, in In re Tru Block Concrete Prods., Inc.,[15] the Bankruptcy Court for the Southern District of California noted: “It is a well settled principal that an advance agreement to waive the benefits conferred by the bankruptcy laws is wholly void as against public policy.” In addition, in In re Madison,[16] the Bankruptcy Court for the Eastern District of Pennsylvania held that a prepetition agreement to waive a debtor’s right to file further bankruptcies within 180 days from the filing of the debtor’s last bankruptcy petition was unenforceable because it violated public policy.
Courts frequently have a similarly harsh reaction to prebankruptcy agreements that waive specific benefits of bankruptcy, such as the automatic stay or the right to a discharge. In In re Shady Grove Tech Ctr. Assocs. L.P.,[17] the Bankruptcy Court for the District of Maryland held: “self-executing clauses in pre-petition agreements purporting to provide that no automatic stay arises in a bankruptcy case are contrary to law and hence unenforceable, and . . . self-executing clauses in prepetition agreements . . . to vacate the automatic stay are likewise unenforceable.” Similarly, in In re Pease,[18] the Bankruptcy Court for the District of Nebraska held: “I conclude that any attempt by a creditor in a private pre-bankruptcy agreement to opt out of the collective consequences of a debtor’s future bankruptcy filing is generally unenforceable. The Bankruptcy Code pre-empts the private right to contract around its essential provisions, such [as] those found in 11 U.S.C. § 362.” Finally, in In re Cole,[19] the Bankruptcy Appellate Panel for the Ninth Circuit held: “a state court stipulated judgment where the debtor waives his right to discharge is unenforceable as against public policy.”
Underlying all of these holdings is the concept that business bankruptcy reorganization laws further the economic policy of preserving viable operating entities not only for the benefit of their owners, but also for their customers, suppliers, employees, and society as a whole. If advance bankruptcy waivers were enforceable, the logical result would be that such waivers would become commonplace in all loan agreements.[20] The effect would be to effectively close the doors of the bankruptcy courts to all parties who do business with sophisticated lenders. The negative consequences of such a result to the national economy and local communities could be substantial.
Operating Agreement Provisions Setting Limits on the Authority of Members or Managers to File a Bankruptcy Case Are Generally Enforced
Notwithstanding the foregoing, operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are generally enforced. Courts enforcing such provisions make a distinction between waivers of the right to file bankruptcy, and members voluntarily agreeing among themselves that authority to file a bankruptcy shall not exist absent satisfaction of certain conditions precedent.
State law determines who has the legal right to sign and file a bankruptcy petition on behalf of an entity. In fact, the U.S. Supreme Court has determined that “[t]he authority to file a bankruptcy petition must be found in the corporation’s instruments and in applicable state law.”[21] As such, courts have held that a bankruptcy case filed on behalf of an entity by one without requisite authority under state law is improper and must be dismissed for, among other reasons, lack of jurisdiction.[22]
State limited liability company statutes generally do not expressly prescribe whether members or managers have the power to file a bankruptcy petition. As such, the authority determination almost always requires an analysis of the terms of the limited liability company’s operating agreement.[23] Limited liability companies are “primarily creatures of contract.”[24] Therefore, great deference is given to provisions contained in operating agreements and other governing documents agreed upon by the members.
Given this great deference, it has been determined that “the long-standing policy against contracting away bankruptcy benefits is not necessarily controlling when what defeats the rights in question is a corporate control document.”[25] Provisions in limited liability company operating agreements that require certain approvals or unanimous consent by managers or members before filing a bankruptcy petition are frequently enforced. For example, in In re Avalon Hotel Partners, LLC,[26] the limited liability company operating agreement required 75-percent member approval for certain “major decisions.” Although bankruptcy was not specifically listed as an event triggering the “major decision” clause, the bankruptcy court easily reached the conclusion that a bankruptcy filing fell within the scope of that provision and, thus, imposed the 75-percent requirement.[27]
When the contractual provision at issue gives lenders an explicit voice in the filing of a bankruptcy petition, the analysis becomes far more complex. Nevertheless, as highlighted by the two cases discussed below, where a lender is acting in its capacity as a member, as opposed to a creditor, such provisions may well be enforced.
In re Global Ship Systems, LLC. In In re Global Ship Systems,[28] the debtor’s operating agreement established a lender as a “Class B Shareholder.” The Class B Shareholder interest consisted of approximately 20 percent of the equity of the company. The debtor’s operating agreement provided that the filing of a voluntary bankruptcy by the limited liability company required the consent of the Class B Shareholder. The lender would not consent to a filing. Therefore, in order to avoid the consent requirement under the operating agreement, the debtor solicited the filing of an involuntary bankruptcy case that it then failed to contest.
The court concluded that the end-run around the lender’s contractual rights as a member was inappropriate and dismissed the case. The court noted: “The fact is that the petitioning creditors’ participation in this case was solicited by the Debtor which was prohibited by the Operating Agreement from filing a voluntary case without [lender’s] consent.”[29] Further noting that the lender was both a creditor and an equity holder, the court found that the lender:
Was granted certain protections in the governance of the LLC. [The debtor] could not sell substantially all of its assets, merge with another company, or file a voluntary bankruptcy case without the consent of [lender]. An absolute waiver of the right to file bankruptcy is violative of public policy if asserted by a lender. However, since [the lender] wears two hats in this case, as a Class B shareholder, it has the unquestioned right to prevent, by withholding consent, a voluntary bankruptcy case.”[30]
Citing various provisions of the Georgia limited liability company statute, the court found that state law permits “to the maximum extent possible, parties to exercise freedom of contract in the structuring of LLCs.”[31] To accord state law’s legislative determination that limited liability companies “should be granted extremely broad discretion in the organization and management of their affairs,” the court concluded that the lender retained a separate, enforceable right, as an equity holder, to refuse to consent to the filing of a voluntary bankruptcy case.[32] Given that the involuntary case was commenced in violation of such right, and in light of other facts unfavorable to the debtor, the case was dismissed as being filed in bad faith.
In reDB Capital Holdings, LLC.In In re DB Capital Holdings,[33] the debtor was a manager-managed limited liability company that was created to develop and sell a luxury condominium project in Aspen, Colorado. The debtor had two members, Aspen and DB Development. The manager had no ownership interest in the debtor but was an affiliate of DB Development.
Under the operating agreement, the rights and powers given to the manager pertained only to managing the affairs of the debtor in the ordinary course of business. The members of the debtor subsequently attempted to strip the company of its ability to file a bankruptcy petition by amending its operating agreement to include a provision that the company: “will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy.”[34]
A few years later, the manager of the debtor filed a voluntary bankruptcy petition on the debtor’s behalf for purposes of defeating a state court receivership commenced by the debtor’s mortgage lender.[35] Aspen did not consent to the filing and sought to dismiss it as unauthorized based on the provision in the debtor’s operating agreement. The manager argued that such a provision should be invalidated on public-policy grounds because the provision was included at the lender’s behest. The bankruptcy court disagreed and dismissed the case.
The Tenth Circuit affirmed on appeal, concluding that the express terms of the operating agreement could prohibit the limited liability from seeking bankruptcy relief. The court rejected the manager’s argument that the antibankruptcy provisions in the operating agreement were void as a matter of public policy, noting that he had not cited any support for the proposition that members of a limited liability company cannot agree among themselves not to file bankruptcy.[36] The court declined to address the manager’s argument that the provision was a product of coercion by the debtor’s secured creditor, and therefore unenforceable, because the evidentiary record did not support such an allegation.
Finally, the court concluded that even if it had disregarded the express prohibition against a bankruptcy filing, such a filing on behalf of the limited liability company was outside the scope of the manager’s authorized duties as set forth in the operating agreement. Under the operating agreement, the manager was only authorized to operate the debtor in the ordinary course of business. The filing of a chapter 11 proceeding, the court found, “represents a radical departure from how any entity carries on its business outside of bankruptcy.”[37] Accordingly, because the members were entitled to, and in fact did, agree among themselves to preclude the manager from filing bankruptcy, and because there was no evidence that such provision was inserted at the insistence of the lender, the appellate panel held that the filing was unauthorized, and therefore affirmed the bankruptcy court’s decision to dismiss the case.
Conclusion
All of the cases discussed above begin with the general premise that waiving or contracting away the right to file for relief under the Bankruptcy Code is contrary to public policy. Nevertheless, as the case law has developed over the years, a number of courts have held that operating agreement provisions that set limits on the authority of members or managers of a limited liability company to file a bankruptcy case are enforceable. The secured lending community has taken note of this, and creative lenders in recent years have structured or characterized their loan transactions to include an equity component, which arguably would give them the power to control its borrower’s fate with respect to its ability to commence a bankruptcy case. Part two of this article will address how courts have dealt with these extremely difficult cases.
[2] The Bankruptcy Code is set forth in 11 U.S.C. § 101 et seq. Specific sections of the Bankruptcy Code are identified as “section __.” Similarly, specific sections of the Federal Rules of Bankruptcy Procedure are identified as “Bankruptcy Rule __.”
[3]See e.g., 11 U.S.C. § 365(b)(2)(B) (“Paragraph (1) of this subsection [dealing with contract defaults] does not apply to a default that is a breach of a provision relating to . . . the commencement of a case under this title. . . .”); 11 U.S.C. § 365(e)(1)(B) (“Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified . . . at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on . . . the commencement of a case under this title.”); 11 U.S.C. § 541(c) (“An interest of the debtor in property becomes property of the estate . . . notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law . . . that is conditioned on the insolvency or financial condition of the debtor, [or] on the commencement of a case under this title. . . .”).
[4]See In re Gen. Growth Props., Inc., 409 B.R. 43, 49 (Bankr. S.D.N.Y. 2009).
[5] Stanziale v. Versa Capital Management (In re Simplexity, LLC), 2017 WL 2385404 (Bankr. D. Del. June 1, 2017) (citing TravelCenters of Am., LLC v. Brog, 2008 WL 1746987, at *1 (Del. Ch. Apr. 3, 2008) (finding that under Delaware law, “limited liability companies are creatures of contract” and, thus, drafters enjoy broad freedom in creating bylaws); In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del. Ch. Mar. 10, 2006) (“Limited liability companies are designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved”).
[6]In re Franchise Services of N. Am., 2018 WL 485959 (Bankr. S.D. Miss. Jan. 17, 2018).
[7] 11 U.S.C. § 109(a) (“Notwithstanding any other provision of this section, only a person that resides or has a domicile, a place of business, or property in the United States, or a municipality, may be a debtor under this title.”).
[17]In re Shady Grove Tech Ctr. Assocs. L.P., 216 B.R. 386, 390 (Bankr. D. Md.1998).
[18]In re Pease, 195 B.R. 431, 435 (Bankr. D. Neb. 1996).
[19] Hayhoe v. Cole (In re Cole), 226 B.R. 647, 651–52 n.7 (9th Cir. B.A.P. 1998).
[20]See, e.g., Continental Ins. Co. v. Thorpe Insulation Co. (In re Thorpe Insulation Co.), 671 F.3d 1011, 1026 (9th Cir. 2012) (“This prohibition of prepetition waiver has to be the law; otherwise, astute creditors would routinely require their debtors to waive.”).
[22]See, e.g., Hager v. Gibson (In re Hager), 108 F.3d 35, 38–39 (4th Cir. 1997) (holding that the bankruptcy court does not acquire jurisdiction over a petitioning corporation if those purporting to act for the corporation lack authority under local law).
[23]See e.g., In re Real Homes, LLC, 352 B.R. 221, 225 (Bankr. D. Idaho 2005); In re Farner, Boring & Tunneling, Inc., 26 B.R. 29, 31 (Bankr. D. Tenn. 1982).
[24] Stanziale v. Versa Capital Management (In re Simplexity, LLC), 2017 WL 2385404 (Bankr. D. Del. June 1, 2017) (citing TravelCenters of Am., LLC v. Brog, 2008 WL 1746987, at *1 (Del. Ch. Apr. 3, 2008) (finding that under Delaware law, “limited liability companies are creatures of contract” and, thus, drafters enjoy broad freedom in creating bylaws)); In re Grupo Dos Chiles, LLC, 2006 WL 668443, at *2 (Del. Ch. Mar. 10, 2006) (“Limited liability companies are designed to afford the maximum amount of freedom of contract, private ordering and flexibility to the parties involved”).
[26]In re Avalon Hotel Partners, LLC, 302 B.R. 377 (Bankr. D. Or. 2003).
[27]See also In re Orchard at Hansen Park, LLC, 347 B.R. 822 (Bankr. N.D. Tex. 2006) (enforcing operating agreement that required unanimous member consent for the filing of a voluntary bankruptcy case); In re 210 West Liberty Holdings, LLC, 2009 WL 1522047 (Bankr. N.D. W.Va. May 29, 2009) (provision that “all decisions” be made by majority vote was sufficient to allow bankruptcy filing over member objection because the objecting member’s approval was not necessary to constitute a majority); In re Ice Oasis, LLC, 2008 WL 5753355 (Bankr. N.D. Cal. Nov. 7, 2008) (in two-member LLC with 50/50 ownership, both members were required to approve the bankruptcy filing because the operating agreement provided for “all decisions” to be approved by a majority).
[28]In re Global Ship Systems, LLC, 391 B.R. 193 (Bankr. S.D. Ga. 2007).
Blockchain is often thought of as bitcoin or cryptocurrency, but it has many other applications. Blockchain has an associated technology known as “smart contracts.” Blockchain and smart contracts are emerging as major applications to electricity markets and to renewable energy and energy storage as these energy technologies revolutionize electricity as we know it.
Most industries and markets struggle with a disruptive technology. Energy as we knew it—centralized, regulated utilities dominated by coal—is rapidly evolving as solar, wind, and energy storage revolutionize the business. Solar and wind have been growing rapidly, while coal plants are shutting down in large numbers because they can no longer economically compete, and their climate risk makes them wholly unattractive for investment in the United States.
Decentralization in terms of distributed energy and storage further contribute to a rapidly changing energy market. Storage is becoming cheaper. Blockchain and smart contracts are emerging at about the same time. Combined, these developments present an opportunity to distribute, decentralize, and decarbonize electricity all at the same time.
Background on Blockchain and Smart Contracts
Blockchain is a form of a distributed ledger where computers or nodes manage the blockchain and its transparency and accuracy. With a copy on each node, if any changes are made to the blockchain, it changes the last number in what is known as a “hash.” Thus, everyone knows if “cheating” has occurred, and the distributed or decentralized nature of blockchain allows for a means of maintaining the records on a blockchain.
Smart contracts are computer code that are managed on a blockchain, mostly on the blockchain know as Ethereum, so that when a particular input occurs, an action is triggered. The “If This, Then That” nature of the code allows for automatic actions based on the input. Thus, smart contracts might act as a form of “escrow,” paying out when a certain event occurs. This allows input from reliable outside sources such as government weather sites, GPS location, sensors, and the Internet of Things. With automation in smart contracts, dispute over the triggering event can be reduced or eliminated if the parties agree in advance on the source of the data.
Blockchain, Renewable Energy Certificates, and Carbon Credits
Blockchain and smart contracts have applications in renewable energy. An example is the use of blockchain to manage renewable energy certificate (REC) transactions. Through their renewable portfolio standards, states provide for the generation of RECs for each megawatt (MW) of renewable energy produced. On the private, “voluntary” side, private entities review and certify renewable energy generation. The resulting RECs from either source may be sold separate and apart from the electricity in what is known as “unbundling.”
When the buyer of the REC uses the credit to demonstrate an “offset” of the use of 1 MW of electrical use, then the REC is retired and can no longer be used by any other power user.
Blockchain as a distributed ledger provides a means of preserving the accuracy and avoiding fraud in REC transactions. One key concern in REC transactions is double selling of the credits. With blockchain, the second transaction would be recognized as invalid by the confirmation process and would not be verified; making double selling impossible. Thus, it brings greater reliability to the system.
Blockchains are also cryptographically secure. Hacking reports in the cryptocurrency market relate to exchanges, not the blockchain itself. Transactions recorded in a digital ledger allow more transparent tracking of transactions because they are available to all the participants in the exchange. Through cryptographic protection, transparency, and avoidance of double selling, the risk of fraud is reduced. Similarly, carbon credit sales and retirement can be placed on a blockchain platform. Companies are working on developing blockchain platforms for the trading of carbon credits and RECs that provide a more transparent and secure means of trading these critical assets that promote renewable energy and reduce greenhouse gas emissions.
Distributed Energy Resources and Blockchain
Energy is getting smaller. Smaller generation sources in terms of wind farms and solar farms are replacing large coal and natural gas plants. Renewable energy is reducing the size of power generation. This is more true with what is known as “distributed energy,” where power generation occurs at or near the point of use, such as solar panels on home or commercial rooftops.
With the decreasing cost of batteries, energy storage is entering the electric grid. Larger storage systems are being installed at solar and wind farms or as separate operations. Smaller systems are being installed at homes and businesses as a growing part of solar plus storage at a distributed level.
As energy is moving toward a more decentralized system—distributed energy and distributed storage—blockchain, at the same time, is an emerging distributed ledger for tracking transactions. Distribution and decentralization are key aspects of distributed energy resources and blockchain technology. These technologies, along with artificial intelligence, may enable each other’s development.
For a decentralized energy network to survive, it must have cyber security. Blockchain is cryptographically secure.
Energy evolution requires the ability to track and react quickly to rapidly changing grid conditions because over time there will be thousands or more distributed solar generation sites and energy storage sites. To manage a grid under such rapid change over time and to manage all of the millions of additional transactions, blockchain provides the technology to track and transact all of those transactions with a distributed ledger and to be more efficient than a centralized intermediary.
Individual and aggregated groups or energy generation and storage can interact with each other to produce outcomes beneficial to each other and the users of the distribution system in a particular area.
The small size of the transactions, limited knowledge of participants in the market, and the large number of such transactions require an automated approach. Blockchain married to artificial intelligence will allow algorithms to execute the trades and record those transactions on a blockchain. The algorithms will present questions to customers through smart phone apps to allow them to trade energy and energy storage resources to other third parties, such as other homeowners or commercial entities, or to utilities, retail electric providers, or grid managers.
These distributed systems managed by computer systems will be key to managing both the distributed energy network and the larger electric grid connected to wind and solar farms and utility-scale storage. These distributed systems are also leading to the emergence of what are known as “micro hedges” to allow the hedging of energy prices at small amounts in terms of kilowatts and for short periods of time. Small commercial entities may manage electricity price risks that vary over the year, season, and day. The networked computer system then matches the most attractive offers by small power sellers, from owners of distributed solar or batteries, or both, creating competitive markets for distributed energy resources.
Conclusion
The new, disruptive electricity network is emerging at the same time as blockchain technology, and they provide a mutualistic relationship; for the distributed energy resources to work with the grid and local distributed system, blockchain may be a key enabler of that energy network. The convergence of these two technologies may create numerous lucrative opportunities for companies focused on solving these energy challenges and enable greater use of renewable energy.
In 2005, four years after Enron’s bankruptcy in 2001, but three years prior to Lehman’s bankruptcy in 2008, I proposed to the Financial Accounting Standards Board (FASB) the addition of a sixth standard financial reporting statement to be called the “Fair Value Statement.” The Fair Value Statement would have been in addition to the Balance Sheet, Income Statement, Statement of Comprehensive Income, Cash Flow Statement, and Statement of Stockholders’ Equity, which are authorized under FASB’s accounting standards codification.[1] FASB did not act on this proposal.
The proposed Fair Value Statement could have mitigated some of the damage arising from the Great Recession of 2008 by making the relative strength or weakness of earnings and assets contained in income statements and balance sheets more transparent to ordinary stockholders and creditors. Adding the Fair Value Statement today would increase transparency in financial reporting going forward, and I urge FASB to adopt the use of the proposed Fair Value Statement.
HISTORY OF FAIR VALUE MEASUREMENT
Fair value measurement is based on the difference between the original cost of an asset or liability and its current clearing value in the marketplace. The notion of using fair value (sometimes called “mark to market”) in financial statements has a long history. One of its earliest proponents was Kenneth MacNeal in his 1939 book Truth in Accounting.[2]
This approach was further developed by Edgar Edwards and Philip Bell in 1961.[3] They made a comprehensive proposal that included a method for recording fair value changes (unrealized changes in value), but they emphasized the need to report realized gains and losses separately from these unrealized values.
A realized value reflects an event that has already taken place, whereas an unrealized value reflects events that have not yet occurred, but which will occur with differing levels of probability in the future. A realized event is frozen, fixed, and unchangeable; an unrealized event is only true at a single moment in time and will change with future changes in the market.
FASB’S AUTHORITY TO DETERMINE GAAP ESTABLISHED BY THE SEC
The generally accepted accounting principles (GAAP) used by all public companies in the United States are established under the governing authority of the Securities and Exchange Commission (SEC). The Securities Act of 1933 and the Securities Exchange Act of 1934 provide that the SEC has the authority to establish the methods to be followed in preparing accounts and the form and content of financial statements filed under the acts.[4] The SEC has currently delegated its authority for setting GAAP to FASB under Accounting Series Release No. 150 (ASR 150).[5]
Historically, the SEC has delegated the authority to set GAAP to the private sector. From 1938 to 1959, the Committee on Accounting Procedure (CAP) was responsible for setting GAAP. In 1959, the Accounting Principles Board (APB) replaced the CAP, and the APB operated from 1959 through 1973. In 1973, the SEC delegated its authority for setting GAAP to FASB.
Criticism of the SEC’s oversight with respect to FASB’s rule setting increased following Enron’s bankruptcy in 2001. The SEC was concerned that FASB had become too “rule-based” and there was a push for more “principle-based” accounting standards. In 2002, Robert K. Herdman, then Chief Accountant of the SEC, noted that:
Rule-based standards make it more difficult for preparers and auditors to step back and evaluate whether the overall impact is consistent with the objectives of the standard. An ideal accounting standard is one that is principle-based and requires financial reporting to reflect the economic substance, not the form, of the transaction.[6]
EFFORTS TO ADDRESS THE ENRON FAILURE AT FASB
The Energy Trading Working Group (the Working Group) was formed by FASB to propose possible changes to financial reporting standards in response to weaknesses that had become apparent following the Enron bankruptcy in 2001.[7] The Working Group’s efforts were continued through the subsequent work of FASB’s Valuation Resource Group (I served on both groups).
In the Working Group, one issue that emerged was the lack of transparency in existing accounting standards regarding the quality of earnings, assets, and liabilities presented by financial statements. This difficulty arises from the “mixed attribute model” used pursuant to GAAP, which mixes realized and unrealized values in both the Income Statement and Balance Sheet. By showing realized and unrealized values in the same Income Statement and Balance Sheet, temporal logic is lost to investors and creditors trying to understand the timing and probability of future cash flows. Without a clear separation of realized from unrealized results, companies with less probable future income streams may appear to be as strong as companies with existing proven income streams.
I became convinced that knowing the quality of a company’s earnings was often related to its relative percentages of realized versus unrealized earnings. In addition, within a company’s unrealized earnings, there were significant differences between unrealized earnings that were fixed versus unrealized earnings that were subject to change. Based on my efforts in the Working Group, I published a series of articles setting out possible improvements.[8] Copies of these articles were provided to FASB.
In “Memo to FASB and IASB,” I first outlined my proposal to add an additional financial reporting statement—the Fair Value Statement—and described how it might be utilized in the future. What was not discussed in “Memo to FASB and IASB” was the fact that I employed this proposed methodology to deconstruct Enron’s final full year of financial reports (calendar 2000) for FASB.
DECONSTRUCTING ENRON’S FINAL FINANCIAL STATEMENTS
On May 6, 2005, I wrote to FASB. In this note, I told FASB that I was preparing pro forma versions of Enron’s calendar 2000 financial statements deconstructed using the methodology described in “Memo to FASB and IASB.” To establish a clearer temporal reporting framework, I segregated items measured at fair value (i.e., the unrealized values as of 12/31/00) that originally appeared as components of Enron’s 2000 Income Statement and its 2000 Balance Sheet into a pro forma “Fair Value Statement.”
The preparation of this pro forma statement did not benefit from hindsight. Instead, its purpose was to reformat the information presented to investors and creditors in early 2001 (i.e., prior to the bankruptcy filing) and to see whether a more useful form of presentation could have been prepared from the same underlying data set. To the extent that available public information was unclear or incomplete, I tried to make reasonable working assumptions.
These financial statements were then formatted into the “Enron Pro Forma Financial Statements” that I presented to FASB during 2005. In discussing the Enron Pro Forma Financial Statements, I told FASB that:
This deconstruction of Enron’s final year financial performance, which accepts all of Enron’s pre-bankruptcy valuations, indicates that (even using Enron’s own numbers) only 41% of Enron’s reported 2000 Net Income had been realized, and that only 65% of Enron’s Shareholders Equity was supported by realized results. A discrete presentation of unrealized events, like the ‘Fair Value Statement,’ separate from the realized results in existing financial performance reports, might prove useful in evaluating future market risks.
Enron’s originally reported Comprehensive Net Income was $735 MM. Of that $735 MM, I determined that $333 MM (i.e., more than 45 percent) was in the form of Fair Value Unrealized Net Gain, After Income Tax. The remaining $402 MM of Restated Realized Net Income is what appears as the Pro Forma Net Income. In addition, only 65 percent of Enron’s Shareholders Equity was supported by realized results ($7,511 MM out of the previously reported $11,470 MM).
To many investors and creditors, these numbers will speak for themselves.
ALTERNATIVES AND CONCLUSION
The need for separation of realized and unrealized data in financial statements became increasingly apparent as the larger bankruptcies of 2008–2010 began to emerge. With the benefit of hindsight, we can now see that the Enron failure in 2001 was in some ways a small-scale trial run for the much larger series of financial failures that began in 2008. By failing to learn from the 2001 Enron experience, the financial and legal communities unnecessarily and inadvertently helped set the stage for the more serious problems that arose in 2008.
[5] SEC Accounting Series Release No. 150, 5 Fed. Sec. L. Rep. (CCH) ¶ 72,172 (Dec. 20, 1973).
[6] Testimony Concerning the Roles of the SEC and the FASB in Establishing GAAP Before the H. Subcomm. on Cap. Mkts., Ins., & Gov’t Sponsored Enters., Comm. on Fin. Servs. (2002) (Statement of Robert K. Herdman, Chief Accountant, SEC).
[7] Daniel Fisher, Enron’s Real Financials, Forbes, Feb. 3, 2003.
[8] Gordon E. Goodman, Differences in the Quality of Earnings, GARP Risk Rev., Nov./Dec. 2003, at 6; Gordon E. Goodman, Transparency Quest: The Battle to Improve Financial Accounting Standards and Avoid the Next Enron, GARP Risk Rev., May/June 2004, at 18; Gordon E. Goodman, Memo to FASB & IASB: How to Repair Statements, GARP Risk Rev., Jan./Feb. 2005, at 22.
We are now two years into the “reform” of Dodd-Frank, and although there has been unanimity on a number of issues, certain changes have drawn dissent. The pruning of certain aspects of the original regulations has been a goal of Federal Reserve Vice Chair Randal Quarles, who has been supported by the other Federal Reserve governors, except for Governor Lael Brainard on six matters. Similarly, for changes on which the Federal Deposit Insurance Corporation (FDIC) board has also issued its approval, support has been unanimous other than for Director Martin Gruenberg on five matters. This article analyzes these competing schools of thought.
Governor Brainard has dissented from six Federal Reserve actions since April 2018. The first was the Federal Reserve’s proposal to further tailor the enhanced supplementary leverage ratio (E-SLR) that applies to U.S. global systemically important banks (G-SIBs), followed by dissents to the October 2018 “tailoring proposal” for U.S. banks, the March 2019 revisions to CCAR’s “qualitative objection,” the March 2019 decision to leave the Countercylical Capital Buffer (CCB) at 0 percent, the April 2019 foreign bank “tailoring proposal,” and the April 2019 proposal relaxing resolution planning requirements.
As for Director Gruenberg, as of August 31, 2019, he had dissented from all four of the six proposals above that came before the FDIC (E-SLR, the “tailoring proposals,” and the resolution planning proposal). In addition, he dissented from the revision to the regulations implementing the Volcker Rule.[1]
From these divisions, certain principles may be derived. Despite the dissents, there does seem to be agreement that most Dodd-Frank reforms that relate to G-SIBs are appropriate. No member of the Federal Reserve or FDIC has sought a material reduction in the capitalization of the nation’s largest, most complex banks. The changes to the E-SLR may appear to be an exception, but here the debate is best seen as whether the E-SLR should be a backstop to the risk-based capital rules, or whether it should continue to be—as it was for half of the U.S. G-SIBs at the holding company level and all of their lead bank subsidiaries—the binding constraint.[3] This debate has always followed use of the leverage ratio and is not new. It turns on two positions: (1) if the leverage ratio is the binding constraint, whether that encourages more risk-taking, versus (2) whether risk-based capital ratios are truly trustworthy. According to staff data, the recalibration of the E-SLR will not materially reduce capital at G-SIB holding companies, but it will result in a $121 billion reduction in capital at their lead bank subsidiaries. As of June 30, 2019, however, those lead banks’ traditional leverage ratios were anywhere from 132 to 840 basis points above well-capitalized.[4]
A second exception could be Governor Brainard’s dissent on setting the CCB at zero; however, it is possible here that the Federal Reserve’s position will change. Vice Chair Quarles has recently spoken positively of the CCB; therefore, it may return at a percentage higher than 0 percent when or after the Federal Reserve finalizes its stress capital buffer regulations.[5] Setting the CCB at a higher percentage should mean more G-SIB capital.
Third, the revisions to the Volcker regulations benefit G-SIBs, but Director Gruenberg’s dissent leaves out the principal weakness of the original version, which is its refusal to define in any meaningful way the very activity that the Volcker Rule proscribes: trading undertaken with short-term intent. The dissent also ignores that a substantial amount of trading activity beyond the Market Risk Capital Rule prong is caught by the new regulation’s nonstatutory “dealer” prong, which was not revised. To run with former Federal Reserve Chairman Volcker’s analogy to obscenity,[6] the essence of the new Volcker regulations is that they have freed only certain National Geographics from being required to be wrapped in a regulatory brown paper bag.
Where the debate between the Quarles and Brainard-Gruenberg positions seems to focus is on the rules for institutions above $100 billion in assets and below the range of the G-SIBs. It is there that Governor Brainard has been vocal, criticizing the reduction in the liquidity coverage ratio (LCR) and AOCI capital requirement opt-out for banks with between $250 billion and $700 billion in assets, as well as the elimination of the LCR for banks with assets between $100 billion and $250 billion. In two, public dissenting statements, she referred to the effects of the Washington Mutual failure ($300 billion) and two distress acquisitions of banks in the $100 to $250 billion range during the 2008 financial crisis as among the reasons for her “no” vote. She further contended that the 2008 financial crisis reduced the number of banks that could acquire such large competitors and thus raised the specter of a future depletion of the Deposit Insurance Fund.[7] On this point, Director Gruenberg has also agreed.[8] In addition, by voting against the revisions to the Volcker Rule, Director Gruenberg opposed the tailored regulatory relief the new regulation provides to banks without significant trading assets and liabilities—non-G-SIBs to be sure.
The response to these concerns from Vice Chair Quarles is that the recalibration is modest and must be judged with respect to the totality of existing regulation. For example, with respect to the domestic tailoring proposal, Vice Chair Quarles stated:
But liquidity risk still exists for firms [between $100 billion and $250 billion] and, accordingly, liquidity requirements would not disappear altogether. The firms’ internal liquidity stress testing, risk management, and reporting requirements would continue . . . .For capital, these firms would move to a two-year cycle for supervisory stress testing . . . .
The total amount of capital maintained by large bank holding companies that are subject to stress testing requirements is currently about $1.3 trillion. The cumulative effect of the proposed changes we are considering today would result in a decrease of $8 billion of required capital, or a change of 0.6 percent.
On the liquidity side, the same set of firms maintains approximately $3.1 trillion of high quality liquid assets. The cumulative effect of the proposed changes, would be a reduction of between 2 to 2.5 percent of high quality liquid assets, depending on where the final rule lands in the proposed 70-85% range.[9]
Similarly, on the elimination of the qualitative objection to stress testing, he commented:
[E]xamination work would continue on a year-round basis, taking into account the firm’s management of other financial risks, and culminating in a rating of the firm’s capital position and planning. Firms with deficient practices would receive supervisory findings through the examination process, and would be at risk of a ratings downgrade or enforcement action . . . .[10]
Focusing on banks in the $100 billion to $700 billion range, it seems that the debate, therefore, is over the right amount of regulatory “deterrence” to prevent another Washington Mutual or similar failure. This, of course, is a matter of judgment, and an answer to this debate will come only in a situation of material distress. It is nonetheless interesting to note that Vice Chair Quarles’ claimed effects of the U.S. domestic tailoring proposal on reductions in capital and liquidity are not material in either case.
Also relevant to the debate is the Economic Growth, Regulatory Relief, and Consumer Protection Act of 2018 (EGRRCPA), which passed Congress with bipartisan support. The Quarles versus Brainard/Gruenberg debate extends to whether the tailoring proposals are appropriately consistent with the statute. By retaining the original Dodd-Frank concept of tailoring, but raising the threshold of mandatory enhanced prudential standards to $250 billion and discretionary standards to $100 billion, Congress intended that G-SIBs be treated differently from large- and medium-sized regional banks in some ways.
Dodd-Frank 2.0 is still not finally implemented, and the debate outlined in this article will undoubtedly continue. In addition, the 2020 election is underway, and bank regulation has not died as a significant issue. In particular, how the Quarles versus Brainard/Gruenberg debate is seen in light of the bipartisan statutory changes to Dodd-Frank made by EGRRCPA will be critical in the event there is a new president but no congressional appetite to strengthen bank regulation statutorily. If the current recalibration is viewed as a reasonable approach to implementing EGRRCPA, increasing requirements post-2020 will have a higher burden of justification.
[1] The Federal Reserve Board has not, at this writing, considered the new Volcker regulations.
[2] Martin J. Gruenberg, An Essential Post-Crisis Reform Should Not Be Weakened: The Enhanced Supplementary Leverage Capital Ratio, Remarks to the Peterson Institute for International Economics (Sept. 6, 2018).
[3] Based on call report information on the FDIC’s website.
[4] Vice Chair for Supervision Randal K. Quarles, Refining the Stress Capital Buffer, Speech at Program on International Financial Systems Conference, Frankfurt, Germany (Sept. 5, 2019).
[6] Statement on Proposals to Modify Enhanced Prudential Standards for Large Banking Organizations by Governor Lael Brainard (Oct. 31, 2018).
[7]See Statement by Director Martin J. Gruenberg, Meeting of the FDIC Board of Directors, Notice of Proposed Rulemaking on Changes to Applicability Thresholds for Regulatory Capital and Liquidity Requirements (Nov. 20, 2018).
[8]See Vice Chairman for Supervision Randal K. Quarles, Statement on Proposals to Modify Enhanced Prudential Standards for Large Banking Organizations (Oct. 31, 2018) (emphasis added).
[9] Vice Chairman for Supervision Randal K. Quarles, A New Chapter in Stress Testing, Speech at the Brookings Institution (Nov. 9, 2018).
Lenders foreclosing FHA-insured mortgages in Ohio often face challenges that contest the lender’s compliance with relevant regulations from the U.S. Department of Housing and Urban Development (HUD). Like most courts throughout the nation, Ohio courts treat HUD regulations as contractual terms incorporated into FHA-insured mortgage loan documents. As Ohio case law on this issue continues to evolve, confusion—and sometimes shock—can arise for out-of-state lenders unfamiliar with the state-specific intricacies of litigating contested foreclosures involving FHA-insured mortgage loans in Ohio.
This article answers some of the questions that most commonly arise, beginning with more basic questions relating to what the relevant HUD regulations are and when the face-to-face meeting is required. The article then moves on to more challenging issues, such as whether compliance is a condition precedent or affirmative defense and why that matters, whether HUD deadlines are mandatory or aspirational, and how lenders should correct compliance errors if discovered after they already started a judicial foreclosure.
What Are the Relevant HUD Regulations?
Most lenders are familiar with the notice provisions governing acceleration in standard mortgages and notes. These provisions typically require lenders to send borrowers notice of their default and the action required to cure the default, provide a deadline not less than 30 days from the notice for the borrower to cure the default, and advise the borrower that failing to cure the default could result in acceleration and foreclosure.
Most mortgages and notes for FHA-insured loans do not expressly include these provisions. Instead, the loan documents allow lenders to accelerate delinquent loans but also acknowledge that HUD regulations will limit the lender’s ability to require immediate payment in the case of payment defaults. The standard FHA-insured mortgage and note both specify that they do not authorize acceleration or foreclosure if not permitted by HUD regulations. Ohio courts interpret these provisions to incorporate HUD regulations into the mortgage and note as additional contract terms. See, e.g., BAC Home Loans Servicing v. Taylor, 2013-Ohio-355, ¶ 14 (9th Dist.).
HUD codified its mortgage servicing regulations at 24 C.F.R. Subpart C. According to the regulations, “no [lender] shall commence foreclosure or acquire title to a property until the requirements . . . have been followed.” 24 C.F.R. § 203.500. “Before initiating foreclosure, the [lender] must ensure that all servicing requirements . . . have been met.” 24 C.F.R. § 203.606(a).
The regulations require lenders to notify borrowers in default “no later than the second month of any delinquency in payments under the mortgage.” 24 C.F.R. § 203.602. Lenders cannot foreclose until the borrower misses three monthly payments, and lenders must “make a reasonable effort to arrange” a face-to-face meeting with the borrower before the borrower misses three monthly payments, unless certain exceptions apply. 24 C.F.R. §§ 203.604, 203.606(a).
The lender must also evaluate the borrower’s account for appropriate loss mitigation actions before the borrower misses four monthly payments. 24 C.F.R. § 203.605(a). Before moving forward with foreclosure, the lender must notify the borrower that he or she is in default and that it intends to foreclose unless he or she cures the default. 24 C.F.R. § 203.606(a).
Lenders typically comply with most of the regulations governing FHA-insured mortgage loans when following the same procedures developed for non-FHA-insured mortgage loans because most of the requirements substantively parallel other federal regulations and standard mortgage and note obligations. The primary difference is the face-to-face meeting requirement.
When Is the Face-to-Face Meeting Required (and When Is It Not)?
The most often overlooked—and therefore most commonly litigated—HUD regulation is the face-to-face meeting requirement, which is not required by most traditional mortgages for non-FHA-insured loans. According to the applicable rule, lenders “must have a face-to-face interview with the [borrower], or make a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.” 24 C.F.R. § 203.604(b). A “reasonable effort” must include both a certified letter to the borrower attempting to arrange a meeting and at least one trip to see the borrower at the property. 24 C.F.R. § 203.604(d). The trip is not required if the property is more than 200 miles from the lender.
The lender is not required to conduct a face-to-face meeting if the borrower does not reside on the property, has clearly indicated that he or she will not cooperate in the interview, or is making payments on a repayment plan that bring the loan current. 24 C.F.R. §§ 203.604(c)(1), (3), (4). The lender is also relieved of the face-to-face meeting requirement if its reasonable efforts to arrange the meeting were unsuccessful or if the property is more than 200 miles from the lender. 24 C.F.R. §§ 203.604(c)(2), (5).
Is Compliance a Condition Precedent or an Affirmative Defense?
Ohio courts are split over whether HUD regulations constitute conditions precedent or affirmative defenses to the foreclosure. The majority rule is that they are conditions precedent; however, two appellate districts in the state treat them as affirmative defenses. See, e.g., U.S. Bank Nat’l Ass’n v. Cavanaugh, 2018-Ohio-5365, ¶¶ 15, 20–21 (10th Dist.); see also Wells Fargo Bank v. Goebel, 2014-Ohio-472, ¶ 20 (2d Dist.).
Ohio’s Second District, which includes the city of Dayton, holds that HUD’s face-to-face meeting requirement “creates an affirmative defense” for borrowers challenging foreclosure. Goebel, 2014-Ohio-472, ¶ 20. In Goebel, the lender failed to provide evidence showing it complied with the face-to-face meeting requirement despite the borrower having specifically denied the lender’s compliance in his answer. Nevertheless, the Second District affirmed the trial court’s summary judgment award, finding that the borrower did not present sufficient evidence to create an issue of fact as to whether the lender complied.
Ohio’s Tenth District, which includes the state’s capitol and largest city, also considers HUD regulations affirmative defenses. See GMAC Mortg. of Penn. v. Gray, No. 91AP-650, 1991 Ohio App. LEXIS 6004, 1991 WL 268742 (10th Dist. Dec. 10, 1991). In Gray, a borrower appealed the trial court’s summary judgment entry in a foreclosure action despite the borrower’s contention that the lender failed to comply with various HUD regulations. The appellate court reversed.
Although the parties in Gray do not appear to have raised the condition precedent/affirmative defense distinction, and the court did not specifically address the issue, the court found that “the failure of a mortgagee to adhere to the HUD servicing requirements . . . constitutes an affirmative defense to foreclosure.” The court determined that material facts remained in dispute about the lender’s HUD compliance, and it therefore overruled the trial court’s summary judgment order.
The Tenth District recently reaffirmed that Gray “remains good law,” and it confirmed its holding that HUD regulations constitute an affirmative defense as opposed to a condition precedent. Cavanaugh, 2018-Ohio-5365, ¶ 20. However, the court also recognized that multiple opinions from other Ohio courts “have dramatically changed the legal landscape,” and it advised that “the time may have arrived to revisit [the court’s] holding in Gray.” Nevertheless, the court declined to change course for the time being.
Why Does the Condition Precedent or Affirmative Defense Distinction Matter?
Realistically, the distinction between a condition precedent and an affirmative defense only matters to save situations where either the lender or the borrower failed to raise the issue or present any evidence at the trial level and the issue arises on appeal. If the borrower properly brings the issue before the trial court, and both parties submit evidentiary quality material at the summary judgment stage, the affirmative defense/condition precedent distinction impacts only the timing of the parties’ submissions. See, e.g., PNC Mortg. v. Garland, 2014-Ohio-1173, ¶¶ 23–24 (7th Dist.).
For example, whether the borrower raises HUD regulations by specifically denying the face-to-face meeting as a condition precedent or challenging HUD compliance as an affirmative defense, he or she will likely submit an affidavit swearing that he or she did not receive the required notice and has no knowledge of any attempts to visit the property. The lender will then provide business records showing that it sent the notice and that a representative visited the property or that it was otherwise excused. The condition precedent/affirmative defense question simply changes who must present their materials first. See, e.g., Cavanaugh, 2018-Ohio-5365, ¶ 17–19; Goebel, 2014-Ohio-472, ¶¶ 18–19.
More specifically, if compliance is a condition precedent, the lender must submit its evidence of compliance with its motion for summary judgment. See, e.g., Garland, 2014-Ohio-1173, ¶ 23. However, if noncompliance is an affirmative defense, then the lender need not disprove its noncompliance (i.e., the lender does not need to prove its compliance). Instead, the borrower must submit his or her evidence when responding to the lender’s motion for summary judgment or filing his or her own motion. The lender must then refute the borrower’s evidence with the appropriate materials. See Ohio Civ. R. 56(E).
Notably, in either scenario, the lender’s business records should trump the borrower’s unsubstantiated allegations, even at the summary judgment stage. See, e.g., A.J.R. v. Bd. of Educ., 2019-Ohio-3402, ¶ 17 (6th Dist.) (parties “cannot avoid summary judgment by submitting an unsupported, self-serving affidavit”) (internal quotations omitted). This is especially true where the regulation in question requires the lender to prove only that it sent the required notice or made the required visit, not that the borrower received the notice or that its representative actually made contact during the visit. See Goebel, 2014-Ohio-472, ¶ 19 (affidavit that borrower did not recall having a face-to-face meeting would not create fact issue to defeat summary judgment).
Thus, prudent Ohio lenders should submit evidence that they complied with the relevant HUD regulations with their motion for summary judgment regardless of whether the controlling jurisdiction considers it a condition precedent or affirmative defense—at least as to any regulations the borrower alleges the lender failed to follow in its pleadings. Only two appellate districts in the state consider compliance an affirmative defense, and one of those districts specifically advised litigants that it may revisit its ruling if necessary. See Cavanaugh, 2018-Ohio-5365, ¶ 21; Goebel, 2014-Ohio-472, ¶ 20.
Moreover, Ohio’s civil rules do not require defendants to plead affirmative defenses with the same specificity or particularity required when denying conditions precedent, meaning that if the trial court treats compliance as an affirmative defense, then borrowers technically do not need to raise the issue in detail at the pleading stage. Compare Ohio Civ. R. 8(B) with Ohio Civ. R. 9(C). Relatedly, some Ohio courts allow borrowers to raise issues they did not plead when responding to summary judgment motions, at least in some instances. See, e.g., Hillman v. Edwards, 2011-Ohio-2677, ¶¶ 14–18 (10th Dist). But see Nationstar Mortg. v. Young, 2016-Ohio-8287, ¶ 17 (9th Dist.) (assembling cases and discussing contrary rulings).
Thus, if noncompliance is an affirmative defense, borrowers can potentially spring the issue on the lender at a later, more inconvenient stage of the litigation. For example, if the borrower presents a sworn statement that the lender failed to comply with HUD regulations for the first time when responding to the lender’s summary judgment motion, or if the borrower generally alleges noncompliance as an affirmative defense and then specifically raises an issue the lender did not expect during summary judgment, the lender may find itself scrambling to develop evidence of its own compliance within the ordinarily truncated time period for a reply brief. See Ohio Civ. R. 6(C)(1) (providing only seven days for reply briefs unless otherwise ordered).
In contrast, presenting the evidence upfront even in affirmative defense jurisdictions would demonstrate that the borrower cannot prove an essential element of his or her affirmative defense (noncompliance) because the lender complied. See Dresher v. Burt, 75 Ohio St.3d 280, 293 (1996) (explaining summary judgment procedure when the movant does not bear the burden of proof). It would also guard against late-raised arguments from the borrower and problems presented if the appellate court shifted the legal landscape under the lender’s feet.
Are the HUD Deadlines Mandatory or Aspirational?
Until somewhat recently, the timing requirements in HUD regulations caused the biggest headache for lenders foreclosing FHA-insured mortgage loans. For example, HUD regulations require that the face-to-face meeting occur “before three full monthly installments due on the mortgage are unpaid.” 24 C.F.R. § 203.604(b). The regulation’s timing component necessarily begs the question, “what happens if the lender—or, more often, a prior lender—fails to conduct or attempt to arrange the face-to-face meeting within three months of the borrower’s default?” Does the lender forever lose its right to foreclose?
All Ohio courts to have considered this issue now answer that question in the negative. See, e.g., Wilmington Savings Fund Society v. West, 2019-Ohio-1249, ¶¶ 18–31 (5th Dist.) (compiling and discussing cases). See also Cavanaugh, 2018-Ohio-5365, ¶ 32 (clarifying the Tenth District’s prior ruling in Wells Fargo v. Burd, 2016-Ohio-7706). As Ohio’s Fifth District recently explained, “the obligation to conduct a face to face meeting, or a reasonable attempt to do so is mandatory, but the requirement that the meeting or attempt occur before three full monthly payments are due is aspirational.” West, 2019-Ohio-1249, ¶ 23.
Notably, Ohio’s universal recognition that the timing components for HUD regulations are aspirational in the foreclosure context accords with the state’s standard principles of contract interpretation. The Ohio Supreme Court confirms that “[w]here possible, a court must construe [contracts] to give effect to every provision in the agreement.” In re All Kelly & Ferraro Asbestos Cases, 2014-Ohio-7104, ¶ 29. Courts therefore must “avoid [contract] interpretations that render portions [of the contract] meaningless or unnecessary.” Wohl v. Sweeney, 2008-Ohio-2334, ¶ 22.
Thus, because courts deem HUD regulations incorporated into the mortgage and note as contract terms, they must construe the regulations in a way that avoids nullifying the parties’ rights and obligations whenever possible. See Asbestos Cases, 2014-Ohio-7104, ¶ 29; Wohl, 2008-Ohio-2334, ¶ 22. Reading a prohibition against correcting loan servicing timing errors into the mortgage and note would necessarily render other portions of those documents meaningless—including the lender’s overall right to payment and to foreclose the security given with the loan if the borrower defaults, which together constitute the entire purpose of the mortgage contract.
Moreover, neither the standard mortgage nor the standard note for FHA-insured loans specifically incorporates all HUD regulations into the agreement’s terms. Instead, the mortgage indicates that the instrument “does not authorize acceleration or foreclosure if not permitted by [HUD] regulations,” and the note specifies that it “does not authorize acceleration when not permitted by [HUD] regulations.” As discussed, courts must construe these provisions to avoid nullifying other contract terms if possible, and nothing in HUD’s regulations suggests that the agency intended to forever prohibit acceleration or foreclosure after the described timelines passed.
In fact, the regulations’ plain language seems to oppose the idea that mistakenly missing a deadline forever bars a lender from foreclosing on FHA-insured mortgages. The relevant regulations all speak in terms of barring foreclosure until the lender complies, not forever barring foreclosure if a lender temporarily fails to comply. See, e.g., 24 C.F.R. §§ 203.500 (No lender “shall commence foreclosure or acquire title to a property until the requirements of this subpart have been followed.”) (emphasis added), 203.606(a) (“Before initiating foreclosure, the [lender] must ensure that all servicing requirements of this subpart have been met.”). This language suggests that lenders need only comply before starting foreclosure proceedings.
Similarly, the regulations specifically outline the consequences of failing to comply. See 24 C.F.R. § 203.500. Those consequences include imposing “a civil money penalty” on the lender or withdrawing “HUD’s approval of a [lender].” They do not include prohibiting the lender from foreclosing the security for an FHA-insured loan. Indeed, “[t]he overall purpose of the FHA mortgage insurance program is to encourage lenders, in exchange for a government guarantee of the loan, to extend mortgages to those carrying higher credit risks.” Goebel, 2014-Ohio-472, ¶ 20 n.3 (quoting Wells Fargo v. Neal, 922 A.2d 538, 546 (Md. App. 2007)). Effectively wiping out mortgage liens for servicing errors hardly furthers that purpose.
How Should Lenders Correct Compliance Errors?
The last remaining—and likely most pressing—question is what a lender should do if it finds itself embroiled in a contested foreclosure without having complied with the relevant HUD regulations before filing its complaint. At least one Ohio appellate court holds that a face-to-face meeting conducted after commencing a failed foreclosure does “not comply with 24 C.F.R. 203.604(b) when the lender based its subsequent action on the same default as the first action.” Cavanaugh, 2018-Ohio-5365, ¶ 31 (discussing Burd, 2016-Ohio-7706). Some attorneys worry that this holding could require lenders to advance the loan’s due date before proceeding with a new foreclosure. However, lenders facing this situation should first consider options for distinguishing their circumstances from these rulings before choosing to credit payments on the loan.
In Burd, a borrower successfully challenged a lender’s foreclosure complaint on the grounds that the lender failed to comply with HUD’s face-to-face meeting requirements. The lender then filed another foreclosure alleging the same default date and contending that it complied with the face-to-face meeting requirement by participating in a court-sponsored mediation during the initial foreclosure. The trial court ruled that the lender again failed to comply with HUD’s face-to-face meeting requirement, and Ohio’s Tenth District affirmed.
The Tenth District rejected the lender’s position that it complied with the face-to-face meeting requirement despite not conducting or attempting a meeting within the first three months of the borrower’s default because the requirement’s specific timing component is aspirational, and it engaged in a court-sponsored mediation during the initial foreclosure. Burd, 2016-Ohio-7706, ¶ 13. The court acknowledged other Ohio courts’ determinations that the timing components are aspirational, but it found that the decisions did not bind its own review. It also distinguished those decisions from the facts at hand.
Noting that the court-sponsored mediation in the first foreclosure necessarily did not occur until after the lender had already filed at least one foreclosure based on the same alleged default in the current foreclosure, the court held that the lender “failed to comply with either the letter or the spirit of the regulation” because the borrower “had no opportunity to avoid foreclosure arising from that alleged default.” The court therefore upheld the trial court’s summary judgment ruling against the lender. It also expressly reserved a question about whether the lender “could demonstrate compliance with the regulatory requirements in another foreclosure action, perhaps based on a different default date.”
In Cavanaugh, the Tenth District later clarified that Burd “did not hold that a lender is barred from seeking foreclosure if it fails to appropriately act within the time period specified in 24 C.F.C. 203.604(b).” Cavanaugh, 2018-Ohio-5365, ¶ 32. Instead, the court confirmed “that a lender complies with 24 C.F.R. 203.604(b) if it conducts a face-to-face meeting, or if it makes reasonable efforts to arrange a force-to-face meeting, before filing its foreclosure.” However, the court reaffirmed its holding that a face-to-face meeting conducted after a failed foreclosure “did not comply with 24 C.F.R. 203.604(b) when the lender based its subsequent action for foreclosure on the same default as the first action.”
Importantly, the Tenth District in Burd indicated the ruling’s fact-specific nature several times. See Burd, 2016-Ohio-7706, ¶ 14 (“[u]nder the circumstances of this case . . .”, “[t[his is not a case where . . .”, “[r]ather, in this case . . .”). The court’s later clarification in Cavanaugh further supports this point. See Cavanaugh, 2018-Ohio-5365, ¶¶ 30–32 (reiterating the facts it found specific to its ruling in Burd). Thus, taken together, the opinions suggest that situations exist when lenders foreclosing in the Tenth District do not need to advance the loan to comply with the face-to-face meeting requirement after a failed foreclosure. However, the question remains exactly what facts the Tenth District would find sufficient to allow foreclosure without adjusting the loan’s due date.
First, once the lender confirms that it cannot demonstrate HUD compliance, it should voluntarily dismiss the foreclosure without prejudice. Proceeding through summary judgment risks an adverse ruling that may implicate res judicata concerns for later foreclosures. Relatedly, if the lender—or a prior lender—has voluntarily dismissed any earlier foreclosures, then it should avoid Ohio’s double dismissal rule by moving to dismiss under Rule 41(A)(2) rather than filing a notice of voluntary dismissal under Rule 41(A)(1)(a). See Olynyk v. Scoles, 2007-Ohio-2878, ¶ 23.
Next, the lender should take—and document—whatever steps are needed to fully comply with the applicable HUD regulations. The appellate court in Burd specifically noted with disapproval that the lender “made no other attempt” to arrange the face-to-face meeting beyond the court-sponsored mediation in its original foreclosure. Burd, 2016-Ohio-7706, ¶ 14 (emphasis added). It also expressly distinguished the case from a situation where a lender “holds a face-to-face meeting a few months after a third payment is missed but prior to filing foreclosure.”
These clarifications suggest that the Burd court may have viewed the situation more favorably had the lender made an effort to comply with the regulation apart from its court-mandated activity during the first failed foreclosure. Thus, taking steps to rectify previous oversights after dismissing the foreclosure may sufficiently comply with the “spirit of the regulation” by allowing the borrower an “opportunity to avoid foreclosure arising from that alleged default,” about which the court in Burd expressed concerns.
Moreover, dismissing the complaint without prejudice returns the parties to their pre-filing positions under long-standing Ohio law. See Denham v. City of New Carlisle, 86 Ohio St. 3d 594, 596 (1999) (“[a] dismissal without prejudice leaves the parties as if no action had been brought at all”) (quoting Deville Photography, Inc. v. Bowers, 169 Ohio St. 267, 272 (1959)). Accordingly, once the lender dismisses its prior complaint without prejudice, the earlier filing should no longer impact its options with respect to complying with conditions precedent for future foreclosures.
Finally, even if a lender chooses to take the conservative approach of advancing the loan’s due date before filing a new foreclosure, crediting the account for a single month—rather than bringing the account current or to within three months of a meeting attempt—should suffice. In Burd, the court posited without ruling that a lender could potentially “demonstrate compliance with the regulatory requirements in another foreclosure action, perhaps based on a different default date.” Burd, 2016-Ohio-7706, ¶ 14 n.2. Later, in Cavanaugh, the court confirmed that HUD’s specific timelines are aspirational, not mandatory. Cavanaugh, 2018-Ohio-5365, ¶ 32.
Reading the two opinions together, even if Burd precludes lenders from suing on the same default for inadvertently filing their complaint before fully complying with HUD—a position not mandated by a careful review of the opinion—moving the borrower’s due date up one month would allow the lender to sue on a different default. The lender could then take the necessary actions before filing its new complaint, thereby meeting its HUD obligations notwithstanding the passing of any aspirational deadlines. See Cavanaugh, 2018-Ohio-5365.
Conclusion
FHA-insured mortgages incorporate HUD regulations as contract terms in the loan documents. Although the specific deadlines are aspirational, lenders must comply with the regulations before foreclosing. When litigating a contested foreclosure where the borrower alleges failure to comply with applicable HUD regulations, lenders should determine as early as possible whether they can demonstrate full compliance. If they cannot, then they should voluntarily dismiss their action without prejudice and take all reasonable steps to comply with the spirit and the letter of the regulations.
The term “whistleblower” was coined over three decades ago by a New York Times reporter and subsequently adopted by Ralph Nader to describe a Washington, D.C. conference wherein numerous papers were presented on the subject. Today, the whistleblower is a well-known term throughout the world; however, industries face new dilemmas as governmental or internal mandates increase the implementation of whistleblower systems for the reporting of misconduct. With the advancement of technology, there are many options, but it is proposed herein that the blockchain protocol is an innovative solution to this directive, given its broad applications to diverse fields and markets. This article provides an overview of blockchain and its defining attributes and a supportive discourse of the blockchain on usage in a whistleblower programs.
I. What Is the Blockchain?
The blockchain platform is a streamline application or software that brings simplicity by decentralizing access to data through peer-to-peer technology so individuals or entities can view information and communicate directly with each other on a distributed database rather than through a centralized server.[1] Hence, no one entity or person has control over the information contained on the blockchain ledger because each computer on the network or “node” contains a copy of every transaction completed on a particular blockchain. These records, or transactions, are grouped together in a structure referred to as a “block” that is labeled with a hash “to the last block so that any attempt to change a prior block has a cascading effect on each subsequent block.”[2] This procedure precludes change to the content stored on block—often referred to as “immutability.” In addition to these attributes, blockchain provides transparency and computational logic regarding the inputted data.[3] Although there are other characteristics of blockchain technology that are relevant, the essential attributes that would assist in reporting of misconduct are the following:irreversibility, or immutability of data, and the distributed ledger. The former characteristic, “immutable,” means that once the informant reports an impropriety, the data cannot be altered[5]; this attribute is secured by computational logic or algorithms that ensure the integrity of the data. The distributed ledger provides that everyone on the blockchain can see changes to the data as well as the data itself.
II. Public Versus Private Public Blockchain
The term “blockchain” is readily associated with the exchange of cryptocurrencies, e.g., bitcoin, to verify the exchange of currencies;[6] however, it is most likely that users selling or buying cryptocurrencies do not understand that the system backing their activity is on the blockchain. Notably, the cryptocurrency bitcoin, the value which is based on supply and demand in contrast to fiat currency, was first introduced and founded on public blockchain technology. Shortly thereafter, it was noted that the underlying technology of bitcoin could be facilitated for other interorganizational cooperation, and a proliferation of other forms of the blockchain were employed.[7] Although this association is correct, this use is referred to as the “public” blockchain. As the term implies, all members can download the application and exchange cryptocurrency. The most profound feature, and one frequently stressed by proponents of the public blockchain, is that the user on the public blockchain is anonymous. Although it is conceptually valid that users are unknown on a public blockchain, there exist various methods in which identities can be known, including, but not limited to, legal discovery procedures.[8] To verify transactions on a public blockchain, each node on a network reaches a consensus on the validity of each transaction. This validation is performed by certain nodes, or “miners,” who apply various algorithms to verify the transactions. Once the miners reach an agreement, the transaction is recorded on the block chain. In exchange for their computation, miners on public blockchains are given a percentage of cryptocurrency.
In contrast to the public blockchain, there is the “private” blockchain. Specific industries have adopted the “private” blockchain,[9] including clinical research,[10] and more recently several state legislatures have implemented blockchain legislations to record data on a blockchain ledger.[11] Unlike public blockchains, where the identity of users is anonymous, a private blockchain is permissible, and only individuals invited on the network have access to the information, but the security and immutability of data still applies. The performance of the miners is provided through permissible access to the blockchain. Hence, both public and private serve as an ideal platform for implementation for a whistleblower program based on the needs of the entity.
III. Online Reporting
Over half of the world’s population is active internet users, with a large percentage of that number from China, India, and the United States.[12] These numbers suggest that a viable way for a company or industry to self-monitor themselves, whether required by law or for internal practices, is to facilitate an online informant program. The use of the internet for said purposes is not new in that numerous governmental agencies have developed online tools for reporting of misconduct. The Security Exchange Commission’s Tips, Complaints, and Referrals Intake and Resolution System (TCR System)[13] serves as an online recipient of all tips and complaints received by the Security Exchange Commission (Commission) and intakes referrals from self-regulatory organizations and other government agencies.[14] Although the Commission has reported an “upward trajectory” in reporting corporate misconduct, it is conclusive that the Commission has annotated that the reporting online is more effective and efficient as the tipper gets an automated response and the inputted information is populated among the staff, and after that distributed according to Commission protocol.[15] The European Commission Anonymous Whistleblower Tool to uncover cartels and other anticompetitive practice[16] and the U.S. Department of Labor’s Occupational Safety and Health Administration Online Whistleblower Protection Program[17] are other programs that have adopted an online reporting system. Although the protocol used for these programs varies, the blockchain platform is an affordable and efficient method, particularly for the private sector.[18]
IV. Whistleblowing Program Based on the Blockchain
The internal development of a whistleblower program as suggested by this article is a private blockchain with the primary establishment of the program itself at the business. It is essential that individuals are made aware of the program and of the reporting protocol. Once the informant is linked onto the protocol, entry of the data is recorded on the blockchain. At this juncture, the option of anonymous reporting can be implemented into the program by a variate in the system. The first block on the block chain is referred to as the genesis block. Once an informant reports information, the data entered cannot be deleted or changed due to the immutability capabilities of the program, and the information can be reviewed by those having access to the private blockchain, including the informant. The blockchain would also be an ideal mechanism for the fulfillment of recording mandates. As a business investigates a complaint, it can invite more people onto the network to partake in the investigation. See Illustration A.
V. Conclusion
The increase of compliance, whether it is medical research misconduct or internal business fraud, warrants exploration of innovative methods to address and resolve these matters. The blockchain protocol is a new mechanism to address these issues while providing transparency in its application. Although the platform does have flaws, given that no technology is without one, when properly implemented with other resources, the blockchain is a valuable source for regulatory issues and should be explored by entities seeking to achieve this outcome.
[1] Marco Iansiti & Karim R. Lakhani, The Truth About Blockchain, Harvard Bus. Rev. (Jan.–Feb. 2017); see also Scott D. Hughes, Cryptocurrency Regulations and Enforcement in the U.S., 45 W. St. L. Rev. 1 (Fall 2017).
[2] Shawn S. Amuial, Josias N. Dewey & Jeffrrey R. Seul, The Blockchain: A Guide for Legal and Business Professionals (Thomas Reuters 2016).
[11]See generally, National Conference of State Legislatures summary of states that have adopted legislation regarding data preservation on the blockchain.
If they have not already moved some of their information footprint to the cloud, most companies will soon enough. The cloud market is growing because the cloud provides “infinite” storage space for a company’s rapidly expanding information trove, but there are many compelling economic reasons as well. What is clear, however, is that migrating to the cloud—be it AWS, Google Cloud, or Microsoft Office 365—is replete with issues on which lawyers must weigh. Failure to engage the legal eagles upfront will result in unnecessary risk and exposure.
Microsoft Office 365 (Office 365) cloud is used by many companies the world over, but a company contemplating migrating its data to any cloud storage provider will do well to seek input from its lawyers (and other key stakeholders). Of note is that IT folks generally have two primary issues that make them not want to engage with lawyers. First, they do not like “it depends” type of answers, and second, they do not like to wait for legal advice. IT projects, including migrating to new environments, are generally on tight timeframes, and waiting for legal advice tends to delay implementation. However, migrating to Office 365 presents an organization with some unique opportunities, including cleaning up the current data debris as well as reducing privacy and information security risks associated with retaining unnecessary information. Further, the migration process will allow new policy and data governance rules to be applied to information that could address legal, compliance, regulatory, and privacy issues.
Although Office 365 offers organizations rich features and functionality to better manage its data from a security, discovery, access, and retention standpoint, getting it set up correctly will be hugely valuable during normal business operations as well as when litigation strikes. In addition, getting policies and rules decided upfront will help make the migration process more manageable and valuable.
Here are a few questions lawyers and risk and compliance professionals can answer:
What data should be migrated to Office 365? Most companies have decades of unstructured data and e-mail messages that have minimal value to the business. Such content may not need to be retained for legal or regulatory purposes and could pose an unnecessary risk and cost to the organization if it remains. There are simple rules that can be agreed upon to determine what information should be migrated and what information should be purged. Bringing the necessary stakeholders together with the lawyers can help the organization determine what type of diligence is needed before the content can be legally and defensibly purged. If the information is not needed, there is no good reason to migrate it to the new clean environment.
What happens with stored data from employees who have left the company and that are not on a litigation or preservation hold? Companies often do not have policy or practices that address data created or stored by employees who depart the company, either voluntarily or involuntarily. This lack of policy or practice leaves abandoned data sitting (sometimes forever) and likely unproperly managed. If the data are not on a legal or regulatory hold, then the lawyers can help IT determine what, if any, data should be migrated.
What policies should be developed or augmented to automate information management? Certain cloud providers like Office 365 allow an organization’s information to be managed automatically by pre-established rules. Most organizations probably do not have much, if any, management controls that govern unstructured content (like e-mail message, Word documents, etc.) stored in shared drives, personal drives, hard drives, e-mail, etc. This new functionality will remove the burden on today’s employees while promoting compliance, given that technology is usually better than individual employees at classifying information. Getting this issue right will require lawyers’ involvement. If lawyers understand the available functionality in Office 365, they can assist the organization in modifying policy that can be implemented by the technology. As an example, privacy labels (classification rule) can be put on content that includes personal information. This can limit who gets access to that type of content and can also require that a higher level of security be applied—all automatically.
How will discovery and litigation response be managed? Some of the cloud platforms offer tools that can help with discovery. In that regard, lawyers should also be involved in the technology-vetting process to ensure the organization is buying technology that satisfies its needs. In the case of Office 365, a rich set of tools is available for performing e-discovery, which can conduct searches across Exchange, SharePoint, OneDrive, Teams, etc. Prior to migrating to Office 365, lawyers must understand the new environment’s functionality in order to address issues regarding end user versus system preservation, or how long data will be retained after the end user deletes it, among other things.
How can an organization proactively establish records retention rules to support defensible disposal? Retention policies can be applied in Office 365 that can ensure records are retained for a specified duration and/or purged automatically when the retention period expires. This helps ensure compliance, mitigates risk, and minimizes the expense of storing unnecessary content longer than necessary. Policies can be set up to force labels to be applied to content by end users or can be automatically applied. Retention policies can be created based on the company’s retention schedule or a more simplified and defensible set of rules (i.e., three years for nonrecords). Retention can further be refined automatically for specific sets of data such as sensitive data types (credit-card, Social Security, and passport numbers).
How will event-based retention be managed? Event-based retention (a retention period that begins after some future event happens, such as a contract expiration date, for example) has been and continues to be a major headache for most organizations. If a retention rule for life insurance policies is tied to the death of a person in the future, managing that future event and retention can be a cottage industry for most companies. Similarly, if employees’ personnel records retention is tied to their termination, which is an unknown future date, retention of those records for all employees can be a challenge. Rules within Office 365 can be set up to address these complicated event-based retention periods (like contract expiration, employee termination, etc.).
Which information and e-mails should be encrypted? Cloud environments like Office 365 can tag and therefore protect e-mail by allowing users to select templates such as Encrypt and Do Not Forward when composing or replying to e-mail. Further, system administrators can also set up custom rules to automatically encrypt outgoing messages based on specific business criteria. Lawyers should help determine if automated rules to address content types (trade secret, intellectual property, PII, etc.) are needed and what those rules should be.
What can the company do to automatically protect its information assets? Cloud applications increasingly provide greater tools to help protect company information. Companies are turning to Data Loss Prevention (DLP) technology to automate the protection of information. Office 365 allows for the creation of policies that can alert, encrypt, or even block the transmission of sensitive data as identified based on predefined data types. As with encryption rules, lawyers should provide guidance on what content must be blocked based on the risk it poses to the company. Data theft by employees or outsiders is a real issue today, and lawyers must help define the parameters that would help sniff out and minimize this risk.
When is data removed from the old environment(s) after successful migration? Most business and IT professionals like to keep data “just in case” someone needs it down the road. Lawyers, on the other hand, may want information gone quickly if it does not have business, legal, or regulatory value. Discussing the real business, legal, and regulatory needs with lawyers and other key stakeholders is imperative to delete the data in its original storage location once it is validated that the information in the new environment is accessible and complete.
What other regulatory compliance rules must be proactively managed (GDPR or CCPA)? Lawyers can provide guidance to ensure regulatory compliance is automated as much as possible with the functionality available in Office 365. As regulations are passed, lawyers should work with IT to modify the rules applicable to the company’s data.
Flipping the switches, buttons, and toggles can be done by IT, but getting information management and governance right will require guidance and input from lawyers, compliance and privacy professionals, and business folks. Anything less will result in information not being there when needed or being there forever and creating liability and risk.
The cloud makes great business and technical sense for many companies. It can also be a boon to better information security and privacy management if companies choose wisely. The fact remains that not all clouds are created equal, but the good ones are valuable and even more so when lawyers play their part in making them come to life.
Many believe that blockchain technology is synonymous with cryptocurrencies, such as bitcoin and ethereum, yet cryptocurrency is just one of a multitude of applications of blockchain technology, and there are numerous industries, such as financial services and transportation, that will also benefit from this emerging technology.
Similar to artificial intelligence (AI), blockchain, or “distributed ledger technology” as it is more formally described, also has the potential to revolutionize aspects of the financial services industry as seen through the emergence of a wide range of FinTechs. One such area is structured finance where blockchain technology can be utilized to reduce servicing and reporting costs, create data management efficiencies, and increase transaction transparency throughout the securitization process from asset origination to secondary market trading. This article explores some of the benefits that would be offered from the application of blockchain technology to the securitization industry, thereby further enabling the monetization of otherwise illiquid long-term financial assets.
The Existing Process of Securitization
In the world of structured finance, securitization is the creation of liquid, asset-backed securities from pools of illiquid assets such as mortgages, lease agreements, and credit-card debt. These asset-backed securities are then sold to investors.
Almost any asset that generates a recurring stream of cash flow payments can be securitized if those payments can be used to fund their maintenance in aggregating structures and regular distributions to security holders. A special purpose vehicle (SPV) is typically used to purchase and hold the relevant assets, using the proceeds from the issuance of securities to investors to fund the purchase of these pooled assets. Securitization creates opportunities for both investors and creditors. Investors, in addition to enjoying attractive fixed returns on their equity, enjoy a reduction in risk because the risk is spread over a larger and more diversified basket of assets. Investors can also receive improved returns positively leveraged by debt. Traditional creditors benefit as their capital is freed up, thus increasing the availability of credit and promoting greater liquidity in the marketplace.
For all of its benefits, securitization is a complex process requiring numerous stakeholders relying on different sets of data and information. These stakeholders include legal counsel, accountants, rating agencies, and underwriters. Given that information and data relied on by stakeholders to structure or trade the security is not currently shared among stakeholders, nor in a standardized form, there exists significant inefficiencies that now pervade many aspects of the securitization lifecycle.
A lack of transparency, as well as difficulties in tracing relevant transactions related to the security, creates both reporting and underwriting inefficiencies that lead to increased expense and delay. This lack of transparency can also cause interpretation issues between stakeholders when performing various tasks surrounding the securitization process, such as valuing the assets and calculating the waterfall of payments that must be satisfied by the securitized asset pool.
Permissioned Blockchains
Blockchain technology is rapidly evolving, with many adaptations of this technology already in use. Even so, certain features underpin this technology and exist throughout all its variants. Blockchain technology offers an immutable, secure, transparent, and immediately verifiable method for performing transactions without the requirement for a trusted intermediary to process and report all transactions. The decentralized nature of this technology makes it considerably more secure than a database with only one single authority. It allows for faster transaction processing as the concept of objective “consensus” to the validity and accuracy of the transactions is built into this technology.
As outlined above, there are many adaptations of blockchain technology. One such variant is permissioned (or private) blockchains. Unlike permissionless (public) blockchains, which is the blockchain technology underpinning cryptocurrencies such as bitcoin, permissioned blockchains can restrict a party’s access to the blockchain and also limit such party’s read and write access to the data stored on the blockchain.
Blockchain Applied to Securitization
Administrators of permissoned blockchains can decide what parties may access or write data to the blockchain. This ability to control read/write access offers several advantages over permissionless blockchains in that it allows stakeholders to securely input proprietary information relevant to the transaction and ensure that only the appropriate parties have read access to such information. Permissioned blockchains still allow for data stored on the blockchain to remain auditable and traceable. The ability to restrict the read and write access to permissioned blockchains makes it well suited for securitization. This means that the information available to investors can differ from that available to regulators, investors, creditors, or credit rating agencies. In this example, regulators may be required to receive access to all information stored on the blockchain, whereas investors could be limited to accessing only necessary information. This ability to grant regulators with broader access rights is even more pertinent due to the ever-growing compliance obligations required by regulators in this sector.
Blockchain’s potential to establish a single source of information consistent among all parties will ultimately drastically reduce inefficiencies and costs. This leads to traceable, transparent, and auditable data at all stages in the securitization lifecycle from loan origination to secondary market transactions. In addition to minimizing the risk of fraud or error generally, compliance obligations could be more easily met in that regulators and auditors can use the blockchain to trace the ownership of the underlying securitized assets and any associated transactions. This single source of information reduces information asymmetry and creates a fairer system for all stakeholders, and offers the potential to remove intermediaries, thereby further reducing costs. The information on the blockchain can be used to better understand the available pool of underlying assets, including each asset’s payment history permanently associated with it.
The speed in which blockchain technology can process and record transactions could also reduce inefficiencies relating to trading and servicing the security. Trust in the accuracy and availability of information allows for increased certainty and faster payments and even greater trust in the securitization sector as a whole.
Potential Barriers to Adoption
With all its inherent and potential promise, blockchain technology must overcome several hurdles on the path to adoption in securitization. There must be significant buy-in from all stakeholders due to the upfront costs of developing, testing, and implementing blockchain technology for this industry. Stakeholders must agree on a standard or “protocol” for all data to be added to the blockchain and set up internal processes and procedures to ensure that it meets these standards. Stakeholders must also ensure that their infrastructure can interoperate with blockchain technology.
For securitization transactions, the laws that apply will depend on, and vary in relation to, the underlying assets and the applicable jurisdictions. Due to this complexity, organizations should engage regulators at an early stage to ensure that the technology is compliant with applicable laws. Organizations looking to implement blockchain technology for securitizations should seek advice from legal counsel with an understanding of the technology as well as the relevant applicable legal framework.
Conclusion
Although adoption of blockchain technology for securitization will require a significant concerted effort from and education of all stakeholders, including domestic and international regulatory bodies, the range and scope of benefits that this technology enables are substantial. Reduction in time and cost of securitization activities, coupled with greater transparency generally for all stakeholders, means that blockchain technology could indeed be transformational for securitization, if not altogether revolutionary.
Connect with a global network of over 30,000 business law professionals
