The purpose of this article is to address the intersection between corporate governance and artificial intelligence (AI), and to explain why corporate board members must be familiar with basic AI concepts in order to fulfill their fiduciary duties. AI is permeating all industries, and directors must be aware of risks associated with the ever-evolving landscape of such technology. Thus, at least a basic understanding of AI and its applicability to a board’s particular industry is necessary for board directors to comply with their fiduciary duties and for effective corporate governance.
What Is AI?
AI is the capacity of a computer or electronic device to use characteristics commonly associated with human intelligence, including reasoning and learning from prior experiences. AI devices can be based upon algorithms consisting of rules for initial assessment and directions of next steps to take depending on the initial assessment, machine learning where devices learn autonomously based on initial rules and data, and even deep learning, which is learning through “the development of large artificial neural networks.” See https://www.zendesk.com/blog/machine-learning-and-deep-learning/. Based on the algorithm or learning method, the AI devices are able to process significant amounts of data and reveal patterns to solve problems, make decisions, perform complex maneuvers, or provide additional data for human consideration. Examples of AI in daily life include:
Netflix and Pandora recommending movies and songs based on past watching and listening behavior;
Amazon recommending products for purchase based on past shopping behavior and shopping behavior of other individuals who have purchased the same product;
self-driving cars that are able to detect motion around the vehicle and maneuver the car safely in response; and
the ever-present Siri and Alexa that continually learn and improve based upon natural-language inquiries and requests.
In addition to the above-noted examples, other AI examples include programs to analyze credit eligibility, decipher which e-mails may be spam, and detect fraud in banking and credit transactions.
Risks of AI
Along with the increasing presence of AI, there is an underlying fear many have, no doubt due in part to movies like “The Terminator,” and “I, Robot,” that one day human usefulness will be eliminated, and mankind will be taken over by AI machines. Although some jobs have already become obsolete (e.g., automated phone systems, with voice-recognition software replacing some customer-service operators), other risks associated with AI relate to data privacy and making some businesses obsolete.
In addition, as computers and machines continually evolve into deep learning, it may be more problematic to discern how massive amounts of unreliable data are interpreted through AI. Further, it seems that almost every day there is a new headline about companies being hacked; thus, there are increasing concerns about privacy and protection of data in an AI world.
Brief Background on Fiduciary Duties
Delaware law, which is viewed by many as the “nation’s corporate law,” requires members of boards of directors to comply with the fiduciary duties of loyalty and care. In Re PLX Tech. Stockholders Litig. 2018 Del. Ch. LEXIS 336, *64 (Oct. 16, 2018). That is, they have a duty to act in the best interests of the corporation and its shareholders, Frederick Hsu Living Trust v. ODN Holding Corp., 2017 Del. Ch. LEXIS 67, *43–*44 (Apr. 14, 2017), and they must be fully informed before making decisions on behalf of the company. McMullin v. Beran, 765 A.2d 910, 921 (Del. 2000).
There are also subsidiary duties that derive from the duties of loyalty and care. One subsidiary duty is that board members have the duty of oversight, which is sometimes referred to as a Caremark duty, after the name of the case that articulated it. In essence, the duty of oversight requires that directors have in place an effective reporting or monitoring system and an information system that allows them to detect potential risks to the company. Reiter v. Fairbank, 2016 Del. Ch. LEXIS 158, *18–*22. This information and reporting system has been described by the courts as part of a risk-management program that allows the directors to be properly informed and to become aware of any developing trends or activities at their company that may create a risk of liability for the company. Id.
Another subsidiary duty is the duty of nondelegation. Directors cannot delegate to nondirectors “in a very substantial way their duty to use their own best judgment on management matters.” Canal Capital Corp. v. French, 1992 Del. Ch. LEXIS 133, *5 (“It is settled law that directors may not delegate to others those duties that are ‘at the heart’ of the management of the corporation”).
Intersection of Fiduciary Duties and Consideration of AI
In order to comply with their duties of loyalty and care, boards should consider whether AI can be useful to improve the business practices of the organization, or whether it should be incorporated to assist the board in making informed decisions.
In the first instance, if AI will reduce employee workload or overhead costs in general by automating a transaction, it may have the potential to significantly increase profits for the business. AI is available to analyze trends in the marketplace to assist in marketing the business and targeting new consumers. If the board does not keep abreast of such technological advances, then it is not being materially informed or investigating developing trends to effectively govern the corporation, and thus failing to fulfill its duty of care. It is essential for board members to continually keep informed about developments of AI that may have transformative effects on the business or make a particular business less necessary. For example, use of ubiquitous, free GPS that adapts to wrong turns and online, live traffic mapping displaced the necessity for printed maps. Board members of companies that printed maps should have seen this development around the bend.
If a board considers incorporating AI, key factors include whether the existing data maintained by the company is suitable for the data mining that would be needed for the particular AI technology. Data management will be key for implementation of AI. In order to comply with the duty of care and oversight, the board must have an understanding of how data is obtained and maintained to understand whether AI will be effective, or whether overarching changes in data management and storage must be undertaken. Further, how to secure the data and protect it from hackers will be crucial in incorporating AI, as will audits about whether AI is accurately interpreting data.
Utilizing AI to enhance the board’s decision-making capabilities and analysis of data may soon be more commonplace. AI can be used to track overall trends in how the business is spending and allocating funds as well as to mine information and data for alignment with the overarching goals of the business in various departments.
In 2014, a venture capital firm claimed to have “appointed” an AI program called “Vital” to its board of directors. Vital sifted through research of drugs used to test age-related diseases and would then advise as to whether the firm should invest in the drugs. Although Vital was not a voting member, and although all boards can consider experts or various sources of information to assist in decision-making, appointing an AI program to the board was indicative of the role AI can play in the governance of a corporation. It is important to note, however, that in Delaware board members must be “natural persons,” so “appointing an AI program” as a board member for a Delaware corporation would be impermissible. DGCL § 141(b).
To the extent a board moves forward to adopt AI, it is crucial that the board does not delegate its essential management functions and rely solely upon AI in making decisions for the corporation. Doing so would be a prohibited delegation of its duties. Further, although many AI technologies can reach a decision based on their interpretation of data, keeping a record of how they reached that decision can be more problematic. AI should not be the sole source upon which board members rely in governing a business or making decisions.
Conclusion
This article has only scratched the surface of the extent of AI’s potential impact on fiduciary duties if a board fails to consider AI. As with any development that may create risk or bring value to its shareholders, every board, regardless of industry, should consider what impact AI may have on its business and its corporate governance.
The use of mediation in the bankruptcy context continues to grow, particularly in complex cases. Across the United States, a wide range of bankruptcy-related disputes have been addressed effectively through mediation, including disputes such as avoidance actions, valuation disputes, claim issues, disputes over lien priorities, confirmation issues, post-confirmation litigation, etc. Some bankruptcy courts have required mediation of such matters (such as the U.S. Bankruptcy Court for the District of Delaware), whereas other courts suggest and encourage, but do not require, mediation as a means of resolving particular disputes before a trial is necessary.
So long as the dispute is ripe for mediation (i.e., any necessary discovery or other preparations have been completed) and the practical likelihood of reaching resolution warrants any associated delays or costs, parties to a bankruptcy-related dispute may benefit from taking the time to seek resolution at mediation before extended litigation takes place. However, parties taking the time to think through certain aspects of the mediation and to adequately prepare will be better positioned for success in the process.
Choosing a Mediator
In bankruptcy-related mediation, one of the first significant decisions to be made is the determination of whether to choose a current or former bankruptcy judge or a practitioner as the mediator. Although parties may find it harder to reveal weaknesses in their case to a sitting judge, the chance of later appearing before the judge may encourage admirable behavior. A practitioner may feel more leeway to voice opinions on a party’s position, which may be what a party needs to hear to understand the weaknesses of their position and facilitate resolution. However, a judge’s opinion in mediation, when given, may be significantly compelling to a party stuck in its own mindset. Regardless of whether a judge or practitioner is chosen, it is helpful to have a mediator with experience in bankruptcy-related matters when such matters are at issue, given some of the unique factors present in the bankruptcy context. Finally, when appropriate, allowing the opposing party to choose the mediator can show strength of position and avoid any concerns that party may have about mediator bias.
The Importance of Preparation
Parties participating in mediation can help or hinder their chances of a successful mediation through their preparation efforts. Each party should walk into a mediation knowing its case, goals, and capacity to compromise and prepared to present its case to the mediator thoroughly yet succinctly. This latter goal may be aided by mediation or settlement conference statements presented premediation and/or with PowerPoint or other presentation materials. Walking in with a realistic view of the time it may take to reach a deal can help parties avoid discouragement when resolution is not met earlier in the day(s) of mediation.
Evaluate Strengths and Weaknesses
One of the most important areas of preparation (for both clients and their lawyers) is for a party to develop an understanding of the strengths and weaknesses of its own case. The better a party understands the strengths and weaknesses of its side of the case, the better it will understand its capacity to compromise. Before mediation day, consider what biases, emotions, or unrealistic expectations exist and how to address them. One way to gain a fresh perspective during this process is to consult with someone not involved in the case prior to mediation. Once the mediation begins, mediators may further facilitate this understanding by asking questions to uncover strengths and weaknesses. Having one or more open mediation sessions can ensure that the other party (not just their attorney) has heard any key points another party wants to communicate. If the mediation is taking longer than anticipated, consider what may have been missed in evaluating the other party’s case.
Harm Caused by Lack of Preparation
An advocate will accomplish more for his or her client by being completely prepared for the mediation. It is startling how many attorneys walk into a mediation without any preparation whatsoever. The failure to prepare adequately for the mediation will drive down the value of the unprepared party’s case, leaving the mediator little to work with in attempting to forge a settlement. An advocate who is well prepared will almost always succeed in settling the matter in a favorable manner for his or her client.
Clients should be advised in advance of a mediation that it is their one chance (before trial) to tell their side of the story and that they should prepare in every way possible. A mediation is often the only place (other than in the courtroom) where clients have the opportunity to (1) vent; (2) tell their story; and (3) attempt to reach a satisfactory result.
Building Consensus
Like any other mediation, in a bankruptcy-related mediation parties should consider discussing larger concepts before getting into details and finding points of agreement (even if on smaller and/or side issues) early in the process to encourage progress and facilitate movement on the larger issues. Avoiding unrealistic initial demands and offers can discourage the other party from beginning in that fashion and can disarm parties walking in with a “dig in your heels” approach. Instead, consider giving the other party an offer they are tempted to “think about” under the circumstances of the case. Identify reasons that parties may be motivated to settle, even if those are not related to the key issues in the case.
Each mediation scenario is different and requires attention to the particular circumstances of the case and the temperaments and priorities of the parties. Ask questions to uncover underlying motivations and help parties identify different views of their bargaining position and consider providing opportunities for “venting” and airing grievances where emotions are involved. Although each party is concerned with the presentation of its own case, listening to the other party’s case is also key to determining areas of possible compromise and underlying issues hindering resolution. An attorney should beware of taking on a client’s impatience or stubbornness or projecting his or her own personal impatience or stubbornness into the process.
When parties are not moving from their position, consider seeking a mediator proposal from the mediator to flush out a party’s willingness to adjust its position and consider options without the risks of a formal offer/counteroffer. Where overall resolution is not possible, consider reaching consensus on damages tied to a court ruling (i.e., if the court rules X, then we agree to pay Y). Taking steps toward resolution, even if merely fulfilling the minimum involvement requirements of a court-ordered mediation, can help avoid possible sanctions for lack of “good-faith” participation. See In re A.T. Reynolds & Sons, Inc., 424 B.R. 76 (Bankr. S.D.N.Y. 2010), rev’d, 452 B.R. 374, 383 (S.D.N.Y. 2011) (imposing sanctions and holding that creditor and its counsel were in contempt of mediation order for lack of good-faith participation); Spradlin v. Richard, 572 F. App’x 420 (6th Cir. 2014) (affirming a bankruptcy court’s award and district court’s affirmance of sanctions for participants failing to have full settlement authority and participate in good faith); Corp. for Character v. FTC, 2016 U.S. Dist. LEXIS 194752, at *18–*33 (D. Utah Apr. 22, 2016) (providing discussion of good-faith mediation cases and imposing sanctions for party’s failure to have all key parties at mediation, to provide opening statement, and to be prepared with respect to financial aspects of the matter).
Illustrative Cases
Mediation has been used successfully in many complex bankruptcy cases involving numerous parties and significant disputes. See, e.g., Lehman Brothers Holdings, Inc., No 08-13555 (Bankr. S.D.N.Y.) (debtors engaged in hundreds of mediations under court-ordered ADR procedures in place to avoid litigation in every individual case, recovering over $2 billion in proceeds for distribution to creditors); In re Tribune Co., No. 08-13141 (Bankr. D. Del.) (several-month mediation resulted in a plan with broad support that was ultimately confirmed); Cengage Learning, Inc., No. 13-44106 (Bankr. E.D.N.Y.) (mediation resulted in global settlement with main stakeholders and led to confirmed plan); In re City of Detroit, Michigan, No. 13-53846 (Bankr. E.D. Mich.) (thousands of hours of negotiations with the main parties to the case, including the state, city, and related counties, resulted in agreements to address virtually all of the claims involving the city). A mediation team was appointed to resolve disputes in the Commonwealth of Puerto Rico’s bankruptcy (D.P.R., Case No. 17-BK-3283), and numerous cases have moved forward to confirmation through the mediation of disputes impeding key chapter 11 transactions. See, e.g., In re The Rockport Company, LLC, No. 18-50636 (Bankr. D. Del.) (successful mediation of dispute with former owners of debtor over outstanding liabilities resulted in plan support).
Not all bankruptcy mediation efforts have resulted in success, however, highlighting how the initial assessment of the case and parties involved is essential in determining whether mediation is the appropriate next step. See, e.g., Nortel Networks Inc., No. 09-10138 (Bankr. D. Del.) (debtors engaged in numerous rounds of mediation, but ultimately the court had to resolve dispute); Old HB, Inc. (fka Hostess Brands, Inc.), No. 12-22052 (Bankr. S.D.N.Y.) (debtors’ issues with labor unions remained unresolved after mediation and case resulted in liquidation).
In order to assess, for purposes of diversity jurisdiction (28 U.S.C § 1332), the citizenship of an unincorporated business organization (e.g., partnership, limited partnership, LLC, business trust, etc.), there will be attributed the citizenship of each of the members. This is in contrast to the rule applicable to the citizenship of corporations, which are the citizens of the states in which they are incorporated and maintain the principal place of business. Who, then, is a member? Although resolving this question typically will be rather straightforward, there are of course cases on the margins of the analysis. In a recent case from Kentucky, the court was called upon to determine whether a “nonequity” partner’s citizenship to the firm, in this instance organized as a limited liability partnership, would be attributed to it. EQT Production Co. v. Vorys, Sater, Seymour & Pase, LLP, 2018 WL 6790486 (E.D. Ky. Dec. 26, 2018).
In this case, there was no dispute that an LLP has the citizenship of each of its partners. The question turned on whether the citizenship of a particular “nonequity partner” resident in Pennsylvania would be attributed to the partnership. The court held that it would be. The EQT Production court wrote that Carden v. Arkonia Assocs., 110 S. Ct. 1015 (1990), “‘reject[ed] the contention that to determine, for diversity purposes, the citizenship of an artificial entity, the court may consult the citizenship of less than all of the entity’s members.”’
Eschewing further consideration, it was held that “[i]nstead, under Carden, nominal partner status—i.e., status vel non as ‘partner’—is the sockdolager.” This author had to look up the definition of “sockdolager”; it is “something that settles a matter.” In the end, the “partner” title was enough, and consideration of rights in the partnership are not to be of issue.
It bears noting that there is not consistency across all of the courts with respect to this question. For example, in Morson v. Kreindler & Kreindler, LLP, 616 F. Supp. 2d 171 (D. Mass. 2009), the citizenship of a “contract partner” who had no voting rights in the firm was compensated on the basis of a Form W-2, did not share in the profits and losses, and was classified as an employee who would not be attributed to the partnership. The EQT Production decision distinguished the Morson decision on the basis that it “is thinly reasoned” and was based upon partner status under Title VII rather than partnership law. In Passavant Memorial Area Hospital Ass’n v. Lancaster Pollard & Co., 2012 WL 1119402 (C.D. Ill. Apr. 3, 2012), the citizenship of certain “contract partners,” who had no equity interest in the partnership, did not share in the firm’s profits and losses, did not have voting rights in the partnership, and were paid a fixed amount by contract, were not “partners” whose citizenship would be attributed to the partnership.
Thomas E. Rutledge is a member of Stoll Keenon Ogden PLLC in the Louisville office. A frequent speaker and writer on business organization law, he has published in journals including The Business Lawyer, the Delaware Journal of Corporate Law, the American Business Law Journal, and the Journal of Taxation, and is an elected member of the American Law Institute. He blogs at Kentuckybusinessentitylaw.blogspot.com.
Debt limits in chapter 12 of the Bankruptcy Code are often exceeded by farm operations, necessitating a chapter 11, and issues involving perfection and realization of security interests, or voiding of rights, will be an important issue for business bankruptcy lawyers involved in farm bankruptcies—sometimes perjoratively called industrial farm bankruptcies, which tells one the scale of debt that can be involved.The issue of farm bankruptcy merited a recent Wall Street Journal article: “‘This One Here Is Gonna Kick My Butt’—Farm Belt Bankruptcies Are Soaring,” Feb. 6, 2019.
Farm operations have more complex statutory overlays than many businesses. In addition to the usual Uniform Commercial Code issues, there are two important overlays of law: First, 7 U.S.C. § 1631 revising at a federal level the so-called farm products exception in the UCC, and second, a potpourri of statutory liens varying from state to state, generically referred to as agricultural liens, mostly falling within the UCC definition of “agricultural liens.” These are not new problems—just ones that are likely to re-emerge given current prices, the size of operations, and foreign trade issues.
Fertile opportunities are presented for bankruptcy lawyers to recover assets and avoid liens, and unfortunately there are many opportunities for error by commercial lawyers generally. For lawyers who are associated with traditional financing who never heard of section 1631, it can be a rude awakening, particularly with the section 1631(c) exception that actual notice makes no difference (i.e., knowing about the lender’s UCC filing make no difference) and that the governing location for filing and “effective financing statement” is not the “birthplace state” for 1631 protections—yet , by contrast, for perfection of a security interest against the debtor and its creditors, the filing location remains the “birthplace state.”
Chapter 12 focused on family farm bankruptcies. Chapter 12 had what seemed to be generous debt limits at the time of passage, but as the economies of scale of farming have increased, and the complexity of farm ownership structures has increased, the debt limits are often exceeded, and nonfarm operation affiliates are involved. In order to be a family farmer eligible for chapter 12, among other requirements, the debt must be under a certain level, and 50 percent of the debt must arise out of the farming operation, excluding principal residence debt. The current total debt limit is $4,153,150. There is no separate limit for secured debt.
In the “old days” prior to 1985, the controlling law on farm products and security interests was in what is now UCC 9-320(1):
(a) Except as otherwise provided in subsection (e), a buyer in ordinary course of business, other than a person buying farm products from a person engaged in farming operations, takes free of a security interest created by the buyer’s seller, even if the security interest is perfected and the buyer knows of its existence [emphasis added].
In plain English, once a lender was perfected under the UCC, no buyer of farm products took free of a lien unless the buyer had a waiver or delivered the proceeds to the lender (that usually worked).
Since 1985, for lenders, buyers, and those reserving rights in goods, the most critical statute is 7 U.S.C. § 1631. For farm products, section1631 pre-emptively overrides state law and the so-called farm products exception in UCC section 9-320(a). In pertinent part, section 1631 entitled “Purchases free of security interest” reads:
Except as provided in subsection (e) and notwithstanding any other provision of Federal, State, or local law, a buyer who in the ordinary course of business buys a farm product from a seller engaged in farming operations shall take free of a security interest created by the seller, even though the security interest is perfected; and the buyer knows of the existence of such interest. [Emphasis added.]
Referring to UCC 2-401(1):
Title to goods cannot pass under a contract for sale prior to their identification to the contract (Section 2-501), and unless otherwise explicitly agreed the buyer acquires by their identification a special property as limited by this Act. Any retention or reservation by the seller of the title (property) in goods shipped or delivered to the buyer is limited in effect to a reservation of a security interest. Subject to these provisions and to Article 9, title to goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties. [emphasis added]
Unfortunately, some parties read the contracts and not the law governing contracts and forget the UCC rule that title is often immaterial, and words that may not look like a security interest are, in fact, a security interest. This is particularly important once title or possession has passed to a buyer.
In theory, under section 1631, lenders using farm products as collateral can still protect their security interest against buyers by an “effective financing statement.” In practice, it is more difficult. Attorneys might make the mistake of thinking an effective financing statement is like a UCC financing statement, but that is not the case; there may be different places of filing and perfection and different technical requirements. The section 1631 form must be technically perfect to protect the lender. Complicating the notice aspects are two statutory schemes in section 1631 that may govern depending on the “birthplace” state of a farm operation and the location of where the product is located or produced. There are U.S. Dept. of Agriculture regulations implementing section 1631 that deserve attention.
One statutory scheme authorized under section 1631 creates a central filing scheme similar in scope to a UCC central filing scheme. There are 17 states with this type of system listed on a USDA website. For section 1631 purposes, the state for a central filing is where the farm product is located or produced, not necessarily the birthplace state. The rest of the states and other jurisdictions, including obvious major farm states (e.g., Iowa, Wisconsin, New York, California), do not have a central filing scheme. In those states, actual notice of the section 1631 form of effective financing statement must be given to buyers, which is a daunting task for a lender—arguably so much so that it is not realistic for protection and might explain why these 33 states chose not to be central filing states.
A first question in an insolvency context is whether a security interest or reservation of rights constituting a security interest is created. Suppose there is perfection under the UCC, but no effective financing statement, and a buyer buys farm products; these purchased farm products are clearly free and clear of any security interest under section 1631 and many 1631 cases. However, the buyer may not be free and clear of agricultural liens, and if one of them is not perfected and can be avoided, do sections 544/547 come into play? Agriculture liens generally would be perfected in the “birthplace state.” Failing proper perfection of an agricultural lien, does the preservation of an avoided lien for the benefit of the estate come into play? What if the lender perfected by an effective financing statement where the products are produced or located, but filed a UCC-1 in the nonbirthplace jurisdiction or did not file at all? Can the trustee avoid the lien on proceeds (not the sale to the buyer) for the benefit of the estate? What if the debtor-to-be moves the collateral to another state just before or perhaps after the effective financing statement is filed? Does the buyer win and the lender lose because of the “located or produced” rule? If the buyer were buying free and clear, so the secured lender loses to the buyer, but the lender did perfect its security interest under the UCC, does the lender receive a lien on the proceeds? Similar to inventory cases where the merchant sells inventor to buyers in the ordinary course, the answer would seem to be “yes.” What if a contracting party failed to recognize they have what amounts to a security interest under UCC 2-401(1) and took no action to perfect under the UCC and/or section 1631?
Farm product prices were significantly higher in 2013, but in the last few years as production increased and global production increased, there has been significant downward farm price pressure. Economies of scale have absorbed some of the pressure on margins, but generally if a significant price reversal occurs and U.S. farm price supports are inadequate to buttress operations against that pressure, a farm bankruptcy is inevitable. Although farm businesses are traditionally smaller than many other chapter 11 cases, the numbers are becoming respectable enough to attract and support the fees of skilled lawyers.
A nice case example illustrating the various section 1631 issues arose out of Mississippi in First Bank v. Eastern Livestock Co., 837 F. Supp. 792, 802 (S.D. Miss. 1993). Proceeds of a security interest were not remitted to First Bank, which claimed that Eastern Livestock was on notice of First Bank’s UCC-perfected security interest and should have remitted those proceeds to the bank because Eastern Livestock had to recognize the security interest (Eastern Livestock had already paid the seller, which was the borrower from the bank):
First Bank argues that regardless of the disposition of the issue of whether First Bank’s UCC–1F was sufficient, it is entitled to summary judgment since Eastern had actual notice of First Bank’s security interest by virtue of Wells’ having identified First Bank as a lienholder on a certain cattle purchase confirmation contract with Eastern. However, whether Eastern had actual notice of the Bank’s claimed security interest is not material. [italics added] The Act provides the only means by which a buyer may be made subject to a security interest, i.e., filing of an “effective financing statement” or providing “written notice,” and explicitly states that unless one of those methods is followed, then a buyer who buys a farm product in the ordinary course of business from a seller engaged in farming operations takes free of a security interest created by the seller, even if “the buyer knows of the existence of such interest.” Thus, actual notice is not relevant, unless such actual notice is imparted to the buyer by the secured party in the manner prescribed by the Act.18 [f.n. 18: The court would note that there is, in any event, a factual dispute between the parties concerning whether Eastern, in fact, had actual notice as claimed by the Bank.]”
I would be completely remiss without crediting a member of our section with lead articles on the subject:, Drew L. Kershen & J. Thomas Hardin, Congress Takes Exception to the Farm Products Exception of the UCC, Retroactivity and Preemption, 36 U. Kan. L. Rev. 1 (1987) (in two parts) available (for a fee) at Hein Online. The articles are the starting point to begin to comprehend this area of the law.
Some whistleblowers do well, but many do not. For the ones who have a big payday, you might not think they have tax issues to address, but lots of money means taxes, of course, and everyone pays taxes—even whistleblowers.
Some whistleblowers consider moving to a no-tax or low-tax state. If you are about to recover a very large and long-awaited sum, you might want to consider the tax consequence of where you reside. If you live in California, for example, you will pay up to 13.3 percent in state income tax on your recovery. Would you be just as happy living in Nevada or Florida, which has no state income tax? The laws governing residence and domicile vary, but most of the steps that are appropriate to establish or move one’s residence are common sense. These include physical presence, intent, voting, driver’s license, and vehicle registration.
You may want to seek professional help from a qualified tax attorney to ensure everything is in order, however. Depending on your timing and thoroughness, be aware that high-tax states may claim you are still a resident after you receive your recovery. If you plan your move well in advance and follow the advice of a tax professional, you can reduce any chance of controversy and maximize your chance of success.
What about the tax treatment of attorney’s fees? Most plaintiffs and whistleblowers assume that the most that could be taxable to them by the IRS (or by their state) is their net recovery after costs and fees. Lawyers often receive the gross amount, deduct their fees, and remit only the balance to the plaintiff or whistleblower. Actually, all of the money is technically the client’s money in the government’s view.
For many plaintiffs and whistleblowers, the first inkling that the gross recovery may be their income is the arrival of Forms 1099 in January after the year of their recovery. Generally, amounts paid to a plaintiff’s attorney as legal fees are gross income to the plaintiff, even if paid directly to the plaintiff’s attorney by the defendant. The Supreme Court said so in Comm’r v. Banks, 543 U.S. 426 (2005).
For tax purposes, the plaintiff is considered to receive the gross award, including any portion that goes to pay legal fees and costs. The IRS rules for Form 1099 reporting bear this out. A defendant or other payor that issues a payment to a plaintiff and a lawyer must issue two Forms 1099.
The lawyer and client each should receive a Form 1099 reporting that they received 100 percent of the money. When you receive a Form 1099, you must put the full amount on your tax return. Plaintiffs receive Forms 1099 in many other contexts, which they must explain. For example, plaintiffs who are seriously injured, and who should receive compensatory lawsuit proceeds tax-free for their physical injuries, may still receive a Form 1099. In those cases, they can report the amount on their tax return and explain why the Form 1099 was erroneous.
Plaintiffs and whistleblowers do not have this argument because they are required to report the gross payment as their income. The question is how the plaintiff or whistleblower deducts the legal fees and costs. Successful whistleblowers may not mind paying tax on their net recoveries, but paying taxes on money their lawyers receive has long been controversial.
In 2005, the U.S. Supreme Court resolved a bitter split in the circuit courts about the tax treatment of attorney’s fees in Comm’r v. Banks. The court held—in general at least—that the plaintiff has 100 percent of the income and must somehow deduct the legal fees. That somehow is important.
In 2004, just months before the Supreme Court decided Banks, Congress added an above-the-line deduction for attorney’s fees, but only for certain types of cases. The above-the-line deduction applies to any claims under the federal False Claims Act, the National Labor Relations Act, the Fair Labor Standards Act, the Employee Polygraph Protection Act of 1988, and the Worker Adjustment and Retraining Notification Act, as well as claims under certain provisions of the Civil Rights Act of 1991, the Congressional Accountability Act of 1995, the Age Discrimination in Employment Act of 1967, the Rehabilitation Act of 1973, the Employee Retirement Income Act of 1974, the Education Amendments of 1972, the Family and Medical Leave Act of 1993, the Civil Rights Act of 1964, the Fair Housing Act, the Americans with Disabilities Act of 1990, chapter 43 of title 38 of the United States Code, and sections 1977, 1979, and 1980 of the Revised Statutes.
The above-the-line deduction also applies to any claim under any provision of federal, state, or local law, whether statutory, regulatory, or common law, that provides for the enforcement of civil rights or regulates any aspect of the employment relationship. Beyond that, up until 2018, a deduction for attorney’s fees and costs would be a miscellaneous itemized deduction. That was a below-the-line deduction under I.R.C. section 212.
An above-the-line deduction means you pay no tax on the attorney’s fees. Under the Tax Cuts and Jobs Act of 2017, the miscellaneous itemized deduction was eliminated until 2026. That makes the above-the-line deduction even more important. If you do not qualify, you are paying taxes on money paid to your lawyer that you never see.
Whistleblowers
The tax law also allows for the deduction of legal fees connected with many federal whistleblower statutes. I.R.C. section 62(a)(21) allows for the deduction of legal fees incurred in connection with federal tax whistleblower actions that result in awards from the IRS. Under I.R.C. section 62(a)(20), any action brought under the federal False Claims Act can qualify for an above-the-line deduction of legal fees. See I.R.C. § 62(e)(17). However, up until early 2018, these provisions did not explicitly include SEC whistleblower claims. Whistleblower claims often arise out of employment, and many SEC whistleblowers were employed by the firms whose conduct they reported. As a practical matter, some SEC whistleblowers claimed an above-the-line deduction as an employment case, but now, with the statutory change made in early 2018, even SEC claims are covered.
Under 26 U.S. Code § 62(a)(21), as amended by the Bipartisan Budget Act of 2018, an SEC or Commodity Futures Trading Commission (CFTC) whistleblower receiving an award from the SEC whistleblower program or CFTC whistleblower program can now claim the attorney’s fee as an above-the-line deduction.
Deductibility Limits
One detail of the above-the-line deduction that is easy to miss relates to gross income. Normally, a cash-basis taxpayer is eligible to claim a deduction in the year the underlying payment was made. See I.R.C. § 461(a); Treas. Reg. § 1.461-1(a)(1). However, I.R.C. section 62(a)(20) limits the available deduction to the income derived from the underlying claim in the same tax year. As a result, a deduction allowable under section 62(a)(20) cannot offset income derived from any other source or received in any other year. This is usually not a problem, but occasionally it can be. For example, where there is a mixture of hourly and contingent fees, the issues can be thorny and may require professional help.
Co-relator Payments and Finder’s Fees
In some cases, whistleblowers have other whistleblowers they need to pay. Can those be deducted too? It is not so clear, and the IRS’s answer might be “no.” Some of it may depend on how you orchestrate the documents and the mechanics of payment. Some people may try to cast the payments to others as a type of cost of the case, seeking to lump them in with the legal fees.
The agreements between parties and attorneys can help with this effort. The idea is that legal fees and costs are generally treated the same for tax purposes. So, if the extra payments can somehow be categorized as costs, maybe they qualify for an above-the-line deduction as well.
It is appropriate to consider an additional way that taxpayers may qualify for above-the-line deductions. A taxpayer operating a trade or business and incurring legal fees—contingent or otherwise—need not worry about these issues. In a corporation, LLC, partnership, or even a proprietorship, business expenses are above-the-line deductions.
Some plaintiffs have even argued that they were in the business of suing people. This may sound silly in the case of plaintiffs in employment cases. That is where the argument first appears to have surfaced (long before the above-the-line deduction was enacted in 2004). See, e.g., Alexander v. Comm’r, 72 F.3d 938 (1st Cir. 1995). However, it is quite credible in the case of some serial whistleblowers. Some file multiple claims, and some go on the lecture circuit, especially after their claims bear fruit. Thus, there is a distinct possibility that a whistleblower can, in a very real sense, be operating a business. A proprietor—a taxpayer operating a business without a legal entity—reports income and loss on Schedule C to his or her Form 1040.
To be sure, you are not likely to want to make a Schedule C argument if you have a good argument for a statutory above-the-line deduction. Schedule C to a Form 1040 tax return is historically more likely to be audited than virtually any other return, or portion of a return. In part, this is due to the hobby-loss phenomenon, with expenses usually exceeding income. It is also due to self-employment taxes. Placing income on a Schedule C normally means self-employment income, and the extra tax hit on that alone can be 15.3 percent. Over the wage base, of course, the rate drops to 2.9 percent. Even so, most whistleblowers and plaintiffs do not want to add self-employment tax to the taxes they are already paying.
Still, when it comes to deducting legal fees, the Schedule C at least deserves a mention. Plaintiffs or whistleblowers who have been regularly filing Schedule C for business activities in the past stand a better chance of prevailing with their Schedule C.
Conclusion
Long before and shortly after the Supreme Court’s Banks case in 2005, there was considerable discussion about the tax treatment of legal fees. Plaintiffs’ employment lawyers were especially vocal in the years leading up to 2004, and they were particularly effective in lobbying Congress. That led to the statutory change in 2004, which ended up covering some whistleblower claims, too.
In part, the statutory changes in late 2004 blunted the impact of the Banks case, which even the Supreme Court itself noted in its opinion, yet a vast number of plaintiffs and some whistleblowers still worry about how to deduct their legal fees. In the case of SEC whistleblower claims, a long-awaited statutory change in 2018 brought needed relief.
A large number of successful plaintiffs and whistleblowers end up surprised at tax time, either with the tax result, the mechanics of gross income and deductions, or both. As more SEC whistleblower claims are paid, there should now be fewer whistleblowers surprised by their tax preparer, or worse, by the IRS.
Artificial Intelligence is becoming an increasing large part of the healthcare sector. Along with the advances it brings, it also brings a variety of new and different legal concerns. Attorneys need a basic understanding of Artificial Intelligence and how its use impacts various legal concepts in order to counsel clients. To that end, the Health IT Task Force is pleased to provide this FAQ, offering a quick, bite-size introduction to this subject. The Health IT Task Force gratefully acknowledges Rebecca Henderson, a Solicitor with MacRoberts LLP in Scotland, for her invaluable assistance in creating this FAQ.
1. What is Artificial Intelligence?
Short answer–a tool!
Broadly, artificial intelligence (“AI”) is where technology or systems perform tasks and can analyze facts and/or situations independently of a human. AI comes in a few slightly different “flavors,” including Machine Learning and Deep Learning:
Machine Learning is when the system uses algorithms to review data in an iterative process until it “learns” how to make a determination or prediction; this can relieve humans of tedious tasks.
Deep Learning is a type of Machine Learning wherein the system is similar to human neural networks. It is fed an enormous amount of data (often labelled images) until it “learns” by example, discovering patterns in the data; driverless cars are the most obvious example of this—the system must learn the difference between a stop sign and a pedestrian and then apply that knowledge—but there are plenty of healthcare applications, too.
2. How is it used in healthcare?
Healthcare professionals envision that AI technology will streamline services and increase how quickly the healthcare system can react to ensure that the right people are seen at the right time in accordance with their medical needs, and that medical claims and other administrative and workflow tasks can be optimized.
AI is used in healthcare to complement human decision making, not to replace it. Current examples of AI in action can be found in robotic-assisted surgery, medical claims analysis, virtual observations, chronic care management, and just about any area where an abundance of high-quality data can improve patient outcomes and industry efficiencies.
For instance, rather than a pathologist viewing thousands of images to find the few that may be problematic, the system does the initial cut, freeing the pathologist to focus on the problematic slides.
Exciting new AI-based applications have recently been introduced to screen for diabetic retinopathy as well. Another example is chronic condition management program using Machine Learning: a recently implemented a system that identified diabetes patients who could benefit from additional monitoring, then analyzed the data collected from monitoring kits provided to those patients. Data is sent directly to the patient’s EHR, and care providers received an automated alert if intervention was called for.
The conducted a study in Oxford providing patients with complex respiratory needs with a tablet and probe which measured heart rate, blood oxygen levels, and more daily and reported this back to the clinical team at the local hospital. Over time, the AI system behind the app and system learned about the patient and their vital signs and learned to predict when certain drops in heart rate/blood oxygen levels meant that the patient required intervention from the medical team. During the time the trial was running, hospital admissions dropped by 17% for the group of participants as the app allowed the patient and clinical team to schedule appointments when the health of the individual began to deteriorate, instead of emergency hospital visits.
3. Any warning flags? Concerns to consider?
Trust
Many people may not feel comfortable with a machine making potentially life and death decisions about their healthcare. There is potential for such mistrust to impede the adoption of AI technologies in the healthcare sector where so many rely on personal interactions and the qualifications and experience of doctors and other healthcare professionals to feel comfortable. Resistance to or slow adoption of AI technologies in healthcare may come in part from fallout from the increasing ubiquity of AI technology in many parts of our lives.
Direct care remains at the core of healthcare; however, AI technology can assist in the creation and management of “personalized care,” allowing patients to feel empowered and in greater control of their own wellbeing. Healthcare experts are also keen to ensure that patients and/or external companies are aware that AI technology is not designed for nor is it intended for use in any way to “replace” doctors, nurses and other healthcare professionals. Medical care is built on “empathy”–a quality AI technology cannot replicate!
Further legislative governance of such technologies and how they are tested before being used in medical contexts may impact the level of trust patients possess towards AI.
Bias
As AI technology learns from data, bias is a concern; the implicit (or even explicit) racial, gender or other biases of the humans that code the algorithms or the data that is fed into the algorithms can skew the results. For instance, the data may not be representative of the population (e.g. ethnic minorities are usually under-represented in the medical studies that make up a lot of today’s medical data) and therefore may lead to some conditions which affect some areas of the population more (e.g. sickle cell anaemia) being under-represented in AI technology, meaning that the AI system output may not be appropriate for a patient who is a member of an under-represented population. Therefore, AI machines and technology are being trained on data which may not be representative of the population as a whole.
Improving the accuracy of and provision of more representative health data should lessen potential bias.
4. Regulatory Issues
Currently, regulations have not quite caught up with AI technology. If the AI is “wrong” and a patient is injured, who is liable? The software vendor? The doctor who used it? The hospital that paid for it? Until there is a regulatory framework to allocate risk, providers may be slow to fully embrace AI.
Part of the problem is that an AI-based system is, by definition, always learning, but regulatory approval is granted to a specific version or type of item; the type of AI-based device approved on Day 1 is not the same type in use on Day 2. Think of it this way: 2+2 will always equal 4, so the results of a device based on 2 plus 2 equaling 4 does not change, no matter how much data it looks at. But what if a device that adds 2 plus 2 on Day 1 “teaches” itself calculus by Day 5? The result of the calculus equation is different from the result of 2+2, .
FDA approval is generally required for technology or a device that provides a diagnosis without a healthcare professional’s review; recent approval of the AI-based device to detect diabetic retinopathy renders it, to date, the only AI-based device to be approved.
5. What are the data privacy and security concerns?
In the United States, HIPAA’s privacy regulations apply to protected health information, regardless of whether AI is involved. This creates an “input” problem; AI requires an enormous amount of data to “learn” and if that data is protected under HIPAA, either patients have to consent to its use as an input, or the protected health data will have to be de-identified before being fed into the system, or the regulations will have to be amended to permit its direct use.
The EU General Data Protection Regulation gives data subjects more control over their personal data and provides more protections for consumers. Health data is classed as “special category data” and there are special controls over this data to ensure it is protected, which would offer unique concerns for AI purposes.
There are potential issues here in obtaining data for use in AI technologies and identifying a legal basis for doing this. There may be certain sectors (for example wearable devices tracking personal fitness objectives) where the legal basis for obtaining this data is different from that of a hospital (i.e. in the U.S., wearables are viewed by the FDA as “low risk”’ whereas in the EU, the protected category of vital interests is more likely to apply).
The implementation of artificial intelligence in healthcare may entail transfers of data between the EU and U.S.: for example, if the hospital is in the UK but the technology being used is based in the U.S. This creates problems for UK hospitals and medical practitioners subject to GDPR and the U.S. companies processing the data of EU citizens.
6. IP challenges
Intellectual property challenges include a basic question of “who owns the input data?” If the AI system vendor doesn’t own it, have appropriate licenses or sufficient approval or consent been obtained? Is consent even necessary if it’s anonymous? Are there times where individuals could be identified using their nominally anonymous health information?
In addition, a vendor may want to protect the complex algorithms its systems use to train AI machines to make medical decisions or perform medical tasks against disclosure to or use by competitors. Presumably, current intellectual property laws (i.e., trade secret/copyright/patent) will operate to protect AI systems just as they do to protect software and systems generally, but wrinkles may arise in creating and maintaining such a framework.
We have been hearing (and writing) for some time now about the wave of consolidation expected to ripple through the banking industry, especially with respect to the community bank sector. Although the pace of mergers and acquisitions has been healthy, the industry has yet to see the anticipated wave of consolidation. However, legislative, regulatory, and economic changes are creating an environment ripe for mergers, acquisitions, and other strategic transactions in the banking sector. As we examine in this article, the changes that have occurred in the last year are opening the gates for consolidations, but it remains to be seen whether such consolidations are pursued and can successfully overcome the challenges of deal making.
Legislative Changes
Congress recently passed the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018 (the Crapo Act),[1] which provides regulatory relief for many banks, and will have a substantial effect for the community bank sector.[2] The Crapo Act grants relief to community banks on a few important fronts.[3] Relief from the Crapo Act includes capital simplification, extended examination cycles, reduced reporting requirements, and increased simplicity for small bank holding companies to finance bank acquisitions.
Specifically, the Crapo Act raised eligibility thresholds for an extended examination cycle from $1 billion to $3 billion in assets and made short-form call reports available for banks under $5 billion.[4] Community banks, generally those banks with assets less than $10 billion, are also granted relief from the prohibitions on proprietary trading and relationships with hedge funds and private equity funds under the so-called Volcker Rule, at least to the extent that they were actually engaged in those relationships.[5]
In addition, with the Democratic takeover of power in the U.S. House of Representatives in the 2018 mid-term elections, Representative Maxine Waters (D-CA) has taken the helm of the House Financial Services Committee. The banking sector generally should expect heightened scrutiny from the new chair, but this is likely to focus at least initially on the larger banks with more publicized regulatory challenges. This also means that the relief granted by the Crapo Act is likely the only legislative relief for the banking sector for the foreseeable future.
Regulatory Change
For bank holding companies, the Crapo Act amended the asset threshold for applicability of the Federal Reserve’s Small Bank Holding Company Policy Statement (the Policy Statement), which was implemented in August of 2018 and became effective the same day the interim final rule was released. Through the legislation, the asset threshold was raised from $1 billion to $3 billion in total consolidated assets.[6] The Policy Statement also applies to savings and loan holding companies with less than $3 billion in total consolidated assets.
In 1980, recognizing the challenges of small bank holding companies accessing the capital markets through equity financing, the Federal Reserve adopted the Policy Statement to permit small bank holding companies to assume debt at levels higher than typically permitted for larger bank holding companies.[7]
Under the Policy Statement, holding companies meeting the specific qualitative requirements may use debt to finance up to 75 percent of an acquisition, subject to the following ongoing requirements:
Small bank holding companies must reduce their parent company debt consistent with the requirement that all debt be retired within 25 years of being incurred. The Federal Reserve also expects that these bank holding companies reach a debt-to-equity ratio of .30:1 or less within 12 years of the incurrence of the debt. The bank holding company must also comply with debt servicing and other requirements imposed by its creditors.
Each insured depository subsidiary of a small bank holding company is expected to be well capitalized. Any institution that is not well capitalized is expected to become well capitalized within a brief period of time.
A small bank holding company whose debt-to-equity ratio is greater than 1:1 is not expected to pay corporate dividends until such time as it reduces its debt-to-equity ratio to 1:1 or less and otherwise meets the criteria set forth in Regulation Y.[8]
This update to the asset threshold is the third time the Policy Statement has been amended.[9] When the Policy Statement was first adopted in 1980, there were more than 14,000 commercial banks according to the FDIC’s Historical Bank Data. Today, there are less than 4,800 commercial banks.[10] Bank failures have played a role in the decline in the number of banks, but so have mergers and acquisitions. For example, in the past decade there have been approximately 2,300 bank mergers in the United States.[11] This increased asset threshold for small bank holding companies to take advantage of the Policy Statement should encourage further consolidation in the community bank sector.
Economic Conditions
In addition to the legislative and regulatory changes over the past year that have further opened the gates for bank consolidation, the economic climate also appears to be a significant factor; however, it is perhaps a challenge for some banks as well. Banks are making money and growing. With rising interest rates, solid earnings, and healthy valuations, it would appear that the market is ripe for deals. Despite the healthy economy over the last few years, however, banks and investors are searching for deals at the right price with long-term sustainability. Some would-be acquirers are sitting out until valuations come down or a clearer path to long-term deposit and earnings growth emerges.
Overall in 2018, the underlying theme for bank deals involved “sellers in high-growth markets finding buyers willing to pay healthy premiums for market share.[12] The average premium paid was 172 percent of tangible book value of the seller, which was an increase over the 165-percent average premium from 2017.[13] Acquirers continue to search for core deposits and low loan-to-deposit ratios, even in remote markets. For example, earlier in 2018, Trinity Capital in Los Alamos, NM, sold itself to Enterprise Financial Services in Missouri after going to market to sell itself. In that deal, Trinity Capital’s strong core deposits and loan-to-deposit ratio of 65 percent rewarded the bank with a price that was 202 percent of its tangible book value.[14]
Although less remote compared to its current footprint, Delmar Bancorp in Maryland agreed in 2018 to purchase Virginia Partners Bank in Virginia, where the deal will bring Delmar its first branches in the neighboring state. In another deal announced in 2018, Cambridge Bancorp in Massachusetts agreed to buy Optima Bank and Trust in New Hampshire with a valuation of 191 percent of tangible common equity. In that deal, Cambridge indicated that the deal was consistent with its growth strategy because of the focus on growth in its wealth-management business line.
At the end of the day, increasing shareholder value is paramount, and whether that is accomplished through organic growth, partnerships, or acquisitions will depend on the institution’s board of directors and particular growth strategy.
Ongoing Challenges
Despite the encouragement for consolidation, challenges persist. Some banks are sidelined with compliance struggles, whereas others are finding it difficult to get to the right price for shareholders. Bank boards of directors are having difficulty in some cases determining the right price at which to buy another institution or sell itself. In many cases, the price targets for the buyer and the seller are just too far apart as sellers seek healthy valuations and buyers worry about the potential short-term devaluation in share price and, in many cases, the longer-term view of the economy.
Banks also continue to face the challenges of financial technology companies, both from competition and partnership opportunities. Financial technology firm Robinhood Financial, for example, recently announced that it would be offering a version of a bank account, Robinhood Checking & Savings, which promises a three-percent interest rate. Although not subject to the same regulations, banks are struggling to compete with these financial institutions nonetheless.
Finally, there are the ongoing challenges of the regulatory approval process after the deal is struck. Filing requirements, newspaper notices, and timing considerations present an entirely separate stage of challenges in the M&A process that must be managed with precision through consummation.
Conclusion
Although it is too early to tell whether 2019 will finally be the year of the merger wave, recent legislation, regulatory relief, and current economic conditions appear to have opened the gates to consolidation, as evidenced by the recent announcement of the proposed merger between SunTrust and BB&T. However, the market will ultimately tell us whether the challenges associated with successful deal making have been overcome by the many or the few.
[1] Economic Growth, Regulatory Relief, and Consumer Protection Act, Pub. L. 115-174 (hereinafter Crapo Act).
[2] Federal Reserve Statistical Release, Large Commercial Banks as of March 31, 2018; see also, Federal Reserve, National Information Center (there were 4,748 commercial banks, 489 savings banks, and 172 savings and loans chartered in the United States with assets less than $10 billion as of March 31, 2018).
[3]See Gregory J. Hudson & Joseph E. Silvia, Crapo Helps Community Banks, 135 Banking L. J. 456 (Sept. 2018) (discussion on how the Crapo Act reduces the regulatory burden for community banks).
[4]See Gregory J. Hudson & Joseph E. Silvia, Recent Legislation Encourages Bank M&A Activity, Bus. Law Today, Dec. 2018 (discussion on how the Crapo Act encourages mergers and acquisitions in the community bank sector).
[5]See Crapo Act, supra note 1, at § 203. On December 21, 2018, the federal banking agencies, as well as the Securities Exchange Commission and the Commodity Futures Trading Commission, released a Notice of Proposed Rulemaking to implement this section of the Crapo bill exempting community banks from certain prohibitions under the Volcker Rule. With the legislative revisions to the Volcker Rule, banks under $10 billion in assets will be exempt from the Volcker Rule’s restrictions if the bank’s total trading assets and trading liabilities are no more than five percent of the bank’s total consolidated assets.
[7] Regulation Y, 12 C.F.R. § 225, Appendix C to Part 225 (Small Bank Holding Company and Savings and Loan Holding Company Policy Statement).
[8]See 12 C.F.R. §§ 225.14(c)(1)(ii), 225.14(c)(2), and 225.14(c)(7).
[9] The Small Bank Holding Company Policy Statement was previously amended in 2006 to raise the asset threshold from $150 million to $500 million. See 71 Fed. Reg. 9902 (Feb. 28, 2006). In 2015, the asset threshold was raised from $500 million to $1 billion, and the scope of the Policy Statement was expanded to include savings and loan holding companies. See 80 Fed. Reg. 20158 (Apr. 15, 2015).
[10]See FDIC Statistics at a Glance (Sept. 30, 2018).
[11]See FDIC Statistics at a Glance, Historical Trends (Sept. 30, 2018).
[12] See Davis, Paul, Top bank M&A deals of 2018, Am. Banker, Dec. 23, 2018.
The organizational law of limited liability companies (LLCs) and partnerships has always fundamentally embraced an idea known as the “pick-your-partner principle,” under which transfers of a member’s or partner’s ownership interest are restricted by statute, and those restrictions may be tightened or loosened by agreement. In recent years the pick-your-partner principle has interacted in complex and not always practical ways with Article 9 of the Uniform Commercial Code (UCC). Since 2001, UCC §§ 9-406 and 9-408 have overridden a broad range of statutory and agreement-based anti-assignment provisions, subject to complex exceptions that have tended to protect the pick-your-partner principle in many significant respects, while also proving analytically very difficult to handle. Recently, however, in an important step forward, Article 9’s overrides of anti-assignment provisions have been amended to make them simply inapplicable to LLC and partnership interests.
One hopes that these amendments to Article 9’s overrides (hereinafter the “2018 amendments” because they were approved last year) will soon be enacted by the states, but in the meantime, the current overrides will remain on the books in various jurisdictions with all of their existing complexities. Accordingly, this article focuses not only on the 2018 amendments, but also on an analysis of the overrides as they now stand, as applied to LLC and partnership interests. The amendments themselves are quite simple, but the article discusses them only after analyzing the overrides because the amendments are more easily understood against that background.
I. Background on Unincorporated Organization Law and UCC Article 9
Any co-owner of a privately held business organization may have a substantial stake in determining who the other co-owners are. If a second co-owner has the power to transfer its interest to a stranger, then the second co-owner can, in effect, force the first co-owner into a venture with the stranger/transferee without the first co-owner’s consent. The policy and effect of the pick-your-partner principle under LLC and partnership law is to prevent such an outcome.
UCC Article 9, by contrast, has the very different policy orientation of facilitating voluntary transfers of personal property. Article 9’s most familiar application is to transfers of property as security for the repayment of loans, but Article 9 also applies to outright sales of certain types of personal property. Some of these transfers and outright sales are precisely those that the pick-your-partner principle seeks to prevent, and as a result, for personal property consisting of LLC or partnership interests, the interaction of the pick-your-partner principle with Article 9 has been complex and thorny. Some have even called it recondite.
Ownership interests in a business organization, particularly one that is unincorporated, can be formally or informally bifurcated into governance rights and economic (or financial) rights. Governance rights consist of the owner’s right to vote on, consent to, or otherwise make decisions about the organization’s activities, and the right to receive information about the organization. Economic rights consist of the owner’s entitlement to receive monetary distributions from the organization, whether from its profits or from an eventual dissolution and winding up. A complete ownership interest typically comprises both governance rights and economic rights. A good example of purely economic rights is a transferable interest in an LLC or limited partnership. See, e.g., Uniform Limited Liability Company Act (ULLCA) § 102(24) (2013).
Article 9 broadly covers ordinary security interests in both of the above aspects of ownership rights as well as in virtually all other personal property, plus the outright sales of some types of personal property, to be explained below. In light of this vast coverage, and in order to provide appropriately tailored rules for particular patterns of transaction, Article 9 subdivides personal property into an array of statutorily defined “types,” or classifications. The most important classification for purposes of this article is general intangibles, which is Article 9’s residual or catch-all classification, meaning that it includes any personal property that does not fall within the other Article 9 classifications. Hence, an asset is a general intangible only if it is not, for example, inventory or other goods, accounts, instruments, chattel paper, or securities or other investment property. See UCC § 9-102(a)(42). Examples of general intangibles range from trademarks to taxicab medallions, and centrally for purposes of this article, the category includes most LLC and partnership interests. (LLC or partnership interests may alternatively be classified as securities, using an opt-in process discussed in Part II.C.)
The other key type of property for purposes of this article is payment intangibles, which is a subset of general intangibles. The distinction between a general intangible that is also a payment intangible on one hand, and a general intangible that is not a payment intangible on the other, is that the former includes only general intangibles under which the “principal obligation” of the “account debtor” is “a monetary obligation.” § 9-102(a)(62). In this article, the important term “account debtor” may be understood simply as the entity that is obligated on a payment intangible or other general intangible, i.e., the LLC or partnership itself as opposed to its members or partners. To determine whether the “principal obligation” is “monetary,” one must weigh the relative importance of a member’s or partner’s governance and economic rights: if the LLC’s or partnership’s principal obligation in respect of the ownership interest is economic and thus “monetary,” then the ownership interest is a general intangible that is also a payment intangible (or simply “payment intangible” for short). Otherwise, the ownership interest is a general intangible that is not a payment intangible. In general, if a member or partner has governance rights that the LLC or partnership is obligated to respect, the ownership interest is likely a general intangible that is not a payment intangible.
This distinction between payment intangibles and other general intangibles affects Article 9’s scope, which is crucial to understanding the overrides because of course the overrides apply only within that scope. Article 9’s scope includes two principal types of transactions relevant to this article: interests in either payment intangibles or other general intangibles that secure a loan or another obligation (referred to in this article as ordinary security interests), and outright sales of payment intangibles. In fact, outright sales of payment intangibles are statutorily defined in Article 9 as “security interests,” purely as a matter of terminological convenience, because many (though not all) of Article 9’s rules for ordinary security interests also apply directly to sales of payment intangibles. By contrast, Article 9’s scope does not include outright sales of general intangibles that are not payment intangibles, because most of such sales have little enough in common with ordinary security interests that inclusion would not be sensible. (The boundary between an outright sale of property and an ordinary security interest in the property is not always self-evident, but that topic is beyond the scope of this article. See, e.g., § 9-109 cmt. 4.) One final note on Article 9’s scope is that transfers by gift or, generally, transfers by operation of law are not covered.
Bringing these strands together, Article 9 typically does not apply at all to the most common kind of transfer in this area—namely, outright sales of a member’s or partner’s complete ownership interest—because such a transaction is typically the sale of a general intangible that is not a payment intangible. By the same token, Article 9 does not apply to outright sales of a member’s or partner’s governance rights alone. But Article 9 does apply, and hence its overrides discussed below might apply, to ordinary security interests in complete ownership interests; to ordinary security interests in economic rights alone; and to outright sales of economic rights alone.
The fact that Article 9 applies to a particular transaction, though, does not necessarily mean that there is a practical conflict between an Article 9 override and the pick-your-partner principle. Whether a practical conflict exists depends on three elements. First, do the applicable statutes governing the organization directly restrict transfers? Such restrictions are universal or nearly so in the case of governance rights and complete ownership interests (e.g., ULLCA § 407(b)(2) (2013)), but they are nonexistent or nearly so in the case of economic rights (e.g., id. § 502(a)). Second, do the LLC’s or partnership’s own organic documents alter (or perhaps track) the statutory law just mentioned, for example by restricting transfers of economic rights? Organizations may indeed adopt restrictions on the transfer of economic rights, in order to ensure that all owners retain their economic stake in the organization and, as a result, have reasonably well-aligned governance incentives. And finally, if a restriction on transfer is imposed by either of the foregoing sources, does one of the Article 9 overrides invalidate or limit the restriction?
II. Navigating Unamended §§ 9-406 and 9-408
Part of what makes Article 9’s overrides of anti-assignment provisions difficult is that they appear in two separate sections that are phrased quite similarly, but have subtle distinctions, and do not overlap. The first override, in § 9-406, is relatively strong and simple in its effects, but it applies to only a narrow set of transactions. The second override, in § 9-408, applies more broadly and is more complex in its provisions that apply to LLC and partnership interests, but it has only relatively weak effects on the transactions to which it applies. Taking into account the narrowness of the first and the weakness of the second, plus the availability of the opt-in process discussed in Part II.C, the overrides have generally not posed substantial problems for those who seek the protection of the pick-your-partner principle. On the other hand, general conclusions only take one so far in particular transactions.
A. Section 9-406
Article 9’s first override, beginning at § 9-406(d), invalidates any “term in an agreement between an account debtor and an assignor” to the extent that that term “prohibits, restricts, or requires the consent of . . . the account debtor” to “the assignment or transfer of, or the creation, attachment, perfection, or enforcement of a security interest in . . . the payment intangible.” The simplicity of this provision is evident from its shortness, and the strength of this provision is that it overrides restrictions on all aspects of security interests, including “enforcement,” as further discussed below.
The § 9-406 override is narrow, however, in three important ways. First, it applies only to payment intangibles (leaving aside its application to other types of property not relevant to this article), and only to ordinary security interests in them. See § 9-406(e). In other words, the override does not apply to transfers of governance rights, in either an outright sale or an ordinary security interest; and it does not apply to transfers of a complete ownership interest in either an outright sale or an ordinary security interest, assuming that the complete ownership interest is a general intangible that is not a payment intangible. Nor does the override apply to an outright sale of a payment intangible (other than a foreclosure sale or a secured party’s acceptance of the payment intangible in satisfaction of the obligation it secures). See the discussion of § 9-408 in Part II.B. The narrowness of the § 9-406 override is important as a practical matter because when an LLC’s or partnership’s organic documents impose restrictions on transfer, the restrictions sometimes apply by their own terms only to governance rights or complete ownership interests, not to purely economic rights (classified as payment intangibles) in the first place.
Second, the § 9-406 override has no effect on an anti-assignment clause in an agreement among the organization’s members or partners inter se, as opposed to terms in an agreement with the organization itself. This is because the override applies only to terms in an agreement with “an account debtor” and the assignor/transferor, and as noted in Part I, the LLC or partnership itself, rather than the other members or partners, is the account debtor in this context. Moreover, there may be substantial grounds to question whether the override applies even to an anti-assignment clause that is set forth directly in the organization’s operating agreement, partnership agreement or other organic documents, because as a formal matter, an LLC or partnership is usually not a party to these agreements. On the other hand, substance-over-form arguments should be borne in mind on this point.
Third and relatedly, if the term of the agreement imposes a consent requirement, the override applies only if the consent required is that of the LLC or partnership itself, as opposed to one or more members or partners. For example, if an LLC is member-managed, the agreement will almost certainly require the consent of the members, and accordingly, the override will not apply to that requirement.
B. Section 9-408
Article 9’s other override, beginning at § 9-408(a), invalidates any term in “an agreement between an account debtor and a debtor which relates to . . . a general intangible” that “prohibits, restricts, or requires the consent of . . . the account debtor” to “the assignment or transfer of, or creation, attachment, or perfection of a security interest in . . . the . . . general intangible.” It also invalidates any provision of a statute or other rule of law that similarly “prohibits, restricts, or requires the consent of . . . [an] account debtor” to “the assignment or transfer of, or creation of a security interest in, a . . . general intangible.” Thus § 9-408 is more complex than § 9-406 as applied to LLC and partnership interests, because it overrides not only terms of agreements, but also statutes or other rules of law. (Although § 9-406 also overrides some statutes or other rules of law, it does so only for classifications of collateral that are not relevant to this article.)
Section 9-408 is also broader than § 9-406 in two additional ways. First, it applies to a broader range of transactions, namely outright sales of payment intangibles (statutorily included in Article 9’s term “security interest,” as noted in Part I) and ordinary security interests in general intangibles that are not payment intangibles. Outright sales of economic rights, covered here, perhaps are more common than ordinary security interests in them, covered in §9-406; and certainly general intangibles that are not payment intangibles is the most common classification of an LLC or partnership interest.
Second, the statutes that § 9-408 overrides are of broad applicability because they are restrictions on the transfer of general intangibles that are not payment intangibles, i.e., virtually all complete ownership interests, plus all governance rights taken alone. As a practical matter, such statutory restrictions are nearly universal in this area, though a particular organization’s organic documents may sometimes alter the statutory default rules.
On the other hand, just as for § 9-406 above, § 9-408 does not apply to an anti-assignment clause in an agreement among the organization’s members or partners inter se, as opposed to an agreement with the organization itself. Similarly, and again just as for § 9-406, if the term of the agreement imposes a consent requirement, § 9-408 applies only if the consent required is that of the organization itself, as opposed to one or more members or partners. This override of consent requirements, in § 9-408 unlike § 9-406, extends to statutes as well as terms in an agreement, but nonetheless only if the consent required is that of the organization itself as opposed to one or more members or partners—but this is not how the LLC and partnership statutes work. Instead, the statutes place the power to give or withhold consent in the hands of the members or partners themselves.
The feature of this override that makes its effects relatively weak, and thereby substantially accommodates parties seeking the protection of the pick-your-partner principle, is that § 9-408 invalidates restrictions only on the “creation, attachment, or perfection” of security interests. It does not, unlike § 9-406, invalidate restrictions on “enforcement” of security interests. Subsection 9-408(d) amplifies on this point by specifying among other things that, even giving effect to the § 9-408 override, a security interest that is subject to an otherwise enforceable restriction is “not enforceable” against the “account debtor” (i.e., the LLC or partnership itself), and “does not entitle the secured party to enforce the security interest.” In other words, under § 9-408, a security interest (including an outright sale of a payment intangible) may go forward as between the transferor and transferee, but not as between the transferee and the LLC or partnership. The secured party acquires property rights (an ordinary security interest or an ownership interest) to the transferring member’s or partner’s ownership interest, and the value of these rights would be respected, for example in a bankruptcy of the transferor, or as applied to proceeds from a transfer not affected by a restriction. See UCC § 9-408 cmt. 7. But the secured party is nonetheless without power of its own to step into the transferor’s shoes and exercise the transferor’s governance or economic rights.
Summarizing the substance of the two overrides, it is useful to think in terms of four permutations, based on the two classifications of collateral and the two forms of transaction. First, an outright sale of a general intangible that is not a payment intangible is not within the scope of Article 9, so neither override applies. Second, with an ordinary security interest in a general intangible that is not a payment intangible, the relatively weak override in § 9-408 applies, so that the secured party cannot enforce the transferred governance or economic rights against the organization. Third, with an outright sale of a payment intangible, again the relatively weak override in § 9-408 applies, so that the secured party cannot enforce the transferred rights against the organization. And fourth, with an ordinary security interest in a payment intangible, the relatively strong override in § 9-406 applies, so that the secured party can enforce the transferred rights against the organization. The Permanent Editorial Board for the Uniform Commercial Code (P.E.B.) is considering issuing a report that would further detail the application of both overrides to LLC and partnership interests.
C. Opting into Article 8
Neither of the Article 9 overrides applies to property that is a security as defined in UCC Article 8. This is because securities are classified by Article 9 as “investment property” rather than as general intangibles or, a fortiori, payment intangibles.
The term “security” generally does not include ownership interests in LLCs and partnerships, but it does include them if the “terms” of the ownership interest “expressly provide that it is a security” governed by Article 8. See §§ 8-102(a)(15), 8-103(c). Hence, one established way for transactional lawyers to avoid the overrides altogether is to have the organization “opt in” to Article 8 by adopting appropriate provisions in its organic documents. Related measures include providing for the security to be certificated or uncertificated, and preventing the organization from opting back out of Article 8 without the consent of the parties concerned.
III. The 2018 Amendments, Non-Uniform Amendments, and Choice of Law
Compared to the complex analysis in Part II, enactment of the 2018 amendments will markedly simplify the law in this area, eliminating the possible conflicts with the pick-your-partner principle that can remain despite the exceptions in §§ 9-406 and 9-408, and without the need for an Article 8 opt-in.
The 2018 amendments statutorily provide that Article 9’s overrides do not apply to “a security interest in an ownership interest in a general partnership, limited partnership, or limited liability company.” (In § 9-406, this language appears in a new subsection (k), which explicitly applies to subsections (d), (f), and (j). In § 9-408, the same language appears in a new subsection (f), which explicitly applies to the entire section.) A new comment to § 9-408 reads:
This section does not apply to an ownership interest in a limited liability company, limited partnership, or general partnership, regardless of the name of the interest and whether the interest: (i) pertains to economic rights, governance rights, or both; (ii) arises under: (a) an operating agreement, the applicable limited liability company act, or both; or (b) a partnership agreement, the applicable partnership act, or both; or (iii) is owned by: (a) a member of a company or transferee or assignee of a member; or (b) a partner or a transferee or assignee of a partner; or (iv) comprises contractual, property, other rights, or some combination thereof.
A new comment to § 9-406 provides that the § 9-408 comment applies to § 9-406 as well.
By excluding from the overrides a “security interest” in an ownership interest, when other law prevents outright sales of payment intangibles, ordinary security interests in payment intangibles, or ordinary security interests in general intangibles from going forward (and the relevant property is an ownership interest), Article 9 does not interfere with the effect of that other law. On the other hand, the overrides remain in effect (so that transfers continue to be enabled) for general intangibles that are not LLC or partnership interests and for other classifications of personal property that are not relevant to this article.
The 2018 amendments were initially recommended by the P.E.B. in conjunction with representatives from the Joint Editorial Board on Uniform Unincorporated Organization Acts. They were then approved in accordance with the respective procedures of the UCC’s two sponsoring organizations, the American Law Institute and the Uniform Law Commission. As a result, they are now a part of the UCC’s official text.
At the time of this writing, it is too early for the 2018 amendments to have been enacted in any jurisdiction. On the other hand, in recent years a number of states, led by Delaware, have enacted non-uniform provisions having the same thrust. Some of the non-uniform provisions appear in the enacting states’ UCC; others appear in their LLC and partnership organizational statutes; and others appear in both spots, as belt and suspenders and to ensure they will be found.
An important conflict-of-laws question can arise if a transaction involves elements from more than one jurisdiction, one of which has the unamended Article 9 overrides, and another of which has an eventual enactment of the 2018 amendments (or an existing, comparable non-uniform provision). Article 9’s conflicts rule for perfection and priority of security interests in general intangibles does not apply to the treatment of transfer restrictions, because this issue is neither “perfection,” “the effect of perfection or nonperfection,” nor “priority.” See § 9-301(1). Article 1’s main catch-all conflicts rule, which leaves some conflicts questions to the agreement of the parties, would also generally be inappropriate here because transfer restrictions inherently present a three-party question that is not amenable to treatment by two-party agreement. See § 1-301(a). Accordingly, a choice-of-law clause in the security agreement or other agreement between transferor and transferee does not control, as Comment 3 to § 9-401 makes clear. Instead, one would hope that a court would apply the version of the overrides enacted by the jurisdiction in which the entity is organized, as the same Comment assumes. (The “internal affairs” doctrine in business entity law would also be consistent with such an outcome, although of course, restrictions on transfers to nonmembers or nonpartners are not strictly internal affairs issues.) In any case, the bottom line is that real certainty in this area will most promisingly have to come from broad enactment of the 2018 amendments. The members of each state’s Uniform Law Commission delegation can often be of direct help in those enactment efforts.
IV. Conclusion
The 2018 amendments will protect the pick-your-partner principle while also greatly simplifying and clarifying its interactions with Article 9. By the same token, as is often true of simple rules, the 2018 amendments may also sometimes reach more broadly than really needed, for example by preventing simple attachment and perfection, without enforcement, of a security interest in a complete ownership interest. However, those transactions can continue to go forward despite the 2018 amendments by means of, for example, the Article 8 opt-in, or other amendment or waiver of the organization’s organic documents. On balance, the gains in this area from simplicity and clarity should clearly outweigh the losses from the occasional extra burden to an Article 9 transaction.
*Carl S. Bjerre is Kaapcke Professor of Business Law at the University of Oregon School of Law. Daniel S. Kleinberger is Emeritus Professor of Law at Mitchell Hamline School of Law. Edwin E. Smith is a partner at Morgan, Lewis & Bockius LLP. Steven O. Weise is a partner at Proskauer Rose LLP.
For the first time in 15 years, Rule 23 of the Federal Rules of Civil Procedure has been amended. The amendments mostly address class settlements, and they come during a pivotal time for class litigation. With changeups in the composition of the Supreme Court and circuits across the nation split on many class action issues, the long-term impact of these amendments on federal class action practice is likely to be significant.
The changes further codify precedent establishing that Rule 23’s requirements are rigorous, including in the context of settlement. On the one hand, the changes should afford more certainty in the settlement process. On the other, the amendments may be a harbinger of stricter standards for class-wide settlements. The new rules contemplate increased court involvement and scrutiny, and will likely increase settlement costs and, by extension, the potential for more class action trials.
In this article, we briefly describe the amendments to Rule 23, dive into the commentary, and flag some of the more nuanced changes that may be coming for all involved in class litigation.
Rule 23’s New Notice Requirements
Rule 23(c)(2), which governs notice to class members, has long required “the best notice [to class members] that is practicable under the circumstances,” without explaining how that notice should happen. The new amendments clarify that notice can be conveyed by various means including electronically. At first glance, this amendment appears to simply reflect the trend of allowing notice via modern technology, a boon to settling defendants who previously have incurred substantial printing and mailing costs.
But the amendments do more than simply indicate courts can allow notice by means like email. The place to dig in is the extensive commentary, which suggests that courts take a harder look at what notice will be “appropriate” under the circumstances. Whereas before all courts had to consider was the “best practicable” standard, now courts must consider what is “appropriate.” The comments confirm that the difference matters.
The advisory committee cautions that the appropriate form of notice will depend on the characteristics of each particular class, and it will be important to evaluate the unique circumstances of each case in choosing the right method (or combination of methods). For example, notice by electronic means may make sense in a class action asserting technology-based claims. But such means might not be appropriate in other contexts, especially when (for example) the notice is being provided to a special population, such as the elderly.
Indeed, the committee emphasizes that in deciding what is an “appropriate” notice, courts should evaluate the “content and format” of the notice, depending on the audience. This signals that courts will be expected to take a more active role in ensuring that notice fairly informs the class members of their rights in an understandable, reasonably clear manner.
The committee explains that the overall governing standard is to enable the class to make “informed decisions” about whether to opt-out, saying that “attention should focus” on ensuring that there is a “convenient as possible” method. Note the committee did not say a practical or appropriate method—but the most “convenient” after being sufficiently informed. What information class members will need to be sufficiently informed, and what will be a sufficiently convenient opt-out mechanism will certainly be adjudicated in the months to come.
All of this commentary suggests that courts might accept the invitation to take a harder look at the notice process, pushing the parties and counsel to spend more time and resources (and potentially seek expert help) to create—and validate—a notice process. Defense counsel may use the changes to press for less costly notice methods (e.g., those not requiring postage); plaintiffs’ counsel may use them to push for multiple notice methods to try to up the claim rate.
Preliminary Class Settlements on the Ropes
The amendments upend the standard for seeking preliminary approval before class notice is sent out. The commentary highlights that giving notice “is an important event” and should only be done if there is a “solid record supporting the conclusion that the proposed settlement will likely earn final approval.” Parties seeking settlement approval under Rule 23(e)(1) must now show that the court will be able to approve the settlement and, if no class is certified yet, “certify the class for purposes of judgment on the proposal.”
Overall, these changes suggest that parties must make a much higher showing at the preliminary stage. That includes details about anticipated litigation outcomes, the risks of continuing the litigation, and other pending or anticipated litigation that is related. Courts already generally considered such factors, but the amendments now suggest they should always be assessed. As a practical matter, these amendments are likely to lead to more aggressive class discovery earlier in the case. At the point at which the parties seek preliminary approval, the parties must now demonstrate both class certification and final approval are warranted. Indeed, the commentary suggests that the parties should be ready to submit all facts and arguments that they would typically raise in the final approval hearing at the “new” preliminary approval stage.
The committee notes now also make clear that defendants will not be prejudiced if things go south during the settlement approval (perhaps anticipating fewer proposed settlements will be approved under this new rubric): “[i]f the settlement is not approved, the parties’ positions regarding certification for settlement should not be considered if certification is later sought for purposes of litigation.”
Another point raised by the commentary is the concern about the disconnect in many cases between attorney fees and benefits to the class. The committee notes that “[i]n some cases, it will be important to relate the amount of an award of attorney’s fees to the expected benefits to the class. One way to address this issue is to defer some or all of the award of attorney’s fees until the court is advised of the actual claims rate and results.” In other words: courts should see what benefit goes to the class before approving the settlement and fees. This concern about class relief and attorney’s fees is commonly raised in courts across the country, and many believe the Supreme Court will wade into the issue soon. The increased scrutiny on plaintiffs’ counsel fee awards make another appearance in the new settlement standards, which we tackle next.
Changing Up Class Settlements
Rule 23(e)(2) requires that a court approve a settlement “after a hearing and only on finding that it is fair, reasonable, and adequate.” The big change is that Rule 23 now sets out criteria for making this determination, codifying a standard that previously varied from court to court. Such considerations include:
The adequacy of class representatives and class counsel;
Whether the settlement was negotiated fairly;
The adequacy of the relief provided to the class; and
Whether class members were treated equitably relative to each other.
The streamlining alone provides increased certainty. There should be fewer questions as to what factors will direct the court’s decision; before, there could be a dozen factors (or more). This made settlements unpredictable and drove up litigation costs. Under the new criteria, it should also be easier to determine the likelihood of settlement approval—but that increased certainty comes at a cost.
By picking some factors and leaving out others, the amendments change the state of play. First, the amendments and commentary place a stronger emphasis on the parties’ process for litigating the case and negotiating. This may require counsel to engage in more thorough negotiations—and keep better documentation of the process. The notes also point out that involving a mediator or other neutral party can help.
Another new focus is the relief provided to the class and attorney’s fees. This is a hot-button issue, as the “relief actually delivered to the class” will now be a “significant factor” in approving attorney awards. The committee is also “concern[ed]” about “inequitable treatment of some class members vis-à-vis others.” This is likely a nod to creative settlement strategies like cy pres and pro rata distributions. Tightening the standards for attorney fees and class relief may make it nearly impossible to settle cases alleging de minimis damages and difficult-to-ascertain classes (like the Frank v. Gaos case at the High Court right now).
The committee notes also suggest more scrutiny should be leveled on class counsel and the class representative. Rather than just rely on the resumes and boilerplate submitted by the attorneys, the committee presses courts to look at how counsel has handled the case itself.
Cracking Down on Bad-Faith Objectors
The rise in “professional objectors” has not been well received. These rent-seeking attorneys hope one or both of the parties will quickly pay them rather than risk delaying the settlement. The Rules used to allow any class member to simply object. Now, an objection must “state whether it applies only to the objector, to a specific subset of the class, or to the entire class, and also state with specificity the grounds for the objection.” This specificity requirement puts a new burden on those seeking to challenge settlements. Perhaps most importantly, any “payment in connection with an objection” must be disclosed and approved by a court, further discouraging counsel who might wish to buy off objectors from doing so. This means, in turn, that negotiating parties will need try to address the kinds of issues that might draw objections (e.g., relatively small relief versus the claims alleged, varying relief to class members based on criteria that does not withstand scrutiny, or a negotiating process that could be attacked as insufficient).
Concluding Thoughts
Rule 23’s amendments should in some ways lead to a more streamlined, predictable class action settlement process. Predictability should make navigating settlement easier. But there are big changes here, especially when you dive into the extensive commentary.
These rule changes may be signaling changing winds in the notice process and class settlements more generally. Courts will need to consider what constitutes appropriate notice in each case. And the additional scrutiny on class relief and attorney’s fee awards is likely to raise the stakes for plaintiffs and defendants alike.
One of the most famous scenes in the movie “Minority Report” features Tom Cruise’s character Jon Anderton walking through a shopping mall as discrete scanners using iris recognition technology are hard at work, scanning his (and other shoppers’) irises. The scanners identify everyone individually to create a personalized shopping experience through targeted video screen advertisements that we can see change and move as Tom does. Far-fetched fictional technology? In the past 16 years the potential uses for biometric technology has grown (see, e.g., “Minority Report” May Come to Real World with Iris Recognition, Bloomberg Tech., Feb. 1, 2011) and today it is almost reality (see Princeton Identity looks to make “Minority Report” tech a reality, SecurityInfoWatch.com, Sept. 25, 2018).
This article briefly defines and describes some biometric applications presently in use, reviews one state’s statutory response to biometrics, and looks at how some courts are handling lawsuits over the use of biometrics and related privacy law and contract law issues. The article concludes with some practical pointers for businesses and their professional advisers to consider when implementing biometric applications into the business process.
What Are Biometrics?
Biometrics measure and analyze people’s unique physical and behavioral characteristics. Biometrics’ many uses include identification, access controls, testing, and numerous other rapidly evolving business applications. Like all technology, biometrics present both many beneficial applications for businesses and individuals, as well as legal risks.
Examples of biometrics include an individual’s DNA, fingerprints, eyeballs/irises/retinas, voiceprints, handprints, and facial geometry, to name just a few. Some biometrics, like fingerprints and retinal blood vessel patterns, generally do not change over time. Others, like facial geometry, can change over time due to age, illness, or other factors, and thus may adversely impact the accuracy of the biometrics. The uniqueness and potential permanence of biometrics are advantageous from a security perspective to accurately identify and distinguish individuals, plus you do not have to worry about forgetting your biometric password.
How Are Biometrics Used in Business Today?
Businesses presently use, and will continue to use, biometrics (and related technologies) in a wide variety of applications to improve their business processes and their customer and employee interactions, conveniences, and trustworthiness. Some examples include:
Workforce management. Consider a modern update to the time clock for employees logging in and out of work. Instead of workers having to wait in line to retrieve a time card, punch the card into a time-stamping machine, and then replace the time card into its slot, biometric readers allow workers to simply tap their fingerprints onto a biometric fingerprint scanner. This can prevent buddy time-punching and time theft, and increase accountability and security. See the Dixon case discussed below.
Hospitals. Although credit-card data breaches make for major headline news, medical identity theft events plus mistakes caused by hospital physicians and staff mixing up patients’ files are increasingly common, costly, and potentially life-threatening. Biometric technologies can help hospitals and other medical providers avoid these risks.
Banking. The banking industry has been looking into and adopting biometric technologies to help reduce identity theft and improve efficiencies and customer experience in the banking process.
Retail. Tanning salons, health clubs, or similar member-model-based businesses allow their customers to easily enter and use the business facility by using a fingerprint scanner at any of the businesses’ locations for customer identification. See the Sekura case discussed below.
Automotive. Biometrics can be used instead of key fobs to enter and operate an automobile, or to recognize whether the driver is becoming impaired (e.g., tired or texting), which could put the occupant(s) of the vehicle and other people and vehicles around it at risk.
However, if compromised, the same characteristics and advantages of biometrics present a potential threat to the individual owner of the biometric markers and risks to the businesses that use, and are the stewards of, biometric data.
Biometrics are unlike other unique identifiers that are used to access finances or other sensitive information. For example, social security numbers, when compromised, can be changed. Biometrics, however, are biologically unique to the individual; therefore, once compromised, the individual has no recourse, is at heightened risk for identity theft, and is likely to withdraw from biometric-facilitated transactions. (740 ILCS 14/5(c)).
Biometric Information Privacy Statutes
Biometric Information Privacy (“BIP”) is permanently ingrained into the privacy legal risk matrix confronting businesses and individuals, and is under review by state and federal legislators and regulators in the United States and other governments and regulators in the international community. October 2018 marked the 10th anniversary of the Illinois Biometric Information Privacy Act (“BIPA”), 740 ILCS 14/1 et seq., a comprehensive BIP statute that has given rise to a number of class-action lawsuits against businesses.
In addition to the Illinois BIPA, other state and federal legislators have considered, or are considering, legislation concerning biometric information privacy. A couple of states (e.g., Texas, 2009; Washington, 2017) have passed biometric information privacy statutes. Other states have considered, or currently are or will be considering, comprehensive legislation regarding biometric information privacy, or currently mention some biometric information (e.g., fingerprints) in their existing statutes. New legislation concerning BIP is under consideration as the legislative and judicial branches of state and federal governments try to understand the impact BIP has on individuals and businesses today, and whether and how biometric information should be regulated. The Illinois BIPA states: “The public welfare, security, and safety will be served by regulating the collection, use, safeguarding, handling, storage, retention, and destruction of biometric identifiers and information.” 740 ILCS 14/5(g). This fundamental concept is applicable to and should be considered in all BIP legislation, and viewed in light of the unique permanence of biometric data.
BIPA (740 ILCS 14/20) provides that for each negligent violation of the act, a prevailing plaintiff may recover liquidated damages of $1,000 or actual damages, whichever is greater, in addition to obtaining other relief such as an injunction. For each intentional or reckless violation of the act, the plaintiff may recover the greater of liquidated damages of $5,000 or actual damages. In addition, the plaintiff may recover reasonable attorney’s fees and costs, including expert witness fees and other litigation expenses, plus other relief, including an injunction, as the state or federal court may deem appropriate.
In February 2018, SB 3053 was introduced in the Illinois legislature to narrow the application of the Illinois BIPA. The present version of SB 3053 would add language to the Illinois BIPA narrowing it as follows:
(f) Nothing in this Act shall be deemed to apply to an entity collecting, storing, or transmitting biometric information if: (i) the biometric information is used exclusively for employment, human resources, fraud prevention, security purposes; (ii) the private entity does not sell, lease, trade, or similarly profit from the biometric identifier or biometric information collected; or (iii) the private entity stores, transmits, and protects the biometric identifiers and biometric information in a manner that is the same as or more protective than the manner in which the private entity stores, transmits, and protects other confidential and sensitive information.
The proposed SB 3053 amendments to Illinois BIPA may appear to help certain businesses avoid legal liability as described in the proposed amendment, but at the end of the day it does not change the fact that biometric data, if compromised, will potentially increase the risks to the individual represented by the biometric data. Further, such a change in the statute may not lessen the legal risks of those businesses collecting and using employee and/or customer biometric data, or improve the business’s appearance of trustworthiness in the minds of the employees and/or customers (particularly after that individual’s biometric information has been compromised). In addition, a further consideration is how this proposed amendment impacts and furthers BIPA’s stated legislative findings and intent (740 ILCS 14/5). As of this writing, the SB 3053 proposed amendment to the Illinois BIPA has not been passed into law.
BIP presents complex business, legal, and technology issues for legislators to consider. Thus, careful, critical thinking and thoughtful drafting is required in crafting legislation addressing BIP. Congress, state legislators, government regulators, and legislative bodies and regulators in other countries, as well as drafters of international treaties, have been considering, and will continue to consider, legislation regarding BIP. Like most legislation dealing with technologies, BIP legislation will continue to evolve as the law and legislation tries to catch up to rapidly evolving technologies and to the impact of these technologies on society in our global community.
Recent BIPA Court Decisions
Several court decisions regarding BIPA have found that simply alleging a violation of BIPA’s notice and consent provisions alone are not sufficient to support standing to bring the lawsuit. However, other court decisions have found standing when the allegations went beyond merely alleging a failure of notice and consent.
A recent example of one of these BIPA lawsuits is a September 2018 class-action lawsuit filed in the Circuit Court of Cook County against Wendy’s International LLC (the fast food restaurant). Other businesses that have found themselves defending against BIPA lawsuits include Facebook, Lowes Chicago Hotel Inc., Omnicell Inc., Southwest Airlines, and United Airlines. BIPA lawsuits are industry independent and may occur in any industry acquiring and using biometric data. The ultimate outcomes of these and other recently filed BIPA cases is yet to be determined.
In a recent court decision, an Illinois appellate court in Sekura v. Krishna Schaumburg Tan, Inc., 2018 Ill. App. (1st) 180175 (Ill. App. Sept. 28, 2018), had occasion to review BIPA. The plaintiff, Sekura, alleged, among other things:
Defendant, a franchisee of L.A. Tan Enterprises, Inc. (“L.A. Tan”), required customers enrolling in L.A. Tan’s national membership database to have their fingerprints scanned (to allow the customer to use their membership at any of L.A. Tan’s locations). Every time the plaintiff visited an L.A. Tan location, plaintiff was required to scan her fingerprints before using the services.
Plaintiff alleged she had never been:
informed of the specific purposes or length of time for which defendant collected, stored, or used her fingerprints;
informed of any biometric data retention policy developed by defendant or whether defendant will ever permanently delete her fingerprint data;
provided with nor signed a written release allowing defendant to collect or store her fingerprints; and
provided with nor signed a written release allowing defendant to disclose her biometric data to SunLync (the third-party vendor receiving the L.A. Tan biometric data) or to any other third party.
In addition, plaintiff alleged that “in 2013, more than 65% of L.A. Tan’s salons were in foreclosure and that defendant’s customers have not been advised what would happen to their biometric data if defendant’s salon went out of business” and that plaintiff “becomes emotionally upset and suffers from mental anguish when she thinks about what would happen to her biometric data if defendant went bankrupt or out of business or if defendant’s franchisor, L.A. Tan, went bankrupt or out of business, or if defendant shares her biometric data with others.”
The only issue before the appellate court was “whether a harm or injury, in addition
to the violation of the Act itself, is required in order to have standing to sue under the Act.” In its statutory interpretation of BIPA, the court carefully parsed the words of BIPA and examined the available legislative intent. The court concluded that the plaintiff did have standing, reversed the trial court’s dismissal, and remanded the case back to the trial court for further proceedings.
In its analysis, the court distinguished another Illinois Appellate court decision concerning BIPA, Rosenbach v Six Flags Entertainment Corporation, 2017 IL App (2d) 170317 (2017), concluding
…even if Rosenbach was correctly decided and an additional “injury or adverse effect” is required, Rosenbach is distinguishable from this case, in the following two ways. Rosenbach, 2017 IL App (2d) 170317, ¶ 28 (requiring an “injury or adverse effect,” in addition to violation of the Act). First, as the federal district court similarly found, disclosure to an out-of-state third-party vendor constitutes an injury or adverse effect, and plaintiff in the instant case alleged such a disclosure, while the Rosenbach plaintiff did not. Dixon, 2018 WL 2445292 *12. Second, the mental anguish that plaintiff alleges in her complaint also constitutes an injury or adverse effect. E.g., Chand, 335 Ill. App. 3d at 823, 269 Ill.Dec. 543, 781 N.E.2d 340 (Kuehn, J., concurring in part and dissenting in part) (actual damages may include “mental anguish”). For these reasons, we must reverse and remand.
The Illinois Appellate Court for the 2nd District decision in Rosenbach was appealed to the Illinois Supreme Court and reversed. In Rosenbach v Six Flags Entertainment Corporation, 2019 IL 123186 (January 25, 2019) the Illinois Supreme Court held “…an individual need not allege some actual injury or adverse effect, beyond violation of his or her rights under the Act [BIPA], in order to qualify as an ‘aggrieved’ person and be entitled to seek liquidated damages and injunctive relief pursuant to the Act.”
In reversing the appellate court, the Illinois Supreme Court stated: “While the appellate court in this case found defendants’ argument persuasive, a different district of the appellate court subsequently rejected the identical argument in Sekura v. Krishna Schaumburg Tan, Inc., 2018 IL App (1st) 180175. We reject it as well, as a recent federal district court decision correctly reasoned we might do. In re Facebook Biometric Information Privacy Litigation, 326 F.R.D. 535, 545-47 (N.D. Cal. 2018).”
In Dixon v Washington and Lee Smith Community-Beverly, et al., 2018 WL 2445292 (USDC IL ND, 20180531), the Illinois district court was presented with the plaintiff-employee alleging, among other things, that her employer, the defendants, had violated BIPA by requiring employees to clock in and out of work by scanning their fingerprints onto a biometric timekeeping device provided by a third-party vendor, and failed to disclose to plaintiff that her fingerprint data was disclosed to or otherwise obtained by a third party. Defendants argued, in part, that plaintiff lacked standing on the ground that the procedural injuries plaintiff alleged are insufficient to support a cause of action under BIPA or a negligence claim. Plaintiff argued that although defendants’ argument is ostensibly aimed at the meaning of “aggrieved” in BIPA, it directly questions whether plaintiff alleged a cognizable injury sufficient to meet Article III standing necessary for federal jurisdiction. “The Court concludes that this alleged violation of the right to privacy in and control over one’s biometric data, despite being an intangible injury, is sufficiently concrete to constitute an injury in fact that supports Article III standing.”
Another recent BIPA related development concerns insurance coverage in BIPA lawsuits. As a result of a lawsuit, Mazya v. Northwestern Lake Forest Hospital, et al., 2018-CH-07161 (June 6, 2018), in the Circuit Court, Cook County, Illinois, one of the defendants, Omnicell Inc., tendered the suit to Zurich American Insurance Co., its insurance company, to defend and indemnify Omnicell in that lawsuit. Zurich responded by filing on August 30, 2018, a lawsuit in the U.S. District Court for the Northern District of California alleging that Omnicell’s general liability policy expressly excludes coverage for alleged violations of state or federal laws that prohibit collection of personal information. The final outcomes of the Mazya case and other BIPA cases discussed in this article are yet to be determined as the courts further explore the facts and the applicable law, and further define the BIP legal landscape.
Practice Pointers
Although not exhaustive, here are some practical pointers for consideration by businesses and their professional advisers regarding the use of biometric applications in business processes:
Develop written policies addressing how the business will collect, use, distribute, and destroy biometric data.
Follow those written policies. It does not look good to a judge, arbitrator, or a government regulator (or to employees and customers) when a business’s written policies say one thing, but the facts show they are actually doing something else. If you need an economic perspective on this, consider the enhanced statutory penalties found in some statutes when a business is found to have intentionally or recklessly violated the statute.
Inform and disclose. Clearly, concisely, and consistent with statutory obligations, notify your employees and customers how you are handling their biometric data. For instance, a. How long will the business keep the biometric data? b. When (and how) will the biometric data be destroyed? c. Will the biometric data be shared with (e.g., processed by) a third-party vendor? d. How will the biometric data be handled if the business is sold, closes, or enters bankruptcy?
Secure with encryption the biometric data at rest and in transit.
Limit the access to the biometric data. If you must distribute the biometric data to a third-party vendor, carefully and concisely craft the contract with that third-party vendor to clearly express the parameters surrounding the biometric data.
Consider storing less than 100 percent of the entire biometric dataset for an individual (i.e., only enough of the dataset to confirm an accurate match between the individual and the individual’s biometric dataset to satisfy the business’s need to use the biometric information).
Consider, when practical, having employees and customers use two-factor authentication in conjunction with biometric information. Use the nonbiometric (second factor) data to randomize the biometric information that is authenticated only when both the biometric information and the second factor are present.
If plaintiffs are alleging BIPA violations, courts will look for allegations that go beyond merely alleging a failure to provide notice or obtain consent and will look for specific factual allegations that constitute an actual and concrete injury as contemplated by the applicable statute(s).
Appropriately address your legal, statutory, obligations regarding biometric data in all of your contracts with your customers, contracts with your vendors accessing or handling biometric data for which you are the steward of that biometric data, and your employee policies/handbooks.
Consider the business’s general commercial liability insurance coverage and whether it provides adequate coverage for BIPA risks, and how (or if) the insurance carrier helps insureds in understanding and managing these risks.
The application of these practical pointers may vary depending on the business and applicable laws, and are not exhaustive of all the considerations regarding the use of biometric applications in business processes.
Conclusion
Biometric data and devices and applications that collect, process, and analyze biometric data are now, and will become even more, ubiquitous. An increasing number of businesses in a variety of industries will increasingly confront BIP issues in their business processes as they begin to realize and recognize the return on investment biometric technologies can provide to the business. The bottom line is that these businesses and their professional advisers must understand and proactively address the legal risks attendant to biometric information and the use thereof with customers, employees, and third-party vendors.
