The recent collapse of two large regional banks, and the expedited sale of Credit Suisse due to similar challenges, have left many in the financial services industry uncertain about the future. What should we understand about what happened, and what it might mean for the future of finance?
What Happened?
As everyone has now read about repeatedly, Silicon Valley Bank (SVB) collapsed due to a “run on the bank” involving customers withdrawing (or attempting to withdraw) their funds simultaneously. The run was prompted by fears that SVB could not honor withdrawals due to the decline in market value of long-term treasuries and other long-term assets. The decline in the value of these assets occurred due to the rise in interest rates over the past year, which has caused fixed income investments with lower interest rates to have a lower market value. Signature Bank was shut down by the New York Department of Financial Services and the Federal Deposit Insurance Corporation (FDIC) due to related concerns. At the time of the SVB collapse, the FDIC followed its protocols regarding the shutdown of a depository institution that is not subject to a systemic risk exception. This included shutting down SVB on Friday, March 10, 2023, establishing a new national bank, and guaranteeing access on Monday, March 13, for any deposits up to the FDIC insurance limit. That limit is presently $250,000 per depositor. As to any amounts in excess of $250,000, the FDIC noted an advance dividend would be paid later that week based upon assets sold, and the remaining amounts would be handled through the FDIC’s receivership process.
To put it mildly, SVB depositors and commentators exploded on social media regarding the potential loss or delayed access to significant amounts of business capital, with some noting various companies would be unable to make payroll without access to the funds in their operating accounts. As we now know, the Treasury, Federal Reserve, and FDIC invoked the systemic risk exception for both SVB and Signature Bank on Sunday, March 12, which enabled the agencies to guarantee all deposits of the banks. This exception is designed to enable federal agencies to prevent the adverse economic consequences of broader financial instability.
The Federal Reserve also established a new Bank Term Funding Program designed to provide liquidity to banks. The program allows banks to borrow money secured by U.S. treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral. The program also allows banks to borrow funds based upon the par value of the assets, not the lower market value.
The Crystal Ball: What (Regulations) Will Come?
The U.S. banking system functions on consumer confidence that the money will be there when depositors need it. The past month introduced what some have called a new variation on a longstanding risk: a social media-fueled bank run. FDIC insurance was designed to be the primary hedge against bank runs, but it proved inadequate in SVB’s case. This was in significant part due to the low level of FDIC insurance when compared to the capital required to operate a business and the concentration of deposits in a single institution by deposit holders. These facts lead to a couple of potential legislative changes.
First, lawmakers are already proposing bills to increase the FDIC insurance limits. Second, lawmakers and regulators will have to grapple with how to deal with what some have called a social media bank run. (It is worth noting, however, that some commentators minimize social media’s role in adding fuel to the fire.) The federal agencies’ response implies that they will backstop deposits well beyond the largest banks, but it is unclear where (and whether) the agencies could stop if smaller banks face financial difficulties as well. Although the present response is designed to prevent the agencies from needing to answer this question now by backstopping other regional depository institutions, policymakers will have to address what to do in the future if additional bank runs occur.
Regulatory agencies will likely also increase their focus on managing interest rate risk on depository institution balance sheets. Regulatory agencies have faced significantcriticism for failing to detect what some refer to as an obvious balance sheet concern caused by the combination of demand deposits that can be withdrawn immediately and long-term government securities pledged to be held to maturity. In response, the agencies will likely increase the urgency of examinations and stress testing focused on the impact of rising interest rates on depository institution balance sheets.
Some lawmakers have already proposed restoring Dodd-Frank’s stress testing of banks above the $50 billion threshold after these standards were reduced several years ago. We will have to see how far the changes will go. Regulators can force depository institutions to amass a fortress-like balance sheet of short-term treasuries, but those assets pay lower interest rates. Likewise, those requirements only go so far before banking products start to become more expensive for customers and lawmakers call for lower-cost banking products.
The Department of Justice (DOJ) Antitrust Division recently suffered another setback in its most recent effort to secure criminal convictions for labor-side violations of Section 1 of the Sherman Act. Having finally secured a successful criminal conviction, which came by way of a plea deal and with a deferred prosecution agreement, the DOJ proceeded to trial in Maine against four home health executives who the government alleged had conspired to enter into a no-poach agreement and fix wages paid to home health aides. After a two-week trial, the jury acquitted all four of the defendants, marking the third time the DOJ has failed to convince a jury to convict defendants for alleged Section 1 violations in the labor market.
U.S.A v. Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah
On January 27, 2022, a federal grand jury in the U.S. District Court for the District of Maine issued a nine-page indictment, charging Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah (defendants) with one count each of engaging in a conspiracy to violate Section 1 of the Sherman Act.[1] Per the indictment, the defendants entered into an agreement to fix the wages paid to personal support specialists (PSS) employed by their respective home health agencies by agreeing not to hire each other’s workers and to fix their wages at $15 or $16 an hour.[2] The alleged two-month conspiracy was supposedly carried out through various virtual and in-person meetings, and both encrypted and nonencrypted messaging apps.[3] The DOJ alleged the defendants’ agreement constituted a per se violation of Section 1.[4]
Motion to Dismiss
In May 2022, defendant Faysal Kalayaf Manahe filed a motion to dismiss the indictment,[5] which was joined by the other defendants.[6] The defendants asserted multiple arguments for why the indictment should be dismissed, including that the indictment failed to state a per se violation of Section 1, and that the alleged agreement reached by the defendants was an ancillary restraint subject to the rule of reason that was not pleaded in the indictment.[7]
The DOJ opposed the motion to dismiss, arguing the alleged no-poach agreement was a classic example of a horizontal restraint of trade, long held to violate Section 1.[8] It further argued that there was no reason to create an exception to the per se rule for no-poach agreements, and that the defendants’ ancillary-restraint argument lacked merit.[9]
Ultimately, the district court denied the defendants’ motion. The court reasoned that the indictment adequately alleged a per se illegal horizontal conspiracy.[10] The court noted that the defendants were correct “that they have a valid defense to the per se rule if they can show that any restraint resulting from the alleged agreement was ancillary to efficiency-enhancing economic activity.” However, the court ruled that the defendants had the burden of making a factual showing to support that argument at trial, and therefore denied the motion to dismiss.[11]
Jury Acquits
Following a two-week trial, on March 22, 2023, the jury acquitted all four of the defendants.[12] Despite the introduction of evidence in the form of messages and recorded meetings that revealed the defendants discussed an agreement to pay all PSS workers $15 or $16 an hour, it appears the prosecution failed to convince the jury that an agreement was ever actually reached or acted upon by any of the defendants. Part of the prosecution’s difficulty likely stemmed from the fact that in practice, the defendants never reduced the PSS workers’ wages—they actually paid them $18 or $19 an hour. Further, while the alleged agreement was reduced to writing, the writing was never signed by any of the defendants. Notably, the defendants—all of whom were immigrants from Iraq—argued that in their culture, the only way to confirm an agreement is to sign a formal written contract.
This third acquittal may also indicate a more fundamental challenge the DOJ is facing: convincing juries that people should face jail time for agreeing not to solicit and hire competitors’ employees. The DOJ’s record appears to support this theory. To date, the DOJ is zero for three in securing a criminal conviction from a jury for a violation of Section 1 related to a no-poach agreement. The DOJ’s sole conviction in this arena was against VDA OC LLC and came via a plea deal.[13] Notably, even that conviction was not a complete success, as its prosecution against VDA’s former manager Ryan Hee resulted in a deferred prosecution agreement and not a criminal conviction.[14]
Conclusion
Businesses should not expect this most recent loss to slow down the DOJ’s enforcement actions. Despite the DOJ’s difficulty in securing jury convictions, the guilty plea by VDA and the Biden administration’s stated policy of trying to protect employees from what it perceives to be unreasonable restraints suggest that the DOJ will continue to indict businesses and individuals for alleged Section 1 violations involving no-poach agreements or wage fixing. Accordingly, clients should be careful when seeking to limit the movement of their employees in agreement with competitors or discussing their employees’ pay with competitors.
Related Cases Worth Watching
Opening arguments have begun in U.S. v. Mahesh Patel, Robert Harvey, Harpreet Wasan, Steven Houghtaling, Tom Edwards, and Gary Prus.[15] There, the defendants are each charged with one count of conspiracy in restraint of trade in violation of Section 1. The government alleges that each of the defendants, who managed or otherwise controlled the hiring decisions at various unnamed companies, entered into a no-poach agreement regarding their employed aerospace engineers.[16] Notably, the court recently denied the DOJ’s motion in limine, seeking to prevent the defendants from arguing the procompetitive benefits of the alleged agreement.[17] While the court agreed that such evidence could not be used to argue that the agreement had procompetitive benefits because the DOJ alleged a per se violation, the court ultimately ruled that the evidence could be used to rebut the allegations that the defendants “joined the charged conspiracy, whether the conspiracy existed as alleged, and whether defendants had the requisite intent to join the conspiracy.”[18] Time will tell if this ruling will further hinder the DOJ’s attempt to convince a jury to deliver the DOJ its first Section 1 conviction following a trial.
United States v. Manahe, No. 2:22-cr-00013-JAW (D. Me. Jan. 27, 2022), ECF No. 1. ↑
No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 79. ↑
No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 77; No. 2:22-cr-00013-JAW (D. Me. June 1, 2022), ECF No. 81; No. 2:22-cr-00013-JAW (D. Me. June 6, 2022), ECF No. 82. ↑
No. 2:22-cr-00013-JAW, at 1–2 (D. Me. May 31, 2022), ECF No. 79. The defendants also argued that the application of the per se rule against criminal defendants was unconstitutional because it instructed juries that certain facts presumptively established an element of a crime and because it rendered the Sherman Act unconstitutionally vague. ↑
No. 2:22-cr-00013-JAW, at 4–7 (D. Me. June 21, 2022), ECF No. 89. ↑
The Federal Trade Commission (“FTC”) continues to pursue its campaign against non-compete clauses. On January 5, 2023, the FTC voted 3–1 to publish a notice of proposed rulemaking, which, if implemented, would bar employers from entering into non-compete agreements with their workers and require employers to rescind existing non-compete restrictions with current and former workers. Originally, the deadline for submitting comments was March 20, 2023. Recently, the FTC voted 4–0 to extend the public comment period for an additional thirty days following numerous requests from the public. As such, the FTC will now accept comments on the proposed rule until April 19, 2023.
Although all four current commissioners voted to approve the extension, Commissioner Christine S. Wilson—the sole Republican—filed a concurring statement regarding the extension. Commissioner Wilson explained that because of the number of requests the FTC had received to extend the comment period by thirty days and the fact that the proposed rule “is a departure from hundreds of years of precedent and would prohibit conduct that 47 states allow,” she would have supported a longer, sixty-day extension. Commissioner Wilson additionally encouraged the public to submit comments on the proposed rule.
To date, the FTC has received more than 16,000 comments related to the proposed rule, a number that is sure to climb over the coming days.
Scope of the Proposed Rule
The proposed rule supersedes state laws that are less protective of employees, but keeps in effect state law that provides employees greater protection. The proposed rule excludes franchisees from the definition of “worker” and has a single, limited exception that applies to the sale of a business.
First, the FTC’s proposed rule would effectively ban worker non-compete provisions by deeming them an “unfair method of competition” under Section 5 of the FTC Act. The proposed rule would make it unlawful for employers to enter into or keep in place any non-compete provisions with current or former workers. Non-compete provisions are defined as contract terms that “prevent[] . . . worker[s] from seeking or accepting employment” or “operating a business” after their employment with the employer ends.
The proposed rule does not apply to customer or employee non-solicitation provisions or generally to confidentiality or non-disclosure agreements. The proposed rule applies a functional test for determining whether a clause is covered by the rule. A provision is considered a “de facto” non-compete provision if it “has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” The proposed rule includes as an example of a de facto non-compete term a “non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer.”
The proposed rule defines the term “worker” very broadly to include any “natural person who works, whether paid or unpaid, for an employer,” including “independent contractor[s], extern[s], intern[s], volunteer[s], apprentice[s], or sole proprietor[s] who provide a service to a client or customer.”
Notice Obligations Imposed by the Proposed Rule
If the rule becomes effective, employers who have existing non-compete provisions that violate the rule would be required to affirmatively rescind existing non-compete clauses with current workers and give individualized notice to workers that they are no longer subject to the non-compete clause. Employers would also be required to rescind non-compete clauses in effect with former workers, and give former workers notice of such rescission as long as the employer has the former worker’s contact information readily available. Employers would be prohibited from representing to a worker that the worker is covered by a non-compete clause when the employer has no good-faith basis to believe the worker is subject to an enforceable non-compete clause.
Exception for Sale of Business
The proposed rule provides a single, limited exception related to the sale of a business. The exception provides that the rule “shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity.” The exception applies, however, only to a person who owns at least a 25% ownership interest in a business entity at the time the person enters into the non-compete clause. The proposed rule is unclear as to whether the exception applies to existing non-compete terms applied to future sales of a business or only to non-compete terms entered into at the time of the sale.
Relation to State Laws
The proposed rule provides that it supersedes any state statute, regulation, order, or judicial interpretation that is inconsistent with the proposed rule. A state statute, regulation, order, or interpretation is not inconsistent with the proposed rule, however, if it provides greater protections to workers than the proposed rule. As a result, the proposed rule would essentially set a floor for worker protection against non-compete agreements but also keep in effect state and federal law that provides workers greater protection.
Public Comment
The FTC’s extended comment period on the proposed rule runs until April 19. The FTC has asked specifically for comments on several different alternatives to this non-compete ban, such as whether non-compete clauses between employers and senior executives should be subjected to a different rule than non-compete clauses between employers and other workers. The FTC also seeks comments on the possible benefits and costs of the proposed rule, the impact of the proposed rule on businesses, and possible compliance costs should the proposed rule be implemented. Commissioner Wilson’s recent and original statements seek to strongly encourage commenters to submit their views on the proposed rule.
Compliance Date
The proposed rule would establish a separate effective date and compliance date. The proposed rule’s effective date will be sixty days after the final rule is published in the Federal Register. The compliance date will be 180 days after the final rule is published in the Federal Register.
The time between the effective date and the compliance date is the “compliance period,” during which employers will need to be prepared to comply with the proposed rule’s provisions by the compliance date.
Effect on Congress
The FTC’s proposed rule has also sparked movement within Congress. In response to the proposed rule, Sen. Chris Murphy (D-Conn.) reintroduced the Workforce Mobility Act (the “Act”), which was cosponsored by Sens. Todd Young (R-Ind.), Tim Kaine (D-Va.), and Kevin Cramer (R-N.D.). This Act had been previously introduced to Congress in 2018, 2019, and 2021 but stalled each time. The Act, like the proposed rule, seeks to ban the enforcement of non-competes across the United States. However, the Act differs from the proposed rule in many ways. Of note, the Act would not retroactively ban non-compete agreements, whereas the FTC proposed rule would apply to all existing and future non-compete agreements.
The Act is currently sitting in committees for additional review.
What Does This Mean for Employers?
Employers should carefully monitor the status of the proposed rule. It will likely face significant legal challenges, and its fate is far from certain. Employers should consider, however, conducting an audit of their non-compete agreements and practices with respect to such agreements to determine whether and to what extent they may be impacted should the proposed rule become the law of the land.
For example, employers who have previously relied primarily on non-compete restrictions to prevent unfair competition or theft of trade secrets may consider strengthening or modifying their non-solicitation and non-disclosure restrictions. Specifically, employers should evaluate their confidentiality agreements, which are often very broad, to evaluate the risk that they may be considered “de facto non-competes” that are invalidated by the proposed rule and ensure that they comply with the antitrust laws. Employers may also consider conducting an audit to evaluate and identify vulnerabilities within their organization in the event that key current and former employees suddenly have unenforceable non-compete restrictions. Having a contingency plan in place now could save resources and potentially prevent significant impacts to the bottom line.
Additionally, although Section 5 of the FTC Act applies to “persons, partnerships, or corporations,” its definition of the term “corporation” covers only entities “organized to carry on business for [their] own profit or that of [their] members.” Therefore, arguably, the proposed rule would not apply to nonprofit entities. The courts, however, apply a fact-sensitive analysis, suggesting that the nonprofit legal status of an entity is not dispositive of Section 5’s applicability. Further, the FTC can also challenge non-competes under other antitrust statutes, such as the Sherman Act. Nonprofits should tread carefully given the other tools available to the FTC and other state and federal authorities and the apparent skepticism toward non-competes.
Should the proposed rule be adopted in its current state, this will also place much greater importance on policing corporate confidential and trade secret information, as companies would lose the ability to prevent former employees from immediately going to work for a direct competitor. This provides additional incentive for companies to proactively take stock of their confidentiality practices and agreements to ensure they are fully prepared in the event the proposed rule is implemented in its current form by the FTC.
It was the spring semester of 1983 when I took the introductory Business Associations (“BA”) class at the University of Texas Law School. As a second-year student who knew nothing about business associations—and who was scared stiff of the professor, Robert W. Hamilton—I didn’t foresee spending most of the next 40 years in a career devoted to the subject, first in law practice, then in teaching. But that’s what happened.
In spring 2023, as I transition to emeritus law professor status at Drake University, I remain a BA student in many respects. I regularly consult with attorneys in my home state (Iowa) on business law matters, serve on the Iowa State Bar Association’s Business Law Section Council and its Legislative Committee, present CLEs, and maintain a treatise on business organizations.[1] As I reflect on changes in the field over the past four decades, the details far exceed the scope permitted in a magazine column. This article instead covers several trends I’ve observed during my years as a BA student, providing, I hope, a forest perspective on some of the trees that comprise modern business entity law.
Increasing Statutory Complexity
In 1983, my study of statutory law in the BA course was largely confined to three acts: the Uniform Partnership Act (1914) (“UPA”), the Uniform Limited Partnership Act (1976) (“ULPA”), and the Model Business Corporation Act (“MBCA”). The latter had just been comprehensively redrafted for the first time since 1950, with my professor serving as Reporter.[2] These same statutes still guided most states’ business associations laws when I began teaching BA at Drake in 1992.
Critically, each act was relatively short. The UPA ran 6,500 words, while the ULPA, including a minor 1985 revision, totaled just 4,000 words. The MBCA was a bit longer but still manageable. Given the relatively simple statutory architecture, in a four-credit BA course I could survey most provisions in each of the three acts, along with interpretative case law. I was also able to contrast parts of Delaware corporate law with the MBCA, and to introduce “baby business” and accounting concepts, as well as some securities law basics.
By the 2021–22 school year, my last year of full-time teaching, the instructor’s task in BA was considerably more challenging because the length and complexity of statutory business associations law had increased dramatically. At 32,000 words, the UPA (1997/2013) was five times as long as the original act.[3] The ULPA (2001/2013) ran 35,000 words—eight times its original length.[4] The Uniform Limited Liability Company Act (“ULLCA”), a newer and critical business entity statute, had grown from roughly 17,000 words in 1996 to 31,000 words in its latest version, ULLCA (2006/2013).[5] Not to be outdone, the most recent version of the MBCA clocked in at roughly 62,000 words.[6]
Although it’s tempting to conclude these modern business associations codes are needlessly prolix, several other trends I’ve observed over the past 40 years help explain the acts’ increased length and complexity.
Economic Perspectives Prevail
Brevity was an appealing feature of older business associations codes, but many provisions in those acts were prescriptive, allowing little or no variation from statutory norms. Scholars began to substitute economic analysis for social and regulatory conceptions of business associations as early as the 1930s, and by the 1980s these views were ascendant and increasingly influential with policymakers.[7] A preference for private ordering over regulation has reshaped the direction of business associations statutes ever since.
Today, whether one organizes a partnership, a limited liability company (“LLC”), or a corporation, business associations codes provide only default rules for many internal matters. Owners of a business entity are thus generally free to tailor the entity’s governance template through partnership or operating agreements, corporate charter or bylaw provisions, and/or secondary contracts.
This emphasis on contractual freedom comes at a price, of course. Modern business entity codes are longer than their former counterparts, in part because they must spell out detailed boundaries for permitted governance variations, as well as “opt-out” or “opt-in” procedures for firms that want to use them.[8]
Limits on Judicial Regulation
Statutory business associations law was also relatively simple in the early 1980s because judicial decisions filled many gaps. As an example, case law—not statutes—traditionally defined the scope of corporate director and officer fiduciary duties, attendant liability and damage risks, and the permissible boundaries for judicial review, like the business judgment rule. The same was true for litigation involving partners of general and limited partnerships.
Both fiduciary duties and the business judgment rule remain key precepts of modern business associations law. And judges remain involved in their development, though far more in Delaware than in other states. But concerns about perceived judicial overreach triggered changes starting in the mid-1980s, and governing codes began to incorporate nuanced yet complex statutory provisions that constrain the role courts play in business entity disputes.[9]
For example, following statutory trends first launched in Delaware in 1986 and consistent with private ordering themes described earlier, the MBCA has, since 1990, allowed corporations to exculpate directors against damage claims for duty of care violations with an optional charter provision.[10] Unincorporated entity acts have embraced similar innovations for partnerships and LLCs.[11] In 1998, the MBCA added complex and lengthy provisions regulating the permissible scope of claims against directors for monetary damages, including grounds for suit and burdens of proof on both claims and defenses.[12]
Current statutory innovations designed to reduce litigation risks for corporations and their fiduciaries include procedures for ratification of defective corporate actions, advance approval or waiver procedures for duty of loyalty claims, enhanced indemnification rights for fiduciaries, and limits on permissible litigation forums.[13] As with other statutory governance options in modern business associations law, the enabling provisions are often both lengthy and complex.
Although most statutory innovations have reduced the potential for judicial involvement in business entity disputes, developments for closely held organizations go both ways. On the one hand, modern statutes authorizing specialized management arrangements and exit planning for privately held corporations have reduced the occasion for judicial challenges to such plans.[14] On the other hand, new statutory oppression remedies in most jurisdictions now supplement or replace minority owner fiduciary protections derived from case law and are available for both closely held LLCs and corporations.[15]
Entity Proliferation
The three acts I studied when taking BA in 1983—the UPA, the ULPA, and the MBCA—also described the primary entity options available to business lawyers and their clients at that time: partnerships, limited partnerships, and corporations, with the potential addition of “professional” or “Subchapter S” options for the latter. Available entity choices have since increased dramatically because of two near-simultaneous developments in the late 1980s.
The first was a 1988 revenue ruling authorizing pass-through taxation for owners (“members”) of an LLC—a novel entity then available in only two states—offering limited liability to all participants, along with flexible options for company management.[16] The second was legislation allowing new limited liability versions of partnerships, a product of malpractice litigation against partners in Texas law firms and national accounting firms in the wake of the savings and loan crisis of 1988.[17]
As a result of these developments, by the mid-1990s all states had amended their business entity codes to encompass these new options, including limited liability partnerships (“LLPs”), limited liability limited partnerships (“LLLPs”), and LLCs, as well as “professional” variations of new entities, like PLLPs and PLLCs. This expanded entity menu necessarily added to the complexity of statutory business associations law, including new provisions in partnership acts governing LLPs and LLLPs, additional freestanding codes (LLC acts), and, in recent years, supplemental legislation authorizing “series” LLCs.
As acceptance of these novel entity choices has grown over the past three decades—with the LLC the clear favorite for closely held firms—that growth has also fueled added complexity for business associations case law as long-established doctrines, like veil piercing and other exceptions to limited liability, and even traditional creditor remedies, like charging orders, are relitigated in new contexts.[18] That trend will surely continue as benefit corporations, now available in 34 states, and other new entity options join the mix.[19]
Technological and Transactional Flexibility
As in other legal fields, many changes in business associations laws over the past few decades were designed to accommodate technological innovations. In corporate law, for example, former requirements for filing paper documents now encompass electronic equivalents.[20] Sanctioned notice processes have also evolved from paper to electronic systems.[21] And these changes extend well beyond documents and recordkeeping. When I studied BA in 1983, statutes authorizing directors to meet through a conference telephone call—a then-recent innovation—seemed “as fur as they could go,” to paraphrase Oscar Hammerstein.[22] But today’s corporation acts go much further, including authorization for fully remote shareholder meetings.[23]
Modern business associations laws also offer considerable flexibility with respect to transactional formalities, including permissive rules for organic changes. For example, in the 1980s, a partnership that reorganized as a corporation might need to first dissolve or take other steps to transfer assets and liabilities to a newly formed corporate entity. Today that partnership could conduct a cross-entity merger or a single-step “conversion” to the corporate form.[24] In the 1980s, if a corporation wanted to change its governing law, the company organized a new corporation in the foreign state and then merged into it. Today a corporation or unincorporated entity can typically conduct a “domestication” transaction that changes its governing jurisdiction in a single step.[25]
Conclusion
Despite all the changes I’ve seen over the past 40 years, the agency law foundations on which business associations are constructed haven’t changed at all. Nor have the fundamental purposes of business associations law: to mediate conflicts that inevitably arise in the life of a business entity between owners and managers, between majority owners and minority owners, and between the entity and third parties.
At the moment, everything old is new again, at least in some quarters. Debates concerning the proper objectives of business associations—debates that began in the 1930s and seemed settled in recent years—now rage anew in fights over corporate missions that include environmental, social, and governance (“ESG”) considerations. As Yogi Berra famously said, “It’s tough to make predictions, especially about the future.” While I wait to see what happens, my mantra is the same as when I took my first BA class in spring 1983: Take good notes!
Doré is the Richard M. and Anita Calkins Distinguished Professor of Law Emeritus, Drake University Law School. Professor Doré’s contact information at Drake is [email protected].
Matthew G. Doré, 5 & 6 Iowa Practice—Business Organizations (Thomson Reuters 2022–23) (latest annual edition). ↑
For a history of the Model Business Corporation Act’s evolution from 1928 through 2000, see Richard A. Booth, A Chronology of the MBCA, 56 Bus. Law. 63 (2000). ↑
See, e.g., Frank A. Easterbrook & Daniel R. Fischel, The Economic Structure of Corporate Law (1991) (an early, influential work). ↑
See, e.g., Model Bus. Corp. Act § 7.04(b)–(g) (optional procedures whereby corporate shareholders can act outside of a meeting with less than unanimous consent); Unif. Ltd. Liab. Co. Act § 105 (describing scope, function, and limitations of operating agreements). ↑
Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), which held that directors were not sufficiently informed when approving a corporate merger and thus not protected by the business judgment rule, is often cited as a catalyst for changes that followed. See, e.g., Bernard F. Sharfman, The Enduring Legacy of Smith v. Van Gorkom, 33 Del. J. Corp. L. 287 (2008). ↑
See Robert W. Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 Colo. L. Rev. 1065 (1995). ↑
For example, courts have had to decide whether and to what extent well-established judicial exceptions to limited liability apply in the new limited liability settings. See Matthew G. Doré, What, Me Worry? Tort Liability Risks for Participants in LLCs, 11 U.C.–Davis Bus. L.J. 267 (2011). For an overview of recent developments concerning charging orders issues, see Daniel S. Kleinberger, What Is a Charging Order and Why Should a Business Lawyer Care?, Bus. L. Today (Mar. 6, 2019). ↑
See, e.g., Christopher D. Hampson, Bankruptcy & the Benefit Corporation, 96 Am. Bankr. L.J. 93 (2022) (considering how traditional bankruptcy principles should apply to benefit corporations). ↑
See, e.g., Model Bus. Corp. Act §§ 1.20, 1.40 (defining “filing” rules for “documents” and encompassing both paper and electronic records). ↑
Id. § 1.41 (providing rules for notices and other communications). ↑
Oscar Hammerstein II, Kansas City, Oklahoma (1943) (“Ev’rythin’s up to date in Kansas City. They’ve gone about as fur as they could go.”). ↑
Model Bus. Corp. Act § 7.09 (permitting remote participation in shareholder meetings). ↑
See, e.g., Model Bus. Corp. Act §§ 9.01–.24. In fact, one of the stated reasons for the 2016, or “fourth,” edition of the MBCA was to recognize and facilitate inter-entity transfers and to coordinate with unincorporated business association acts. ↑
The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished former Business Law Section Chair Mendes Hershman (1974–1975) lends his name to this legacy. Read the abstract of this year’s third-place winner, Max Londberg of University of Cincinnati College of Law, Class of 2023, below. Visit the University of Cincinnati Law Review website to read the full article, published in Volume 91.
Colorblind ideology has hindered the purpose of Title VII, which declared it unlawful to refuse to hire a job applicant because of their race, sex, or other traits. Recent federal court decisions have continued this trend, diminishing legitimate discrimination claims by failing to properly recognize one manifestation of racism and sexism in hiring. This form of bias surfaces when employers adjust their stated hiring criteria, de-emphasizing certain job applicant traits, such as education, held by a marginalized candidate, while emphasizing other traits, such as relevant experience, held by a non-marginalized candidate. Robust empirical research supports that such criteria shifting is motivated by an applicant’s gender or race. In numerous studies, participants hire marginalized candidates when race and gender are concealed but fail to hire them when such traits are revealed. They often rationalize their discrimination, and thus maintain a self-image of fairness, by invoking hiring criteria that they, consciously or not, manipulated to benefit non-marginalized candidates.
Several federal courts have failed to properly recognize this manifestation of discrimination, despite its identification in the social science literature. This piece provides an analysis of these cases interspersed with empirical findings, which together illustrate how inconsistent hiring criteria unlawfully hamper marginalized candidates, leading to adverse employment decisions based on protected traits. Courts must improve their analysis of this form of evidence. When a Title VII plaintiff demonstrates the presence of inconsistent hiring criteria, and when an employer hires an applicant outside the plaintiff’s protected class, courts should rarely grant employer motions for summary judgment. Decisions to the contrary contravene summary judgment standards and the scope of Title VII.
As the legal market moves through the first quarter of 2023, predictions from the team at Reveal-Brainspace have already become a reality—with many more ups and downs to come. From macro headwinds to advancements in AI and Web3 tech, the AI and LegalTech experts at Reveal have outlined the biggest moves that are already taking shape and the focus areas that will be taking much of legal practitioners’ attention for the rest of the year. One thing will stay consistent during 2023: AI will continue to have a multiplying effect on the legal vertical now and well into the future.
Overall market trends in LegalTech
The use of AI for eDiscovery is set to continue its rapid growth, driven by the successes experienced by early adopters in corporate legal departments, law firms, and legal services providers worldwide. The proliferation of artificial intelligence (machine learning (ML), natural language processing (NLP), ethical AI, AI-generated art, etc.) is a key driver of this growth, and 2023 will see a continued wave of AI adoption fueled by cost pressures and the need to accelerate time to evidence and insight. The increasing volume, variety, and velocity of data is also making AI a necessity rather than just a nice-to-have option.
In the area of eDiscovery, the growth and proliferation of new data types will drive innovation and create challenges for legal professionals. Direct connectors and data visualization purposes designed for these new data formats will take center stage in 2023, as more communication formats that don’t fit the traditional four corners of a page gain traction and legal professionals move towards modern eDiscovery.
In the business of law, Alternative Legal Service Providers (ALSPs) will likely continue to consolidate in 2023, in response to both economic pressures and the desire to expand their offerings beyond eDiscovery. More players are expected to enter the fields of information governance, compliance, and cyber functions to get closer to the data and remain stickier with their clients.
Massive advances in eDiscovery technology and use-cases
The mission to perfect AI-powered eDiscovery technology will continue, while new use cases will explode. We’re already experiencing this as we begin Q2 2023. eDiscovery technology will likely expand beyond its traditional boundaries as organizations look to leverage its power in areas such as cybersecurity incident response, privacy, information governance, and much more. Businesses and legal professionals will increasingly turn to the unstructured data analytics within eDiscovery to solve a range of challenges around human-generated and AI-generated data.
If you need any evidence of this already taking place, look no further than the explosion of generative AI tools like ChatGPT and DALL-E. These tools are going to be a major focus area for legal practitioners—creating new considerations and use cases for advanced eDiscovery solutions in a variety of situations.
Additionally, the technology underlying Web3 will continue to proliferate and raise complex legal questions, despite the slow rate of adoption of the Metaverse. For example, the conversion of real-world assets into digital ones with NFTs raises questions about the extent that real-world rights carry into augmented or virtual reality. As Metaverse or Web3 devices become less expensive and the user experience becomes more accessible, adoption and legal questions will continue to grow.
Softening of M&A activity
After several years of robust M&A activity, the market is expected to experience a dramatic slowdown in 2023, driven primarily by economic headwinds. If the global economy continues to experience a period of slow growth or uncertainty, it may make companies cautious about making new investments or acquisitions, with the LegalTech space no exception to the rule.
However, while M&A is softening, it will certainly remain relevant. The activity that will take place will be extremely deliberate, strategic, and meaningful to the companies involved. This is good for the industry, as it gives the entire space time to think, rethink, and make well-informed decisions.
Economic headwinds will drive AI-powered innovation in order to do more with less
While the economic uncertainty will likely affect M&A activity for the remainder of the year, it is simultaneously is driving greater adoption of legal technology to control budgets. Challenges in securing tech budgets may lead to corporate legal departments outsourcing to ALSPs that can provide access to the AI-powered tools they may not be able to directly procure in 2023. eDiscovery is expected to see increased use of AI to reduce document review costs in 2023.
The force multiplier effect of legal AI means it may see widespread adoption as practice groups and legal departments must do more with less. Crisis often is the most fertile time for organizational transformation, and 2023 is no different.
The growing importance of social considerations (the “S” in ESG) has appeared in numerous headlines, as companies learn the hard way that cutting corners in areas like supply chain and human capital does not pay off in the long run. In the past two years, a number of Fortune 500 companies have had to pay out large sums to mitigate the consequences of their poor choices surrounding overseas production. In this article we focus on the “S” aspects of ESG with regards to conducting M&A due diligence, and what companies should evaluate prior to approving an M&A deal.
As discussed in our prior ESG in M&A article, a large number of investors believe that companies with strong ESG initiatives are more lucrative investments, pose less risk, and are better positioned for the long term. Moreover, because of the SEC’s announced plan[1] to create an ESG reporting framework that would complement the current financial reporting framework, targets with higher ESG scores are perceived, in many cases, as having higher market value. Environmental and governance aspects of ESG seem to be easier to measure, which may explain why companies find it easier to tackle those issues first. Acquirers often overlook the social aspects of ESG metrics, which can result in minimal evaluation of social issues during ESG due diligence.
The “S” part of ESG is a broad topic that covers a wide range of social issues; diversity and inclusion, fair pay, workplace safety and environment, employee turnover, company ethics, and reputation are among the factors that are evaluated when assessing a company’s “social” health in ESG metrics. Increasingly, we have seen companies reevaluating their production practices to address supply chain hiccups and questionable labor practices. Many companies have had significant problems resulting from cargo crime,[2] the invasion of Ukraine,[3] the growth of e-commerce, sudden shortages, centralized inventory, and a patchwork of logistics,[4] all of which are significant supply chain problems that fall under the “S” in ESG. We will examine a few of these issues more closely.
1. Supply Chain Risks
Since the beginning of the COVID-19 pandemic, companies have been suffering frequent and major disruptions to global supply chains. Prominent examples include shortages of lumber to build houses and of semiconductor chips for vehicles and mobile phones. To address these issues, manufacturing companies often sought out alternative suppliers. The manufacturers often failed to conduct proper vetting of such alternative suppliers and in many cases wound up with less reputable vendors as a result. In some cases, improperly vetted alternative vendors may be less transparent with their “social” practices and also less ethical in general. Vendor practices are increasingly “broadcast” worldwide via online and social platforms such as TikTok and Instagram. The questionable practices of suppliers—after coming to light—are often viewed by third parties as a reflection of the manufacturer’s practices and ethics, with the publishers of ESG ratings, and sometimes even litigants, holding the manufacturer accountable for its vendors’ practices. Some of the examples of ethical issues in supply chains are:
corruption and bribery;
unsafe labor conditions;
non-living wages or forced labor;
child labor;
cargo crime;
environmental harm; and
discriminatory work environment.
To combat these issues and demonstrate their commitment to social and environmental performance, more businesses are looking to third-party certification processes. For example, many companies dealing with these issues choose to become “B Corp” certified. B Corp certification of for-profit companies is offered by the B Labs Global. The designation confirms that a business is meeting high standards of verified performance, accountability, and transparency on factors from employee benefits and charitable giving to supply chain practices and input materials. As of September 2022, there were 5,697 certified B Corporations across 158 industries in 85 countries. Among some of the best known B Corp certified companies are Ben & Jerry’s,[5] TOMS,[6] and Patagonia.[7] Many of these companies also donate their products to charity to match purchases by consumers. For example, for every pair of TOMS shoes purchased, a pair of new shoes is given to a child in need in partnership with humanitarian organizations.
According to Accenture Strategy’s Global Consumer Pulse Research, more than 60% of surveyed consumers closely consider a company’s ethical values and authenticity before a purchase. Moreover, the research showed that 42% of consumers “stopped doing business with a company because of its words or actions about a social issue.”[8]
To illustrate this with a real-world example, a confectioner was struggling to ensure that harvesting the ingredients it used, like cocoa and soy, did not contribute to deforestation. Also, several confectioners were accused of child labor issues in recent years, and were named in a lawsuit over child labor in cocoa production countries. As a result, the company made changes, such as setting strict policies on deforestation and promising to train all of its buyers on human rights issues. Child labor, forced labor, deforestation, women’s rights, and living wages were among the most pressing human rights issues across the value chain for these companies. Another real-world case that attracted headlines was the investigation of fashion retailer Boohoo, which was accused of being aware of its suppliers underpaying their staff and exposing workers to life-threatening risks in their workplaces.[9] As a result, multiple online retailers removed Boohoo’s products from their websites.[10]
Some companies have chosen an alternative solution to supply chain social concerns: bringing manufacturing in house. However, the high costs, risks, and logistics associated with this option mean it is not always a feasible choice to address supplier concerns.
2. M&A Due Diligence and Supply Chain Risks
The great difficulty with addressing these social and ethical issues is that they are often not discussed or uncovered in the M&A process until the company becomes a defendant in a lawsuit, the subject of an investigation, or the object of press or social media attention. At that point, the company has already suffered severe damage to its reputation due to actions taken by another party, not to mention potential exposure to monetary damages resulting from pre-closing actions. It is hard to measure many of these practices when they are defined differently across industries and from country to country. It also requires significant corporate resources to monitor each vendor and each of their sites. Nevertheless, with the growing pressure from customers and investors, ethical production is a critical component to have a successful and sustainable business in the 21st century.
So, how should a buyer assess a target company’s approach to social compliance in its supply chain? Buyers should confirm that the target company is communicating regularly and often with its vendors and conducting periodic site visits, if possible. It is a good idea for a company to include its ESG standards in its supplier contracts to ensure that the company’s ESG policies have been clearly communicated and vendors know its expectations in that regard. Another good practice is to ask whether the target uses supply chain mapping to maintain awareness of its production sites and those of its vendors. With effective supply chain mapping, a company divides its vendors into different categories, which can allow it to see weak points in its supply chain and avoid incurring costly issues.
What impact do social issues have for potential buyers and targets in M&A transactions? To start with, buyers need to be aware of the prevalence and impact of these issues and be proactive in identifying and evaluating them. According to a study conducted by Accenture during the early months of the COVID-19 pandemic, 94% of Fortune 1000 companies are seeing supply chain disruptions, 75% of companies have had “negative or strongly negative impacts” on their business, and 55% of companies plan to downgrade their growth outlook or have already done so.[11] Based on a survey conducted by Datasite of 200 UK-based dealmakers, almost 20% stated that supply chain problems were the cause of at least one deal falling apart in 2021, and 22% identified supply chain issues as the number one cause that would trigger an M&A deal to fall through in 2022.[12] Many companies that had order backlogs of one to two months prior to COVID-19 now have increased their estimate of the backlog by up to four times.[13] For instance, a target that had backups for almost every component in their products but one key part with no alternate supplier had to be taken down from the market due to potential buyers’ concern.[14] Such a potential outcome suggests that targets also would be well advised to conduct thorough internal due diligence on these topics prior to going to market.
3. Fair Labor Practices and Unionization
Fair labor practices are another important aspect of the social responsibility portion of ESG. More U.S. stakeholders are urging companies to improve labor practices and working environments. If a company’s ESG policies assert that they ensure equitable labor practices, they may face scrutiny if they fail to actively address workplace issues with their suppliers. Moreover, the recent resurgence of unionization activities is evidence of its importance. Unionization offers additional protection and benefits for employees, but can also pose extra costs and burdens on employers; oftentimes a company’s response to these activities is perceived as an indicator of a company’s labor practices and hence a part of its ESG assessment. A Starbucks store in Buffalo, New York, became the first Starbucks location in the U.S. to unionize in 2021.[15] Since then, over 270 Starbucks stores have unionized.[16] Starbucks, like other food and beverage companies, is bracing for the impact of the threat of higher labor costs due to unionization, and has also faced national scrutiny for its response to workers’ attempts to unionize.[17]
In addition to the growing unionization in the U.S., more and more companies are addressing safe labor practices in their non-U.S. factories. One example of such an effort was the result of the tragic accident in Rana Plaza, a factory in Bangladesh that collapsed in 2013 killing over 1,100 people. Workers had noticed cracks in the structure before the building collapsed and begged not to be sent inside, but they were rebuffed by their employers.[18] The collapse of the eight-story building, which housed five garment factories supplying at least 29 global brands, remains one of the deadliest industrial accidents to date.[19] Such a “mass industrial homicide,” as union leaders called it, drew the attention of global organizations that took action to create safer working standards. These standards now show up in retailers’ ESG reports.
However, despite the aforementioned efforts to improve the conditions of factories in Bangladesh and other countries with significant garment sectors, the working environment for many employees remains far from ideal. A 2020 U.S. Senate Report titled “Seven Years After Rana Plaza, Significant Challenges Remain” discusses the unsafe practices of these factories, especially during the COVID-19 pandemic.[20] The report found that in factories that remained in operation during the pandemic, workers were forced to work without adequate precautions, leaving them and their families at great risk of COVID-19 infection.[21]
More recently, a fire at the Nandan Denim factory in India killed seven people in 2020.[22] According to the Nandan Denim website, it is the biggest denim producer in India.[23] The manufacturer sells jeans to more than twenty countries for many high street brands, and import data showed shipments entering the United States from the factory just one month before the fire occurred. Unfortunately, the Nandan Denim fire is not a rarity, as fires in retail factories are not an uncommon occurrence.[24] Such occurrences can lead to damaged reputations as well as an influx of civil lawsuits and a criminal investigation. Following the Nandan Denim incident, the production facility came to a halt, and the director, general manager, and fire safety officer of Nandan Denim were taken into police custody. Additionally, six individuals from the factory’s parent group were charged with homicide and negligence.[25]
In light of these frequent tragedies, more and more U.S. stakeholders are asking companies to improve their labor practices and working environments, with some even supporting union organization activity. Employers that don’t actively inquire into the workplace issues of their suppliers may find themselves under scrutiny if their ESG policies state that the company ensures fair labor practices outside of the United States. Further, where a company represents that it strives to ensure fair labor practices for its vendors, taking action to oppose union organization in the U.S. may be seen as inconsistent with such claimed commitment to fair labor practices.
4. ESG Due Diligence
It is advisable for buyers in M&A transactions to conduct due diligence investigations regarding ESG practices of the target not only to determine whether there are potential risks, but also to ensure that the target will integrate well into the buyer’s own ESG practices and policies. A buyer should request information on whether there have been recent changes in supply chain vendors and suppliers of the target company. Also, a buyer should gain an understanding of how the target company monitors its supply chain and review its applicable contracts. Specifically, a buyer should look into whether there are any contractual requirements outlining ESG expectations in a target’s agreements with vendors and suppliers. Furthermore, buyers should visit physical sites, review compliance certificates, and provide questionnaires in order to be better aware of a target’s supply chain practices. Some industries are likely to have more significant exposure to ESG issues in the supply chain than others, particularly businesses in the automotive, semiconductors, industrials, and retail industries. Lastly, even after conducting appropriate ESG due diligence, a buyer should consider including ESG-related provisions in the purchase agreement. These clauses can include ESG representation and warranties, closing conditions, and ESG-specific indemnities. Such provisions can go hand-in-hand with (and often enhance) a thorough diligence process to give the buyer the best chance of avoiding post-closing losses.
We have seen a tsunami of cryptocurrency exchange bankruptcies—FTX, Celsius, and Voyager, to name a few. Often, disputes arise among stakeholders in these bankruptcy cases regarding whether cryptocurrency maintained by a customer with an exchange in a pure custody relationship is property of the customer or property of the bankruptcy estate. Usually the litigation turns on the account agreement, including what are often referred to as the “Terms of Service,” entered into between the customer and the exchange, and the application of nonstatutory common law contract and property law principles. Given the uncertainty evidenced by this litigation and out of concern for customer protection, federal and state regulators have called for greater clarity on the issue through new regulation or, given the lack of clear regulatory authority, legislation. Yet many customers, exchanges, regulators, and legislatures seem to be unaware of an already existing statutory tool for addressing and resolving the issue: Article 8 of the Uniform Commercial Code (“UCC”).
UCC Article 8: The Basics
The UCC, promulgated by the American Law Institute and the Uniform Law Commission, has been enacted in substantially uniform form by every state of the United States and the District of Columbia. Article 8 of the UCC provides a statutory scheme for the holding and transfer of investment securities, whether held directly by an investor from an issuer (so-called directly held securities) or held indirectly by an investor through a bank, broker, or other custodian acting for its customers, including the investor (so-called indirectly held securities). Of relevance here is the system for holding indirectly held securities (“indirect holding system”).
While the primary focus of Article 8 is generally on investment securities, Article 8’s indirect holding system provisions, contained in Part 5 of Article 8, can apply more broadly to any so-called financial assets as defined under Article 8. “Securities,” as defined in Article 8 (which may not coincide with the definition of securities under securities and other laws), are by definition financial assets. However, any other asset that the securities intermediary and its customer agree to treat as a financial asset is also a financial asset under Article 8 and is therefore within the scope of Article 8’s indirect holding system provisions. The agreement by which the exchange and the customer agree to treat an asset as a financial asset under Article 8 is referred to herein as a “financial asset election.”
Once the financial asset election is made and the financial asset is credited to the customer’s “securities account” at the securities intermediary, the customer (referred to in Article 8 as the “entitlement holder”) obtains a proprietary interest in, and contractual and statutory rights against the securities intermediary with respect to, the financial asset. That proprietary interest and contractual right are, together, referred to in Article 8 as a “security entitlement.”
A securities intermediary has a duty under Article 8, among other duties, at all times to maintain sufficient financial assets of each type to satisfy security entitlements to financial assets of that type. And, of chief importance here, financial assets to which the entitlement holder has a security entitlement are generally not property of the securities intermediary and are generally not subject to the claims of the securities intermediary’s creditors under Article 8.
Application of UCC Article 8 to Cryptocurrency in an Indirect Holding System
A cryptocurrency exchange could be a securities intermediary under Article 8, with the cryptocurrency held for the customer being treated as a financial asset credited to a securities account of the customer at the exchange under a financial asset election included in the account agreement. If that were the case, the cryptocurrency would generally not be property of the exchange and generally not be subject to the claims of the exchange’s creditors. If the exchange became a debtor under the Bankruptcy Code, absent contrary terms in the account agreement, the financial asset election under Article 8 would reduce, if not entirely eliminate, the need to litigate the terms of the account agreement over whether the cryptocurrency is customer or exchange property. This is because Article 8 states so clearly that financial assets maintained by a securities intermediary for its customer are generally not the securities intermediary’s property and are generally not subject to the claims of the securities intermediary’s creditors. In other words, in this circumstance, the cryptocurrency would be property of the customer rather than property of the exchange.
A securities intermediary is a person that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. It is true that the most common examples of securities intermediaries are clearing corporations holding securities for their participants, banks acting as securities custodians, and brokers holding securities on behalf of their customers. But nothing in the definition of the term securities intermediary as used in Article 8 limits securities intermediaries to clearing corporations, banks, or brokers. In addition, because a securities account is an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset, and the definition of financial asset is not limited to “securities” as defined in Article 8, a person may be a securities intermediary even if that person does not credit securities to the account. Rather, the securities accounts that a securities intermediary maintains may consist exclusively of assets that the securities intermediary has agreed to treat as financial assets—even if the financial assets are not securities.
The assets could, indeed, be cryptocurrencies. In 2022, the American Law Institute and the Uniform Law Commission promulgated amendments to the UCC providing rules for digital assets, referred to in a new Article 12 of the UCC as “controllable electronic records.” Controllable electronic records include most cryptocurrencies. The Official Comments to the 2022 amendments, including amendments to Article 8, confirm that a cryptocurrency exchange can be a securities intermediary under Article 8. Furthermore, under the 2022 amendments, a controllable electronic record maintained by a customer with an exchange can be a financial asset if there is a financial asset election under Article 8.
Examples of other assets treated as financial assets that are sometimes credited to a securities account and that are not securities include negotiable instruments, banker’s acceptances, certificates of deposit, and cleared swap agreements.[1] It is not necessary that the cryptocurrency be considered a security or commodity under other law for the asset to be a financial asset under Article 8.
Moreover, the indirect holding provisions of Article 8 are technologically neutral. To obtain financial asset status, it would not matter whether the cryptocurrency is maintained by the exchange on-chain or off-chain or whether the customer has its own private keys to any wallet maintained by the exchange for the customer but with the exchange having ultimate control over the cryptocurrency.
The policy rationale for this broad and flexible interpretation of Article 8 in the context of the indirect holding system is explained in Article 8 itself. The Prefatory Note to Article 8 states, “Rapid innovation is perhaps the only constant characteristic of the securities and financial markets. The rules of Revised Article 8 are intended to be sufficiently flexible to accommodate new developments.”[2] And the Official Comments to Article 8 provide, “That question [of the scope of Part 5 of Article 8] turns in large measure on whether it makes sense to apply the Part 5 rules to the relationship.”[3] Here, the rules of the indirect holding system fit well when the financial asset election is made. The customer obtains the benefits of the duties of a securities intermediary, set forth in Part 5 of Article 8, owed to the customer by the exchange—including the duty of the exchange to maintain sufficient cryptocurrency of each type to satisfy all customer security entitlements to the cryptocurrency of that type. The exchange assumes the Part 5 duties with the ability to modify those duties, to the extent permitted by Part 5 of Article 8, with the agreement of the customer. And, as is the case with indirectly held investment securities, cryptocurrencies held as financial assets credited to the securities accounts of customers generally are not subject to the claims of the exchange’s creditors. There is no obvious policy reason not to permit the exchange and the customer to agree to the benefits and burdens of the indirect holding provisions of Article 8.
Of course, some cryptocurrency exchanges may commingle their proprietary cryptocurrency with cryptocurrency of customers as part of a single fungible bulk. An exchange doing so does not in any way alter the result under Article 8 if there is a financial asset election. Article 8 contains no provision that requires a securities intermediary to segregate proprietary financial assets from customer financial assets. The key is for the books and records of the securities intermediary to reflect what quantity of financial assets of which type is subject to security entitlements and which customers hold the respective security entitlements. If there is a shortfall in the cryptocurrency necessary to satisfy security entitlements to the cryptocurrency of any type, the customers’ rights under their security entitlements will generally be superior to the proprietary interests of the exchange in the cryptocurrency of that type.
UCC Article 8 and Bankruptcy of a Cryptocurrency Exchange
Although there is so far no bankruptcy case addressing the issue, there is no reason why Article 8’s protections for customers’ cryptocurrency should not be recognized if the exchange were to become a debtor under the Bankruptcy Code. Based on the holding from the U.S. Supreme Court in Butner v. United States,[4] the extent of a bankruptcy debtor’s interest in property is determined under applicable non-insolvency law, absent a compelling federal interest to the contrary—and there is no compelling federal interest why the applicable nonbankruptcy provisions of Article 8, after giving effect to financial asset election under Article 8, should not apply to determine the limitations of the exchange’s interest in the cryptocurrency maintained by the exchange for the customer. The interest of any creditor of the exchange would generally be similarly limited.
At most, the exchange’s interest would be limited to mere nominal title, which should not be problematic in the exchange’s bankruptcy case. Under Bankruptcy Code §§ 541(a)(1) and (d), the exchange’s nominal title is includable in the bankruptcy estate of the exchange. However, the bankruptcy estate’s nominal title in the cryptocurrency would remain subject to the limitations on the rights of the exchange as a securities intermediary, described above. The customer as the entitlement holder would have a security entitlement with respect to the cryptocurrency. Despite the exchange’s nominal title to the cryptocurrency, under Bankruptcy Code §§ 541(a)(1) and (d) the security entitlement itself remains the property of the customer and would not be included in the exchange’s bankruptcy estate. The customer may need relief from the automatic stay, and the assistance of the bankruptcy court in the bankruptcy case, for the cryptocurrency to be delivered out to another exchange or to the customer directly. If there is a shortfall in the cryptocurrency of the same type available to satisfy the security entitlements of all customers to cryptocurrency of that type, the customers would bear the shortfall ratably, and each customer would be treated as a general unsecured creditor of the exchange to the extent of the customer’s ratable share of the shortfall.
Caveats
To be sure, a cryptocurrency exchange and its customers making a financial asset election is not a panacea for what many see as the risks of owning cryptocurrency, or for the lack of regulation of cryptocurrency exchanges. A financial asset election under Article 8 in and of itself cannot prevent fraud, self-dealing, or even poor record-keeping by an exchange—or be a substitute for regulation of cryptocurrency as a security, commodity, or otherwise or for regulation of a cryptocurrency exchange as a money transmitter or other licensee. Moreover, the Article 8 protections, even with a financial asset election, may not apply under choice-of-law rules contained in Article 8 or in the Hague Securities Convention, when the customer permits the exchange to use the cryptocurrency for the exchange’s own benefit (including where the customer is promised a return from the exchange’s use of the cryptocurrency), or in exceptional circumstances referred to in Article 8.
Conclusion
Article 8 is clear and flexible, built to practically accommodate areas of expanding economic activity such as the emergence of cryptocurrency exchanges. Cryptocurrency exchanges and their customers should seriously consider the benefits of a financial asset election, and regulators and legislators should seriously consider requiring cryptocurrency exchanges to build a financial asset election into their Terms of Service or other account agreement provisions. An example of a statute requiring a financial asset election is the Uniform Law Commission’s proposed Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act.[5] The comments to that proposed supplemental act go into greater detail on the substantive provisions of Article 8 and related choice-of-law rules applicable to a financial asset election.
Carl S. Bjerre is the Kaapcke Professor of Business Law at the University of Oregon School of Law. Sandra M. Rocks is counsel emeritus at Cleary, Gottlieb, Steen & Hamilton LLP. Edwin E. Smith is a partner at Morgan, Lewis & Bockius LLP. Steven O. Weise is a partner at Proskauer Rose LLP. The views expressed in this article are the personal views of the authors and not of their respective organizations.
See generally Flener v. Alexander (In re Alexander), 429 B.R. 876 (Bankr. W.D. Ky. 2010), aff’d, Case No. 11-5054, 2011 WL 9961118 (6th Cir. Dec. 14, 2011) (treating a bank certificate of deposit as a financial asset credited to a securities account); Wells Fargo Bank, N.A. v. Est. of Malkin, 278 A.3d 53 (Del. 2022) (treating an insurance policy as a financial asset credited to a securities account). ↑
U.C.C. art. 8, prefatory n. (Am. L. Inst. & Unif. L. Comm’n 1994). ↑
The Conference on Consumer Finance Law (“Conference” or “CCFL”) is probably best known to the members of the Business Law Section for its well-attended Frederick Fisher Memorial Program—named in honor of its chairman, Frederick G. Fisher Jr. (1921–1989) (figure 1)—that it has cosponsored at the Section’s Spring Meeting for many years. But it does more than that. The Conference’s law review, the Consumer Finance Law Quarterly Report (“Quarterly Report”) has been published since 1946, nearly as long as the seventy-eight-year history of The Business Lawyer. The Conference also hosts its own educational programs. It has been an affiliate of the American Bar Association (“ABA”) since its founding in 1927.
Fig. 1: Frederick G. Fisher Jr.
This article will give a summary of the CCFL’s history, based primarily on what has been published over the years in the Quarterly Report since 1946. A longer version of this history, including complete footnote references, will be published in the Quarterly Report in the near future.
The Founding of the CCFL
The CCFL was founded when two prominent attorneys, Reginald Heber Smith (1889–1966) (figure 2), known as both the father of legal aid and the father of the billable hour, and Edmund Ruffin Beckwith (1890–1949) (figure 3), known as judge advocate general of the New York State Guard and as the father of Beneficial Finance, brought together a group of about thirty attorneys who were interested in personal finance law at the Annual Meeting of the ABA in Buffalo, New York, in September 1927 to form the Conference.
Fig. 2: Reginald Heber Smith.
Fig. 3: Edmund Ruffin Beckwith.
Reginald Heber Smith
Smith joined the six-man Boston firm of Hale and Dorr as managing partner in 1919, and he remained in that position until 1956. The firm, now Wilmer Cutler Pickering Hale and Dorr LLP, reports on its website that Smith pioneered the use of the billable hour to rationalize the operations of the law firm, along with “[a]ccurate accounting methods, budgets, a mathematical system of profit distribution, [and] timesheets,” over the objections and resistance of his partners. He first made use of these techniques as counsel to the Boston Legal Aid Society after graduating from Harvard Law School in 1913, reducing the average net cost of handling a legal aid case from $3.93 to $1.63 in just two years.
Smith’s 1919 book, Justice and the Poor, based on his experiences as director of the Boston Legal Aid Society, has been called “one of the most important books about the legal profession in history” because of his finding that “people without money were denied access to the courts,” which “undermined the social fabric of the nation.”[1] His book “shamed the elite bar into action and led to the creation of the modern legal aid movement” by arguing that “[w]ithout equal access to the law, the system not only robs the poor of their only protection, but places in the hands of their oppressors the most powerful and ruthless weapon ever invented.”[2] His book led the ABA to create the Special Committee on Legal Aid Work, resulting in the establishment of legal aid programs across the country by the middle of the twentieth century. Smith also published four articles about the rationalization of law firm operations that the ABA published in book form in 1943 under the title Law Office Organization, which went through eleven editions by the early 1990s. Smith’s public service through the ABA also encompassed the creation of lawyer referral services for people of modest means, the establishment of client security funds, and advocating for vigorous professional discipline. Smith’s contributions to the ABA, which the ABA characterized as “prodigious,”[3] led to his becoming the seventeenth recipient of the ABA Medal, its highest honor, in 1951.
Smith’s cofounding of the CCFL was of a piece with his other public service. His “Inaugural Statement” for the Quarterly Report in 1946 encapsulated some of his thoughts on the role of lawyers in society in connection with the field of consumer finance. For example, he asked, “[W]hat should be the maximum charge on a $25.00 loan? Economics says one thing, sociology says the opposite, and the law, forced to compromise, wavers in an unstable equilibrium.” He further noted that
[j]ustice in this country is administered 10% by judges in court rooms and 90% by lawyers in law offices. In that process we have learned that many of our severest battles are with our own clients; anger and vengeance have to be extirpated from their minds and emotions, and a sense of justice instilled. We have to teach them the limits of law; that, for example, no statute or code can rekindle the flame of love that has been extinguished between husband and wife.
Edmund Ruffin Beckwith
Cofounder Beckwith served as chairman of the Conference’s General Committee until his death in 1949.
Beckwith practiced law in Montgomery, Alabama, for ten years after his graduation from University of Alabama Law School in 1915 and then relocated to New York City to serve as counsel to “a group of companies engaged in the field of consumer finance,”[4] which he combined to form Beneficial Industrial Loan Corporation, later known as Beneficial Finance Corporation.
Beckwith also joined the New York State Guard and became its judge advocate general in 1940, retiring from service with the rank of brigadier general. During World War II, “he perceived that the new citizen-army would insist on legal assistance as well as medical assistance” in all parts of the world.[5] To achieve that goal, “he proposed to rally the whole force of the organized bar—national, state, and local” and successfully carried through on that unprecedented proposal despite the doubts and opposition of many “eminent lawyers and devout patriots” who maintained that “it could not be done and so would lead to disaster.”[6]
Beckwith’s memorial stated that his work caused him to want to do something to benefit the public as well as his clients:
As he studied the economic matrix in which his corporate structure must be formed he was appalled to find that in our democracy the average man had so much difficulty in obtaining credit on simple, clean, and decent terms. He was enraged that the legal provisions were conflicting, inadequate, or altogether lacking.
He proposed to do something about it, and his sure instinct told him to proceed through the instrumentality of the legal profession.
Thus was born the Conference, of which he was the guiding spirit for the remainder of his life and the active head except for the periods when he was in the service of his country.[7]
The Leadership and Activities of the Conference
Leadership of the Conference
In the first issue of the Quarterly Report in 1946, Beckwith was shown as chairman of the General Committee (“Committee”), which included eleven other men. Among them were Smith, who became president of the Conference the following year; Jackson R. Collins (1896–1978) (figure 4), secretary of the Committee from 1946 to 1963 and last survivor of the original 1927 group of thirty founders when he died in 1978; Linn K. Twinem (1903–1997) (figure 5), assistant secretary of the Committee, editor of the Quarterly Report, and general counsel of Beneficial Finance Corporation of New York; and James C. Sheppard (1898–1964) (figure 6), a founding member of the Los Angeles firm that would become Sheppard Mullin Richter and Hampton and Beckwith’s successor as Committee chairman in 1949. These men formed a close-knit group as they performed leadership functions for the Conference for many years.
Fig. 4: Jackson R. Collins.
Fig. 5: Linn K. Twinem.
Fig. 6: James C. Sheppard.
Fig. 7: George R. Richter Jr.
Sheppard remained chairman of the Committee through 1962, when his partner, George R. Richter Jr. (1910–2002) (figure 7), took over the chairmanship through 1979 after he had served in the newly created position of vice president from 1960 to 1962. Before that, Richter had been added as Commercial Code editor for the Quarterly Report in 1951 as the Uniform Commercial Code (“UCC”) was being drafted and finalized for submission to the state legislatures; he served in that function through 1986. Among other things, Richter was the California commissioner for the National Conference of Commissioners on Uniform State Laws, now the Uniform Law Commission, and was elected its president in 1959. He also served as chairman of the ABA Section of Corporation, Banking and Business Law, now the Business Law Section, from 1962 to 1963.
Activities of the Conference
The Conference held its twenty-fifth Annual Meeting at the ABA’s Annual Meeting in San Francisco in September 1952, indicating that it had held similar meetings each year after being founded in 1927. The same issue of the Quarterly Report that reported on the Conference’s Annual Meeting also announced that the General Committee of the Conference would hold its midyear meeting in Chicago in February 1953, in connection with the ABA’s midyear meeting, at which “[s]pecial projects of the Conference will be discussed and considered.” The same pattern holds true to the present as the Conference’s Governing Committee, as the General Committee was renamed in 1991, has held its Annual Meeting and midyear meeting in conjunction with ABA or Business Law Section meetings, discussing and considering projects for the Conference and other business.
The report on the twenty-fifth Annual Meeting consisted of several photographs that showed what the General Committee did. Chairman Sheppard handed out twenty-five-year awards to the three remaining founding members of the Conference. Other photos showed the judges and participants in the Annual Argument that the Conference staged on a current issue, with the participants being drawn from the ABA Young Lawyers Division. The Annual Argument was a prominent feature of the Quarterly Report from that point forward through 1989, with judges being prominent jurists like California Supreme Court Justice Roger J. Traynor or prominent attorneys like University of Texas School of Law Dean W. Page Keeton. In 1990, the Annual Argument was replaced by the first annual Frederick G. Fisher Jr. Memorial Lecture, also presented at the ABA or Business Law Section’s Annual or Spring Meeting until the COVID-19 pandemic upended all in-person meetings in 2019.
Along with the report on the twenty-fifth Annual Meeting, the Quarterly Report announced the Conference’s first annual law student writing contest, cosponsored by the ABA’s Law Student Program. For first, second, and third prizes of $500, $250, and $150, respectively, which in those days could pay for a significant portion of a year’s law school tuition, contestants were to write essays of not more than 2,500 words on a question about current interest rate caps in state statutes and constitutions where case law permitted amounts paid to third parties for collateral expenses to be charged, but not always if the lender’s employees rendered such services. The question to be answered was this:
What is the present state of the law, and what should be the policy of the law, with respect to reasonable charges made by the lender for services rendered by the lender or his staff? Should the lender be permitted to or should it be prohibited?[8]
From its beginning through the commencement of the Quarterly Report, the Conference was largely concerned with the state laws that regulated, or failed to regulate, small personal loans and with case law developments on that subject because no federal law existed at that time that dealt with consumer finance issues. Even the UCC was nothing more than a gleam in some law professors’ eyes at that time.
When the UCC became a reality, it was clear to the leaders of the Conference that this was a momentous change, particularly the provisions of Article 9 that dealt with security for financial transactions. This development led Richter to produce a six-part series from the Winter 1951 issue through the Summer 1953 issue in which he and five other authors thoroughly explained what was in Article 9 and its ramifications for personal finance.
During this period, the Conference also began to sponsor stand-alone programs that presented panel discussions on the latest developments in consumer finance law for the benefit of the practicing bar. The first such program was presented at the New York University Law Center in April 1953.
The Next Generation
The early 1970s marked momentous changes for the Conference as the founders retired to emeritus status or passed away. The first federal consumer law, the Truth in Lending Act (“TILA”), which imposed a uniform system of disclosures on all forms of consumer credit but left interest rates for the states to regulate, was enacted in 1968. This was followed by many more federal laws that regulated consumer finance. The Federal Reserve Board also drafted sets of implementing federal regulations for these statutes that grew in length and complexity as the years rolled by.
Fig. 8: Lawrence A. Young.
Fig. 9: Alvin C. Harrell.
The Changing of the Guard
As the new federal regulatory regime for consumer finance emerged, a new editor for the Quarterly Report, Lawrence A. Young (1943–2022) (figure 8), who started his career at Beneficial Finance in New Jersey and then had a long private practice at firms in Houston, succeeded Twinem in 1977. Young edited the Quarterly Report through mid-1984, when Bernice B. Stein took over. She in turn was succeeded in 1988 by Alvin C. Harrell (figure 9), professor at Oklahoma City University School of Law, who edited the Quarterly Report until his retirement in 2017. Harrell also edited the “Annual Survey on Consumer Finance Law” in The Business Lawyer for twenty-two years, until 2013.
The leadership of the Conference also changed. Fisher, mentioned above, succeeded Richter as chairman from 1980 until his death in 1989. As Young often told the story at the start of the Frederick Fisher Memorial Program at the Spring Meeting of the ABA Business Law Section, a young Fred Fisher came to the public’s attention in 1954 when he was attacked by Senator Joseph McCarthy as a suspected Communist in an attempt to smear his boss, the U.S. Army’s counsel, Joseph Welch of Hale and Dorr, during the McCarthy-Army hearings in which McCarthy accused the Army of harboring Communists. Welch’s emotional defense of Fisher during the televised hearings turned the public mood against McCarthy and led to his eventual disgrace and downfall. During Fisher’s long tenure at Hale and Dorr, he held many positions in the ABA and became president of the Massachusetts Bar Association from 1973 to 1974.
Fig. 10: Walter F. Emmons.
Fig. 11: Lawrence X. Pusateri.
Upon his death, Fisher was succeeded as chairman by Walter F. Emmons (1928–2013) (figure 10) for two years and then by Lawrence X. Pusateri (1931–2005) (figure 11) from 1993 to 1998. Pusateri was the first summa cum laude graduate of DePaul University College of Law in Chicago when he graduated in 1953 and had a varied and interesting career thereafter. As an assistant staff judge advocate in the U.S. Army from 1954 to 1957, he was a prosecutor in the famed Bamberg, Germany, rape trial in which the seven defendants were convicted, which became the subject of the movie Town Without Pity in 1961. He then served two terms in the Illinois House of Representatives and became president of the Illinois State Bar Association. After serving as a justice of the Illinois Appellate Court, Pusateri reentered private practice and focused on consumer finance law.
Changes in the Quarterly Report
Young once told the author of this article that the Quarterly Report was “pamphlet-sized” before Harrell became its editor. This was confirmed by surveying the extant issues. The Quarterly Report under Twinem as editor had about 80 pages per year in 1947 and 1948, then grew to 100–160 pages from 1959 to 1976. Under Young as editor, it had a range of 76–108 pages from 1977 through 1984; it then had a range of 56–64 pages through 1987 under Stein as editor. One noticeable feature for today’s reader is the almost total absence of footnotes in the Quarterly Report from 1946 through 1987.
When Harrell became editor in 1988, the Quarterly Report suddenly became a full-fledged law review, with every article thoroughly footnoted. It also mushroomed in size, going from 56 pages in volume 41 under editor Stein to 224 pages in volume 42 under Harrell—and then to 274 pages in volume 43 and 398 pages in volume 45. Law professors’ articles began to be published with some frequency.
Even before the panoply of federal laws regulating consumer finance began to be enacted in 1968, the Quarterly Report’s growth in the 1950s reflected the expansion of its coverage beyond the regulation of personal loans. Consumer bankruptcy law, a subject of great importance to small loan lenders, became a frequent topic. Each state’s enactment of the UCC was chronicled. Mortgage lending and auto finance also became important topics.
In the 1960s and 1970s, each new federal consumer finance law received suitable coverage in the Quarterly Report, as did the development and state enactment of the Uniform Consumer Credit Code (“U3C”). For example, just as when Article 9 of the new UCC was discussed at length in a six-part series of articles, the proposed disclosure regimens in the TILA and the U3C were introduced to the readership of the Quarterly Report in 1967. When the TILA became law, another article explained what was in the final enactment. The “private attorney general” provisions of the TILA that enabled and encouraged private litigants to file class actions, which have been a fruitful source of employment for consumer finance litigators as well as fertile ground for legal commentators to the present day, were also covered in an early Quarterly Report article. The 1967 Annual Argument dealt with the question of whether a federal statute could validly prohibit discrimination by lending institutions well before the Equal Credit Opportunity Act was enacted in 1974.
The CCFL and the Quarterly Report Enter the Twenty-First Century
Fig. 12: Jerry D. Bringard.
At the turn of the twenty-first century, the CCFL’s leadership began a regular rotation. Jerry D. Bringard (figure 12), who had been president for six years during Pusateri’s chairmanship, became chairman for two years from 1999 to 2000. Young then became chairman from 2001 to 2002. The rotation of officers became institutionalized when the Governing Committee of the CCFL adopted bylaws in 2003. Three-year terms were established for the chairman, who was to be automatically succeeded by the president when the term ended, and the other officers.
The turn of the twenty-first century also brought programming changes to the CCFL. Harrell greatly expanded the CCFL’s programming by instituting specialized two-day seminar programs for bankruptcy, debt collection, mortgage lending, and auto finance in addition to an annual two-day overall compendium of consumer finance law issues similar to the Conference’s original 1953 consumer finance law program. However, attendance at the programs dwindled following the foreclosure crisis of 2007–2008 as financial institutions cut back on personnel and expenses. By the time Harrell presented Consumer Credit 2011 in October of that year, it had become uneconomical for such programming to continue, and the CCFL exited the legal education field.
Consumer finance law developments did not cease during this period, however, and the Quarterly Report continued to cover them in depth. The page count grew to a peak of 516 pages in 1994 and continued in the range of 300 or more pages from 1995 to 2005. Volume 60 carried a record 722 pages in 2006—and then the record was broken with 954 pages in volume 61. For the rest of Harrell’s tenure as editor, the Quarterly Report comprised 300 or more pages per volume. A myriad of consumer finance topics was covered, paying close attention to state law developments as well as all of the federal law developments both before and after the landmark sixteen-title Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010 and a new federal agency, the Consumer Financial Protection Bureau, was created to oversee the federal law end of things.
Following Harrell’s retirement in 2017, changes were made to streamline the Quarterly Report and to more fully engage the members of the Governing Committee, which now has more than one hundred members drawn from law firms and in-house counsel offices in all parts of the country, in the operations of the CCFL. Professors Ramona L. Lampley and Chad J. Pomeroy of St. Mary’s University School of Law were recruited to serve as co–executive directors and coeditors of the Quarterly Report.
The CCFL reinstituted two-day seminars in 2016 in partnership with Loyola University Chicago School of Law and Texas A&M University School of Law. After the programs went virtual during the pandemic, live seminar programming resumed in 2022.
With an expanded group of officers as well as a large, diverse Governing Committee whose members are committed to participating in its mission to “encourage study and research in the field of consumer finance law,” to “promote, through education, the sound development of consumer finance law,” and to “provide a forum through which interested persons may exchange opinions,”[9] the CCFL is well positioned to continue for its second century to exercise the leadership that it has exercised in this field since 1927.
John L. Ropiequet is of counsel to the Litigation Group at Saul Ewing LLP’s Chicago office, where he has practiced since 1973. John was chairman of the Conference on Consumer Finance Law from 2015 to 2018, is a fellow of the American College of Consumer Finance Lawyers, and has been coeditor of the “Annual Survey on Consumer Finance Law” in The Business Lawyer since 2012. He is also coeditor of The Law of Truth in Lending (4th ed. forthcoming 2023), has published scores of articles in The Business Lawyer and other publications, and is the author of countless thousands of footnotes.
Insurers like to make their coverage obligations someone else’s problem. One of the ways they do this is by saying that another insurer has to go first. In other words, insurers will sometimes take the position that another insurer has to pay its full policy limit before the first insurer pays anything. The insurers play this finger-pointing game by citing the “other insurance” provision, which is standard in most liability insurance policies. In certain circumstances, courts will “cancel out” dueling “other insurance” clauses and require each insurer to pay on a 50–50 basis when coverage truly overlaps. Other times, courts will establish a “proportional” split of responsibility if one insurer provided higher limits than the other insurer when multiple policies are triggered. As always, the precise words of the insurance policy will directly impact a court’s analysis of the disputed coverage provisions. Recently, the New Jersey Supreme Court tackled another “other insurance” dispute that does not often garner much attention but may be important for corporate policyholders to consider, especially if those policyholders “self-insure” a significant part of their insurance program.
In Statewide Insurance Fund v. Star Insurance Company, a young boy sadly died on the beach in Long Branch. His family sued the town, and they settled the case. Long Branch was part of a “joint insurance fund,” or “JIF,” administered by Statewide, which was an organization of towns in New Jersey that pooled their resources and insurance risk exposures in one fund up to a certain threshold—$10 million. Long Branch also had a separate policy of insurance issued by Star that provided a $10 million limit. When Long Branch settled the claim with the family, Star refused to contribute, taking the position that it was “excess” coverage and Star was on the hook only after “other insurance,” i.e., the Statewide funding, was exhausted. Statewide filed a declaratory judgment action seeking to establish that its coverage was excess to any coverage provided under the Star policy.
Sorting through the finger-pointing, the New Jersey Supreme Court determined that Star was solely responsible for the settlement of the claim. The Court took the commonsense approach that so-called “self-insurance” is not really “insurance” at all when considering the “other insurance” provision contained in the Star policy. That is because in a self-insuring pool such as the JIF, “members retain significant risk by paying claims from member assessments,”[1] and the Court readily acknowledged that such risk pooling stands in stark contrast to typical insurance, where an insurer takes on risk in exchange for the payment of a premium. Accordingly, the Court held that the money Long Branch could get from the JIF was not “other insurance” and that Star had to honor its promise to serve as the primary insurer and was first in line to pay the claim.
The Court’s opinion makes clear that if an insured is responsible for its own loss, it is not to be considered “insured” at all and, therefore, should not lose the benefit of actually valid and collectible insurance available elsewhere. While insurers likely will want to declare this decision is an “outlier” or limited to the “unique” facts of a risk pooling program, the holding of Statewide has far broader implications because it draws a clear distinction between “self” insurance and “real” insurance.
Many corporate policyholders utilize “self” insurance to serve as primary coverage through captive insurance programs or by carrying large self-insured retentions and then having “real” excess coverage. In fact patterns where that same policyholder has additional insured rights under another party’s insurance policy—for example, in the context of a construction defect claim where an owner may have its own insurance coverage and have rights under insurance policies held by general contractors (GCs) or subcontractors—the “other insurance” clause may rear its head again. Insurers for the GC and/or the subs may try to draw the owner into paying for some or all of a claim by invoking their “other insurance” provisions. Relying on Statewide, owners now have an additional arrow in their quiver to push back against that contribution demand. Rather, owners would have the ability to take the position that they have no “other insurance” available because they are self-insured and the GC and subcontractor insurers are first in line to pay.
At bottom, corporate policyholders that utilize captive or fronting insurance, carry large self-insured retentions, or employ other bespoke risk transfer mechanisms need to take a careful look the next time they are told by an insurer that it wants to head to the back of the payment line based on an “other insurance” clause. As the Statewide decision demonstrates, the nuances associated with insurance programs and coverage disputes are complex but also important. Any policyholder that receives a denial of coverage based on an “other insurance” clause will be well served to review that disclaimer with experienced coverage counsel before agreeing to accept responsibility for any payment obligation.
