The U.S. Trustee Program’s (USTP) rule entitled Uniform Periodic Reports in Cases Filed Under Chapter 11 of Title 11 (Final Rule) became effective on June 21, 2021, and provided for the filing of a single Monthly Operating Report and a single Post-Confirmation Report in non-small business Chapter 11 cases.^[1] This article highlights key benefits of the two reports, provides an update on enhancements made to the reporting process since June 2021, and shares important practice tips.^[2]

The New Reports

To help bankruptcy professionals transition to the new Monthly Operating Reports (MORs) and Post-Confirmation Reports (PCRs), USTP staff provided training nationwide on how to complete, finalize, and file the new forms. In July 2021, the first new forms were filed, and since then bankruptcy professionals have filed thousands of MORs and PCRs with bankruptcy courts across the country. The bankruptcy community appears to have made a smooth transition to reporting under the Final Rule. The success of the transition is a credit to the bankruptcy community and reflects the shared and ongoing commitment to greater transparency and efficiency in the bankruptcy system.

Benefits of the New Reports

In addition to the uniformity and consistency provided by having a single MOR and PCR for use in every non-small business Chapter 11 case, the updated forms confer several other new and important benefits.

Modernization: The new MORs and PCRs represent a significant advance in Chapter 11 periodic reporting. The data-embedded “smart forms” allow users to enter and save data in interactive, fillable PDF forms. Plus, with embedded data, the forms offer enhanced searching and extraction capabilities. To simplify data extraction, the forms employ standard barcode technology used widely across government and industry, such as on postage stamps, RealID driver licenses, common carrier shipping labels, and boarding passes issued by commercial airlines. To enhance the user experience with periodic reporting, the USTP introduced MORs and PCRs that are compatible with Windows and Mac operating systems.

Simplicity: The MOR and PCR forms contain easy to understand questions and are accompanied by clear and concise instructions that guide filers through the steps required to complete, save, and finalize reports for filing with bankruptcy courts on CM/ECF.

Transparency: Transparency is a vital pillar of the bankruptcy system. To advance that important interest, the Final Rule requires that MORs and PCRs be filed with bankruptcy courts on CM/ECF. Prior to the effective date, there was no universal filing requirement. Publicly accessible reports promote transparency by providing non-party stakeholders—including members of Congress, the public, academics, and the press—access to information across cases and districts. With greater access to data summarizing Chapter 11 debtors’ post-petition operations, stakeholders can more effectively analyze and report on the operational results of the bankruptcy system.

Enhancements to the Reporting Process

The Final Rule, new forms, and accompanying instructions are the byproduct of the USTP’s collaboration with numerous stakeholders in the bankruptcy system, both before and after the effective date. In response to internal and external stakeholder feedback, the USTP acted quickly to implement certain items that already have enhanced the reporting process. Some key examples follow.

The USTP recognized the need for an efficient and effective way to share important information about periodic reporting with stakeholders across the country. To fulfill that need, the USTP created the “Chapter 11 Operating Reports Email Updates” feature on its website. Presently, almost 1,000 stakeholders nationwide have enrolled to receive email updates from the USTP about periodic reporting. Recent updates were provided in late 2022, when the USTP: (i) announced that updated instructions for MORs and PCRs were posted on its website for immediate use; and (ii) explained how to avoid a mismatch between data reflected on the face of a form and the data embedded in the barcodes by highlighting the need to generate new barcodes any time a report is edited after the “Generate PDF for Court Filing and Remove Watermark” step has been completed.

In December 2021 (about six months after the effective date of the Final Rule), the USTP incorporated barcode technology into the MOR and PCR forms. The barcodes contain the embedded data reflected on the face of the forms, and they provide visual confirmation that the forms have been finalized properly for filing with the bankruptcy court on CM/ECF. Specifically, the presence of barcodes signifies that each field on the form has been completed and that the forms’ data embedded features have been activated properly, thereby preventing the filing of incomplete or flattened forms. The barcodes are generated at the end of the forms automatically after filers complete the “Generate PDF for Court Filing and Remove Watermark” step. Additionally, the barcodes further the Congressional mandate in the Bankruptcy Abuse Prevention and Consumer Protection Act that the new forms “facilitate compilation of data” and maximize public access to the data contained on the forms by providing parties-in-interest, the public, academics, and the press an efficient means of aggregating data from a high volume of reports filed across the country.^[3]

The USTP has also helped several national financial advisory firms transition to reporting under the Final Rule. These firms routinely represent hundreds of debtors in large cases across the country. In addition to answering substantive, procedural, and technical questions through ongoing discussions, the USTP provided schema and data dictionaries for the MORs and PCRs to help the firms design electronic tools to expedite the process of populating individual reports for debtors in large jointly administered Chapter 11 cases. During the ongoing collaboration, the USTP also tested numerous forms prepared by the firms to ensure that their respective methods successfully embedded data in the new forms.

In response to stakeholder feedback received since the effective date, the USTP issued updated Instructions for both the MOR and PCR forms in December 2022. With several substantive, procedural, and technical revisions, the updated Instructions help clarify certain questions raised by stakeholders. The updated Instructions are available on the USTP’s website.

An important feature of the USTP’s commitment to efficiency in the reporting process is the on-demand technical support that it provides to all stakeholders. In addition to offering user-friendly “Troubleshooting Tips” on its website, the USTP provides email access to a team dedicated to responding to technical inquiries related to MORs and PCRs. By emailing inquiries to [email protected], stakeholders can obtain individualized assistance when the need arises. The USTP immediately acknowledges receipt of every email with an automated response that provides troubleshooting tips addressing many commonly asked questions. Quite often stakeholders quickly reply to the automated response indicating that it was all they needed to resolve their inquiry. For instance, one of the most common inquiries involves stakeholders using the prior version of the forms that were deactivated and removed from the USTP’s website in December 2021. Once directed to the active forms on the USTP’s website and provided a hyperlink for quick access, those inquiries are resolved. If these common answers do not resolve the issue, a USTP representative contacts the inquirer directly to work out a solution. Since the effective date in June 2021, the USTP team has successfully resolved hundreds of inquiries from across the country.

On the rare occasion when inquiries are too complex to be resolved by email, the USTP team engages with stakeholders telephonically or by video conference. In one recent instance, a debtor’s counsel had difficulty generating barcodes on an MOR despite using the correct version of the form and following the instructions step by step. To ensure that the forms could be finalized and filed prior to the impending deadline, two members of the USTP team immediately video-conferenced with counsel, working together for an hour. During that time, the USTP team not only diagnosed and corrected the problem—an incorrect default computer setting—but ensured that counsel understood how to finalize and file forms on their own. Since then, counsel has continued to file forms without the need for further USTP assistance.

Whether substantive, procedural, or technological, the post–effective date enhancements will continue to promote the efficiency and transparency of the reporting process.

Practice Tips

Efficiency in the bankruptcy process is a mission priority for the USTP. To further that priority, the USTP recommends that stakeholders responsible for preparing or filing MORs and PCRs adopt the practice tips that follow.

• Take the time to become familiar with the reports and the completion and filing processes. Get acquainted with the periodic reporting resources that the USTP offers by visiting its “Chapter 11 Operating Reports” webpage where stakeholders can find updates, forms, Instructions, Troubleshooting Tips, and other resources and information.
• Always start your reports by downloading the latest version of the form from the USTP website. To start the reporting process, download the latest version of the MOR or PCR form from the USTP website. Be sure to select the form that is compatible with the filer’s operating system (i.e., Windows or Mac). After downloading the MOR or PCR, launch Adobe Reader or Adobe Acrobat to complete the PDF version of the form—do not attempt to complete the form in an internet browser. For step-by-step assistance with this process, consult the Guide for Opening the MOR/PCR Forms posted on the USTP’s website. Note that once you download the latest version of the forms, you can begin by working from an editable version from a prior reporting period, rather than downloading a new form each month or quarter.
• Always complete the forms electronically without inserting or attaching anything. Complete the MOR and PCR forms electronically and do not flatten the forms when finished (i.e., do not print and scan the forms before filing). In addition, do not insert or attach additional pages to the forms. Any supporting documentation, including exhibits, explanatory notes, or bank statements, must be filed as separate PDF attachments.
• Follow the MOR or PCR instructions to prepare your reports for filing. Once all the required information has been entered onto the MOR or PCR and an editable version has been saved, select the “Generate PDF for Court Filing and Remove Watermark” button at the end of the form. Although this step will not file a report with a bankruptcy court, it is required to remove the watermark, embed data, and generate barcodes on the report. To ensure that all data is embedded in the version of the form to be filed with the bankruptcy court, do not edit a report after the watermark has been removed. If last-minute changes to a report are required, revert to the editable version of the report and simply repeat the “Generate PDF for Court Filing and Remove Watermark” step after making the edits. For step-by-step guidance on this process, consult the Instructions for the MOR and PCR posted on the USTP’s website.
• File your reports using the correct CM/ECF docket entry as a stand-alone PDF. When filing forms with the bankruptcy court, select the correct docket entry on CM/ECF established by the local court for MORs or PCRs. In addition, file all pages of each report, including all barcodes. File each report as a stand-alone PDF, and do not combine multiple reports or barcodes into a single PDF.
• Use the technical assistance available on the USTP website and through a dedicated help email. Visit the “Troubleshooting Tips” page on the USTP’s website for technical guidance. If further assistance is required, filers can request technical assistance with MORs and PCRs by emailing inquiries to [email protected]. The USTP has a team dedicated to responding to MOR- or PCR-related technical inquiries. Case-related inquiries may be directed to the local USTP office overseeing the Chapter 11 case, as before.
• Sign up for the USTP’s subscription service to receive all updates on the forms and Instructions. Finally, stay informed by taking advantage of the USTP’s subscription service. Subscribers will receive emails about updated forms, Instructions, and other important information related to periodic reporting under the Final Rule. To subscribe, visit the Chapter 11 Operating Reports webpage.

Conclusion

Periodic reporting remains a vital part of every Chapter 11 case. Fiduciaries have an obligation to account for estates’ operational and financial performance, both pre- and post-confirmation. With those fiduciaries reporting on the modernized and streamlined MORs and PCRs for over a year now, stakeholders in the bankruptcy system have benefitted from increased uniformity, consistency, and transparency. With almost 39,000 MORs and PCRs filed with bankruptcy courts across the county, the USTP is encouraged by stakeholders’ performance under the Final Rule, and it looks forward to the enhanced efficiency and transparency in the bankruptcy system that the new MORs and PCRs provide.

1. 28 C.F.R. § 58.8. The forms promulgated under the Final Rule are designated as UST Form 11-MOR and UST Form 11-PCR. These forms are applicable only in judicial districts where the USTP operates. ↑

2. For an extensive discussion of the rule-making process, including discussion of the public comments, testimony at the public hearing and the USTP’s response, refer to the article entitled Introducing the USTP’s New Chapter 11 Periodic Reports, published in the February 2021 edition of the American Bankruptcy Institute Journal, at page 24. ↑

3. 28 U.S.C. § 589b(b). ↑

As cybercriminals become increasingly sophisticated, they find new ways to infiltrate systems and disrupt operations. Corporations, legal and other firms, nonprofit organizations, academic institutions and government agencies are among the countless victims of data breaches every year.

Until recently, breaches largely involved encryption where threat actors accessed networks and locked down systems, causing business interruption and often demanding a ransom for their release. While this tactic remains a common tool in most breaches, the growing threat that emerged in 2022 is incorporating data exfiltration into the toolkit. Now—with increasing frequency—multiple threat factors are becoming involved in a single incident: encrypting systems, stealing and selling data they have accessed, and threatening to expose the fact that an organization’s data was stolen unless they are paid the requested ransom. Among the many breaches experts handled in Q4 of 2022, very few did not include an element of exfiltration, which is in stark contrast to the first half of 2020, where less than 30% of data extortion incidents included exfiltration.

Due to the rise of exfiltration, lawyers should be on guard and ensure they are compliant with Rule 1.6(c) of the American Bar Association’s Model Rules of Professional Responsibility: “A lawyer shall make reasonable efforts to prevent the inadvertent or unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.” If lawyers do not take “reasonable efforts,” they may risk sanctions, disbarment, and legal liability in the event of a data breach. The ABA issued an opinion^[1] on Model Rule 1.6 clarifying that what constitutes a reasonable effort is not a “hard and fast rule,” but rather a flexible set of factors that are weighed on a case-by-case basis.

The ABA opinion’s factors to be weighed include:

• the sensitivity of information;
• the likelihood of disclosure if additional safeguards are not employed;
• the cost of employing additional safeguards;
• the difficulty of implementing the safeguards;
• and the extent to which the safeguards adversely affect the lawyer’s ability to represent clients.

The ABA Standing Committee on Ethics and Professional Responsibility stresses that attorneys should assess the risk of inadvertent disclosure of client information before connecting to unsecure networks, using computers and servers without anti-virus software, and sending unencrypted communications.^[2]

In some cases of data exfiltration, the threat actors download a copy of the data; in other cases, they download a copy of the data and then also delete it from the network from which it was taken. The latter scenario reinforces the importance of regularly backing up all systems and the data they contain, so that in the event of deletion during a breach, the organization can reinstall a recent version of that data to reduce the impact on regular business operations.

Once stolen, data is often sold or threatened to be sold. Data may be posted on the dark web, or the threat actor may have a buyer already identified before the theft. Regardless of what the criminals do with exfiltrated data, dealing with this type of breach is a logistical nightmare. In many cases the stolen data includes trade secrets or the personally identifiable information of employees and/or clients of the organization, posing a substantial risk to everyone involved.

Among the growing impacts of data breaches is the risk of class-action lawsuits. As more people understand the effects of having their data compromised, more are taking action by initiating or joining class actions. And this isn’t limited to breaches that occur in large organizations like Equifax, Twitter, or Uber, for example. Smaller companies dealing with breaches affecting as few as 1,000 data subjects—small by previous standards—are now facing litigation as well. While the number of impacted data subjects may be relatively small, the scope of the impact felt by the data subjects and the organization is often the same as in larger breaches.

Companies can’t do much to prevent these lawsuits once a data breach has occurred, but they can take steps to help mitigate the consequences:

• Pre-event: Establish strong security protocols upfront, which will help in passing a reasonableness test in the event a suit is filed. If an organization can prove to a court that it took reasonable care in protecting customer data and to prevent a breach, it is more likely to prevail against negligence claims in a suit. Examples of reasonable security measures an organization might point to include having a dedicated security officer, maintaining ISO 27001 and SOC 2 certifications, mandating multi-factor authentication, and providing quarterly cybersecurity training for all employees.
• Post-event: Likewise, if the company can demonstrate it has followed all regulatory compliance requirements, met deadlines, and taken reasonable and necessary steps to address the situation without delay and with as much transparency as possible, it can lower the risk of penalties and fines.

Key tips for dealing with cyberattacks:

1. Lawyers should ensure that their organizations or clients take every incident seriously and put in place mandatory, periodic employee cybersecurity training to help employees understand what incidents might look like, how to prevent them, and to immediately report anything suspicious to IT. From a compliance perspective, lawyers should instruct their organizations or clients not to dismiss something strange as nothing if they do not encounter any immediate impacts, as the company may be vulnerable to a further attack or breach at a later time. Recently a Reddit employee contacted Reddit’s IT department shortly after falling victim to a spear-phishing attack—which led to a website that cloned Reddit’s internal systems and allowed threat actors to steal credentials and second-factor tokens. Had the employee not made that notification, the results could have been disastrous.^[3]
2. The legal department should be informed immediately of a potential incident and should encourage the organization or their client to take immediate action. This is important from both a compliance and mitigation standpoint, as well as the potential for privilege to apply to certain communications in the case of post-event lawsuits. Do not delay, and do not assume that a threat has been resolved once it has been identified, as it may be ongoing. In the Reddit scenario discussed above, because the employee reported the incident right away and Reddit’s IT department took immediate action on the threat, the attacker’s window of opportunity was reduced, and the damage was limited.
3. Lawyers should instruct their organizations or clients to consider retaining a third-party digital forensics expert to verify the risk is contained and that it is safe to conduct business. Digital forensics experts can check all systems and networks to ensure the threat is resolved and that there is no additional risk of ongoing or subsequent threats. This will provide the company and its customers with peace of mind and will limit the business repercussions, to a degree. The third-party digital forensics report and corresponding forensics expert can provide compelling facts in eventual litigation as well.

Importantly, an ounce of prevention is worth a pound of cure. Cybersecurity awareness training remains a critical function for every organization, but it typically does not get the attention it deserves. Threats are constantly evolving, so your training should, too. Keep all employees up to date on the latest protocols and best practices to prevent breaches, as they are your first line of defense against cyberattacks.

1. See American Bar Association Standing Committee on Ethics and Professional Responsibility, Formal Opinion 477R*. Issued May 11, 2017, revised May 22, 2017. Pages 4–5. Available at: https://www.americanbar.org/content/dam/aba/administrative/professional_responsibility/aba_formal_opinion_477.pdf. ↑

2. See id. at pages 6–7. ↑

3. See Reddit Press Release, “We had a security incident. Here’s what we know.” February 5, 2023. Available at: https://www.reddit.com/r/reddit/comments/10y427y/we_had_a_security_incident_heres_what_we_know/. ↑

Mergers and acquisitions (M&A) play a major role in modern economies. Since 2010, there have been more than 500,000 merger and acquisition deals worldwide. According to Statista, in 2021 alone, there were more than 63,000 international M&A transactions.

Due diligence is an essential part of the M&A process. However, many obstacles can get in the way of effective due diligence, including language barriers and cultural differences. This is where legal translation steps in: this specialized field can help smooth the way to a successful transaction.

The Importance of Legal Translations in the M&A Due Diligence Process

The purpose of due diligence during an M&A transaction is to gather all the information needed about the target company to determine if a deal is viable. This allows businesses considering a merger or acquisition to pin down the potential risks and opportunities in the transaction.

Language barriers and cultural differences can complicate due diligence in international M&A transactions. Each country and region has its own legal system and regulations, so any lack of knowledge of these specific complexities can lead to a deal falling apart. Cultural differences can also bring about misunderstandings and miscommunication, which can negatively impact the overall success of the deal.

This is where legal translation services become essential. This domain of translation not only requires that translators be fluent in another language, but they must also have an in-depth understanding of the legal systems of both invested parties as well as cultural awareness and knowledge of specific legal jargon.

Legal translations are crucial in ensuring that cross-border transactions are free of any miscommunication and misunderstandings; certified translation of any foreign-language documentation involved in the process can ensure that the language barrier won’t be a reason a deal is not successful.

Translating contracts and agreements ensures that both parties are on the same page and that their obligations, rights, and liabilities are all properly met. By translating financial statements, parties can have a detailed analysis of the target company’s financial performance, which is critical in determining the deal’s viability.

Despite the rise of AI translation software, it is essential to have language professionals who are specialized in legal translations as part of the process, as there are aspects of law and linguistic nuances that machine translation is not able to reliably convey. Language professionals can also be held responsible if any aspect of the translation goes awry.

Best Practices for Legal Translation in M&A

How do you ensure that a legal translation meets the criteria of something as complex and integral to the M&A process as due diligence? Here are a few of the best practices you can implement to guarantee you are on the path to success.

1. Work with Legal Translators Specialized in M&A

Not all legal translators have experience dealing with corporate finance due diligence and M&A. That’s why it is important to make sure you collaborate with an expert in the field who has experience in the specific countries relevant to the deal. This will help ensure that all the needed information has been laid out effectively.

2. Develop Cultural Awareness

An M&A deal is the beginning of another chapter for the companies involved. The long-term success of an M&A transaction depends on how management is prepared to assimilate into the new culture. Translations during the deal process facilitate effective information sharing and therefore serve as a way for both parties to develop trust and transparency.

3. Quality Assurance and Accuracy

Many legal translation services have documents undergo a thorough quality assurance process that involves the use of state-of-the-art translation tools and human expertise to evaluate the translated documents’ clarity and accuracy. It’s also vital that, from your end, you conduct quality assurance and review documents to ensure that all the details are found in the agreement.

4. Data Security and Privacy

The pandemic didn’t just bring change to the process and practice in due diligence for M&A, but it also changed how transactions are being made. As remote work and hybrid arrangements have become prevalent and more deal closings are occurring digitally, concerns about data security and privacy protocols in place have become more significant. It is important to ensure that the platform used for sharing translations and other aspects of a transaction is secure.

Conclusion

Although according to PwC’s 26^th Annual Global CEO Survey 73% of CEOs didn’t have a positive view of global economic growth in the coming year, about 60% of them stated that they do not plan delay deals in 2023. International M&A due diligence will continue to be important, and having experts in legal translations to bridge cultural and linguistic barriers is a necessity. Businesses looking to close global deals should consider the impact of legal translations on their due diligence process and use the best practices in this article to help minimize the risks and maximize the opportunities associated with cross-border M&A transactions.

Lisa Stark, Business Law Today editor-in-chief: Judge Montgomery-Reeves, you have been hailed as a trailblazer—the first-ever African American to serve as a Vice Chancellor of the Delaware Court of Chancery as well as the first African American associate justice and the youngest jurist to sit on the Delaware Supreme Court. You recently started a new position as a federal judge on the Third Circuit Court of Appeals, having been nominated by President Biden, in June 2022. 

What have been the key drivers of these tremendous accomplishments?

Judge Tamika Montgomery-Reeves: The two main reasons for my career accomplishments are sponsorship and timing. As I have said before, no one gets very far alone in life. I am here because I stand on the shoulders of giants. Many people came before me, in Delaware and on the federal bench, and those people paved the way for me to follow. I also have been extremely fortunate to have people, like former Chancellor William B. Chandler III, who not only mentored me but sponsored me during my career. Finally, I think it is important to put your name in the hat and to take chances on yourself, even if the timing and circumstances are not exactly what you had planned.

Lisa: Did you always want to be a judge?

Judge Montgomery-Reeves: I knew I wanted to be a lawyer in elementary school. I first developed an interest in the law from my grandmother. She grew up in Mississippi, and while she was not highly educated, she talked to me all the time about the importance of the law and knowing your rights. She talked to me about the inequities she witnessed growing up in Mississippi in the 1930s and 1940s, and she influenced me to pursue the study of law.

Lisa: What do you most enjoy about your job?

Judge Montgomery-Reeves: Finding the right answer. My role as a judicial officer is to study the record before me and the applicable law and come to the correct outcome based on that.

Lisa: Who have been the biggest influencers in your career trajectory?

Judge Montgomery-Reeves: My judicial mentor is Chancellor Chandler. He is very smart, and he works very hard. When I worked with him, he was in early, and he stayed late. He was constantly studying all things corporate law. He was a titan in corporate law, but you would never know that from the way he treated people. Every litigant, lawyer, law clerk, really anyone he encountered, he treated with the utmost respect. He is a person who cares deeply about other people, about making sure that everyone feels heard and is treated fairly, and you can see that in every interaction he has.

Lisa: You have worked to improve diversity in the judiciary. Is that something that you feel passionate about?

Judge Montgomery-Reeves: I think the judiciary should reflect the population it serves. And I think this for two reasons. First, having the judiciary reflect the whole population fosters trust in the judicial system, which is essential. Second, it allows children to see themselves in the people on the bench and start to think, “Hey, maybe I can do that too.”

Lisa: Studies have shown that more men than woman argue cases before the country’s high courts. What can we do to increase opportunities for women in the courtroom?

Judge Montgomery-Reeves: It is important that each of us recognizes that we all have the power to influence positive change whatever our position. For example, I make sure to treat every person before me, regardless of gender, with the same levels of engagement and respect. And I would encourage attorneys to consider who is arguing motions or presenting oral argument. If an associate drafted the motion, knows the entire record, and is going to prep the partner for argument, perhaps she should be the one arguing the motion instead.

Lisa: What are your favorite things to do when you are not on the bench?

Judge Montgomery-Reeves: I love to travel, eat good food, and spend time with my family and friends.

This article is adapted from The Fraudulent Transfer of Wealth: Unwound and Explained by David J. Slenn, available from the American Bar Association Business Law Section. Check out the related Book Chat video for more information.

Business Planning

Typical business planning transactions often can trigger fraudulent transfer law. Evidence of intent with respect to transactions involving an entity can be gleaned from direct evidence,^[1] but, like transactions involving individuals, is often gleaned from facts and circumstances. Resorting to the use of a business entity to hinder or delay creditors may result in avoidance under fraudulent transfer law.

In 1932, the Supreme Court decided a case involving a Pennsylvania lumber dealer who was unable to pay his debts as they came due and whose creditors were seeking payment. The dealer believed he could retain assets if a receiver was appointed. However, Pennsylvania did not permit the appointment of a receiver for a business conducted by an individual as distinguished from one conducted by a corporation. Consequently, the Pennsylvania dealer formed a Delaware corporation, then transferred all his assets in exchange for all the stock. The new corporation also assumed all the dealer’s debts. The dealer then sued in conjunction with a creditor against the new corporation.

Justice Cardozo noted the transfer to the corporation was fraudulent as well as the resulting receivership because it was part and parcel of a scheme whereby the form of a judicial remedy was to supply a protective cover for a fraudulent design. “A conveyance is illegal if made with an intent to defraud the creditors of the grantor, but equally it is illegal if made with an intent to hinder and delay them. Many an embarrassed debtor holds the genuine belief that, if suits can be staved off for a season, he will weather a financial storm, and pay his debts in full. Means v. Dowd, 128 U.S. 273, 281, 9 S.Ct. 65, 32 L.Ed. 429. The belief even though well founded, does not clothe him with a privilege to build up obstructions that will hold his creditors at bay.”^[2]

Limited liability companies

Because the asset protection trust is laced with evidence of intent to hinder creditors ab initio, the use of a limited liability company is tempting because it enjoys a disguise as a valid business entity unrelated to the owner’s personal creditor issues. However, if a creditor can show a debtor fraudulently transferred assets to an LLC (e.g., through a contribution of capital), the transfer to the LLC may be voided, just as a fraudulent transfer to a trustee of a trust may be voided.^[3] To the surprise of some planners, a contribution of capital in exchange for membership interests does not necessarily equate to “reasonably equivalent value.”^[4]

The limited liability company, and its charging order protection preventing creditors from reaching a member’s distribution until the LLC makes a distribution, is expressly permitted by most state laws. In a minority of states, an LLC need not have more than one member but still provide charging order protection. With an LLC, a veil of protection is created so that a business owner’s individual assets are protected from the claims of creditors of the business (inside creditors).^[5] This protection helps promote entrepreneurial spirit and is long recognized by the courts. “After all, there is nothing fraudulent or against public policy in limiting one’s liability by the appropriate use of corporate insulation.”^[6] But where the LLC is used as a trust substitute to protect assets from a member’s personal creditors, the member’s concern is not creditors of the business, but rather, the debtor’s personal creditors (outside creditors.)

LLCs as Trust Substitutes

Conceptually, the LLC is developing into a variant of the self-settled trust, where the rights of members and creditors are handled primarily by statutes, which in turn, permit the parties to do as they please under an operating agreement. This contrasts with centuries of developed case law and modern statutes adopting the case law as it applies to the use of trusts. With trust law, certain safeguards developed over time to protect creditors, the most obvious being the centuries old rule against self-settled trusts, which essentially provides one cannot use a trust to have his cake and eat it, too. The LLC and the law of contract, coupled with the benefit of not having to account to beneficiaries, are options for some to sidestep centuries of trust law and its protections for creditors and beneficiaries alike.

Today, some may attempt to enjoy the benefits of a self-settled trust in the form of an LLC. Managers can make decisions instead of trustees. The tax treatment can be replicated as well. A self-settled trust is usually treated as a so-called grantor trust in tax parlance, meaning the settlor pays the income tax on trust income. The LLC achieves the same result where it has a single member. This is because the default classification of a single-member LLC, for federal tax purposes, is to treat the LLC as disregarded (meaning all the tax consequences flow through to the member.)

The concept of a charging order has roots in trust law. At its core, a charging order is a lien on a debtor’s interest where a creditor has to wait for distributions to be made from a third party to the debtor before seizing the distributed property.^[7] In the trust setting, generally a court does not refer to this lien as a “charging order” but instead enters an order permitting a creditor to attach present and future mandatory distributions due to a trust beneficiary. If the trust is discretionary, a court may enter an order permitting garnishment of distributions when made in the discretion of a trustee.^[8]

According to section 736.0504(2), a former spouse may not compel a distribution that is subject to the trustee’s discretion or attach or otherwise reach the interest, if any, which the beneficiary may have. The section does not expressly prohibit a former spouse from obtaining a writ of garnishment against discretionary disbursements made by a trustee exercising its discretion. As a result, it makes no difference that the instant trusts are discretionary. Casselberry is not seeking an order compelling a distribution that is subject to the trustee’s discretion or attaching the beneficiary’s interest. Instead, she obtained an order granting writs of garnishment against discretionary disbursements made by a trustee exercising its discretion.^[9]

Where the trust is self-settled, generally, a creditor may reach the maximum amount that could be distributed to the settlor. Where a debtor does not contribute assets to a trustee but is merely a discretionary beneficiary of the trust (referred to as a third-party trust), the beneficiary’s interest generally is protected from creditors, at least until distributions are made.^[10]

Contrast with the LLC, which essentially takes a best of both worlds approach; the debtor-member may contribute assets to the LLC much like the debtor would a self-settled trust, however, the debtor-member is essentially treated as a beneficiary of a third-party trust because the LLC charging order statutes permit a creditor to reach distributions only if made by the LLC.^[11] If the LLC was treated like the self-settled trust, a creditor could, like a creditor of a beneficiary of a self-settled trust, take the maximum amount distributable to the member. With an LLC, this would mean foreclosing on the member’s interest, voting the member’s interest, etc.

But the LLC is not a trust; the LLC is a business entity. The charging order for purposes of trust law was meant to ensure a beneficiary could not thwart a creditor by enjoying the benefits of a trust despite an obligation to creditors. For LLCs (and partnerships), the charging order is justified on the grounds that a creditor should not step into the debtor’s shoes as a member of the LLC. Instead, the creditor may receive the same economic benefits the debtor member enjoyed. The goal with the LLC charging order is to prevent the creditor from interrupting other members of the LLC in conducting LLC business. But if there is no business other than dodging creditors, the public policy supporting the charging order weakens.

The law in some jurisdictions is written in a way that makes it difficult to disregard public policy. Like choice of law disputes in the trust context, debtors also attempt to hardwire the governing law of an operating agreement to force creditors to play by the rules of debtor-friendly states or countries.

In sum, the LLC is increasingly being used as a quasi-trust with the goal of protecting a member’s assets from the member’s personal creditors. Consequently, creditors who engage in discovery will look for evidence of the LLC serving as a personal use vehicle. This may lead to a court viewing the LLC as an alter ego or sham, permitting the creditor to reach the assets. Not only can general creditors rely on personal use evidence to reach assets, but the lack of a true business purpose can have negative consequences for federal tax law purposes.

Capital Contributions

In some cases, the contribution of an asset to a business entity is not meant to assist with business operations but instead intended to help the owner insulate the transferred asset from the claims of the owner’s creditors. Fraudulent transfer law provides a creditor with an opportunity to challenge the transfer of assets to a business entity.

In Firmani v. Firmani, the court reviewed debtor’s argument that the transfers to an LLC were made not to hinder a creditor, but for estate planning purposes. The court did not buy the excuse and found the transfer to the LLC to be fraudulent under an actual fraud analysis.

Defendants failed to present any substantial evidence to counter the strong inference of fraudulent intent established by these badges of fraud. Firmani submitted a certification which asserted that he established the Family Partnership and conveyed the Haddonfield property to this entity for “estate planning purposes.” However, we are unable to discern from Firmani’s certification how the transaction could have served any estate planning purposes, except by increasing the total amount of his estate by the $25,000 he seeks to avoid paying plaintiff and by the amounts of the judgments that certain casinos have against him. In any event, N.J.S.A. 25:2–25(a) does not require that an intent to hinder, delay, or defraud a creditor be the exclusive motivation behind a transfer in order for the transfer to be deemed fraudulent.^[12]

If more than one person transfers assets to an LLC, but only one person is a debtor, such that his transfer is voidable by a creditor, it should not matter if the transaction involved a non-debtor; one cannot insulate a fraudulent transfer by arguing the avoidance would complicate matters or affect another person’s interest. Such was the case in First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, where the debtor transferred his 50 percent interest in real property, together with the other 50 percent owner (Whiteman), to PDC, LLC. It should be noted that debtor offered evidence of his intent, which included legitimate business planning, to no avail.^[13] Despite the complications of unwinding a transfer to an LLC where some members do not have fraudulent intent, the court ruled in favor of the creditor:

Accordingly, we find the conveyances of Whiteman’s 50 percent interest and Clifton’s 50 percent interest to PDC were each distinct transfers that Whiteman and Clifton merely chose to accomplish in a single deed. The fact they utilized one instrument to transfer their separate interests does not negate the distinct ownership interest each person possessed in the Property. As mutually exclusive conveyances, we also find that the invalidity of one does not necessarily invalidate the other. To that end, Whiteman’s intent in transferring her share of the Property to PDC is irrelevant to the circuit court’s finding of fraudulent intent as to Clifton. Clifton’s proportional interest is subject to the claims of his creditors, and he cannot legitimize the fraudulent transfer of his interest by lumping it together with Whiteman’s presumably valid transfer of her interest. Regardless of the parties’ choice of instrument to convey the Property, we find the circuit court properly set aside the conveyance pursuant to the Statute of Elizabeth.^[14]

The transfer of assets to an LLC may be viewed as a badge of fraud where the debtor removed assets by transferring to an LLC to enjoy charging order protection.^[15] The Official Comments to the UVTA also address the intersection between charging order protection and fraudulent transfer law.^[16]

In Interpool, the debtor, Cuneo, transferred non-exempt assets to an LLC (RMC). The RMC interests were then transferred to a trust (RAC). The court examined the transfers under both New York and Florida fraudulent transfer law, finding their holding would have been the same, regardless of the applicable law because there was no conflict between the state laws. As is typical in wealth transfer transactions challenged under fraudulent transfer law, the debtor argued he was motivated by non-creditor reasons. This did not persuade the court to find in the debtor’s favor.

Cuneo was deposed in March 1995 in connection with the proceedings to enforce the judgment. His explanation for the challenged transfers was un-illuminating. He was unable, or chose not, to explain how he and his wife determined what property to transfer into RMC and RAC or why the transfers were made other than to say that he “picked stuff that [he] thought had a worth to it” and that he did so on the advice of counsel for “estate planning” reasons. He testified that he did what [Attorney] suggested and that he “assume[d] that it had to do with tax purposes if [he] die[d].” But he did not articulate any specific reasons why he believed the transfers to be advantageous.^[17]

As to whether the membership interests received in exchange for non-exempt assets constituted reasonably equivalent value, the court did not focus on the LLC’s value, and thus, the potential value of the LLC interests Cuneo received in exchange for his assets. Instead, the court focused on a creditor’s rights to the property that was transferred. In other words, the court examined a creditor’s rights before and after the transaction in determining the value of the debtor’s asset from the creditor’s perspective.

The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited *266 partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.

Interpool can be contrasted with United States v. Holland, where the debtor transferred assets to a limited liability company but remained the sole member. The transfer of assets to a single-member LLC, where the governing law does not provide single-member charging order protection, is akin to the transfer of assets to a revocable trust.

The US contests this characterization, contending that, when compared to the prospect of garnishing the Royalty Assets, the 1998 Transaction left Holland’s creditors with “the far less appealing recourse of seizing [Holland’s] partnership interest (which is subject to major partnership-level debts).” (Doc. 310, p. 7). In this connection, the US asserts that “a conveyance is not an exchange for equivalent value when it makes the debtor ‘execution proof.’” (Id.). In support, the US cites Interpool Ltd. v. Patterson, 890 F.Supp. 259 (S.D.N.Y. 1995), in which a debtor-husband transferred assets to a partnership jointly owned by his wife, and Dunn v. Minnema, 323 Mich. 687, 36 N.W.2d 182, 184 (1949), in which a debtor-husband “invest [ed] of $9,600 of his personal assets in property to which he and his wife held title by the entireties.”

Under the particular facts of this case, the transfer to EHLP did not make Holland “execution proof” because, unlike the debtors at issue in Interpool and Dunn, Holland was the sole owner of the assignee entity, EHLP. Accordingly, seizing Holland’s partnership shares would, apparently, enable a creditor to reach the Royalty Assets. The US is correct that, under this scenario, the Royalty Assets would be subject to “partnership-level debts.” However, because Holland received the benefit of such partnership-level debts in the form of the Note proceeds, this factor is of no avail to the US. If Holland had simply left the Note proceeds in his bank account, his creditors would have been no worse off—they could garnish the cash and recover the remaining value of the Royalty Assets upon repayment of the Notes.

In view of these factors, the 1998 Transaction and 2005 Transaction did not significantly hinder Holland’s creditors. Accordingly, the transfer did not result in the type of “wrong” that would support a finding that (i) that EHLP held title to the Royalty Assets as Holland’s nominee, (ii) that Holland fraudulently conveyed the Royalty Assets to EHLP, or (iii) that EHLP is the alter ego of Holland. Because the US demonstrates no basis for attaching property held by EHLP, the Court must deny its motion for summary judgment.^[18]

United States v. Holland illustrates why some states have enacted statutes providing charging order protection for a single-member limited liability company. The LLC becomes a quasi-exemption debtors may use to avoid paying their personal creditors. Like the asset protection trust, the single-member LLC offering charging order protection presents public policy issues relevant to fraudulent transfer law and choice of law for debtors attempting to import protections into their own state against their personal creditors.

Although avoiding a transfer to a business entity has an impact on the business and its owners, this is of no consequence if the transfer is fraudulent. As previously addressed, some have argued that it is unfair to other business entity owners if a creditor may void a transfer to the business entity by a debtor. This argument has also been used in the trust context, where some maintain it is not fair to void a transfer to a trust if the debtor created rights in third parties (via beneficial interest.) Like the choice of law in a trust agreement, or avoidance of a transfer to a self-settled trust, a creditor who has been injured and seeks relief under fraudulent transfer law is not always held subject to rules created in advance by a debtor. Stated differently, a debtor cannot transfer assets to an entity or trustee, muddy the ownership rights to such property by creating rights in third parties (often insiders), and then expect these third-party interests will automatically defeat a creditor.

If business entities are utilized to effectuate a fraudulent transfer, there is a risk that the court will disregard the business entity. This could have the effect of rendering the individual who controls the business entity liable as transferee. For example, In re Pace featured an attorney who helped his client (the debtor) transfer assets to an LLC controlled by the attorney. This was done to avoid the debtor’s creditors. The court held the LLC was the initial transferee, and further found that the attorney, due to his participation, was jointly liable and might have been considered the person for whose benefit the transfer was made.^[19] As discussed in the civil liability section of this book, lawyers must be careful as to their degree of involvement in fraudulent transfers.

1. Fish v. East, 114 F.2d 177, 182 (10th Cir. 1940). (“The court found that an additional object of making that lease and organizing the Placers Company to receive the grant or demise as lessee was ‘to hinder and delay creditors’ of the Mines Company, direct evidence of such fact being found in the minutes of the meeting of the board of directors of the bankrupt held November 2, 1932, at which a resolution was adopted to the effect that the stock of the Placers Company should be issued to Edward Cunningham, Erland F. Fish, and John A. Traylor, as trustees for the Mines Company, and the president of the Placers Company, stating that one of the reasons for this arrangement was that it was desired to have the stock ‘out of the name of Mines Company, so it could not be attached.’ In re Holbrook Shoe & Leather Co., D.C., 165 F. 973; In re Looschen Piano Case Co., D.C., 261 F. 93; Shapiro v. Wilgus, 287 U.S. 348, 53 S.Ct. 142, 77 L.Ed. 355, 85 A.L.R. 128.”) ↑

2. Shapiro v. Wilgus, 287 U.S. 348, 354, 53 S. Ct. 142, 144, 77 L. Ed. 355 (1932). ↑

3. See SE Prop. Holdings, LLC v. McElheney, No. 5:12CV164-MW/EMT, 2016 WL 7494300, at *11 (N.D. Fla. May 7, 2016). (“For Crestmark, it appears at this point that there is nothing to garnish—there is no debt owed to McElheney individually by the LLC. But SE Property may be able to garnish assets of Crestmark if it can show that McElheney transferred those assets to Crestmark fraudulently.”) ↑

4. See, e.g., Interpool Ltd. v. Patterson, 890 F. Supp. 259, 265-66 (S.D.N.Y. 1995) (“The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.”) ↑

5. See generally, Thomas O. Wells & Jordi Guso, Asset Protection Proofing Your Limited Partnership or LLC for the Bankruptcy of A Partner or Member, Fla. B.J., January 2007, at 34. (“An FLP has two types of creditors — inside creditors and outside creditors. Inside creditor claims arise from alleged actions or omissions of the FLP. Inside creditors may levy against the assets of an FLP, but generally cannot levy against the individual assets of limited partners or members of the FLP. Outside creditor claims arise from alleged actions or omissions by a debtor partner of the FLP. This article’s focus is on the rights of outside creditors to the debtor partner’s interest in the FLP.”) ↑

6. See Miller v. Honda Motor Co., 779 F.2d 769, 773 (1st Cir. 1985). ↑

7. See Loring and Rounds, Section 5.3.3.3(a). (“A creditor is then left with little recourse other than perhaps to attempt to obtain a judicial charging order that, if granted, might snare any discretionary distributions actually made to the beneficiary.” citing Hamilton v. Drogo, 241 N.Y. 401, 401, 150 N.E. 496 (1926) (“By the enactment of section 684 of the Civil Practice Act, providing that an execution may issue against a certain proportion of income from trust funds due and owing, or thereafter to become due and owing to a judgment debtor, it was the intention of the Legislature to extend the scope and effect of an execution as it had theretofore existed. There is no requirement that the income be due at the time the order is made and the execution served. It is enough either that it will become due in the future from the trustee to the cestui que trust, or that it may become so due. If ever the day of payment arrives the lien of the execution attaches.”) ↑

8. Historically, a beneficiary has a “reachable” interest in a trust when the interest has vested. This may occur when an event occurs such as the death of a lifetime beneficiary where the debtor-beneficiary receives the trust corpus outright, or when a trustee has decided to make a distribution in favor of the debtor-beneficiary. An interest may vest in a debtor-beneficiary but be non-possessory; in this situation, a creditor may reach the property unless state law provides otherwise. (See Ariz. Rev. Stat. Ann. §14-10506. “Whether or not a trust contains a spendthrift provision, a creditor or assignee of a beneficiary may reach a mandatory distribution of income or principal if the trustee has not made the distribution to the beneficiary within a reasonable period after the mandated distribution date unless the terms of the trust expressly authorize the trustee to delay the distribution to protect the beneficiary’s interest in the distribution.”) ↑

9. Berlinger v. Casselberry, 133 So. 3d 961, 965–66 (Fla. Dist. Ct. App. 2013). ↑

10. See, e.g., Hamilton v. Drogo, 241 N.Y. 401, 150 N.E. 496 (1926). (“In the present case no income may ever become due to the judgment debtor. We may not interfere with the discretion which the testatrix has vested in the trustee any more than her son may do so. Its judgment is final. But at least annually this judgment must be exercised. And if it is exercised in favor of the duke then there is due him the whole or such part of the income as the trustee may allot to him. After such allotment he may compel its payment. At least for some appreciable time, however brief, the award must precede the delivery of the income he is to receive and during that time the lien of the execution attaches.”) ↑

11. Transfers to an LLC are subject to avoidance under fraudulent transfer law. Florida’s charging order statute also expressly refers to fraudulent transfer relief. See Florida Statute Section 605.0503(7)(b). (“This section does not limit any of the following: *** The principles of law and equity which affect fraudulent transfers.”) ↑

12. Firmani v. Firmani, 332 N.J. Super. 118, 123, 752 A.2d 854, 857–58 (App. Div. 2000). ↑

13. See First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 342, 797 S.E.2d 409, 414 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (“At trial, Clifton asserted he transferred the Property to PDC at the insistence of Whiteman. Clifton testified that Whiteman was ‘hammering’ him every day to place the Property into an LLC based on her fear of the liability associated with the Property being used for recreational hunting. Renee Gilreath, Clifton’s daughter, also testified they transferred the Property to PDC based on Whiteman’s liability concerns as well as for legitimate business purposes.”) ↑

14. First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 344, 797 S.E.2d 409, 415 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (Emphasis added.) ↑

15. Firmani v. Firmani, 332 N.J. Super. 118, 122–23, 752 A.2d 854, 857 (App. Div. 2000). (Firmani’s conveyance of the Haddonfield property to the Family Partnership manifested at least five of the “badges of fraud: set forth in N.J.S.A. 25:2–26. Defendant was the sole general partner and primary limited partner of the Family Partnership prior to the conveyance, and therefore the conveyance was made to an insider. N.J.S.A. 25:2–26(a); see Gilchinsky, supra, 159 N.J. at 478–79, 732 A.2d 482. By continuing to use the Haddonfield property as a residence and place of business, and as the sole general partner with a total ninety-five percent interest in the Family Partnership, defendant clearly retained possession or control of the property after the conveyance. N.J.S.A. 25:2–26(b). Firmani does not dispute that he was aware that the $25,000 had become due to plaintiff, and therefore he knew or should have known that absent voluntary payment, an enforcement action *123 probably would be brought. N.J.S.A. 25:2–26(d). By putting plaintiff in a position where she could only recover the money owed through the Limited Partnership charging process, defendant “remove . . . assets.” N.J.S.A. 25:2–26(g); see Gilchinsky, supra, 159 N.J. at 479, 732 A.2d 482 (“[I]n transferring assets from New York to New Jersey [where more debtor-protective IRA laws exist], defendant effectively prevented them from being attached by [her creditor].”). ↑

16. See Comment 8 to UVTA Section 4. (“Likewise, it is voidable for a debtor intentionally to hinder creditors by transferring assets to a wholly-owned corporation or other organization, as may be the case if the equity interest in the organization is more difficult to realize upon than the assets (either because the equity interest is less liquid, or because the applicable procedural rules are more demanding). See, e.g., Addison v. Tessier, 335 P.2d 554, 557 (N.M. 1959); First Nat’l Bank. v. F. C. Trebein Co., 52 N.E. 834, 837-38 (Ohio 1898); Anno., 85 A.L.R. 133 (1933).”) ↑

17. Interpool Ltd. v. Patterson, 890 F. Supp. 259, 263 (S.D.N.Y. 1995). ↑

18. United States v. Holland, No. 213CV10082MOBMKM, 2017 WL 4676607, at *5 (E.D. Mich. Sept. 12, 2017). ↑

19. In re Pace, 456 B.R. 253, 278 (Bankr. W.D. Tex. 2011). (“The court’s previous findings and conclusion that Hensley [the attorney] did not act in good faith in connection with the transfer of the condo underscores the conclusion here that Hensley used CFM to help Pace [the debtor] carry out a fraudulent transfer. That evidence is sufficient to justify piercing the corporate veil and to thus recover the condo from both Hensley and CFM under the theory of joint and several liability. See Resource Dev. Int’l, LLC, 487 F.3d at 303 (affirming district court’s conclusion that defendant shareholder had ‘utilized his control over defendant corporation’ to perpetuate the debtor’s fraudulent conduct where defendant had agreed with debtor to pay debtor’s legal fees in exchange for a wire transfer to defendant’s corporation, and holding defendant and defendant’s corporation jointly and severally liable under section 550).”) ↑

In today’s digital world and especially as businesses move toward building large brands, companies are building and accumulating significant intellectual property portfolios, whether it be trademarks in branding assets, copyrights to website pages, patents to artificial intelligence processing applications and modules, or trade secrets to a highly valuable recipe or a client list. As businesses combine, divide, and engage in mergers and acquisition activities, many businesses are finding that their value may be partly grounded in their intellectual property and that evaluating their intellectual property assets makes up a core portion of the diligence behind such a transaction.

A major part of intellectual property due diligence today also includes issues relating to technology (aka information technology due diligence). The goal of any intellectual property due diligence in a potential transaction will include determining what intellectual property (if any) the target holds and its value. It will also include understanding the target company’s policies and practices regarding document retention; its various intellectual property registrations across jurisdictions; past, ongoing or anticipated disputes; intellectual property enforcement; intellectual property protection measures; and the location of any intellectual property owned or licensed by the target company, as well as the local practices and IP compliance environment.

In cross-border deals or deals that involve target companies with foreign subsidiaries or affiliates, where the buyer company is looking at intellectual property assets abroad, the goal of such intellectual property due diligence will also be to understand the relevant jurisdictions’ intellectual property laws. For example, in Canada, there is no “work for hire” concept, and moral rights in intellectual property not only exist, but stay with the inventor or creator. And in India, for example, intellectual property in software is handled only by copyright and cannot be patented.

Assessing the quality and integrity of the intellectual property assets helps the acquirer, whether domestic or abroad, not just determine the risks associated with them, but also their value and therefore the overall value of the business. For example, the integrity of the chain of development, acquisition, and transfer of intellectual property from the creator to the eventual beneficial “owner” often surfaces as the biggest risk in transactions involving companies based in India.

To illustrate: the way India handles IP in software (being only eligible for copyright and not patent rights) may be the reason why a strict movement of IP is not documented or easily done. There may also be issues that arise when intellectual property is owned by a third party or jointly owned with a third party. In carve-out transactions, it is important to inquire whether the intellectual property is owned or used by the target or an affiliate that is not being acquired. Often, the seller assumes that even after the intellectual property is transferred, it will continue to be used by third parties or affiliates! Not all such inconsistencies are deal breakers, but they definitely are red flags.

As a buyer’s counsel providing a due diligence request list to the seller’s counsel, it is critical to understand that the disclosures and agreements provided by the seller, while useful, often do not paint the full picture of the target’s intellectual property portfolio, assets, and liabilities. It is, therefore, important to understand the proposed deal and the parties’ motivations for exploring and entering into the deal, and to seek more context from each party when necessary. In addition to the context of the deal, market standards and practices are important to bear in mind while conducting an intellectual property due diligence, both domestically and abroad. It is only then that one can articulate any issues that need to be remedied pre- or post-closing to solidify the buyer’s rights and ability to protect the intellectual property being purchased in the M&A transaction. For example, while in the West it is common for due diligence to be separated based on category or portion of the deal (like a separate intellectual property team or a separate security or privacy team), in India, due diligence teams typically report into the same partner to take a more holistic view, reviewing many elements, such as the findings on accounting and financials of the company, as well as the intellectual property due diligence report.

As the world continues to digitize, moving to a more digital standard with an increasing number of companies in IT, data, and online spaces and with fewer brick-and-mortar operations, often there is proprietary software (i.e., the software is the primary product of the target company) at stake. So it is not just a reliance on representations and warranties that is needed, but a deeper knowledge of the primary software itself, the intellectual property being purchased.

As such, the intellectual property due diligence must involve review of invention assignment agreements to confirm they contain present-tense assignment language or meet other assignment criteria in the relevant jurisdictions. The due diligence should also include review of employment agreements, licensing agreements, service agreements, etc. These should be taken in light of the relevant jurisdiction of the target, the intellectual property, and any applicable subsidiaries or affiliates.

For example, since India doesn’t have any trade secret laws, one needs to review confidentiality obligations, use restrictions, and other protections of trade secrets. Open source is a concern while reviewing software licenses and other documents related to use of such software. In addition to the above, there are other pieces of standard information typically reviewed and/or requested, including:

• Patents and patent applications;
• Trademarks;
• Copyrights;
• Trade secrets (usually protected by contract);
• Corporate names;
• Domain names;
• Tag lines, by-lines, slogans, and brand hashtags;
• Publicity rights;
• Written works;
• Brand assets;
• Websites, online publications, and social media;
• Software; and
• Databases (data, particularly personal data, is the new asset class requiring scrutinous review).

Privacy and data security diligence often raises data and intellectual property issues. This particularly happens with trade secrets, as maintaining their value and status as a trade secret largely falls on confidentiality, security, and privacy measures taken by the holder. It also arises today because of the digital nature of how businesses are run; many (if not most) intellectual property assets are captured in, stored in, transmitted by, used in, and/or concern a digital medium, which inevitably and with any reasonable care requires data and security activity.

This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.

Two companion statutes, Sections 204 and 205 of the Delaware General Corporation Law, permit Delaware corporations to fix defective transactions. For example, sometimes—perhaps all too often—a Delaware company may accidentally issue more stock than its charter or stock plan permits. The company can “fix” the error using these statutes, by “ratifying” the issuance of the stock and retroactively changing the corporate charter to increase the permitted number of shares. Doing so, however, has always required the company to first admit that it made a mistake.

That might no longer be true. The Delaware Court of Chancery’s recent decision in In re Lordstown Motors Corp.^[1] suggests that Delaware companies can “ratify” corporate transactions which they merely believe may be bungled. Is Lordstown just an anomaly? Or is it the beginning of a broad expansion of Sections 204 and 205 that would allow companies to seek the Delaware Court of Chancery’s^[2] blessing of transactions that they merely think might be defective?

Basic Background on Sections 204 and 205

In 2014, Delaware’s General Assembly enacted Sections 204 and 205 to enable Delaware companies to retroactively “fix” a company transaction that suffers from a mistake or defect. The statutes call such a mistake or defect a “defective corporate act.” Under Section 204, a Delaware company may “fix” defective corporate acts on its own, without the Chancery Court’s assistance, simply by passing appropriate board resolutions and following certain other processes. Section 205, though, allows a Delaware company to commence a proceeding to ask the Court of Chancery to “validate” the defective corporate act.

Until now, both of these sections required that the company acknowledge there was a defect—otherwise there was nothing to ratify or validate. In re Numoda Corp.^[3] is a good example. That was an early Section 205 case in which the Chancery Court held:

• the Chancery Court is not free to exercise equitable powers under the statutes unless there was a “defective corporate act”;
• the Court’s equitable power under the statutes is designed only to “remedy the technical validity of the act or transaction”; and
• the Court’s equitable power under the statutes does not supersede “traditional fiduciary and equitable review.”

The Numoda opinion goes on to explain, “The Court does not now draw a specific limiting bound on its powers under Section 205, but it looks for evidence of a bona fide effort bearing resemblance to a corporate act but for some defect that made it void or voidable”, for “it is the legislation, not broad equitable theories, that instructs interested parties of the steps and requirements for ratification and validation of defective corporate acts and putative stock.”^[4]

In a subsequent case, In re Genelux Corp.,^[5] the Chancery Court concluded that Section 205 is a “remedial statute” that was designed only to “cure otherwise incurable defective corporate acts, not a statute to be used to launch a challenge to stock issuances on grounds already available through the assertion of plenary-type claims based on alleged fiduciary duty or common law fraud or a Section 225 action, if the stock had been voted.”^[6]

In an unpublished (and often overlooked) decision, In re Baxter International, Inc., ^[7] the Chancery Court held that the purpose of Section 205 is to enable Delaware companies to seek judicial validity of “defective corporate acts” or corporate acts that suffered from “procedural defects.” There, Vice Chancellor Bouchard observed:

Section 204 and 205 of the Delaware General Corporation Law were recently enacted to provide certain avenues for the ratification or validation of defective corporate acts. Under Section 205, a corporation or a member of its board may submit an application to the Court of Chancery for a determination of the validity and effectiveness of defective corporate acts ratified under the related Section 204. The Court is also empowered by Section 205(a)(4), the provision that applies here, to “determine the validity of any corporate act or transaction.” The Court has used this power to validate, for example, an issuance of stock that suffered from procedural defects.^[8]

In sum, Chancery Court cases before Lordstown consistently made clear that a Delaware company had to show that a transaction suffered from a defect that needed to be “fixed” before it could ask the Chancery Court to “validate” the transaction. But this might be changing. Recent case law appears to permit using Section 205 even when there is mere uncertainty about whether a corporation action was valid.

The Chancery Court Issues Its Decision in Lordstown To Resolve “Uncertainty”

On December 27, 2022, the Chancery Court decided Garfield v. Boxed, Inc.^[9] In that case, the Chancery Court held that if a company had multiple series of common stock outstanding and wanted to issue more shares in order to accomplish a going-public merger with a special purpose acquisition company (SPAC), Section 242(b)(2) of the Delaware General Corporate Law requires each class of shares to vote separately to approve the new stock issuance.^[10]

In the wake of Boxed, dozens of companies with multiple series of common stock that had issued new shares of common stock without following the voting procedure the Chancery Court required in Boxed filed Section 205 petitions to remedy potentially defective votes. Although some of these involved SPAC transactions, many did not. On February 20, 2023, Vice Chancellor Will held hearings on several of these petitions and approved each in rulings from the bench, including the first one, which was filed by Lordstown Motors Corporation in In re Lordstown Motors Corp.^[11]

Lordstown Motors, a Delaware corporation, had filed a Section 205 petition seeking to validate under Section 205 an amendment to its corporate charter that increased the number of authorized Class A common shares, but which had not been approved by “a separate Class A vote” under Section 242(b)(2).^[12] In granting the application, Vice Chancellor Will observed that “post-de-SPAC companies are experiencing uncertainty over their capital structures and the validity of their stock” and “a contrary ruling [i.e, to deny validation under Section 205] would invite untold chaos.”^[13] Without a Section 205 validation of the potentially defective votes, Vice Chancellor Will held, similarly situated companies might be unable to satisfy auditors, complete periodic filings with the US Securities and Exchange Commission (SEC), obtain financing, or remain listed on a national securities exchange.^[14]

Vice Chancellor Will added that in Lordstown, the Chancery Court could not “conceive of any legitimate harm that would result from validating” the amendment, and that “absent validation, a number of parties would face widespread harm.”^[15] Consequently, Vice Chancellor Will determined that relief under Section 205 was “the most efficient and conclusive—and perhaps the only—recourse avai­lable.”^[16] Vice Chancellor Will has scheduled hearings to handle waves of similar Section 205 petitions in the near future.

The key here is that Vice Chancellor Will approved using Section 205 to validate a cor­porate act, as long as there is “uncertainty” as to whether the corporate act is “void or voida­ble”—that is, so long as there is uncertainty as to whether a “defective corporate act” (as opposed to a corporate act that is legally valid and does not suffer from any defects) occurred:

Regardless of whether these acts are technically void or voidable due to a failure of authorization, the Company has encountered sudden and pervasive uncertainty as to its capitalization. Section 205 provides the court “with a mechanism to eliminate equitably any uncertainty” where questions of validity persist. The statute confers “substantial discretion on the court and, absent obvious procedural requirements, does not set a rigid outer boundary on the Court’s power.” The Delaware General Assembly intended Section 205 to provide an “adaptable, practical framework” for correcting blemished corporate acts “without disproportionately disruptive consequences.^[17]

This decision—i.e., that Section 205 validation may be granted regardless of whether or not the company can show that an actual “void or voidable act” constituting a “failure of authorization” occurs—is directly at odds with prior decisions of the Chancery Court. As discussed above, those decisions held that Section 205 review can be granted only if the Section 205 applicant who seeks validation of a corporate act sufficiently shows that the corporate act in question is a “defective corporate act” or one which, at a minimum, suffers from a procedural defect.^[18] The Lordstown decision also does not seem to fit within the language of the statute.^[19] The statute on its face does not contemplate that it can be used to remedy uncertainty, only that it can used to fix what is undoubtedly a technical defect.

But Lordstown departs from this prece­dent: it requires Delaware companies to show the Chancery Court only that such a transaction might be defective.

Lordstown’s Potential Impacts

Because Lordstown appears to broaden Section 205 to cover corporate acts that merely might be defective, under Lordstown virtually any corporate act can be ratified that is within a Delaware corporation’s power to do, but for an uncertain defect. Thus, if the Chancery Court follows Lordstown going forward, Delaware companies and their boards will undoubtedly turn to Section 205 more frequently as a “belt-and-suspenders” approach to protecting corporate acts from attack by any shareholders who may, in the present or in the future, become disgruntled.

This strategy could turn out to be a mixed blessing. One the one hand, boards may take advantage of this looser standard by acting preemptively. In other words, they may file applications under Section 205 to ask the Chancery Court to “validate” corporate acts just to make sure that a possibly questionable corporate step they took is legally in order, with a view to achieving certainty and foreclosing future litigation. This could have the salutary effect of enabling companies to run their businesses without having to look over their shoulders for possible legal challenges.

But on the other hand, this more relaxed standard could embolden some bad actors. By definition, company insiders know more about the company’s inner workings and future prospects than any court possibly can. Indeed, the company chooses which facts to disclose to the court—so even without outright deception, this situation appears to be ripe for possible abuse. For example, a board intent on enriching itself might undertake acts of questionable or borderline legality that they might not otherwise have undertaken, knowing that they could seek judicial “validation” of such acts, long before the effects of their action become clear to the company’s shareholders, and without having to admit there is anything “wrong” (i.e., defective) with what the company did.

Conclusion

The Chancery Court’s recent decision in Lordstown departs from prior Chancery Court precedent which requires a Section 205 applicant to show that a company transaction suffers from a defect before asking the Court to validate the transaction. It remains to be seen if Lordstown is merely an outlier, or if it marks the beginning of a new and much more expansive Section 205 landscape.

The authors welcome any questions about this article and can be reached via email at [email protected] and [email protected].

Scott Watnik and Stuart Riback are litigation partners at Wilk Auslander, LLP in New York City.

The opinions expressed above are those of the authors and do not necessarily reflect the views of Wilk Auslander LLP, it clients or its respective affiliates. This article is for general information purposes and is not intended to be, and should not be taken as legal advice.

1. Del. Ch. C.A. No. 2023-0083-LWW, Feb. 21, 2023 ↑

2. The Delaware Court of Chancery is the only court with jurisdiction to hear matters pertaining to Sections 204 and 205. ↑

3. In re Numoda, 2015 WL 402265, at *8 n.96 (quoting H.R. 127, 147th Gen. Assemb., Reg. Sess. (Del. 2013). ↑

4. Id., 2015 WL 402265, at *10, 11 (emphasis added). ↑

5. In re Genelux, 126 A.3d. ↑

6. Id., at 667-668. ↑

7. In re Baxter International, Inc., 1/15/15 Tr. ↑

8. Id., 80:22-81:19 (emphasis added). ↑

9. C.A. No. 2022-0132-MTZ, 2022 WL 17959766 (Del. Ch. Dec. 27, 2022). ↑

10. Id., at *9. ↑

11. C.A. No. 2023-0083-LWW (Del. Ch. Feb. 21, 2023). ↑

12. Id., 14. ↑

13. Id., 3, 15. ↑

14. See id., at 25, 28. ↑

15. Id., 24. ↑

16. Id., 26. ↑

17. Id., 19-20 (emphasis added). ↑

18. See, e.g., In re Numoda, 2015 WL 402265 (Del. Ch. Jan. 30, 2015); In re Genelux, 126 A.3d 644 (Del. Ch. 2015), vacated, in part, on other grounds, 143 A.3d 20 (Del. Sup. 2016); and In re Baxter International, Inc., (Del. Ch. C.A. No. 11609-CB May 17, 2012). ↑

19. See, e.g,. 8 Del. C. § 204, subd. (h)(1) and (h)(2) (defining “defective corporate act” and “failure of authorization”). ↑

If a purchase agreement has a fee-shifting provision and the prevailing party hires counsel on a contingency fee basis, does the losing party have to pay the contingency fee? The answer is yes, based on the Delaware Chancery Court’s ruling in Williams Cos., Inc. v. Energy Transfer LP.^[1] We look at the court’s ruling and suggest a modification to the fee-shifting provision to alter this result. We also offer a drafting tip regarding the calculation of interest.

Background

The Williams case is based on a dispute over the merger agreement between The Williams Companies, Inc. (Williams) and Energy Transfer LP (ETE). The deal fell through, and the court found that Williams was entitled to a $410 million judgment as liquidated damages, as specified in the merger agreement. Normally, courts follow the American Rule—each litigant pay its own attorneys’ fees—but, in this case, the parties had altered that default rule. The merger agreement provided that if Williams prevailed in the recovery of the breakup fee, Williams was entitled to recover its reasonable attorneys’ fees and expenses related to such recovery from ETE.

Williams hired its counsel under a contingency fee structure, and the main dispute in this last opinion of the Williams v. ETE saga was whether the contingency fee was reasonable.

Contingency Fee

The Chancery Court concluded that the contingency fee was reasonable in this case. Consequently, ETE had to pay the 15 percent contingency fee that Williams had agreed to pay to its counsel Cravath, Swaine & Moore LLP (Cravath). Two of ETE’s failed arguments merit a close review.

First, ETE argued that it was unreasonable for Williams to switch from an hourly arrangement to a contingency fee arrangement mid-litigation. However, the Chancery Court found this was reasonable because the change occurred when the nature of the case shifted from one seeking injunctive relief (which called for a noncontingent representation) to one seeking recovery of the breakup fee (for which contingent representation was a business option). However, the Chancery Court cautioned that a change to a contingency fee arrangement may be unreasonable in some circumstances. For example, if the litigation had progressed significantly or the uncertainty of the outcome had diminished, switching to a contingency fee in an attempt to penalize the other side would be unreasonable.

Second, ETE argued that Cravath’s fee under the contingency fee arrangement ($74.8 million) was unreasonable because it was 1.7 times what Cravath would have received based on a traditional hourly rate ($47.1 million). This disclosure came out because Williams had to provide a “lodestar”—calculated as the number of hours Cravath expended multiplied by its hourly rate—to support the contingency fee.^[2] Additionally, ETE complained that the number of hours and the billing rate of Cravath was higher than the number of hours that ETE’s counsel billed to the matter and the billing rate of ETE’s counsel. However, the Chancery Court held that the 1.7 lodestar multiple was within the range of reasonableness. The Chancery Court also found that the number of hours Cravath expended (which involved Williams having to produce approximately ten times more documents than ETE) and its billing rates (which reflected a discount and rate freeze and were at a level the market would bear for its services) were both reasonable.

Interest

This opinion also addressed two issues regarding interest.

First, how is interest computed (simple or compound) if the merger agreement is silent? The Chancery Court concluded that when parties are silent, they manifest an intent to leave that determination to the Court. The Chancery Court decided that prejudgment interest should be compounded because compounding more accurately reflects the standard form of interest in the financial market.

Second, ETE argued that prejudgment interest should be tolled because there was a delay caused by an inadvertent error by Williams’s discovery vendor. And then, because of that delay, the trial was further delayed by the COVID-19 pandemic. Although the Chancery Court has discretion to reduce prejudgment interest, the Chancery Court declined to toll the interest. The discovery error was inadvertent, and Williams didn’t cause the pandemic. Additionally, the purpose of interest is to address the lost time value of money, and here ETE had the use of the $410 million judgment during the litigation.

Conclusion

If your purchase agreement has a fee-shifting clause and the other side hires counsel on a contingency fee basis, your client would most likely be liable for the other side’s contingency fee (absent a contrary provision) under Delaware law. Thus, if your client has potential liability for a contingency fee (e.g., a buyer agreeing to a reverse termination fee or a seller agreeing to an indemnity—in each case, with a fee-shifting clause), you might want an express provision to the contrary. One approach is to provide that the contingency fee will be reduced to the fee payable had the prevailing party hired counsel on an hourly basis:

. . . provided, however, that if costs and expenses include a fee determined on a contingency or similar basis, then the contingency or similar fee must be reduced to a reasonable fee computed on the basis of an hourly rate or similar basis.

No one likes to lose in litigation. Adding insult to injury, losers that are subject to a fee-shifting provision have to pay the prevailing party’s attorneys’ fees. Don’t make it worse by allowing that fee to be a percentage of recovery due to a contingency fee arrangement. And while you are at it, consider specifying how interest will be calculated.

The views expressed in this article are exclusively those of the authors and do not necessarily reflect the views of Sidley Austin LLP and its partners. This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.

1. C.A. No. 12168-VCG, 2022 WL 3650176 (Del. Ch. Aug. 25, 2022). ↑

2. Id. at *3. ↑

The fiduciary duty of oversight has been one of the hottest topics of discussion among practitioners and boards of directors since it was thrust back into the limelight by the Delaware Supreme Court’s decision in Marchand v. Barnhill.^[1] In Marchand, the Delaware Supreme Court reversed a decision by the Delaware Court of Chancery to dismiss, among other things, a claim for breach of the duty of oversight—known as a Caremark claim—against the directors of Blue Bell Creameries, reasoning that a successfully pled oversight claim should not be “a chimera.”^[2] Since Marchand in 2019, multiple plaintiffs have successfully overcome motions to dismiss filed by directors pursuant to oversight theories.

On January 25, 2023, in In re McDonald’s Corporation Stockholder Derivative Litigation,^[3] the Court of Chancery settled the open question of whether officers, like directors, owe a fiduciary duty of oversight. The Court explained that most officers “have particular areas of responsibility,” and that officers have a duty to make a good faith effort to ensure information systems are in place and to address and report upward red flags within their areas. The Court noted, however, that “a particularly egregious red flag might require an officer to say something even if it fell outside the officer’s domain.”

Denying defendants’ motion to dismiss, the Court in McDonald’s found that an officer’s duty of oversight is “an essential link in the corporate oversight structure,” as critical parts of an officer’s job are (i) “to identify red flags, report upward, and address them if they fall within the officer’s area of responsibility,” and (ii) “to gather information and provide timely reports to the board about the officer’s area of responsibility.” Like directors, officers will only be held liable for violations of the duty of oversight if a plaintiff can prove such officers acted in bad faith. On March 1, 2023, the Court dismissed the claim against the officer under Rule 23.1 for failure to plead demand futility, after finding that the complaint failed to plead a claim against the director defendants for breach of fiduciary duty.

Even before the Court’s ruling in McDonald’s made clear that officers owe a fiduciary duty of oversight, stockholder plaintiffs were focused on the role of technology professionals in cybersecurity incidents. In Construction Industry Laborers Pension Fund v. Bingle,^[4] and Firemen’s Retirement System of St. Louis v. Sorenson,^[5]the plaintiffs alleged that the board and certain officers had breached their oversight duties in relation to cybersecurity matters. The Court in both cases dismissed the claims after determining the companies’ boards were sufficiently independent and disinterested to determine for each corporation whether to bring the claims and therefore did not reach the issue addressed in McDonald’s. Now that McDonald’s has clarified that officers have a duty of oversight as well, the question is whether and when officers might be on the hook for overseeing data privacy and security.

In Firemen’s Retirement System of St. Louis v. Sorenson, plaintiff brought Caremark claims against the board of directors of Marriott International, Inc. following a data security breach that exposed the personal information of up to 500 million guests. In dismissing the claims under Rule 23.1 for failure to plead demand futility, the Court credited the Marriott board’s systems to assess cybersecurity risks. The board and audit committee were “routinely apprised on cybersecurity risks and mitigation, provided with annual reports … that specifically evaluated cyber risks, and engaged outside consultants to improve cybersecurity practices.” Notably, the Court further found that when management discovered “red flags” related to cybersecurity, relevant reports were delivered to the board. The Court found that cybersecurity “is an area of consequential risk that spans modern business sectors” and that the “corporate harms presented by non-compliance with cybersecurity safeguards increasingly call upon directors to ensure that companies have appropriate oversight systems in place.” Following the holding in McDonald’s, it is probable that Delaware courts will equally call upon the appropriate officers to focus on reporting red flags to the board and how such red flags are addressed.

Almost one year later, in Construction Industry Laborers Pension Fund v. Bingle, a plaintiff brought Caremark claims against SolarWinds’ board of directors following a major cyberattack on the company’s software system, through which Russian hackers were able to insert malware that gained access to up to 18,000 of SolarWinds’ clients’ systems. The directors were alleged to have failed to monitor corporate efforts in a way that prevented cybercrimes. The Court dismissed these claims under Rule 23.1 and, in so doing, found that the SolarWinds board (i) did not utterly fail to implement a reporting system for cybersecurity risks, since both the nominating and corporate governance committee and the audit committee were charged with oversight responsibility for cybersecurity, and (ii) did not ignore any red flags related to cybersecurity risks. Notably, in its analysis, the Court described the reporting systems SolarWinds had in place as “subpar” because, among other reasons, the board did not receive any reports from either committee with respect to cybersecurity for over two years.

The Bingle Court held that “a subpar reporting system between a Board subcommittee and the fuller Board[, however,] is not equivalent to an ‘utter failure to attempt to assure’ that a reporting system exists.” Accordingly, the Court continued “[w]ithout a pleading about the Committees’ awareness of a particular threat, or understanding of actions the Board should take, the passage of time alone under these particular facts does not implicate bad faith.” The Court was not required to address, however, whether SolarWinds’ officers had adequately complied with their oversight duties in reporting to the board or had received information amounting to a red flag.

Given these prior attempts by plaintiffs to plead cybersecurity-related Caremark claims, what should companies be focused on in the wake of the McDonald’s holding? The Court in McDonald’s observed that, unlike directors, “nondirector officers may have a greater capacity to make oversight and strategic decisions on a day-to-day basis.” Furthermore, the Court found that “[a]s the day-to-day managers of the entity, the officers are optimally positioned to identify red flags and either address them or report upward to more senior officers or to the board. The officers are far more able to spot problems than part-time directors who meet a handful of times a year.” Accordingly, companies should focus on determining which officers’ “areas of responsibility” could be viewed to encompass data privacy or cybersecurity, as the cybersecurity-specific oversight by such officers will likely now face greater scrutiny. This analysis, unfortunately, may not be as straightforward as one would hope, particularly since there exists no single comprehensive data privacy law in the United States to provide guidance. Instead, companies must consider the various state laws to which they might be subject—such as the recently adopted and fairly comprehensive California Privacy Rights Act (“CPRA”)—and federal laws and regulations enforced by federal agencies, like the Federal Trade Commission.

If a company has a Chief Technology Officer, Chief Privacy Officer, and/or Data Protection Officer—which is required under the European Union’s data privacy law, the General Data Protection Regulation—it seems likely a court would find that data protection and cybersecurity fall within that officer’s area of responsibility, and therefore that each officer has a fiduciary duty to oversee data management and protection. But who else might be responsible for overseeing those matters? Would a company’s Chief Human Resources Officer be potentially liable for breach of fiduciary duty if there is a cybersecurity breach or if employee data is compromised? One could imagine a scenario in which a court might find that a human resources professional is responsible for oversight of employee information received pursuant to the Americans with Disabilities Act or Fair Credit Reporting Act, and therefore owes a fiduciary duty of oversight with respect to the protection of such data.

Furthermore, to what extent would a Chief Executive Officer, especially a technology-oriented one, a Chief Compliance Officer, or even a Chief Legal Officer be liable for cybersecurity oversight, given that the Court in McDonald’s found such officers “likely will have company-wide oversight portfolios”? Given that the CEO, CCO, and CLO are charged with broader oversight responsibilities, a court’s analysis of the exercise of fiduciary duties might more closely resemble the board-level duty of oversight analyses conducted in Sorenson and Bingle.

Recent Delaware caselaw suggests that fiduciaries of many companies may owe a duty of oversight encompassing the protection of consumer data and cybersecurity. The Court’s ruling in McDonald’s makes clear that such duty would be owed not only by a company’s directors, but also by those officers whose areas of responsibility include consumer data and cybersecurity. For some companies, it may be clear who should be responsible for cybersecurity oversight; for others, it may be advisable to delineate the roles and responsibilities of executive officers and board committees such that it is clear which officers are charged with oversight responsibility over specific functions. Companies should, at a minimum, make an effort to determine which of the officers are principally responsible for the establishment and monitoring of the company’s data and information protection systems. Such efforts could potentially prevent confusion regarding responsibilities, increase the likelihood that cybersecurity-related issues are identified and addressed in a timely manner, and help directors establish the reporting system required by Delaware law. The law recognizes that no system is foolproof. Fiduciary liability is not premised on the occurrence of the underlying event but rather the failure of officers and directors to make a good faith effort to attempt to establish systems of controls or the failure to report clear red flags when they emerge.

This area of Delaware law is rapidly developing. Similarly, data privacy law in the United States is continually evolving, and a handful of states have enacted comprehensive legislation specific to data privacy, including the CPRA, the Virginia Consumer Data Protection Act, and the Colorado Privacy Act, and many others have similar legislation under consideration or pending. Companies should therefore stay apprised of potentially relevant data privacy legislation, as well as future cases resolving cybersecurity-related and/or officer-level Caremark claims.

The views expressed in this article are those of the authors and not necessarily those of Richards, Layton & Finger or its clients.

1. 212 A.3d 805 (Del. 2019). ↑

2. Id. at 824. ↑

3. C.A. 2021-0324-JTL (Jan. 25, 2023). ↑

4. 2022 WL 4102492 (Del. Ch. Sept. 6, 2022). ↑

5. 2021 WL 4593777 (Del. Ch. Oct. 5, 2021). ↑

The ABA Business Law Section is pleased to announce publication of the fifth edition of Ken Adams’s A Manual of Style for Contract Drafting. One of the most popular titles of ABA Publishing, this book is always in the Top Five for best-selling titles among all ABA books.

You can buy print and e-book versions only from the ABA. (ABA members and members of the Business Law Section, remember your discount!)

With each new edition of MSCD, we have wondered, what more can Ken offer? Each time, the answer has been, “a lot of substantive changes”—and this holds true for the fifth edition. In the preface, Ken describes what’s entirely new and what has been revised. Cumulatively, the updates amount to more than seventy pages of additional material.

In the nineteen years since it was first published, MSCD has grown from a small-format paperback of fewer than 300 pages to a bigger-format hardback that weighs in at 667 pages, with no padding.

One result of this evolution is that MSCD is somewhat intimidating. It contains within its covers some mind-bending complexity. And Ken will tell you that even he can’t remember everything it covers—often enough he consults MSCD as if he were an ordinary reader. On the other hand, that complexity is offset by Ken’s clear and no-nonsense prose.

The sheer size of the book is valued by those who work with contracts and need guidance on all issues relating to how to clearly say whatever you want to say in a contract. Readers have come to rely on Ken’s wisdom, his eye for detail, and most important, his clear writing.

For a taste of the breadth of the book and its new material, here is the new section from chapter 13 (“Selected Usages”) on the phrase public domain.

***

PUBLIC DOMAIN

13.706 The phrase in the public domain is used in contracts in two ways.

Used in the Exception to the Definition of Confidential Information

13.707 It’s standard to state exceptions to the contract definition of what constitutes confidential information, and one exception covers information that’s public or becomes public other than as a result of breach of an obligation under the contract. Information falling within that exception can be described in different ways, besides public. For example, publicly available, available to the public, and publicly known. Another of those variants is in the public domain.

13.708 Public domain originally referred to land belonging to the public, but it has also come to refer to anything, including information, that is available to all. Hence use of the phrase in that exception to what constitutes confidential information. But using in the public domain to mean simply public is wordy and primarily British. Furthermore, it’s confusing, as in the public domain has another meaning that is more entrenched in legal circles; that meaning is discussed in the following section. So don’t use in the public domain to refer to information being public.

Used Regarding Intellectual Property

13.709 The phrase in the public domain is also used to refer to the copyright status of a work of authorship that is no longer subject to copyright protection. And formerly patented inventions and unpatentable inventions are also sometimes said to be in the public domain.

13.710 The Oxford English Dictionary gives as a definition of public domain (besides the one pertaining to land) “The state or condition of belonging or being generally available to all, esp. through not being subject to copyright.” That suggests that the copyright meaning of public domain is more prevalent than using it to say that information is public (see 13.707).

13.711 But you can’t count on readers outside of intellectual-property circles knowing the intellectual-property meaning of public domain, so if you use the phrase in the public domain, consider explaining what it means. That would give you the speed of messaging offered by a term of art while letting everyone else in on the secret. But it would be even simpler to omit public domain and say what you mean instead of using a confusing term of art:

Except for portions in the public domain (that is, not subject to copyright protection), the Acme Products and related documentation are the property of Acme and are protected by law, including U.S. copyright laws and international treaties.