Every year, I teach a biotechnology practicum to a class of second- and third-year law students enrolled in a ten-week externship program with technology companies in the Bay Area, and I present case studies of real problems I’ve encountered as a public biotech company GC. While my day-to-day responsibilities largely fall within three categories—leadership, management, and the practice of law—a more accurate image of what I do every day is juggle water balloons (delicate and precarious matters) and knives (matters requiring dauntless initiative and strategic precision).
Leadership
As an executive charged with overseeing all legal matters for the company, I lead my legal team every day toward optimized coordination and partnership with our clients on a broad range of matters, some of them sensitive, others requiring bold business judgment. Because of my 360-degree perspective on the company, combined with my legal and compliance expertise, my broad strategy experience, and my standing as a reliable leader, I’m often asked to opine on enterprise-level (bet-the-company) types of risks.
I serve not only as a sounding board for my CEO and a resource for our board of directors, but also as a “consigliere” for my peers in executive management seeking advice on how to best handle a problem or lead through obstacles to a desired goal. I spend a fair amount of time each week leading my peers by modeling resourcefulness, collaboration, and empathy. And because I’m a lawyer, my fellow executives turn to me for conversations requiring both discretion and diplomacy; I am informally viewed as a back-up CPO. I am often called upon to manage executive peer relationships and leadership team dynamics behind the scenes—which requires unwavering ethics as the foundation for my advice.
Below the executive team, employees in other service or business functions look to me for leadership in navigating risk, especially during periods of uncertainty—complex, high-stakes litigation and investigations; stock price volatility; and competitive defeats, to name a few. And in my role as the head lawyer, I’m expected to model the highest level of ethical standards at the company. Therefore, I believe it is a natural complement to my role to lead on cross-company initiatives critical to the creation and maintenance of my company’s culture. To exemplify this belief, I lead on diversity, equity, and inclusion (DEI), which requires a willingness to listen to a variety of perspectives, an ability to build consensus, and the strength of character to fight for change. I have seized opportunities to use my leadership position, and the political capital that comes with it, to launch new initiatives. Examples include a mentoring program for, and by, women; interactive ways to give back to the community that tie into my company’s mission; company-wide DEI educational and awareness campaigns; and bringing successful women entrepreneurs to share their experiences with our employees. And by serving as the executive sponsor on the board of my company’s women’s group, I seek to continue to improve the conditions for female professional development and advancement, as well as promote broad collaboration with our other employee affiliation groups.
Finally, I take my leadership to the streets. I not only sit on professional practice panels to teach peers about recent developments in substantive areas of the law like M&A, but I also speak regularly on issues relevant to women in the practice of law or in business generally. I speak about the importance of mentoring and sponsorship, not only of women and of lawyers, but across gender and other diversity lines and professional categories. And I practice what I preach; currently, I’m mentoring three senior scientists in my company, two women and one man. I speak out for women and other marginalized people—to lead, to demand equitable opportunities, to be heard. I speak about leadership by women and offer creative approaches to bypass common pitfalls in a female leader’s path. I’m relentless in my own self-education on diversity, bias, and racism and in tackling those issues head-on—not only at my company but also in my industry, within my profession, and in my community. I believe that giving back to my profession, to other women leaders, and to the community at large is my ethical obligation as a lawyer; I learn and grow every time I extend myself as a leader outside my company.
Management
While carrying these leadership responsibilities, I am always taking care of my own team—each member individually and as a unit. I’m currently serving in my second public company GC position, and at the outset, I made a two-pronged promise to my teams: commitment to our company’s mission on the one hand, and a pledge to the development of their individual careers on the other. My pledge requires discernment and conviction: to commit to an individual’s career trajectory even if that trajectory results in the person leaving my team—for another group within the company or for another company entirely. In striving to be the best manager for my team, I sometimes have to prioritize an individual’s growth above the needs of my team and our company. Similarly, I help my team navigate power politics, teach them how to network, guide them to improve through failure, model for them the skills of influence and persuasion, with the ultimate goal to help them turn everyday politics into opportunities for growth and recognition within the company. Here, I must balance thoughtful guidance with adroit maneuvering.
Law
And then there’s the practice of law. Every GC comes to her position with a few areas of substantive legal expertise. I am an M&A lawyer by training, with strategy and securities law expertise. I have more than two decades of experience in corporate governance, compliance, and complex cross-border business and corporate transactions. As a GC, I have built compliance programs from scratch to serve the business activities and operational realities of global organizations. Through my international practice, I have become a multi-jurisdictional corporate governance expert. And through the challenges my companies have faced while I have been at the helm of their legal teams, I have become an experienced litigator and a sophisticated manager of governmental inquiries. I have also learned the practice of intellectual property law, from partnering with scientists and product developers at the ground level to setting top-line global strategy in coordination with the head of R&D and the CEO. I guide my senior team members through complicated transactional developments in negotiations and post-closing disputes while developing their peer and executive management skills. I teach all my team members, regardless of job function or experience level, how to best partner with our clients. I render precise political guidance on how to communicate in each specific situation encountered in their practice. As a GC who actively practices law, I seek to further develop the lawyers on my team to become better lawyers by modeling optimal practice behaviors.
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My life as a public company GC is an ongoing juggling act. Simultaneously serving as an executive leader, leading on matters critical to my company’s culture, representing the company externally, managing a legal team and its members, and practicing law means that I have to be constantly vigilant, responsive to critical matters with a steady hand. And I have to be equally fearless and skillful at making the tough decisions. Every day, I balance caution against risk, grace against force: water balloons and knives.
Artificial Intelligence (AI) is disrupting almost every industry and profession, some faster and more profoundly than others. Unlike the industrial revolution that automated physical labor and replaced muscles with hydraulic pistons and diesel engines, the AI-powered revolution is automating mental tasks. While it may be merely optimizing some blue-collar jobs, AI is bringing about a more fundamental change to many white-collar roles previously thought safe from automation. Some of these professions are being completely transformed by the superhuman capabilities of AI to do things that were not possible before, augmenting — and to some degree replacing — their human colleagues in offices.
In this way, AI is having a profound effect on the practice of law. Though AI is more likely to aid than replace attorneys in the near term, it is already being used to review contracts, find relevant documents in the discovery process, and conduct legal research. More recently, AI has begun to be used to help draft contracts, predict legal outcomes, and even recommend judicial decisions about sentencing or bail.
The potential benefits of AI in the law are real. It can increase attorney productivity and avoid costly mistakes. In some cases, it can also grease the wheels of justice to increase the speed of research and decision-making. However, AI is not yet ready to replace human judgment in the legal profession. The risk of embedded bias in data that fuels AI and the inability to adequately understand the rationale behind AI-derived decisions in a way understandable to humans (i.e., explainability) must be overcome before using the technology in some legal contexts.
Superhuman Lawyers
Attorneys are already using AI, and especially Machine Learning (ML), to review contracts more quickly and consistently, spotting issues and errors that may have been missed by human lawyers. Startups like Lawgeex provide a service that can review contracts faster, and in some cases more accurately, than humans.
For some time, algorithms have been used in discovery — the legal process for identifying the relevant documents from an opponent in a lawsuit. Now, ML is also being used in this effort. One of the challenges of requesting and locating all the relevant documents is to think of all the different ways a topic may be described or referenced. At the same time, some documents are protected from scrutiny, and counsel (or the judge) may seek to limit the scope of the search so as not to overburden the producing party. ML threads this needle using supervised and unsupervised learning. Companies like CS Disco, which went public recently, provide AI-powered discovery services to law firms across the US.
Another area where AI is already used extensively in the practice of law is in conducting legal research. Practicing attorneys may not even be aware they are using AI in this area, since it has been seamlessly woven into many research services. One such service is Westlaw Edge, launched by Thomson Reuters more than three years ago. The keyword or boolean search approach that was the hallmark of the service for decades has been augmented by semantic search. This means the machine learning algorithms are trying to understand the meaning of the words, not just match them to keywords. Another example of an AI-powered feature from Westlaw Edge is Quick Check, which uses AI to analyze a draft argument to gain further insights or identify relevant authority that may have been missed. Quick Check can even detect when a case cited has been indirectly overturned.
Automated Legal Scholars
AI can generate content as well as analyze it. Unlike AI used to power self-driving cars where mistakes can have fatal consequences, generative AI does not have to be perfect every time. In fact, the unexpected and unusual artifacts associated with AI-created works are part of what makes it interesting. AI approaches the creative process in a fundamentally different way than humans, so the path taken or end result can sometimes be surprising. This aspect of AI is called “emergent behavior.” Emergent behavior may lead to new strategies to win games, discovering new drugs or simply expressing ideas in novel ways. In the case of written content, human authors are still needed to manage the creative process, selecting which of the many AI-generated phrases or versions to use.
Much of this is possible due to new algorithms and enormous AI models. GPT-3, created by OpenAI, is one such model. GPT-3 is a generative model that can predict the next token in a sequence, whether that token is audio or text. GPT-3 is a transformer, meaning it takes sequences of data in context, like a sentence, and focuses attention on the more relevant portions to extend the work in a way that seems natural, expected and harmonious. What makes GPT-3 unusual is that it is a pre-trained model, and it’s huge — using almost 200 billion parameters, and trained on half a trillion words.
This approach has already been used in creative writing and journalism, and there are now lots of generative text tools in that area, some built on GPT-3. With a short prompt, an AI writer can create a story, article or report — but don’t expect perfection. Sometimes the AI tool brings up random topics or ideas, and since AI lacks human experience, it may have some factual inaccuracies or strange references.
In order for AI to draft legal contracts, for example, it will need to be trained to be a competent lawyer. This requires that the creator of the AI collect the legal performance data on various versions of contract language, a process called “labeling.” This labeled data then is used to train the AI about how to generate a good contract. However, the legal performance of a contract is often context-specific, not to mention varying by jurisdiction and an ever-changing body of law. Plus, most contracts are never seen in a courtroom, so their provisions remain untested and private to the parties. AI generative systems training on contracts run the risk of amplifying bad legal work as much as good. For these reasons, it’s unclear how AI contract writers can get much better any time soon. AI tools simply lack the domain expertise and precision in language to be left to work independently. While these tools may be useful to draft language, human professionals are still needed to review the output before being used.
Judge-Bots
Another novel use of AI is predicting legal outcomes. Accurately assessing the likelihood of a successful outcome for a lawsuit can be very valuable. It allows an attorney to decide whether they should take a case on contingency, or how much to invest in experts, or whether to advise their clients to settle. Companies such as Lex Machina use machine learning and predictive analytics to draw insights on individual judges and lawyers, as well as the legal case itself, to predict behaviors and outcomes.
A more concerning use of AI is in advising judges on bail and sentencing decisions. One such application is Correctional Offender Management Profiling for Alternative Sanctions (COMPAS). COMPAS and similar AI tools are used by criminal judges in many states to assess the recidivism risk of defendants or convicted persons in decisions on pre-trial detention, sentencing or early release. There is much debate about the fairness or accuracy of these systems. According to a ProPublica study, such assessment tools seemed biased against black prisoners, disproportionately flagging them as being significantly more likely to reoffend than white prisoners.[1] Equivant, the company that developed COMPAS, sought to refute the ProPublica analysis and rejected its conclusions about racial bias.[2]
Regardless, using AI in this context may reflect, or even amplify, the inherent bias in the data of the criminal justice system. The data used to train the ML models is based on actual arrests and conviction rates that may be slanted against some populations. Thus it may enshrine past injustices, or worse, falsely cloak them in the vestment of computer-generated objectivity.
Is AI Ready to Practice Law?
AI raises a host of questions in the context of the legal profession:
Will the failure to use AI in some aspects of the law (like discovery) ever amount to malpractice? For example, if not using AI is shown to slow the discovery process, or results in incomplete disclosures, there may arise a professional obligation to use AI in discovery.
Should criminal defendants have a right to access AI tools if helpful to their case?
Do attorneys need to disclose their use of AI in a case? If so, do they need to disclose the training data or other inputs used to configure the ML models?
Does the lack of effective transparency of ML models make them inappropriate for some applications in the law?
How can we ensure there is no embedded bias, reflecting sexist or racist sentiments?
As a way to make the process of law faster and more free from errors or omissions, AI is a welcome tool in the cause of justice. AI may be a more efficient way to resolve civil cases, while at the same time increasing predictability without creating a moral hazard.
Where it becomes more problematic is when AI is used to replace human judgment, especially in the criminal law context. AI is not ready for this for a number of reasons. For one, there may exist bias in the training data which will be amplified and further institutionalized by the resulting ML models. We may be able to overcome this problem; indeed, the process of driving bias out of our training data may cause us to realize and correct some of the inherent racism and sexism of our legal system.
However, there is also the due process problem of lack of transparency and explainability with using AI. One cannot cross-examine a deep learning artificial neural network… at least not yet! AI is a mirror to humanity, revealing some of our inherent flaws. The process of unwinding the reasons an AI makes a recommendation may lead us to better understand the reality and limitations of human explanations or rationalizations for their decisions.
But more importantly, the idea of allowing algorithms to make liberty-depriving decisions may simply be unconscionable. It is not inconceivable that machine learning algorithms will begin to predict when a person is likely to commit a future crime with high confidence, like the science fiction movie Minority Report. Another compelling reason to limit the use of AI in the criminal context may be that judges, lawyers and society as a whole could grow to have too much trust in these algorithms. Even if humans retain ultimate decision authority, it is not uncommon for them to become overly reliant on technology-based recommendations, a phenomenon called automation bias. With AI, this trust may be especially misplaced since the actual capabilities of the technology may not be as “intelligent” as they seem.
Note: This article is based on a lecture given by Matthew Stepka at UC Berkeley School of Law in November 2021. The article will be cross-posted on his blog “Making Sense of AI.”
Business divorces, like regular divorces, come in all shapes and sizes. Some are amicable, and the parties are able to consensually resolve their split. Others are more adversarial, beginning with a disagreement over the direction or management of the business and later devolving into a knock-down, drag-out fight with various allegations of wrongdoing.
Whatever situation precipitated the need for a business divorce, there are four items that must be addressed before diving headlong into the process.
1. Determine Your Client’s Objective
In all aspects of law, it is important to determine the client’s objective at the outset so the lawyer can craft a strategy to achieve that objective. In the business divorce context in particular, it is especially important for business owners to know where they want to go before their lawyers can help them figure out the best way to get there.
Business partners part ways for varied reasons. Amicable separations where one owner leaves while the business continues on, planned liquidations where the business simply closes its doors, and contested expulsions involving allegations of wrongdoing all are common scenarios that cause business owners to break up. Each situation has its own associated issues and complications that must be anticipated and then addressed in the process. Understanding why a separation is desired or necessary and what a business owner is seeking to achieve through the process dictates how to best approach the situation.
2. Know Your Client’s Rights
It is remarkable how many businesses (large and small) operate on handshakes and mutual understandings instead of the agreements that they paid to have someone prepare when they started the business years (or even decades) earlier. If your client does not know whether the business has any formal governance documents, ask them to dig out the old corporate kit—it is probably black, with the name of the business embossed in gold lettering on the spine, and covered in a healthy amount of dust—and find out what is inside. If there are bylaws or a shareholder agreement (for a corporation), an operating agreement (for a limited liability company), or a partnership agreement (for, obviously, a partnership), then that is the starting point for assessing the parties’ respective rights and obligations. If not, then the governing state’s default rules for the type of entity at issue will typically apply.
The corporate lawyers and accountants who help business owners form their entities include these agreements in their formation packages for a reason—usually to protect the rights of the controlling parties who hired them to do the work. But oftentimes these agreements contain provisions that can be used to the advantage of minority owners who otherwise might think that they have little or no leverage in the situation. For example, the business’s voting provisions may require unanimous consent for actions such as bringing on a new owner or selling a major asset. If the majority owner wishes to take action that cannot be done unilaterally, then the minority owner’s blocking position becomes all the more valuable in negotiating an exit.
Business divorce lawyers can be extremely creative—and even dangerous—once they get their hands on these agreements, utilizing provisions that the business owners never even knew about to cause all sorts of mischief to advance their client’s cause. Understanding what these agreements provide at the outset of the representation is critical and will help avoid any unhappy surprises when engaging with the other side.
3. Understand the Financials
Understanding the finances and operations of the underlying business is one of a commercial lawyer’s most important tasks. When it comes to business divorces, irrespective of whether the company is making money hand over fist or teetering on the edge of bankruptcy, the company’s books and records (e.g., QuickBooks, financial statements, bank statements, and tax returns) tell the story. For help understanding what those books and records mean for a departing business owner, accountants are a business divorce lawyer’s best friend.
Accountants, like lawyers, have varied skillsets and expertise. Understanding the circumstances that led to the business divorce and what the client hopes to achieve in the process will inform whether and how one or more accountants can add value.
In hostile situations, such as where one business owner believes another is stealing or diverting business opportunities, engaging an expert forensic accountant early in the process is often critical to understanding the business’s true financial position, including untangling any complex transactions or structuring that otherwise may make it difficult to “follow the money.” In amicable separations that are unlikely to spark litigation, expert business accountants can help with a variety of issues that may arise in the process, ranging from differentiating between the value of the business as going concern and the value of a departing owner’s minority stake, to modeling the business’s future cash flows to assess the feasibility of a payout over time in a situation where the business will continue on without the departing owner. Even if the situation does not call for forensic accounting or business valuation expertise, the business owner’s personal accountant should be involved to help advise on the tax implications of any buyouts, write-downs, and other personal income tax issues that may come up and to ensure that any resulting transactions are structured in the most tax-efficient way.
Clients may be wary of adding another professional to the team, particularly at the outset of a representation. It is unquestionably an added expense but is usually worth it in the long run.
4. Ascertain Your Client’s Exposure
Business owners often approach these situations thinking only about how much money they are entitled to for their stake. It is hardly, if ever, that simple.
Particularly in the context of contested expulsions, business owners are liable to fall prey to believing that the other owner is the only one with something to lose. Often that is not the case. Allegations of wrongdoing are typically met with allegations of wrongdoing. For example, when one partner criticizes the other for having his child on the business’s payroll and health insurance for a no-show job, don’t be surprised when your adversary responds by carrying on about your client’s use of the company credit card, and the car lease and cell phone for your client’s spouse that the company has been paying for years. Avoiding getting bogged down in what amount to trivial expenditures of which both sides are guilty is usually the better part of valor, but sometimes it is unavoidable. Always be prepared for a two-way fight.
Potential liability also lurks in amicable separations. Particularly in the small business context, company credit cards, bank loans, and leases often require personal guaranties from the individual business owners. Those creditors may not be inclined to release departing owners from outstanding liabilities, especially if the business is in financial distress. Remaining on the hook for the debts of an ongoing business over which you have no control is a risky proposition, and indemnifications are only as good as the solvency of the indemnitor. Eliminating all manner of risk is not always possible, but the departing business owner must understand the full nature and extent of that risk when making any final decisions on how to separate. Similarly, the lawyer needs a complete picture to include protections where possible.
Most important of all, it is crucial that the business owner try, as hard as it may be, to maintain a businesslike demeanor and remain focused on achieving the desired objective. Business divorces can be expensive, time-consuming, and extremely emotional ordeals for all the parties involved. It is far too easy for some business owners to get so wrapped up in the fight—wanting more than anything else to “win”—that the costs render even a successful outcome a pyrrhic victory.
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Business divorces require a deep understanding of practically all aspects of commercial law, ranging from litigation and corporate governance to tax and restructuring. It is a full-service practice area that requires a full-service team. Lawyers and clients alike are best served by leveraging the expertise of a variety of legal and financial professionals so that the myriad issues that may arise in the process are thoroughly explored and addressed.
When asked to deal with numbers and valuations, most lawyers will say they went to law school for a reason—to avoid math at work. Nevertheless, valuations are an important part of any attorney’s practice. Whether arguing the value of a company’s common stock in a shareholder dispute, evaluating a potential acquisition target for a client, assigning value to assets held in trust, or attempting to determine the ability of a business to reorganize under the Bankruptcy Code, so many different variables must be reviewed and determined, and an attorney may quickly find themselves underwater. For instance, at what point in time should an asset be valued? What valuation methodology should be used? What weight should recent financial data be given compared to projections going forward? These and many other factors must be decided before any reputable valuation can be made, all while running complex calculations that attorneys typically hope to avoid.
With the rise and continued encumbrance of the COVID-19 pandemic, the questions facing those attempting to prove or argue a valuation have become even harder to resolve. For existing, pre-2020 valuations, practitioners must consider the new reality of the pandemic in assessing or disputing now-unrealistic valuations. For valuations completed during the pandemic, questions arise about whether a valuation can project a value of an asset that assumes a general emergence from pandemic depression or whether it instead should give greater weight to recent, concrete financial data (based on the idea that current economic trends are slowly becoming the new “normal” for the economy and markets).
These compounding questions, whether they arise in the middle of an acquisition, in preparation for trial, or in a bankruptcy case, can prove daunting. When faced today with a difficult valuation, there are a few key resources and considerations that attorneys can use to help them wrap their heads around the valuation questions they face. By keeping these resources and considerations in mind, attorneys can go forward more confident in their development or rebuttal of a valuation even in the heart of this seemingly endless pandemic.
If Possible, Hire a Financial Advisor or Valuation Expert
Valuations, particularly of complex assets in high-stakes litigation or acquisitions, are difficult, likely requiring the creation of discount rates, the identification of countless inputs, and in-depth knowledge of relevant industries. Such valuations can therefore quickly outstrip the training or expertise of most attorneys. Additionally, if involved in a valuation dispute preparing for summary judgment or trial, a definitive report, testimony, or additional evidence will likely be needed to prove the party’s proposed value of the asset or claim at issue. Therefore, to the extent possible, a party in need of a valuation (or a party preparing a rebutting valuation) should consider hiring an expert depending on the type of valuation needed—for instance, hiring a financial advisor to prepare projections and a business valuation, or hiring an appraiser for a real estate transaction.
Initially, this expert can lead the valuation process on behalf of the client to ensure the valuation’s efficacy and accuracy. Later, this individual can serve as a party’s expert witness if needed, providing expert testimony and creating a valuation report to submit to the factfinder to support the client’s valuation or refute an opposing party’s valuation.
Without expert assistance, an attorney runs the risk of relying on a questionable or inadequate valuation, lacking sufficient persuasive evidence, or, if the attorney prepares the valuation, being placed in the untenable situation of becoming a fact witness. While valuation experts certainly will cost clients additional funds, the benefit provided will normally outweigh such cost significantly.
Get the Cold, Hard Facts from Your Client
Regardless of whether a valuation expert is retained or the attorney intends to prove a valuation without an expert, an accurate valuation requires the client to disclose all of the cold, hard facts and documents related to the asset, claim, or potential target. Discovering and understanding each of these facts and documents helps to independently verify the actual value of the claim or asset instead of relying solely on the client’s word. While there may be no ill-intent, clients’ financial projections are routinely overly optimistic, and clients often lack a complete understanding of the value of individual assets and the various obligations that may encumber the assets and reduce the equity available. Without the underlying facts and information, an attorney runs the risk of depending on the client’s own projections or valuations.
Zombie companies are perfect examples of the dangers of relying on valuations based on inaccurate facts and underlying data. A “zombie company” is one that is economically unviable or unprofitable but limps along by leveraging various loans from banks and investors, low interest rates, and the leniency of its creditors. These zombie companies have a higher than realistic valuation based on pie-in-the-sky projections for the company that show its ability to pay its debts based on alleged future income. A thorough investigation of a zombie company would uncover red flags, such as leverage above the annual median for its industry, an interest coverage ratio (ICR) below one, or negative real sales growth over the prior three years. If present, a party opposing a valuation of a zombie company or targeting the zombie company for acquisition will not be tricked by the company’s optimistic but unrealistic valuation.
Additionally, accurate facts and information are vital to establishing a strong evidentiary basis for the valuation if the valuation is needed as part of litigation. Proving a valuation is similar to proving any other factual element that must be shown at trial: attorneys must determine what facts are needed to support the valuation, what witnesses will testify regarding those facts, and what exhibits may be used to support the witnesses’ testimony. Overall, when creating the valuation and any corresponding report, it is important to rely as much as possible on concrete facts and documents, such as financial statements, that provide actual data that can be used to prove the validity of the valuation and create a persuasive basis for a potential factfinder.
Consider Whether the Pandemic Economy Is the New Normal
For valuations that occurred prior to the pandemic, the projections did not (and could not) incorporate the effects of the pandemic. Since then, during the pandemic, similar valuations have tended to predict a societal recovery from the pandemic’s lingering economic impacts with the main variation being how long the recovery will take. For the minority of businesses somehow unaffected by the pandemic, pre-2020 valuations may still be accurate. For other businesses, the pandemic’s effect on the business may have already (for the most part) subsided.
However, for the majority of businesses, these valuation scenarios occurring both before and after the start of the pandemic can lead to valuations that ignore present conditions and thus potentially result in overestimations of an asset’s or business’s actual value. Now that the pandemic is nearing its third year and with the next virulent strain seemingly always on the horizon, it begs the question whether the pandemic economy is actually the new “normal” that should be considered a constant in any valuation going forward. While this change in perspective may lead to more reserved valuations of assets or claims, in the long run it may prove more realistic and persuasive as prior valuations continue to underperform due to the pandemic’s sobering effects on the actual value of assets or claims. Unless global circumstances change drastically in the near term, it may not be long until present conditions are considered our new reality.
Conclusion
The valuation of assets or claims has never been an exact science within the legal profession. With the emergence and lingering presence of the COVID-19 pandemic, calculating a formula for an evaluation has grown even harder. Nonetheless, utilizing a financial expert, independently conducting due diligence on the asset or claim, and recognizing current economic reality can provide some clarity to the valuation process going forward. While not foolproof, these considerations create a sound base supporting a secured creditor’s alleged valuation of its claim, a litigant’s valuation of an asset at issue, or a potential purchaser’s valuation of a target company. Without these considerations, a party runs a real risk of falling victim to an unrealistic valuation that could cause significant issues and potential liability down the road.
An opinion that an extension of credit does not violate margin regulations is sometimes requested in loan transactions and certain debt offerings as an aspect of an opinion that the transaction does not violate applicable laws. A typical opinion expressly covering margin regulations may be stated as follows:
The execution and delivery by [the Company] of each [Loan Document] to which it is a party do not, and the performance by [the Company] of its obligations thereunder will not, result in violation of Regulations T, U or X of the Board of Governors of the Federal Reserve System.
Opinion Coverage as a Matter of Customary Practice
The laws that a lawyer exercising customary professional diligence would identify as being applicable when giving an opinion depend on the type of the transaction. In a lending transaction, particularly a loan that will be used to acquire margin stock or that is secured by margin stock, a lawyer might identify the margin regulations as being applicable, and a lender might reasonably expect those regulations to be addressed by the opinion letter, but the coverage of the margin regulations, as part of the securities laws in general, in an opinion letter is not entirely clear. For that reason, when the margin regulations may be applicable to the transaction, a lender may request the margin regulations to be expressly addressed in the opinion letter. On the other hand, if the transaction does not involve margin stock, the opinion letter may not be expected to address the margin regulations. In that case, although the margin regulations may be understood as a matter of customary practice not to be covered unless done so expressly, some lawyers choose to exclude expressly the margin regulations from the opinion letter’s covered law, especially when they are expressly excluding other laws from coverage.[1]
Margin Regulations; Applicability and Definitions
The margin regulations are Federal Reserve Regulations T, U and X, 12 C.F.R. §220.1 et seq., §221.1 et seq. and §224.1 et seq., respectively, issued by the Federal Reserve Board under Section 7 of the Securities Exchange Act of 1934 (the “Exchange Act”). That section authorizes the Board to issue rules and regulations “for the purpose of preventing excessive use of credit for the purchase and carrying of securities.” Section 7 of the Exchange Act also prohibits banks and broker dealers, with certain exceptions, from extending credit or arranging the extension of credit in contravention of those rules and regulations, and prohibits U.S. persons and foreign persons controlled by or acting on behalf of a U.S. person from obtaining such credit.
Regulation T applies to brokers and dealers as defined in the Exchange Act and members of a national securities exchange, and certain related persons. Regulation U applies to banks and to non-bank lenders who in the ordinary course of business extend credit secured directly or indirectly by margin stock in the amount of $200,000 or more during a calendar quarter or have $500,000 or more of such credit outstanding at any time during a calendar quarter. Regulation X applies to borrowers. It was added to the margin regulations after some borrowers tried to use a violation of the margin regulations applicable to lenders as a defense to payment of the credit.
Regulations T and U prohibit a covered lender from entering into or arranging an extension of credit for the purpose of purchasing or carrying margin stock in an amount in excess of the maximum loan value of the margin stock if the loan is secured directly or indirectly by margin stock. Regulation X prohibits a borrower from entering into a transaction that violates the margin regulations. Credit that is extended for the purpose of buying or carrying margin stock is referred to as “purpose credit.” Margin stock includes equity securities listed or traded on a national securities exchange or qualified for trading in the National Market System. Margin stock also includes warrants or rights to subscribe to margin stock or debt securities convertible into margin stock or carrying a warrant or right to subscribe to margin stock, and certain securities issued by a registered investment company. Margin stock does not include the stock of a borrower’s wholly-owned operating subsidiaries that is not traded in the market.
An opinion that an extension of credit does not violate the margin regulations will turn on whether the credit is purpose credit and whether the credit is directly or indirectly secured by margin stock.
Not Purpose Credit
In a general lending transaction, the loan agreement may include the stated purposes of the loan and may include a provision that the loan may not be used to purchase or carry margin stock. A lawyer’s reliance on the borrower’s obligation to comply with the provisions of the loan agreement may form the basis for the lawyer to conclude that the credit is not purpose credit and thus permit the lawyer to give the opinion that the transaction will not violate the margin regulations. For revolving or multiple draw loans secured directly or indirectly by margin stock, a covered lender is required to obtain from the borrower a completed form FR U-1 (banks), FR T-1 (brokers and dealers) or FR G-3 (other covered lenders) in which the borrower states whether or not any part of the credit is a purpose credit and if not, the purpose of the credit. A representation of the borrower on such a form, or in a separate certificate on which the opinion giver can rely, that the credit will not be used to purchase or carry margin stock may also be the basis for an opinion that the transaction does not violate the margin regulations based on the credit not being a purpose credit. An example of a non-purpose loan representation is:
No proceeds of the [Loan] will be used for the immediate, incidental or ultimate purpose of buying or carrying margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System).
Purpose Credit Indirectly Secured by Margin Stock
If credit is purpose credit and the borrower owns or will acquire margin stock, even if the credit is not explicitly secured, the transaction may still run afoul of the margin regulations if the credit is deemed to be indirectly secured by margin stock. A credit may be deemed to be indirectly secured by margin stock if the borrower has agreed not to pledge any of its assets to secure any other obligation and if the borrower has no other substantial assets than the margin stock. Examples of such a borrower would be a shell acquisition subsidiary with no assets other than the acquired margin stock or a company that is an investment company that has invested in margin stock. On the other hand, if the borrower has substantial assets or cash flow without regard to the margin stock, the unsecured loan with a negative pledge clause may not be deemed to be indirectly secured by the margin stock.
The definition of “indirectly secured” in Regulation U has several exceptions. One of the exceptions is that, if after applying the proceeds of the credit, “not more than 25% of the value (as determined by any reasonable method) of the assets” subject to the negative pledge clause is margin stock. 12 C.F.R. § 221.2. In a close valuation case, the choice of a method for valuing the assets may make a difference whether the 25% safe harbor is available, but where the value of the margin stock is negligible in relation to the other assets of the borrower, the opinion giver may be confident that the safe harbor is available. Depending on the values, a simple certificate from the borrower may be sufficient, or the conclusion in the certificate may need to be supported by calculations showing how the values of margin stock and the borrower’s other assets were calculated. The conclusion of the certificate might state:
As of the Closing Date, the value of the margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System) constitutes less than 25% of the value of the assets of the [Borrower] that are subject to any limitation on sale, pledge or other restriction under the [Loan Documents].
An additional exception in the definition of “indirectly secured” in Regulation U is that the lender “in good faith, has not relied upon the margin stock as collateral in extending or maintaining the particular credit.” 12 C.F.R. § 221.2. The specific evidence sufficient to support an opinion that the lender is not relying on the margin stock as collateral may depend on the particular facts of the transaction, and might include statements of the lender to this effect on which the opinion giver could rely. Such evidence is more persuasive if other valuable assets of the borrower have been pledged to secure the credit, and the negative pledge clause creating the indirect security on the margin stock is clearly not intended as additional collateral. As an alternative, a lender may accept an opinion that the transaction does not violate the margin regulations based on an expressly stated assumption in the opinion letter as to the lender’s non-reliance on the margin stock as security.
This article originally appeared in the Winter 2021–2022 issue of In Our Opinion, the newsletter of the ABA Business Law Section’s Legal Opinions Committee. Read the full issue and previous issues on the Legal Opinions Committee webpage.
See Gail Merel et al., Laws Commonly Excluded from the Coverage of Third-Party Opinions in U.S. Commercial Loan Transactions, 76 Bus. Law. 889, 896 and n. 25 (2021). ↑
Project Chairs: Anshu Pasricha (formerly of Koley Jessen, P.C., L.L.O.) and Thomas B. Romer (Greenberg Traurig LLP) Key Contributors: W. Ian Palm and Stefan Nasswetter (Gowlings), Kathy Woeber Gardner and Karen Masterson Dienst (Montgomery Pacific), Tali Sealman (White & Case) and Brittany Sakowitz (Kirkland & Ellis LLP) Subcommittee Chair and Contributor: Daniel Rosenberg (Charles Russell Speechlys LLP) Peer Review: Glenn West (Weil, Gotshal & Manges) Committee Chair: Wilson Chu (McDermott Will & Emery LLP)
Introduction
As in-person closings, much less in-person signings, go the way of livery of siesen,[1] the Technology Subcommittee of the ABA Mergers and Acquisitions Committee (“MAC”) has prepared a protocol which represents the best practices used by M&A lawyers in arranging for the proper execution and delivery of documents digitally.[2] The “MAC Digital Documentation Protocol” is not an exclusive means to digitally execute and deliver documents, but rather a set of governing principles counsel can rely on to ensure documents are effectively reviewed, executed and delivered digitally.
The digitization of the M&A agreement process has significantly increased the speed with which documents can be changed and greatly enhanced the ability of parties to fine tune agreements up to the last minute—or even second—before signing. Although there have been few cases to date in which the enforceability of an agreement has been challenged due to the failure of the execution and delivery process that was not held in person,[3] we believe adherence to the guiding principles of the MAC Digital Documentation Protocol will help parties to avoid potential disputes on issues such as “what was the final version of an applicable agreement” or “that a party never agreed to the terms of the purported final agreement.”
MAC Digital Documentation Protocol Guiding Principles
The MAC Digital Documentation Protocol is comprised of four guiding principles:
complete documents should to be made available to signatories for review before or at least as they are signed;
review of complete documents by the signatories should be confirmed;
execution of documents by electronic means in accordance with applicable law is supported; and
delivery of reviewed, confirmed and executed documents should be clearly established.
By executing and delivering a document in concert with these guiding principles, we believe sufficient evidence of due execution and delivery of that document has occurred amongst the signatories.
How to use the MAC Digital Documentation Protocol
In our view, simply including a reference to the MAC Digital Documentation Protocol in a transaction document is sufficient to document the parties’ intent to execute and deliver documents in accordance with its guiding principles.
Failure to adhere to the MAC Digital Documentation Protocol, whether or not it has been referenced, should not in-and-of-itself mean a document is not effectively executed and delivered. However, adherence to the MAC Digital Documentation Protocol, whether or not referenced, is intended to be a sufficient means through which documents can be executed and delivered by electronic means and thereby enforceable amongst the parties to such documents.
Including the MAC Digital Documentation Protocol (whether by reference or by including language that reflects its guiding principles) is intended to create a presumption that the parties have complied with the MAC Digital Documentation Protocol absent clear evidence to the contrary.
Sample Language
Sample language to be included in documents consistent with the MAC Digital Documentation Protocol is provided below. Including this language in an agreement is not required to evidence the parties’ intent to execute and delivery documents in accord with the MAC Digital Documentation Protocol. However, incorporating the MAC Digital Documentation Protocol by reference is considered to be sufficient evidence of the parties’ intent.
The MAC Digital Documentation Protocol guidelines are designed to apply to the execution and delivery of any agreement or document that is signed by one or more parties. With the exception of the sample signature page language which is designed to be applicable to any document, the sample language is designed to be incorporated into a purchase or merger agreement and applicable to the documents required to close a transaction.
Incorporation of the MAC Digital Documentation Protocol by Reference
Specific reference to the MAC Digital Documentation Protocol is the clearest way to document the parties’ intent to sign an agreement or close a transaction in accordance with the MAC Digital Documentation Protocol.
Sample Signature Page Language:
The undersigned hereby execute and deliver this Agreement in accordance with the MAC Digital Documentation Protocol as of the day above first written.
Sample Closing Language:
The Closing. On the terms and subject to the conditions of this Agreement, the closing of the transactions contemplated by this Agreement (the “Closing”) shall take place on the Closing Date by the electronic exchange of documents in accordance with the MAC Digital Documentation Protocol (the “Protocol”). No Party shall be required to appear at any specific physical location to effect the Closing. The Closing shall be deemed effective at 12:01 a.m. Eastern Time on the Closing Date (the “Effective Time”).
Principle 1: Making Available Complete Documents to be Executed and Delivered Via Electronic Means.
By incorporating the MAC Digital Documentation Protocol into their agreement, parties are agreeing to make available to each party (or their counsel)[4] who will be executing and delivering a document electronically the entire contents of that document (together with all addendums, exhibits, annexes, supplements and other materials incorporated by reference)[5] by:
circulating electronic versions of such document (and all referenced materials) via email;
providing access to electronic versions of such document (and all referenced materials) via a shared work folder on a mutually agreed secure website; or
providing access to such document by any other means in which the document and (and referenced materials) can be accessed and viewed by the signing party.
Sample Language:
Preparation of Final Documents. Unless otherwise agreed by the Parties in writing, prior to Closing, Buyer’s counsel, on behalf of the Buyer, will circulate [by email/by providing appropriate access to a work folder on a mutually agreed upon secure website] final, execution versions of the Purchase Agreement and all other Transaction Documents, together with all addendums, exhibits, annexures and supplements thereto (collectively, “Closing Documents”).
Principle 2: Ensuring Review of Complete Documents to be Executed and Delivered via Electronic Means.
Each party to a document made available pursuant to the MAC Digital Documentation Protocol or their counsel,[6] will review each document to be executed by that party to ensure that such document manifests the agreement to which such party intends to be bound once executed and delivered.
Sample Language:
Review and Confirmation. Each party will review and confirm that such Closing Documents are acceptable as final documents that can be executed and delivered by the Parties.
Principle 3: Valid Execution of Documents Via Electronic Means.
Execution of a document circulated and reviewed in accordance with the MAC Digital Documentation Protocol or similar means, using a technology that complies with applicable law governing the execution of documents by electronic means[7] is an acceptable way to execute documents in accordance with the MAC Digital Documentation Protocol.[8],[9],[10] Though not a required part of the MAC Digital Documentation Protocol, the collection—and holding in escrow—of signature pages to documents by one or more counsel and/or parties to a transaction prior to delivery or release of such signature pages (including prior to finalization of the terms of such documents) is a common practice. Such practices, if the other aspects of the MAC Digital Documentation Protocol are otherwise complied with, do not violate the terms of the MAC Digital Documentation Protocol. Delivery or release of such signatures in accordance with the MAC Digital Documentation Protocol is addressed in Principle 4.
Sample Language:
Execution and Collection of Signatures. On receipt of such confirmation from Seller’s counsel, Buyer’s counsel shall circulate by [email/mutually agreed upon E-Signing Application Service Provider that is compliant with the U.S. federal E-SIGN Act of 2000], all such Closing Documents to all Parties and any other signatories to the applicable Transaction Documents. Prior to the Closing, all Parties and any other signatories to the applicable Transaction Documents shall have executed and circulated the signature pages to the Closing Documents to Buyer’s counsel, to be held in escrow pending release of such signature pages to the Closing Documents in accordance with the terms agreed amongst the Parties and any other signatories to the applicable Transaction Documents.
In addition, a proposed counterparts and e-signatures language could be:
Counterparts and Electronic Signatures. This Agreement may be executed (i) in a single document signed by all parties or (ii) in multiple counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. Counterparts may be (i) signed in person and delivered in person, via facsimile, or via other means of electronic delivery (including emailing an electronic copy thereof) and/or (ii) signed and delivered by means of employing electronic signature technology that complies with the Electronic Signatures in Global and National Commerce Act of 2000 (E-SIGN), or other Applicable Law governing the execution and delivery of this Agreement through electronic means. Any counterpart executed and delivered in accordance with the terms of this paragraph will be deemed to have been duly and validly executed and delivered by such party.
Principle 4: Effective Delivery of Executed Documents (Release of Signatures).
In order for a document to be enforceable against a party that document must be duly executed and delivered by that party.[11] A document executed in accordance with the MAC Digital Documentation Protocol will be effectively delivered in accordance with the MAC Digital Documentation Protocol if a party, their counsel or an authorized person affirmatively expresses the intent of the applicable party to deliver (often referred to as release their signature to) the duly executed document to the other party(ies). Any means by which a party or their counsel communicates their intent to deliver a duly executed document that clearly demonstrates both the applicable document they intend to deliver and the required intent to deliver it (whether by electronic means, or via verbal communication in person, by phone, or any other means in which the party or their representative can be heard and can hear the other participants) is acceptable under the MAC Digital Documentation Protocol. Though not required, the MAC Digital Documentation Protocol encourages practitioners to use a secure website, at which the applicable document can be viewed by both the party intending to deliver their executed copy thereof and receiving party, together with a communication (phone or video conference, in person meeting, or email) stating that a signature can be affixed to the posted document and such document may be delivered to the other party. Many websites can track and make available all activity with respect to documents posted to the website which will provide parties and their counsel assurance that a document which has been previously confirmed has not been changed. Emailing or circulating documents in a way that otherwise meets the principles of the MAC Digital Documentation Protocol is also accepted.
Sample Language:
Delivery of Executed Documents (Release of Signatures). On the Closing Date, at a mutually agreed on time, Parties and any other signatories (together with authorized representatives of such parties) shall coordinate a closing teleconference call (“Closing Call”). At such Closing Call, Buyer’s counsel (on behalf of Buyer) and Seller’s counsel (on behalf of Seller) shall confirm that the Parties are satisfied that (i) in the case of signing, all Parties are in agreement that all signature pages shall be released by Buyer’s counsel concurrently, and (ii) in the case of closing, all conditions to Closing have been satisfied or waived in accordance with the terms of the Purchase Agreement, and all Parties are in agreement that all signature pages shall be released by Buyer’s counsel concurrently, subject only to Buyer providing wire transfer confirmations/fed. reference numbers to the Parties promptly (and in any event, no later than [two hours] following the Closing Call).
Archive and Distribution. Buyer’s counsel shall provide a copy of the archived Closing Documents circulated by Buyer’s counsel in accordance with [Section [●]—Preparation of Final Documents]. Buyer’s counsel shall provide a copy of all fully-executed and delivered Closing Documents to Seller and Seller’s counsel.
[1] An English common law ceremony dating back to the Middle Ages in which the selling party intending to convey an interest in real property literally handed to purchasing party a clump of soil, a twig, a key to a building, or other token. The Law of Property Act, passed in 1925 (15 & 16 Geo. 5, ch. 20 [Eng.]), abolished the practice.
[2] Our use of the term “digital” is intended to cover a number of situations ranging from fully digital execution and delivery of documents to hybrid situations where documents are emailed, signed manually, and delivery of those signatures is sent electronically.
[3] See, Kotler v. Shipman Assoc., LLC, (Del. Ch. Aug. 27, 2019) (finding a contract unenforceable despite the agreement being fully executed, because the signature page was attached to a version of the contract that was not the version that the CEO signatory intended to execute); UBEO Holdings, LLC et al. v Drakulic (Del. Ch. April 30, 2021) (finding a forum selection clause unenforceable in part because Drakulic was never provided a copy of the merger agreement and was not informed of the agreement’s forum selection provision or other provisions restricting his livelihood, and Drakulic was intentionally kept in the dark of the contents of the agreement).
[4] Circulating or providing access to documents to counsel only, with the understanding that counsel will circulate or provide access to such documents to their clients is a common and accepted practice. Opposing counsel can assume, absent specific knowledge to the contrary, that a party’s counsel will ensure their client has been provided access to documents to be executed electronically.
[5] Often transaction documents (with attachments) are too bulky and cumbersome to circulate by email. In particular, all attachments to disclosure schedules are unlikely to be circulated via email (unless multiple emails are circulated). As such, consider providing the alternative of uploading to a website.
[6] Review and confirmation by counsel on behalf of their client that a document contains the terms and conditions negotiated by the parties is an accepted practice. Opposing counsel can assume, absent specific knowledge to the contrary, that a party’s counsel will ensure their client has been provided access to documents to be executed electronically.
[7] e.g., The Uniform Electronic Transactions Act (UETA), which is the law in all but a few United States jurisdictions, or the Electronic Signature in Global and National Commerce Act, 15 USCA §§ 7001 et seq. (E-SIGN), which is federal law and preempts state law in certain instances.
[8] Practitioners should confirm that each document to be executed via electronic means may be so executed in accordance with applicable law. Certain documents (such as deeds and negotiable instruments) may not be executed electronically under applicable law.
[9] See TriBar Opinion Comm., Comment Concerning Use of Electronic Signatures and Third Party Opinion Letters, 75 Bus. Law. 2253 (2020). Our European colleagues can comment on the relevance of Regulation (EU) No 910/2014 (the eIDAS Regulation) that applies to EU Member States from 1 July, 2016. Similarly, in Canada, we understand that all provinces and territories have adopted e-commerce legislation providing that an electronic signature is valid and enforceable so long as the electronic signature is reliable for the purpose of identifying the person and the association of the electronic signature with the relevant electronic document is reliable.
[10] Note: In the United Kingdom, the Law Commission (which is the statutory independent body which reviews the law of England and Wales and recommends reform where needed) has recently summarised the English legal position in its September 2019 report (Law Commission report: Electronic execution of documents (Law Com No 386, September 2019)) as being that electronic signatures are capable in law of being used to execute documents (including deeds). This conclusion is based on the provisions of the EU eIDAS Regulation (Regulation (EU) No 910/2014 of the European Parliament and of the Council of 23 July 2014 on electronic identification and trust services for electronic transactions in the internal market and repealing Directive 1999/93/EC), the UK’s Electronic Communications Act 2000 and case law relating to electronic signatures and signatures more generally. However, it also recommended that an industry working group be established to consider practical issues relating to the electronic execution of documents and the law relating to deeds more generally. The UK Government subsequently endorsed these views in March 2020, noting that the timing of a wider review of the English law of deeds would be subject to overall government and Law Commission priorities given the current volume of UK law reform work.
[11] Due authorization is also required but is not within the scope of the MAC Digital Documentation Protocol.
Law firm leaders today are like circus jugglers flipping balls into the air so fast you can hardly see them. Yet most leaders primarily focus on putting out fires to keep themselves afloat. Issues of the moment include:
Addressing the Great Resignation: what do employees want?
Managing the return to office
Implementing guidelines and processes for a hybrid office
Reimagining the physicality of the office
Rethinking safety for humans and cyber-safety for work product
It’s a beginning. Futurists might hope that leaders would think more strategically to address the impact of the tech-driven world we are moving into. But most law firms are not receptive to dramatic change. The typical law firm organization is paramilitary. Lawyers work their way up to equity partner and, once there, set the rules for everyone else without asking for anyone else’s input. It’s top-down decision-making with little regard for input from others.
Law firm leaders will be more comfortable addressing issues as they arise rather than tackling a comprehensive cultural overhaul.
This article looks at the importance of inclusive communication practices as an essential underpinning for any change. The assumption is that the more inclusive, receptive kind of communication required to make any changes “stick” will necessarily chip away at the dictator-leader model. A new kind of communication will foster worker buy-in to small changes that will, over time, lead to more democratic, decentralized, inclusive firm communications.
Communication Basics
“Communicating means establishing good relationships and reaching the right persons with the right messages at the right messages at the right time, usually for the purposes of getting something done.”[1] Good communication requires preparation and knowledge. “Right persons,” “right messages” and “right timing” presume that the communicator knows the organization, the players, the leaders and the culture—their jargon, their values, their biases, the way they have always done things.
Workplace communications almost always involve an element of persuasion, where the speaker is looking for buy-in. To persuade requires the persuader to:
Be trusted by those in the audience.
Be sincere about personal beliefs and use appropriate body language to reinforce that sincerity.
Use stories to emphasize points that resonate with the audience.
Use their language and communicate the main “ask” clearly.
Audiences never hear exactly what the speaker says because they process words through their own life experiences, beliefs, and preferences. Workplace leaders create greater alignment with their audience when they seek their involvement. To increase the likelihood that they will hear “real” answers from those lower down on the office ladder, the leader has to create a safe environment for the dialogue.
To achieve audience rapport, the leader should be empathetic, open-minded, non-judgmental, and willing to adjust the original idea to incorporate some of their input. To see how these generalities play out in the law firm environment, let’s look at two of today’s issues: 1) what employees want; and 2) the return to the office.
What Employees Want
The assumption that work could only be done in an office died after two years of productive remote work. The ability to work elsewhere enabled professionals to carry out work assignments as just one among many daily activities. Women tasked with childcare responsibilities could interweave the two activities. For many, it worked.
Of course, while some flourished, others felt isolated, burned out, lonely, and depressed. They found it difficult to separate work and home activities either physically or mentally. Without something as arbitrary as a commute to separate work and life, they overworked. This tendency was made worse by bosses who called innumerable videoconference meetings to compensate for the lack of in-office collaboration.
Employees had time to think about preferable work environments. Especially for younger lawyers and new hires, the absence of in-person mentors and colleagues creates a feeling of isolation—and often depression. Despite a multitude of team meetings, it is difficult to become friends with online colleagues; to understand firm culture; and to behave according to informal office norms.
2021 saw approximately four million workers a month disappear from the workforce either through firing and attrition or worker resignations. As worker shortages grow, employees are in the catbird seat.
They want more than more money. They would like their law firms to accept work as one part of a balanced life rather than the focus of their waking hours. They are asking for:
Respect
An understanding that flexibility includes both scheduling and location plus the ability to decide for themselves how to get their work done
Clarity as to career paths and development of pathways to personal growth
Leaders willing to include their input when making decisions about their work lives
Firm values aligned with theirs regarding issues such as climate change, Black Lives Matter, and DEI
Leaders used to docile followers were surprised and disoriented. They were focused on confusing health mandates, client demands, and technology disruptions. Instead, they have to deal with demands for new workplace relationships and opportunities.
The Return to Work
Important concerns complicate any return to office-based work. Firm leaders are faced with the need to:
Assuage health worries focused on COVID upticks and returning to elevators, shared lunchrooms, and cubicle offices.
Change firm cultures to meet new worker definitions of an acceptable workplace.
Reconsider partner-associate and lawyer-staff relationships.
Deal with the impact of 20th-century thinking about the role of in-office participation in career success versus the new reality that people want to work asynchronously.
Firms’ knee-jerk response was to offer a hybrid work model that would include the option to work remotely. Less thought was given to details like scheduling and meeting employees’ emotional demands for participation, career success, and well-being.
Culture-changing questions include:
What needs to be done in the office and what is better done alone?
For knowledge workers, does the nine-to-five workday still make sense?
Does everyone in a law firm need to be in the office together all the time?
How does the autonomy to decide when and where to work coexist with the reality of teams or set work schedules?
Does choosing remote work need to negatively impact careers, especially for women lawyers?
Law firm leaders have begun to respond to these pressures. Successful responses begin with those good communication skills, that is, the willingness to be authentic; open to others’ ideas; empathetic; and ready to change. Rather than lay down an arbitrary rule, modern leaders will move toward more inclusive decision-making that shows respect, support, and interest in what other people in their firm think.
Questions that guide this kind of conversation include:
What do you think?
How can I help?
Why is that important to you?
What do you suggest to resolve the issue?
What can we as a firm do to meet your expectations?
An example of a brief but positive conversation with a complaining employee:
Employee: Complaint.
Leader: I hear you and I understand. I have some thoughts about the issue but I am more interested in how you would resolve the problem. I’d love to hear your ideas. Let’s get together next Wednesday to find a solution. I will send you a calendar invite.
The leader has in four sentences expressed understanding of where the employee is coming from; said she wants to hear their solution; given them time to craft a workable result; and shown respect for the employee’s issue by setting a specific time to resolve the issue.
Conclusion
All the pandemic-induced changes of the past two years have created an opportunity to alter the dynamic between law firm leaders and employees—non-equity partners, associates, and staff. As firms try various solutions in 2022, there is an opportunity to make the best ones permanent: To address a future where lawyers will be paid for their knowledge rather than the process of creating specific products.
In subsequent issues I will discuss specific solutions to the problems raised here.
[1] George de Mare, “Communicating: The key to establishing good working relationships,” Price Waterhouse Review, 1989, p. 32.
Mortgage foreclosure cases sometimes yield surprising and unexpected results,[1] and the recent opinion issued in Freedom Mortg. Corp. v. Olivera[2] is no exception. In Olivera, the Appellate Court for Illinois’ Second District ruled that mortgage lenders attempting to foreclose an FHA-insured mortgage must demonstrate strict compliance with a HUD regulation mandating face-to-face meetings within three months of a payment default or “forgive potentially years of monthly payments” because lenders cannot go back in time to correct their alleged noncompliance.[3] Yet the court openly “agreed to an extent” that its own ruling was “unjust.” This article discusses some of the arguments Illinois foreclosure practitioners should examine to challenge the court’s analysis.
HUD Face-to-Face Meeting Requirements
The National Housing Act of 1934[4] (Housing Act) created the Federal Housing Administration (FHA) to encourage the construction of affordable housing.[5] The Housing Act expressly affirmed “the national goal . . . of a decent home and a suitable living environment for every American family.”[6] The U.S. Department of Housing and Urban Development (HUD) administers the Housing Act’s various housing programs,[7] including a program that provides mortgage insurance on loans made by FHA-approved lenders to borrowers who may otherwise struggle to qualify for a mortgage.[8]
In connection with administering the FHA-insured loan program, HUD promulgates regulations governing the servicing of FHA-insured loans.[9] These regulations include a requirement that, unless excused for specific reasons, lenders must “have a face-to-face interview with the mortgagor, or make a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.”[10] Under the regulations, a “reasonable effort to arrange a face-to-face meeting” requires at least “one letter sent to the mortgagor certified by the Postal Service as having been dispatched” and “at least one trip to see the mortgagor at the mortgaged property,” unless an exception applies.[11]
HUD-mandated language in FHA-insured mortgages precludes lenders from “requir[ing] immediate payment in full of all sums secured” when limited by the HUD regulations, and it specifies that the mortgage “does not authorize acceleration or foreclosure if not permitted by [HUD regulations].” The HUD-mandated language for FHA-insured mortgage notes includes substantively identical provisions. Most courts — including some courts in Illinois — hold that these provisions in the mortgage and note incorporate at least some HUD regulations into the parties’ mortgage contract, and most courts agree that they therefore incorporate HUD’s face-to-face meeting requirement.[12]
Courts holding that the mortgage and note incorporate HUD regulations into lenders’ obligations under the loan documents typically rely on regulatory language found in Section 203.500, which specifies HUD’s intent “that no mortgagee shall commence foreclosure or acquire title to a property until the requirements of this subpart [Subpart C, Sections 203.500 to 203.681] have been followed.”[13] Similarly, Section 203.606 provides that “[b]efore initiating foreclosure, the mortgagee must ensure that all servicing requirements of [Sections 203.500 to 203.681] have been met.”[14] Courts predominantly interpret these provisions as requiring substantial compliance with the relevant sections before filing a foreclosure complaint.[15]
Importantly, HUD itself confirms that it did not intend the language in the loan documents to “incorporate all of HUD’s servicing requirements.”[16] Instead, according to a 1989 Notice of Policy HUD published in the Federal Register, the loan documents’ reference to the regulations only applies to regulations that “specifically state prerequisites to acceleration or foreclosure.”[17] And notably, unlike some of HUD’s servicing regulations,[18] HUD’s face-to-face meeting requirements do not specify they are prerequisites to acceleration or foreclosure.[19] Therefore, it is reasonable to conclude that HUD did not intend for the loan documents to incorporate the face-to-face meeting requirement according to its own published understanding of the controlling terms and regulations.[20]
National Trend on Applying HUD Face-to-Face Meeting Requirements
Although the face-to-face meeting regulation does not appear to qualify as a pre-condition to acceleration and foreclosure under HUD’s explicit policy statement on the governing mortgage language, most courts still require lenders to comply with HUD’s face-to-face meeting requirement before foreclosing. Nonetheless, the balance of courts that have considered the issue also recognize that the specific timeframe for compliance is “aspirational” and not mandatory.[21] In other words, most states require lenders to comply with the HUD regulations before filing a foreclosure complaint, but they do not preclude lenders from ever foreclosing merely because the lender fails to comply with all regulations before three full monthly installments become unpaid.[22]
The New York Supreme Court’s commonly cited opinion in U.S. Bank Nat’l Ass’n v. McMullin[23] addresses the issues involved in detail. In McMullin, the borrowers defaulted on their loan payments in March 2009. The lender “did not claim to have had a face-to-face meeting with [the borrowers] before [they] missed three full monthly payments.”[24] However, the court determined that the lender had “made good-faith, reasonable efforts over a multi-year period to negotiate a consensual resolution of [the borrowers’] longstanding default before commencing [the foreclosure],”[25] which the court found sufficient to allow the foreclosure to proceed.[26]
The McMullin court analyzed the standard language in the HUD-approved mortgage and note and concluded that the loan documents “establish[ed] a condition precedent to suit, the occurrence of which [the lender] must establish as part of its prima facie case” to foreclose.[27] The court continued: “The issue then becomes whether [the lender] has established the occurrence of the condition stated in the mortgage: that the HUD regulations did not prohibit the commencement of this action.”[28] Noting the difference under New York contract law between express conditions, which “must be literally performed,” and constructive conditions, “which ordinarily arise from language of promise” and “are subject to the precept that substantial compliance is sufficient,”[29] the court found that the lender had substantially complied with the regulations, and that the regulations therefore did not prohibit commencing the foreclosure action.[30]
In determining that the lender had substantially complied, the court considered HUD’s regulatory language that “[b]efore initiating foreclosure, the mortgagee must ensure that all servicing requirements . . . have been met.”[31] The court contrasted that language against the language HUD employed in the next sentence of the regulation: “The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid.”[32] The court found that the second sentence — addressing the lender’s duty to wait until the borrower missed three monthly payments to foreclose — “employ[ed] the unmistakable language of condition through the use of a term such as unless,”[33] whereas the first sentence — addressing the lender’s duty to ensure it met all servicing requirements — “is not cast in the form of a clear prohibition.”[34] “Instead,” the court determined, the first sentence “employs the type of doubtful language that courts routinely interpret as embodying a promise.”[35]
In other words, the court examined HUD’s language requiring lenders to “ensure that all servicing requirements . . . have been met,” and it concluded that when read in context, the language constituted a constructive condition subject to substantial — not strict — compliance. The court found additional support for its ruling in the “highly inequitable consequences” of a contrary interpretation, noting that “[i]t seems inconceivable that the HUD regulations, promulgated in respect to the federal agency’s role as an insurer of mortgages, were intended to create a permanent and impenetrable barrier to foreclosing” where a lender failed to conduct a face-to-face meeting within three months of the borrower’s default.[36]
Accordingly, the court held that the lender’s “good-faith, reasonable efforts over a multi-year period to negotiate a consensual resolution” to the default constituted substantial compliance with HUD regulations.[37] Courts throughout the country that have examined HUD’s face-to-face meeting requirement have employed a similar analysis and reached similar results.[38]
The Olivera Opinion
Nevertheless, despite mostly widespread agreement on allowing substantial compliance with HUD’s face-to-face meeting requirement from courts in multiple jurisdictions, the Illinois Appellate Court’s Second District recently opted to buck the national trend.[39] Its ruling creates confusion for Illinois lenders seeking to comply with the face-to-face requirement in good faith.
In Olivera, the lender filed a foreclosure complaint in May of 2017 alleging that the borrower remained in default on the loan since September 2011. The lender had previously dismissed two foreclosure actions without prejudice. In January 2017, prior to filing its May 2017 complaint, the lender had sent the borrower a certified letter trying to arrange a face-to-face meeting with the borrower, and it had sent a representative to visit the property to attempt to arrange a face-to-face meeting. The trial court granted the borrower’s motion to dismiss the third foreclosure action filed in 2017, finding that the lender had failed to meet a condition precedent to filing its complaint when it failed to conduct a face-to-face meeting within three months of the borrower’s default. The Second District affirmed the trial court’s dismissal.[40]
Refusing to adopt the “common-sense approach” followed in other jurisdictions, the court found that “Illinois authority does not support that the regulations require only substantial compliance before foreclosure actions may proceed.”[41] However, the court acknowledged that “it would be inequitable to presume that, where a lender fails to comply with the initial three-month time frame, foreclosure is forever barred and that borrowers may simply remain in the premises indefinitely without ever paying their mortgage.”[42] Accordingly, the court confirmed that its “holding does not . . . mean that [lenders] can never foreclose.”[43] “Rather, after ‘forgiving’ past missed payments, waiting for potentially more missed payments, and timely complying with the regulations, [lenders] could, legally, file a new complaint with a new default date.”[44]
Oddly, the court “agree[d] to an extent” that “it would be unjust to require a lender to forgive potentially years of missed payments, simply because we decide that strict compliance with the regulations is required.”[45] Nevertheless, the court opined that “[t]he payments would not exactly be ‘forgiven.’”[46] Rather, the court said, forgiving the payments would just decrease “the extent of personal liability resulting in a possible deficiency judgment.”[47] The court did not appear to have considered the possibility that not all foreclosure sales result in deficiencies. Nor did it explain why wiping away five to six figures of potential financial liability somehow makes the result of its ruling less unjust. In other words, the court accepted that its decision would produce an unjust result, but it purported to help lenders avoid the decision’s inequitable consequences by creating an avenue for them to forgive multiple thousands of dollars of debt and restart their collection efforts after several years of contested litigation.
Third District’s Denton Opinion
The Second District’s Olivera opinion relied heavily on Bankers Life v. Denton,[48] a 1983 decision from Illinois’s Third District.[49] In Denton, the Third District considered whether borrowers could raise a lender’s failure to comply with HUD regulations — including the face-to-face requirement — as affirmative defenses to a foreclosure. It held that they could.[50]
The court acknowledged that HUD regulations imposed a penalty on lenders who refused or failed to comply with HUD regulations but since that penalty did not prohibit lenders from foreclosing delinquent mortgage loans, the court decided that it did “not believe this to be an adequate remedy for the individual mortgagor.”[51] Accordingly, the court held that borrowers could raise HUD non-compliance as an affirmative defense in a mortgage foreclosure, because “HUD’s withdrawal of a mortgagee’s approval to participate in the mortgage insurance program after repeated violations of the servicing requirements is a useless remedy for the individual faced with the immediate problem of a foreclosure action.”[52]
Notably, the Denton court never held that HUD regulations mandated strict as opposed to substantial compliance, and it never discussed how courts should apply its ruling to the three-month window for the face-to-face meeting requirement. To the contrary, the court specifically described foreclosure actions where the lender failed to comply with HUD regulations as actions “which could possibly be avoided by . . . further efforts to arrange a revised payment plan.”[53] In other words, the Denton court appears to have assumed the parties could participate in “further efforts” at loss mitigation after the lender’s non-compliance, which stands in sharp contrast to Olivera’s ruling requiring lenders who miss the three-month window for face-to-face meetings to forgive substantial sums of principal and interest instead. Nevertheless, the Second District relied on Denton to impose a new strict compliance standard for HUD regulations.
The Illinois Supreme Court on HUD Regulations
Importantly, both Olivera and Denton may conflict with earlier Illinois Supreme Court authority explaining how Illinois courts must apply HUD regulations governing FHA-insured mortgage loans.[54] Notably, neither the Second District in Olivera nor the Third District in Denton recognized or discussed the Illinois Supreme Court’s binding analysis in La Throp v. Bell Federal Savings & Loan on the issue.
In La Throp, borrowers under FHA-insured mortgage loans brought a class action lawsuit against lenders alleging that HUD regulations required lenders to hold escrow funds in trust for borrowers and to pay borrowers any interest accrued on those funds. The Illinois Supreme Court rejected the borrowers’ allegations, noting in part that HUD regulations govern “the relationship between the mortgagee and FHA, rather than the relationship between the mortgagee and the mortgagor.”[55] Accordingly, the court held that “in an action between a mortgagor and mortgagee (not between the mortgagee and FHA), where the mortgage contract does not specifically incorporate the FHA regulations or expressly indicate agreement thereto, such regulations are not determinative of the content of the contract created between the parties.”[56]
In the face-to-face meeting situation, the mortgage contract does not specifically incorporate the applicable regulation or expressly indicate agreement thereto, as La Throp requires. Rather, the loan documents prohibit acceleration or foreclosure “if not permitted” by HUD regulations. As the New York Supreme Court recognized in McMullin, the question then becomes not whether the lender timely completed the face-to-face meeting requirements, but whether the HUD regulations at issue would preclude foreclosure if it did not. As discussed above, the court in McMullin applied standard principles of New York contract law to conclude that failing to strictly comply with the face-to-face meeting requirements would not preclude foreclosure. Illinois courts recognize the same standard principles of contract law.[57]
Constructive Conditions of Exchange Versus Conditions Precedent
Like in New York, Illinois courts have distinguished between constructive conditions and conditions precedent. Illinois courts “define a condition precedent as one which must be performed either before a contract becomes effective or which is to be performed by one party to an existing contract before the other party is obligated to perform.”[58] “Distinctly different, although analogous to the concept of a condition, are constructive conditions of exchange,” which “play an integral role in assuring the parties to a bilateral contract that they will receive the performance that they have been promised.”[59] Illinois courts typically apply the concept of constructive conditions of exchange “when one party seeks to justify its own refusal to perform on the ground that the other party has committed a breach of contract.”[60]
HUD regulations incorporated into an FHA-insured mortgage more closely align with constructive conditions of exchange than with conditions precedent. In the typical mortgage relationship, the borrower receives a loan of several hundred thousand dollars to purchase a home the borrower could not otherwise afford, which the lender provides in exchange for the borrower’s promise to pay the money back as outlined in the agreement. In the face-to-face meeting situation, the lender has already given the borrower the hundreds of thousands of dollars, and the borrower has stopped making payments as outlined in the agreement. When the lender then files a foreclosure action, the borrower seeks to avoid their obligation to repay the money based on the lender’s failure to conduct a face-to-face meeting before the borrower missed three full monthly payments. It is difficult to imagine a better example of “one party seek[ing] to justify its own refusal to perform on the ground that the other party has committed a breach of contract.”
Notably, the appellate district court that decided Olivera recognized the substantial performance doctrine in the context of constructive conditions of exchange.[61] In MXL Industries v.Mulder, a tenant entered into a five-year commercial lease with an option to terminate the lease following specific procedures. When the tenant tried to terminate the lease, the lender refused, and the tenant filed a declaratory judgment action asking the court to nullify the lease. The Second District discussed the substantial performance doctrine as it relates to constructive conditions of exchange in detail, but it ultimately followed other Illinois courts that had imposed a strict compliance standard on lease termination options.[62]
However, the option to terminate a lease differs from the face-to-face meeting situation in at least one important and relevant way: an option to terminate a lease allows one party to unilaterally cancel the contract. It makes intuitive sense that a court would require a party seeking to avoid its agreed contractual obligations without the other side’s consent to strictly comply with the contractual provision allowing it to unilaterally cancel the contract. In contrast, the lender in the typical face-to-face meeting situation has already met its obligations under the mortgage contract by loaning the borrower the hundreds of thousands of dollars the borrower needed to purchase a home. The borrower — not the lender — has breached the contract by failing to repay the money as agreed. Requiring the lender, who has already performed to the tune of several hundred thousand dollars, to strictly comply with the face-to-face meeting requirements allows the borrower — not the lender — to unilaterally avoid its agreed contractual obligations.
Relatedly, Illinois courts strictly construe “express conditions precedent” in the contract.[63] For FHA-insured mortgages, it is important to distinguish what exactly the express condition precedent is that courts must strictly construe. Under the mortgage, the lender may accelerate and foreclose “except as limited by regulations issued by [HUD].” The mortgage “does not authorize acceleration or foreclosure if not permitted by regulations of [HUD].” Thus, strictly construing the condition precedent at issue only precludes acceleration and foreclosure if prohibited by HUD regulations. HUD’s own interpretation published in the Federal Register specifies that it only intended for regulations that “specifically state prerequisites to acceleration or foreclosure” to prevent acceleration or foreclosure.[64] HUD’s face-to-face meeting requirement does not specifically state that it is a prerequisite to foreclosure,[65] meaning that strictly construing the mortgage contract’s express condition precedent should not preclude foreclosure.
Applying HUD Regulations with the Force and Effect of Law
Notably, some Illinois courts treat HUD’s regulations as having “the force and effect of law” independent of the parties’ mortgage contract,[66] despite the Illinois Supreme Court’s unambiguous ruling that “where the mortgage contract does not specifically incorporate the FHA regulations or expressly indicate agreement thereto, such regulations are not determinative of the content of the contract created between the parties.”[67] Nevertheless, the result should remain the same. Illinois courts “construe administrative rules and regulations under the same principles that govern the construction of statutes,”[68] and their “primary objective is to ascertain and give effect to the drafters’ intent.”[69] Importantly, they “may not depart from the plain language of a regulation by reading into it exceptions, limitations, or conditions that the agency did not express.”[70] Yet this is exactly what the Second District did in Olivera.
Nothing in the plain language of the relevant HUD regulations suggests that the drafters intended to forever bar lenders from foreclosing if they failed to strictly comply with the regulations, or that they intended to require lenders to forgive substantial sums of principal and interest as punishment for any failure to comply with a regulation. To the contrary, Section 203.500 specifies HUD’s intent “that no mortgagee shall commence foreclosure . . . until the requirements of [Sections 203.500 to 203.681] have been followed.”[71] Similarly, Section 203.606 requires that “[b]efore initiating forecloure, the mortgagee must ensure that all servicing requirements of [Sections 203.500 to 203.681] have been met.”[72] By precluding foreclosure “until” the lender follows the regulatory requirements and requiring compliance “[b]efore initiating foreclosure,” the plain language of these sections expressly anticipates allowing the lender to take future action to bring itself into compliance.
Importantly, if HUD had intended to prohibit lenders from foreclosing or to force lenders to forgive substantial amounts of debt for servicing errors, it could have done so.[73] HUD could have drafted Section 203.500 to read: “The mortgagee shall not commence foreclosure unless the requirements of [Sections 203.500 to 203.681] have been met.” It could have drafted Section 203.606(a) to read: “The mortgagee cannot initiate foreclosure if all servicing requirements of [Sections 203.500 to 203.681] have not been met.” It did not. Instead, HUD used different language that specifically contemplated the possibility of future action to correct alleged noncompliance. HUD presumably chose this language for a reason; the agency’s chosen words should matter.
Moreover, HUD itself confirmed in its Notice of Policy published in the Federal Register that only “some regulations [ ] exist which limit a lender’s rights to foreclose,” noting that the language required in its form mortgage “does not incorporate all of HUD’s servicing requirements into the mortgage.”[74] Rather, HUD explained, the language “simply prevents acceleration and foreclosure on the basis of the mortgage language when foreclosure would not be permitted by HUD regulations.”[75] HUD continued: “If a mortgagee has violated parts of the servicing regulations which do not specifically state prerequisites to acceleration or foreclosure, [ ] the reference to regulations in the mortgage would not be applicable.”[76] In other words, unless the regulation at issue specifically states it is a prerequisite to acceleration or foreclosure, then a lender’s failure to comply does not bar foreclosure.
The regulations creating HUD’s face-to-face meeting requirements do not specifically state prerequisites to acceleration or foreclosure, as required for a lender’s failure to comply to bar foreclosure.[77] To illustrate what constitutes a specific prerequisite to acceleration or foreclosure, HUD highlighted the language from Section 203.606 that “specifically prohibits a mortgagee from foreclosing unless three full monthly payments due on the mortgage are unpaid.”[78] This language reads: “The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid.”[79] Section 203.604 — which creates HUD’s face-to-face meeting requirements — has no corresponding prohibition against foreclosure or acceleration.[80]
By its express terms, Section 203.604 creates a requirement that lenders conduct a face-to-face interview or make reasonable efforts to arrange such an interview, unless specified circumstances exist to excuse the requirement.[81] The section outlines the time that the lender should conduct or make a reasonable effort to arrange the interview, but it nowhere prohibits the lender from foreclosing if the lender fails to meet the timeline. In fact, under its express terms, the section does not even prohibit the lender from foreclosing if the lender fails to conduct or attempt to arrange the interview at all. According to HUD’s own explanation, a lender’s failure to comply with Section 203.604’s face-to-face meeting requirement therefore does not limit foreclosure or acceleration under the terms of the mortgage.[82]
As with Sections 203.500 and 203.606, HUD could have used language that made compliance with Section 203.604 a prerequisite to acceleration and foreclosure. For example, it could have written the regulation to read: “The mortgagee shall not commence foreclosure for a monetary default unless it has a face-to-face interview with the mortgagor, or makes a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.” It did not. Again, HUD’s chosen words should matter.
Importantly, applying HUD’s Notice of Policy to preclude foreclosure for noncompliance with a regulation only where the regulation specifically states that it is a prerequisite to foreclosure would conform to the rules governing other types of mortgage foreclosures. As already discussed, it would preclude foreclosure until at least three full monthly installments become unpaid, which tracks with CFPB regulations governing other types of mortgage foreclosures.[83] It would also preclude foreclosure where the lender failed to “notify the mortgagor . . . that the mortgagor is in default and that the mortgagee intends to foreclose unless the mortgagor cures the default,”[84] which would track with the standard notice of default requirements in non-FHA-insured mortgages.
In other words, interpreting the HUD-mandated language in FHA-insured mortgages in accordance with HUD’s own Notice of Policy provides borrowers with the same protections they would receive under non-FHA mortgages. Illinois courts should not question HUD’s policy decision to treat the mortgage language in this way, and they should not read additional requirements or conditions into the regulations that HUD did not express.[85]
The Housing Act’s Purpose
The Second District in Olivera did not address the regulations’ plain language, or HUD’s specific explanation about which regulations it intended to bar foreclosure under the mortgage. Instead, the court focused on its own misunderstanding of the Housing Act’s purpose.
Extensively quoting the Third District’s opinion in Denton, the Second District’s Olivera ruling recites the Housing Act’s purpose “to assist in providing a decent home and a suitable living environment for every American family.”[86] According to Olivera and Denton, HUD’s decision to limit the penalty for a lender’s noncompliance to levying a fine against the lender or withdrawing its status as a HUD-approved lender does not sufficiently protect “the individual faced with the immediate problem of the foreclosure action.”[87] To correct HUD’s perceived oversight, the court in Olivera improperly departed from the plain language of HUD’s regulations to impose a strict compliance standard on the face-to-face meeting requirement.
Yet both Olivera and Denton misunderstand the Housing Act’s legislative purposes. As discussed above, the Housing Act created the FHA during the Great Depression to achieve “the realization as soon as feasible of the goal of a decent home and a suitable living environment for every American family.”[88] Congress’s purpose in pursuing policies to realize this goal was to “contribut[e] to the development and redevelopment of communities and to the advancement of the growth, wealth, and security of the Nation.”[89] The Olivera and Denton courts mistakenly refocus Congress’s purpose away from community development and national growth to individual homeowners, and they seek to equip individual homeowners with extra tools to ensure a lender’s compliance with HUD regulations beyond those HUD itself chose to create.
Put differently, Congress designed the Housing Act to create programs that would help communities grow so “every American family” could have “a decent home and a suitable living environment.” This included programs that would encourage lenders to make financially risky mortgage loans to borrowers who may not otherwise qualify for the financing needed to purchase a home. Interpreting HUD regulations to effectively require lenders to choose between forgiving substantial amounts of principal and interest or losing the ability to promptly foreclose will discourage — not encourage — lenders from making the intended loans. In any event, even if the Olivera and Denton courts disagree with HUD about the appropriate penalties for noncompliance with its regulations, it is not their place to supplant their opinions for HUD’s.[90] Congress gave the responsibility for administering the Housing Act to HUD, not to the Illinois Appellate Court.[91]
Impractical and Absurd Results
Similarly, Illinois courts interpret administrative regulations under the same rules applied to statutes,[92] and the Illinois Supreme Court “has long held that statutes should be construed in such a way as to avoid impractical or absurd results.”[93] Applying Olivera to real-world scenarios leads to just such impractical and absurd results.
Consider the not-uncommon scenario where a lender acquires its interest in the loan after three full monthly installments have already become unpaid under the regulation. Examining an entire hypothetical foreclosure step-by-step, starting from the beginning, helps illustrate the problem. Let’s say that Borrower takes out a $250,000 mortgage loan from Bank with a 30-year term on July 1, 2012. The loan has an annual interest rate of 2.5%. Borrower’s first payment is due August 1, 2012, and the loan matures on July 1, 2042. An amortization schedule showing the monthly amounts due on the loan is included as Appendix No. 1.
Borrower timely pays on the loan for the first five years, but she defaults on her payment due July 1, 2017. After the first missed payment, Bank’s loan servicer sends Borrower a letter inviting her to apply for loss mitigation and providing her contact information to call to schedule a face-to-face meeting. Bank’s servicer sends one copy by regular mail and another copy by certified mail. It also conducts a field visit to the property, where an agent hand-delivers a copy of the letter to Borrower and offers to go over her loss mitigation options with her in person.
Borrower applies for a loan modification following the instructions in the letter, and the parties spend four months exploring Borrower’s loss mitigation options, with a substantial portion of that time devoted to Borrower gathering and sending in the necessary documents. In late October 2017, Bank approves Borrower for a trial loan modification requiring three timely payments before it will consider Borrower for a permanent modification. The offer sets trial payments to begin November 1, 2017. Borrower makes the November and December 2017 trial payments, but she misses the January 2018 payment, and she makes no more payments on the loan.
During the trial period, Bank sells the loan to Trust, who transfers servicing of the loan to a new servicer. At the end of January 2018, Borrower submits a second loss mitigation application to the new servicer, and she sends all the necessary documents by mid-February 2018. Trust’s servicer determines that Borrower does not qualify for a loan modification and invites her to consider other loss mitigation options such as a deed-in-lieu of foreclosure or short sale. Borrower appeals the loan modification denial, which Trust’s servicer timely reviews and denies.
On May 1, 2018, after nine months of cumulative loss mitigation efforts, Trust’s servicer refers Borrower’s account to foreclosure. It sends Borrower a notice of default advising her of the amount of her delinquency and notifying her that unless she pays the delinquency within thirty days, Trust may accelerate the balance of her mortgage loan and foreclose. After the notice of default’s thirty-day period expires, Trust’s servicer directs its foreclosure attorneys to begin taking the necessary steps to file a foreclosure complaint under Illinois law. The attorneys file the complaint on August 1, 2018, and they serve Borrower on August 15, 2018. Borrower does not answer the complaint, and after sixty days pass from the date of service, Trust moves for a default judgment on October 15, 2018, which the court schedules for hearing on November 15, 2018. At the hearing, an attorney appears for Borrower and requests thirty days to respond to the complaint, which the court allows.
On December 15, 2018, Borrower moves to dismiss the complaint, alleging that Trust lacks standing despite having attached a copy of the blank-indorsed note to its complaint. She obtains a hearing for her motion to dismiss on January 15, 2019. The trial court denies the borrower’s motion to dismiss without briefing, and it gives her another thirty days to answer the complaint. On February 15, 2019, Borrower files her answer and affirmative defenses, alleging for the first time that Trust failed to comply with HUD’s face-to-face meeting requirements. On March 1, 2019, Trust files its reply to the affirmative defenses.
On March 15, 2019, Borrower serves written discovery on Trust. After Trust responds to the written discovery, Borrower sends a notice to depose Trust’s corporate representative. She schedules the deposition for June 1, 2019. Shortly after the deposition, on June 8, 2019, Trust moves for summary judgment. Trust provides copies of the face-to-face letter Bank’s servicer initially sent to Borrower along with the account notes from Bank’s servicer indicating that it sent letters by certified and regular mail. It also provides the account notes from Bank’s servicer describing the field visit. The court sets the motion for presentment on July 1, 2019.
At the hearing, the court enters a briefing schedule giving Borrower twenty-eight days to respond and giving Trust fourteen days to reply. It sets a hearing on the motion for September 1, 2019. Borrower responds by alleging that she only received a copy of the face-to-face letter by regular mail and not certified mail, and she attaches a copy of the letter she received by regular mail to her response. On September 1, 2019, the court enters summary judgment in Trust’s favor and grants Trust’s judgment of foreclosure giving Borrower three months to redeem.
Borrower fails to redeem, and Trust schedules a foreclosure sale for December 15, 2019. After the sale, Trust moves to approve the sale, and it receives a hearing date for its motion on January 7, 2020. The court enters a briefing schedule on the motion giving Borrower twenty-eight days to respond and giving Trust fourteen days to reply. It sets a hearing date for March 1, 2020. Borrower does not file a response to the motion, and on March 1, 2020, the court enters the order approving sale.
On March 30, 2020, Borrower files a notice of appeal challenging the trial court’s ruling. After briefing and oral arguments, the appellate court finds that the question of whether Bank’s servicer sent the letter by certified mail constitutes a material issue of fact. On January 15, 2021, over three and a half years after Borrower’s initial payment default, the appellate court reverses the trial court’s judgment and remands for further proceedings.
Applying Olivera to this hardly unrealistic timeline, Trust would face a decision after the appellate court’s ruling.[94] It could continue to litigate whether Bank’s servicer sent the face-to-face letter by certified mail, or it could cut its losses and forgive three and a half years of missed payments — amounting to $42,475.50 of combined principal and interest[95] — to bring the loan current. Importantly, Trust must base this decision not on a definitive ruling that Bank’s servicer failed to comply, but instead on the chance that Trust may not be able to prove Bank’s servicer complied — a prospect that only first arose as a realistic possibility over three years after Borrower’s first payment default.
The Olivera court agreed “to an extent” that this result, i.e. “requir[ing] a lender to forgive potentially years of missed payments,” was “unjust.”[96] Nevertheless, the court pushed forward, deeming the openly recognized injustice of its holding mitigated because it “simply incentivizes lenders to follow the rules or quickly cure any violation thereof.”[97] So when should either Bank or Trust in this hypothetical have “quickly cured” the alleged possible violation of HUD’s face-to-face meeting rules by bringing the loan current under Olivera?
Should Bank have brought the loan current after its servicer fully complied with the regulation, while the servicer was negotiating a loan modification with Borrower in response to its HUD face-to-face letter? Should Bank have brought the loan current after it approved Borrower for a trial loan modification? Should Trust have brought the loan current when Borrower defaulted on the trial loan modification, or after it determined Borrower could not qualify for a new modification? Should Trust have brought the loan current after it filed its foreclosure, or after Borrower moved to dismiss the foreclosure complaint on grounds the trial court rejected without briefing? Or should Trust have brought the loan current after Borrower filed her affirmative defenses, or when the trial court ruled in Trust’s favor on the face-to-face issue, or after the trial court confirmed the foreclosure sale, or after the parties finished briefing the appeal, or after the appellate court conducted oral arguments?
Of course, it would not have made sense for either Bank or Trust to “quickly cure” its alleged violation and bring the loan current at any of those points. Bank never had any indication that its servicer failed to comply with HUD’s face-to-face requirement. Indeed, its servicer did comply. The only question is whether Trust — who later purchased the loan — can prove Bank’s servicer complied. Moreover, the first indication Trust had that a court may not accept the prior servicer’s notes alone as proof of certified mailing occurred when the appellate court reversed the trial court’s summary judgment order, and even then Trust still had no definitive reason to believe Bank’s servicer failed to comply with HUD regulations, or even that Trust necessarily could not ultimately prove full compliance. The problem facing Trust is that it now risks having to forgive more principal and interest for every month that goes by while it waits to see what evidence the trial court, and then the appellate court, will accept as proof of compliance.
Yet over three and a half years passed between Borrower’s first payment default and the appellate court’s ruling. Bringing the loan current in accordance with Olivera’s new strict compliance standard would involve forgiving over $40,000 in principal and interest. Trust must therefore decide whether to risk having to forgive even more principal and interest for the possible benefit of not having to forgive any principal and interest at all if it can prove the prior servicer’s compliance — all despite Bank and Trust’s extensive efforts to negotiate a loan modification in good faith, and despite Trust moving as quickly as reasonably possible to finish the foreclosure once it became clear that continued loss mitigation efforts would not bear fruit. Illinois courts should not interpret HUD regulations to compel such an impractical and absurd result.[98]
Adverse and Unintended Consequences for Borrowers
Importantly, applying the Olivera opinion to real-world fact patterns may also cause adverse and unintended consequences for borrowers. Initially, forgiving over $40,000 in principal and interest in accordance with Olivera could create tax consequences for borrowers that the Olivera court may not have considered.[99] As other courts have recognized, Congress created the FHA-insured mortgage loan program to help low to moderate income borrowers obtain financing from reputable lenders.[100] Potentially imputing a significant amount of additional taxable income on low to moderate income borrowers could significantly affect their tax liability, possibly cutting into — or altogether wiping out — tax refunds that many families rely on as part of their yearly income.
The lender could avoid this negative result for borrowers by instead moving up the next payment’s due date, rather than forgiving missed payments outright. Consider Appendix No. 2’s modified amortization schedule for the hypothetical above. In the hypothetical, Borrower first defaulted on her July 1, 2017, payment. Instead of forgiving over $40,000 in principal and interest, Trust could alternatively move the due date for that payment up to January 1, 2021,[101] which would return Borrower to the position of not having missed three full monthly installments without resulting in a huge potential increase in Borrower’s taxable income. However, that would then create either a balloon payment of $39,684.87 when the loan matured after Borrower’s July 1, 2042, payment,[102] or Trust would have to reamortize and increase the remaining payments to allow Borrower to pay the full balance by the maturity date. The lender likely could not take either of these actions without the borrower’s agreement.
Notably, the parties’ mortgage contract does not expressly contemplate any of these scenarios, including Olivera’s requirement that lenders forgive monthly payments, which only highlights the problems with applying Olivera to real-world fact patterns. The ruling effectively forces the parties to rewrite their contractual obligations to adjust for the court’s desire to mandate strict compliance with HUD regulations that are not expressly included in the contracts themselves. And this is all despite HUD having specified that it never intended for courts to treat regulations that do not specifically state they are a prerequisite to acceleration or foreclosure, such as the face-to-face meeting requirement, as a bar to foreclosure.[103]
Alternatively, the lender could also choose not to forgive significant portions of principal and interest and simply leave the entire loan balance as a mortgage lien against the property without foreclosing. At most, reading the mortgage contract together with HUD’s regulations only prevents the lender from accelerating the loan balance and foreclosing for payment defaults. The lender’s failure to strictly comply with HUD’s face-to-face meeting requirements would not invalidate the mortgage against the property, or prevent foreclosure for non-payment defaults.[104] Rather, the mortgage would remain, continuing to accrue interest and late charges (among other fees), and preventing the borrower from selling the property.[105] In other words, to purportedly protect borrowers “faced with the immediate problem of” foreclosure, Olivera creates a scenario where borrowers could instead face the long-term problem of being stuck in a house they cannot sell, encumbered by ever-increasing debt they cannot repay or refinance.
Relatedly, Olivera’s impact on the borrower’s ability to sell the property also runs counter to Illinois courts’ longstanding recognition that “law and public policy favor the free alienability and transferability of property.”[106] The Second District in other contexts has described analytical approaches that leave the lender “without any remedy unless and until the property was sold or transferred” as an “unreasonable and unjust result” that would “reward” the borrower for “defaulting every month” for an extended period of time.[107] Thus, when applied to real-world fact patterns, Olivera creates an unreasonable and unjust result for lenders that rewards borrowers in the short term for continuing to ignore their payment obligations while harming borrowers in the long term by locking them into property ownership without any ability to sell the property, build equity in the property, or otherwise enjoy the attendant financial benefits.
Further, Illinois courts treat mortgage loans as installment contracts.[108] “The general rule is that where a money obligation is payable in installments, a separate cause of action arises on each installment and the statute of limitations begins to run against each installment as it becomes due.”[109] Also: “the party entitled to payments may bring separate actions on each installment as it becomes due or wait until several installments are due and then sue for all such installments in one cause of action.”[110] Thus, even if HUD’s regulations prevent acceleration and foreclosure under Olivera’s strict compliance standard, the lender could obtain separate judgments against the borrower for each missed installment payment or sue for multiple missed installments at once.
In fact, the lender in the hypothetical above could presumably dismiss its foreclosure after the appellate court’s adverse ruling, accept Olivera’s premise that its alleged failure to comply with the regulation prevented it from properly accelerating the loan, sue on three and a half years of missed unaccelerated installment payments, and then record and foreclose a judgment lien for its judgment on those missed payments.[111] At that point, the lender’s mortgage would take priority over its separate judgment lien, and the lender could recover the full amount due under its senior mortgage from the proceeds of its judgment lien foreclosure sale.[112]
Simply put, Olivera does not protect borrowers “faced with the immediate problem of the foreclosure action,” as the court seems to have wanted to do.[113] Instead, the opinion subjects borrowers to a host of unforeseen adverse and unintended consequences with unpredictable outcomes, from increased tax burdens to defending alternate legal actions. Other appellate districts in Illinois should not follow Olivera down this path.
Conclusion
Olivera creates a new strict compliance standard for interpreting HUD’s face-to-face meeting requirement by reading non-existent terms into the mortgage loan documents. Yet HUD itself specified that it did not intend for regulations not expressly stated as prerequisites for acceleration to bar foreclosure, and the Second District’s contrary ruling creates impractical and absurd results that could ultimately harm borrowers. Illinois practitioners should challenge Olivera as needed to prevent it from becoming commonly accepted practice, and other Illinois courts should decline to follow the opinion’s ill-considered analysis.
The opinions expressed in this article are solely those of the author, and they should not be attributed to any other person or entity. Nothing contained in this article represents the official or unofficial position or opinion of any of the author’s current or former employers or clients. The article is not intended as and should not be construed as legal advice. ↑
See, e.g., Olivera, 2021 IL App (2d) 190462, ⁋ 34 (citing U.S. Bank v. McMullin, 47 N.Y.S.3d 882, 890 (Sup. Ct. 2017); Wash. Mut. Bank v. Mahaffey, 2003-Ohio-4422, para. 24). ↑
See, e.g., 24 C.F.R. § 203.606(a) (“The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid . . . [P]rior to initiating any action required by law to foreclose the mortgage, the mortgagee shall notify the mortgagor . . . that the mortgagor is in default and the mortgagee intends to foreclose unless the mortgagor cures the default.”). ↑
The Second District itself rightly acknowledged in Olivera that “plaintiff is generally correct that courts in other jurisdictions have held, in essence, that strict compliance with section 203.604’s three-month window is not required and that, as long as the requirements are reasonably performed before the foreclosure is filed, common sense dictates that the regulations should not be construed to command an impossibility.” 2021 IL App (2d) 190462, ¶ 34. See also, e.g., Kuhnsman v. Wells Fargo, 311 So. 3d 980, 985 (Fla. App. Ct. 2020) (“The [borrowers] urge us to conclude that [the lender] failed to strictly comply with the face-to-face interview requirement. They urge too much.”); U.S. Bank v. Cavanaugh, 2018-Ohio-5365, ¶ 29 (“[R]ead together, [Sections 203.604(b) and 203.606(a)] mandate a face-to-face meeting, or a reasonable attempt to arrange such a meeting, before a lender commences foreclosure proceedings.”); Grimaldi v. U.S. Bank, C.A. No. 16-519, 2018 WL 1997277 *3 (D. R.I. Apr. 27, 2018) (unpublished) (lenders “met their contractual obligation to comply with 24 C.F.R. § 203.604” where they sent three letters to the property and made a field visit five years after the default at issue); Rourk v. Bank of America, No. 12-cv-42, 2013 U.S. Dist. LEXIS 147373 *14-*15 (M.D. Ga. Oct. 11, 2013) (unpublished) (“[T]he Court concludes that [the lender] substantially complied with the requirement that it make a reasonable effort to arrange a face-to-face meeting with [the borrower].”). ↑
Olivera, 2021 IL App (2d) 190462, ¶¶ 35-36 (“Illinois courts, starting with Denton, have held that failure to comply with HUD’s servicing regulations is a defense to foreclosure.”). ↑
See Olivera, 2021 IL App (2d) 190462, ¶ 35 (“The failure to comply with [HUD’s] servicing regulations which are mandatory and have the force and effect of law can be raised in a foreclosure proceeding as an affirmative defense.”) (quoting Denton, 120 Ill. App. 3d at 579) (cleaned up). ↑
See Fish v. Kobach, 840 F.3d 710, 740 (8th Cir. 2016) (“When Congress knows how to achieve a specific statutory effect, its failure to do so evinces an intent not to do so.”) (emphasis in original). ↑
54 F.R. 27596. Even to the extent that the Notice of Policy acknowledged HUD’s “general position recited in 24 CFR 203.500, that whether a mortgagee’s refusal or failure to comply with servicing regulations is a legal defense is a matter to be determined by the courts,” the point remains that HUD plainly did not intend to incorporate regulations that did not specifically prohibit foreclosure as a bar to foreclosing, and the relevant considerations under Illinois law are (1) whether the mortgage contract expressly incorporates the prohibition; and (2) whether HUD intended the regulation to bar foreclosure. See, e.g., Cruz, 2019 IL App (1st) 182678, ¶ 34; Perez, 384 Ill. App. 3d at 772. Moreover, Section 203.500 no longer includes the referenced language recited in the Notice of Policy in any event. See 24 C.F.R. § 203.500. ↑
12 C.F.R. § 1024.41(f)(1)(i) (prohibiting foreclosure until “[a] borrower’s mortgage loan obligation is more than 120 days delinquent). ↑
See, e.g., Country Mut. Ins. v. Livorsi Marine, 222 Ill. 2d 303, 319 (2006) (“Balancing dueling policy concerns is a more appropriate role for the legislature than this court.”). ↑
Nowak v. Country Club Hills, 2011 IL 111838, ¶ 21. ↑
The Second District previously left open whether “the use of a private carrier [as opposed to certified U.S. mail] can never satisfy section 203.604(d),” and it questioned whether a tracking label showing that the lender prepared the letter for delivery with tracking information could sufficiently demonstrate strict compliance with the regulation. See U.S. Bank v. Hernandez, 2017 IL App (2d) 160850, ¶¶ 32-33. ↑
As a general rule, forgiven debt can qualify as taxable income, although some temporary exceptions may currently apply. See I.R.S. Pub. 4681 (Jan. 26, 2022), available atirs.gov/pub/irs-pdf/p4681.pdf. This article does not address Olivera’s implications under tax law other than to note that its ruling could result in unacknowledged consequences for borrowers now and in the future. ↑
Under Illinois statutory law, the mortgage would remain a lien until at least twenty years from the borrower’s last payment, with the option for the lender to extend the lien for an additional twenty years at least once. See 735 ILCS 5/13-116. The standard HUD-approved mortgage form only adopts the relevant regulatory language precluding acceleration and foreclosure in the case of payment defaults. It should allow foreclosure in other situations, including once the loan reaches maturity under its own terms. ↑
The standard HUD-approved mortgage form allows foreclosure in most situations where the borrower sells or transfers its interest in the property. ↑
Martin v. Prairie Rod and Gun Club, 39 Ill. App. 3d 33, 36 (3d Dist. 1976). ↑
Bank of N.Y. Mellon v. Dubrovay, 2021 IL App (2d) 190540, ¶ 38. ↑
See, e.g., Wilmington Savings Fund v. Barrera, 2020 IL App (2d) 190883, ¶ 19; Deutche Bank v. Sigler, 2020 IL App (1st) 191006, ¶ 42. ↑
Illinois courts appear to disagree about how to treat acceleration after a voluntary dismissal in the context of the state’s single refiling rule. Compare, e.g., Dubrovay, 2021 IL App (2d) 190540, ¶ 28 (lender could recover for installment payments that came due after voluntary dismissal of prior foreclosure) and McHenry Savings Bank v. Moy, 2021 IL App (2d) 100099, ¶ 37 (lender could recover for installment payments that came due after an adverse judgment and a dismissal with prejudice in respective prior foreclosures) with Deutsche Bank v. Sigler, 2020 IL app (1st) 191006, ¶ 54 (single refiling rule barred subsequent filing based on different default after more than one voluntary dismissal). However, Olivera’s underlying premise relies on the mortgage contract precluding acceleration if not permitted by HUD regulations. Accordingly, accepting Olivera’s ruling necessarily means that the lender could not have effected acceleration, which should thereby allow it to pursue all of the borrower’s missed installment payments. ↑
See, e.g., 735 ILCS 5/12-101 (judgment liens “may be foreclosed . . . in the same manner as a mortgage of real property”); 735 ILCS 5/15-1106(e) (“General principles of law and equity, such as those relating to . . . priority . . . supplement [the Illinois Mortgage Foreclosure Law] unless displaced by a particular provision of it.”). ↑
The COVID-19 crisis continues to cause unprecedented disruptions and damage to the world’s economy and business relationships. At the same time, the crisis has also considerably slowed the resolution of pending court cases and exacerbated the already significant backlog of cases in many courts. Even as U.S. courts re-open and resume in-person proceedings, delays due to the pandemic and prioritization of criminal cases have led to long wait times, especially for commercial litigation. One recent study found that on average across all federal circuits, there is a 13-month expected delay for commercial case resolutions.
Fortunately, there are faster routes to resolution once a dispute arises: parties can bypass court and submit their disputes to an alternative dispute resolution (ADR) process to resolve their disputes and return their focus to business more quickly. Parties can file a “submission agreement” with their preferred dispute resolution body, which allows the parties to submit their dispute to arbitration or mediation in order to take advantage of all the benefits that the ADR process has to offer. Submission agreements are a useful tool that all counsel should add to their toolbox.
BENEFITS OF USING ALTERNATIVE DISPUTE RESOLUTION PROCESSES
Parties can count on faster speed (and therefore lower costs) when using alternative dispute resolution to resolve their disputes. Speed to reaching a decision is often critical so that business planning can continue, and long-term projects can proceed uninterrupted. For example, the average duration for a “full-length” commercial arbitration case from commencement to award is 14.4 months, according to statistics from CPR Dispute Resolution, the ADR provider arm of the International Institute for Conflict Prevention and Resolution (CPR). Currently, the median time from filing to trial in a civil case in the U.S. District Court is 28.3 months—without taking into consideration the additional time an appeal may add to the process. In contrast, arbitration facilitates resolution on a faster track, with a shorter process and truncated deadlines. Moreover, most institutions provide an option for expedited arbitration proceedings, such as the CPR Fast Track Arbitration Rules, which contemplate a 90–180 day proceeding.
Speed and savings are not the only benefits of ADR. Party control of the process is one of the tenets of ADR, allowing the parties to craft their own process to fit their needs. For example, parties may select knowledgeable neutrals with subject-matter expertise, rather than judges or juries without any experience in the subject. By using ADR, parties are afforded greater confidentiality and privacy for sensitive matters, such as proprietary business information, trade secrets, and other intellectual property. ADR offers the possibility of selecting a venue that is neutral to the parties and logistically convenient to both sides. Arbitration offers the certainty of resolution, as awards are generally final and binding (though parties may elect to add an appellate review). Finally, parties will find greater flexibility in ADR processes, which allows them to proceed on their own schedules, rather than a court’s, and provides the option to conduct hearings virtually.
WHAT YOU NEED TO KNOW ABOUT SUBMISSION AGREEMENTS
Parties often assume that, if they have not elected for arbitration or mediation in their business contracts before a dispute arises, they inevitably are left with litigation as their only option. This is not the case. Rather, parties can submit their dispute to ADR at any time after the point of dispute—they may do so when the dispute arises, while the parties are engaged in negotiations toward resolution, or even if the dispute is already being actively litigated in court.
In the submission agreement, the parties agree to submit the specific dispute at issue to ADR. The process is rather straightforward—parties simply need to agree to an alternative process for resolving their dispute, whether it is arbitration, mediation, or a combination of both. Some ADR providers help the parties with this process by providing a simple form that may be filled out by the parties and submitted as a case filing. These forms solicit the basic necessary information to commence a matter, including the names of the parties, a brief statement of the dispute, and the requested location for the mediation or arbitration. In the form, parties can also choose the specific rules or procedures that should govern the resolution of the dispute. They can also specify the name of the neutral (mediator or arbitrator) that they wish to help resolve the dispute or the process by which the neutral should be selected. The form also provides the required language to submit parties to binding arbitration, if that is the choice of the parties.
Since ADR is a flexible and party-driven process, the simple form is not the only option available to the parties. They may also choose to draft a submission agreement that is more detailed. For parties wishing to draft a submission agreement, they have the benefit of using model clauses that provide standard language and cover various considerations in doing so. Most institutions provide sample language that parties can use in these circumstances. For example, parties can start with the following sample language, provided by CPR Dispute Resolution:
We, the undersigned parties, hereby agree to submit to arbitration in accordance with the International Institute for Conflict Prevention and Resolution (“CPR”) Rules for Administered Arbitration (the “Rules”) the following dispute:
[Describe briefly]
We further agree that we shall faithfully observe this agreement and the Rules and that we shall abide by and perform any award rendered by the arbitrator(s). The arbitration shall be governed by the Federal Arbitration Act, 9 U.S.C. §§ 1 et seq., and judgment upon the award rendered by the arbitrator(s) may be entered by any court having jurisdiction thereof. The place of arbitration shall be (city, state).
In this instance, the parties would incorporate the clause into a signed agreement, which can be filed with the ADR provider institution. Additionally, parties may choose to proceed with arbitration using specialized rules that might be more applicable to the dispute, such as proceeding under Fast-Track Arbitration Rules, International Arbitration Rules, or subject matter rules like Employment Arbitration Rules. Parties likewise may choose a different process altogether, such as Mediation, a Concurrent Arbitration-Mediation process, or Early Neutral Evaluation. Model clauses are available for all these scenarios from CPR; many other institutions may provide similar options as well. The most common routes for submission agreements include the following processes:
Mediation provides a non-binding process where parties resolve the dispute on terms that the parties agree upon themselves. There is only a resolution if all parties agree to one. The process can go very quickly, as parties can narrow their issues or settle the dispute in just one session.
Fast Track Arbitration asks an arbitrator or arbitrators to resolve the matter for the parties after hearing each party’s positions. Fast Track Arbitration is intended for parties that desire an accelerated, streamlined arbitration with truncated deadlines.
Concurrent Mediation-Arbitration provides parties the option to proceed with mediation and arbitration at the same time, maximizing the opportunity for a settlement informed by both of those proceedings.
Commercial Arbitration is intended for parties that desire a full-length arbitration proceeding, while still completing the process faster than under a court proceeding.
As with any ADR clause, the submission agreement can be further customized to include all the elements that the parties deem important. Because the dispute has already arisen, parties have the benefit of understanding the issues and are in a better position to tailor their process to suit their needs and interests. They should consider the number of arbitrators they wish to have deciding the dispute—noting that with three arbitrators, costs may increase by more than three times those with a single arbitrator. Parties may also wish to incorporate procedural elements into the submission agreement, including the scope of discovery for the proceeding, a procedure for the testimony of witnesses, or whether motions can be filed. Those looking for guidance in this area may consider looking to the Protocol on Disclosure of Documents & Presentation of Witnesses in Commercial Arbitration, offered by CPR, which can be used in disputes administered by any provider. Finally, parties should consider what kind of decision they want from the arbitrator—from a simple, unreasoned award, to a full-length reasoned award, to findings of fact and conclusions of law. Some parties may wish to see that the tribunal has carefully considered the evidence, arguments, and law and issued an objectively “correct” award, and more detailed awards also enable the parties to better understand the award. On the other hand, more detailed awards often take longer and cost the parties more money.
Parties wishing to participate in the ADR process have several options available to them, even when they do not have an ADR provision in their contract. Following the straightforward steps described herein—via a form submission or drafting a submission agreement using model clauses—parties may file their disputes with the ADR provider of their choice, even after a dispute arises. Armed with this knowledge, counsel can help their clients find faster routes to solve their disputes.
The Corporate Transparency Act of 2020 (the “CTA”) was enacted as part of the William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021.[1] At the core of the CTA are reporting requirements imposed on substantially every small business organized or registered to conduct business in the United States through any type of limited liability entity. Reporting companies will be required to submit identifying information regarding their owners and individuals who participate in the formation and domestic registration of those businesses. Implementation of the CTA is largely deferred. Its reporting requirements take effect on the date regulations prescribed by the Secretary of the Treasury become effective.[2] No indication has been given as to when final regulations may be issued, although the proposed regulations discussed later in this article suggest the guidance necessary for implementation is being assembled.
Who is required to report?
Domestic or foreign companies may be required to report under the CTA. Domestic entities subject to reporting requirements include corporations, limited liability companies, and any other entity “that is created by filing of a document with a secretary of state or any similar office under the law of a State or Indian tribe.”[3] Thus, domestic reporting companies will also include limited partnerships, limited liability partnerships, limited liability limited partnerships, business trusts, and any other entity offering limited liability to its owners by virtue of a State or Tribal charter. Foreign entities that have registered to do business by filing with a secretary of state or similar office of any State or tribal jurisdiction are subject to the same reporting requirements as domestic entities.
What companies are not subject to reporting requirements?
The scope and purpose of the CTA is best understood by recognizing the types of companies that are exempt from its reporting requirements. The proposed regulations identify more than 22 different types of exempt entities. The vast majority of these exempt entities are subject to state or federal supervision, such as companies that report to securities, investment, insurance, and banking regulators.[4] Exemptions are also extended to public companies issuing securities under § 12 of the Securities Exchange Act of 1934,[5] governmental authorities, venture-capital fund advisors, public utilities, pooled investment vehicles, tax exempt entities, and entities assisting tax exempt entities. Also exempt are “large operating companies,” defined as any entity that:
employs more than 20 full-time employees in the United States,
has an operating presence at a physical office in the United States, and
filed a federal income tax return or information return for the prior year reporting more than $5 million in gross receipts or sales, excluding gross receipts or sales outside the United States.[6]
In the case of an entity that reports as part of an affiliated group under a consolidated return, the $5 million threshold applies to the amount reported on the consolidated return for the entire group.[7] Thus, any privately-held, for-profit business operating through a limited liability entity in the United States will be subject to the reporting requirements of the CTA unless it satisfies the definition of a “large operating company” and or qualifies for another exemption.
Generally, existing entities get no relief and, as explained below, are subject to the same reporting requirements as newly formed entities. However, certain inactive entities are exempt from the reporting requirements of the CTA. Entities are considered “inactive” if such entities were in existence on or before January 1, 2020, and such entities:
are not engaged in active business,
are not owned by a foreign person (directly or indirectly, wholly or partially),
have not experienced any change of ownership in the preceding 12-month period,
have not sent or received any funds in an amount greater than $1,000 either directly or through any financial account in which the entity or any affiliate of the entity has an interest in the preceding 12-month period, and
do not otherwise hold any kind or type of assets (including an equity interest in any limited liability entity).[8]
What information about the company must be reported?
The CTA requires reporting companies to disclose:
the full name of the reporting company,
any trade name or “doing business as” name of the reporting company,
the business street address,
State or Tribal jurisdiction of formation (or, in the case of a foreign entity subject to CTA reporting, the State or Tribal jurisdiction in which the foreign company first registered), and
the taxpayer identification number (TIN) under which the reporting company reports to the Internal Revenue Service.[9]If the reporting company has not yet been issued a TIN, it may instead use the Dunn and Bradstreet Data Universal Numbering System Number of the reporting company or Legal Entity Identifier.[10]
Which individuals are subject to disclosure by the reporting company?
In addition to the information regarding the reporting company that must be disclosed under the CTA, the reporting company must also provide information regarding every individual who is a beneficial owner and every individual who is a company applicant. The proposed regulations define a beneficial owner as “any individual who, directly or indirectly, either exercises substantial control over such reporting company or owns or controls at least 25 percent of the ownership interests of such reporting company.”[11]
How is “substantial control” of a reporting company determined?
For purposes of defining a “beneficial owner,” substantial control over a reporting company is defined to include:
service as a senior officer of the reporting company,
authority over the appointment or removal of any senior officer or a majority or dominant minority of the members of the board of directors (or similar body),
direction, determination, or decision of, or substantial influence over, important matters affecting the reporting company as more specifically set forth in the proposed regulations, and
“[a]ny other form of substantial control over the reporting company.”[12]
The proposed regulations further clarify the circumstances in which an individual’s authority will be viewed as sufficiently substantial as to require reporting information regarding that individual. Regardless of office or title, substantial control over a reporting company includes the ability to direct, determine, decide, or exercise substantial influence over important matters affecting the reporting company. Such matters include
the nature, scope, or attributes of the business conducted by the reporting company, including mortgage, lease, sale, or other transfers of its principal assets, reorganization, dissolution, or merger of the reporting company,
major expenditures or incurring significant debt,
issuance of any equity interests by the reporting company,
approval of the operating budget of the reporting company,
selection or termination of business lines or geographic areas in which the reporting company does business,
approval of compensation schemes,
adoption of incentive programs for senior officers,
approval, performance, or termination of important contracts,
amendment of any substantial governance documents of the reporting company, including the articles of incorporation, other formation documents,
amendment of important polices or procedures of the reporting company, or
exercise of any other form of substantial control over the reporting company.
The person executing the foregoing authority with respect to a reporting company will be subject to the disclosure requirements of the CTA.[13] The means through which such control is exercised by an individual is irrelevant and such control may be direct or indirect, formal or informal, including simple business relationships. An individual may be deemed to have substantial control for purposes of the CTA if the ability to exercise substantial control (as set forth in the CTA) exists, even if such control is never actually exercised.[14]
Disclosure of information regarding non-controlling owners is required if their ownership of the reporting company equals or exceeds 25 percent. Ownership interest is broadly defined to include a variety of interests. Any type of equity interest — whether financial or simply voting — including “participation in a profit-sharing arrangement” is sufficient to be measured and considered to identify beneficial owners. In the case of non-corporate entities, any proprietary interest, any interest in capital or profits including limited and general partnership interests must be accounted for. Less direct interests are also considered ownership interests, including convertible debt, warrants, rights to purchase or subscribe to equity interests, and any “put, call, straddle, or other option or privilege of buying or selling” any ownership interest.[15]
Measuring whether an individual owns or controls 25 percent of the ownership interests of a reporting company requires accounting for “all ownership interests of any class or type, and the percentage of such ownership interests that an individual owns or controls shall be determined by aggregating all of the individual’s ownership interests in comparison to the undiluted ownership interests of the company.”[16] Consistent with the statute, the proposed regulations are clear that certain equity owners will be exempt and, therefore, not subject to reporting, including:
minor children (provided the reporting company discloses the required information regarding the parent or legal guardian of the minor child);
individuals acting as nominees, intermediaries, custodians, or agents;
employees of reporting companies “acting solely as an employee and not as a senior officer, whose substantial control over or economic benefits from such entity are derived solely from the employment status of the employee”;
individuals whose only interest is an expectancy through a right of inheritance; and
With respect to creditors, the proposed regulations make it clear that creditors who are not required to be disclosed are individuals whose beneficial ownership is derived “solely through rights or interests in the company for the payment of a predetermined sum of money…and the payment of interest on such debt.”[18] If the right or interest in the value of the reporting company is a right or interest in its value or profits, such an obligation is not one “for payment of a predetermined sum” even if it takes the form of a debt instrument. This means participating debt must be accounted for as an ownership interest.
Must the ownership interest in the reporting company be owned by the beneficial owner?
An individual may be deemed a beneficial owner in a reporting company without holding an ownership interest in such reporting company. Not only are the equity and other interests described above sufficient to establish beneficial ownership, whether owned directly or indirectly, but beneficial ownership may also exist when the beneficial owner shares ownership or does not directly or indirectly hold the ownership interest. Specific examples set forth in the proposed regulations include:
joint ownership,
control of an ownership interest owned by another, and
holding an interest as a settlor, trustee, or beneficiary of a trust or similar arrangement that holds the ownership interest.[19]
In the case of an ownership interest owned or controlled by a trust, the identity of the trustee or other individuals (if any) with the authority to dispose of trust assets will always require disclosure. In addition, if the trust has a single beneficiary that is the sole permissible recipient of income and principal from the trust, the identity and other reporting information regarding such beneficiary must be disclosed. In the case of a trust with more than one beneficiary, disclosure of information is only required of those beneficiaries who have the right to withdraw or demand distributions of substantially all the trust assets.[20] If the settlor of the trust has the ability to revoke the trust or otherwise withdraw trust assets, the identity and other information regarding the settlor of the trust must be disclosed. Thus, in the right set of circumstances, an ownership interest in a reporting company held through a trust may require disclosure of the trustee, one or more beneficiaries, and the settlor of that trust. It is probably not coincidental that the revocation and withdrawal rights that make settlors or beneficiaries subject to disclosure also make those persons owners of trust income and corpus under the grantor trust rules of subpart E of the Internal Revenue Code.[21]
Who are “company applicants” requiring disclosure?
For professionals involved in entity formation, the most intrusive aspect of the CTA is the requirement for disclosure of information regarding company applicants. The proposed regulations define the term “company applicant” to mean any individual who files the document that creates the domestic reporting company or registers a foreign reporting company “including any individual who directs or controls the filing of such document by another person….”[22] Thus, a company applicant is not only the lawyer or paralegal who files the articles of incorporation, certificate of limited partnership, articles of organization, or similar document for establishing a domestic company (or the registration of a foreign entity) with a State or Tribal authority, but also a partner, senior lawyer, or any other person directing the activity of the paralegal or associate undertaking the organization or registration.
What information must be reported regarding beneficiaries and company applicants?
In the case of every individual who is a beneficial owner and every individual who is a company applicant with respect to a reporting company, the reporting company must disclose
the full legal name of the individual;
the individual’s date of birth;
the complete address of either:
such individual’s business, in the case of a company applicant who files the document organizing or registering the company in the course of such individual’s business, or
in the case of any other individual, the residential street address used by that individual for tax residency purposes; and
either the passport number, driver’s license number, or other unique identifying number from a non-expired identification document issued to the individual by a State, local, or Tribal government for identification purposes.[23]
In addition to providing the foregoing information, the reporting company must also provide a picture ID for the beneficial owner or company applicant which includes the disclosed identification number. In lieu of any beneficial owner or company applicant providing the information described above, the individual who is a beneficial owner or company applicant may, instead, provide a FinCEN identifier.[24] The proposed regulations do not provide guidance regarding how an individual may obtain a FinCEN identifier. Presumably that guidance will be forthcoming and will involve direct submission of the information described above to FinCEN. The proposed regulations require updating and correcting information submitted to FinCEN regarding beneficial owners and company applicants “at the same time and in the same manner” as updated or corrected reports are required to be submitted by reporting companies.[25]
When is reporting required?
The initial report for domestic or foreign reporting companies must be filed within 14 calendar days of the date of formation (in the case of a domestic reporting company) or within 14 calendar days of registration (in the case of a foreign reporting company).[26] For entities that pre-exist the effective date of final regulations, the initial report of the company is due not later than one year after the effective date of the final regulations.[27] In the case of an entity that no longer meets the criteria for exemption, the initial report is due within 30 calendar days after the date the exemption criteria are no longer satisfied.[28] Initial reports must be updated in a variety of circumstances, including:
within 30 days of the date on which there is “any change with respect to any information previously provided, including changes with respect to beneficial ownership, as well as any change with respect to the information reported for any particular beneficial owner or applicant”;[29]
when the reporting company becomes an exempt entity; and
within 30 days of settlement of the estate of a deceased beneficial owner.
In addition to updating the initial reports for changes in the status of the company, its beneficial owners, and company applicants, reporting companies are also obligated to correct inaccuracies and information reported within 14 calendar days after the date on which the reporting company becomes aware or has reason to know any required information previously submitted to FinCEN was inaccurate when filed and remains inaccurate.[30] How reporting companies will know or compel disclosure of corrections to the reporting information of beneficial owners and company applicants remains a mystery.
In what form is information required to be disclosed?
The proposed regulations do not provide any further elucidation as to the manner or form under which reporting will be undertaken other than to specify that it be done “in the form and manner that FinCEN shall prescribe in the forms and instructions for such report or application.…”[31]
What penalties apply to failures to report completely and accurately?
The proposed regulations do not elaborate on the penalty regime that will apply in the case of failures to report or for inaccuracies in reporting. Consistent with the statue, the proposed regulations simply assert that “it shall be unlawful for any person to willfully provide or attempt to provide, false or fraudulent beneficial ownership information…or to willfully fail to report, complete, or update beneficial ownership to FinCEN in accordance with this section.”[32] The proposed regulations do make it clear that a willful failure to report is subject to penalty. Persons who direct or control others with reporting obligations will also be held to have violated the CTA.[33]
Observations
The proposed regulations fill in some, but not all, of the gaps left by the CTA’s statutory language. For example, the proposed regulations provide no definitive guidance with respect to attribution of beneficial ownership other than as described above. Thus, there are no specific rules corresponding to §318 or §958 of the Internal Revenue Code by which constructive ownership would be attributed to a potential beneficial owner. While the proposed regulations require accounting for a broad array of ownership interests — including convertible debt, straddles, jointly owned interests, and beneficial interests in trusts — they provide no guidance as to measurement of these interests for purposes of the 25 percent threshold for disclosure of their owners, although aggregation of such interests with an individual’s other ownership interests is clearly required.
There appear to be multiple ways to avoid the reporting requirements:
Only entities deriving limited liability through State or Tribal charter (in the case of domestic entities) or registration with State or Tribal authorities (in the case of foreign entities) are subject to reporting.
Ownership of a reporting company through a non-grantor multi-beneficiary trust with respect to which the beneficiaries do not possess withdrawal rights requires disclosure of information regarding the trustee, but not the settlors or beneficiaries of the trust. Consequently, trusts with Crummey powers will not avoid disclosure of beneficiaries holding powers of withdrawal, nor will section 2503(c) trusts. However, many settlors may be willing to forego annual exclusions for gifts to such trusts if the identity and information regarding beneficiaries can be protected.
Organization of the reporting company as one of the types of organizations exempted from reporting avoids disclosure of beneficial owners and company applicants, as well. Obviously, this opportunity is limited and may require a willingness to assume other reporting obligations and regulatory oversight. However, in certain cases, regulatory oversight may not exist or may not extend to disclosure of individuals exercising substantial control or satisfying the 25 percent beneficial ownership threshold of the CTA.
Although the information the CTA requires regarding the reporting companies may be seen as not significantly greater than that necessary to organize or register the company with State or Tribal authorities, do not be deceived. The reporting obligations the proposed regulations impose on reporting companies regarding the professionals who organize those companies are clearly intended to compel disclosure of the beneficial owners of those reporting companies. Without proper planning, the corporate curtain of secrecy will be lifted.
The CTA will significantly impact lawyers who organize business entities. The exposure it creates for counsel and their staff involved in preparing and filing organizational documents will require rethinking the information to be gathered and the content of client engagement letters. If a client is unwilling to provide the information the CTA requires, the terms of the law firm’s engagement should permit termination of its representation. It would be prudent to gather the necessary information regarding beneficial owners before the engagement commences and to set forth in engagement letters who will be responsible for updating and correcting information previously filed. New engagement letters will likely be compelled for existing clients when they form new entities and when entities formed prior to the effective date of the CTA are compelled to report to FinCEN.
There is no grandfathering of existing entities unless those entities are “inactive” as defined by the CTA. Making this determination requires the ability to contact the persons who currently operate the reporting company and solicit information regarding its operations, revenues, and expenditures. Every existing entity provided limited liability by a State or Tribal government and every foreign entity registered to do business with a State or Tribal government that is not otherwise exempt must not only provide information about itself, but also must provide information about its beneficial owners. Reluctance to provide required information should be anticipated, as should be possible reluctance to compensate counsel for the effort involved to collect and report that information to FinCEN. Like it or not, the CTA will change the way you practice law.
Robert E. Ward, J.D., LL.M. is a fellow of the American College of Tax Counsel who advises businesses and individuals on U.S. international and domestic tax matters from his firm’s offices in Vancouver, British Columbia and Bethesda, Maryland.
“The requirements of this subsection shall take effect on the effective date of the regulations prescribed by the Secretary of the Treasury under this subsection, which shall be promulgated not later than 1 year after the date of enactment of this section.” 31 USC §5336(b)(5). ↑
31 CFR §1010.380(c)(1)(i)(C). All citations are to the regulations as proposed and published at 86 Fed. Reg. 69920-69974 (Dec. 8, 2021). ↑
The types of exempt entities are identified in Prop. Reg. §31 CFR §1010.380(c)(2). ↑
In the case of an individual who does not have one of the foregoing identification documents, a non-expired passport issued by a foreign government to such individual will suffice. 31 CFR 1010.380(b)(1)(ii)(D)(4). ↑
“A person fails to report complete or updated beneficial ownership information to FinCEN if such person directs of controls another person with respect to any such failure to report, or is in substantial control of a reporting company when it fails to report compete or updated beneficial ownership information to FinCEN.” 31 CFR 1010.380(g)(5). ↑
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