Introduction

There seemingly are lots of new ways to make payments today. New apps for smart phones, new peer-to-peer payment networks, new currencies, and new ledger systems offer to meet the needs of U.S. consumers and businesses in ways that legacy payment methods do not. Many of these new ways to pay have improved end-user experience by providing more convenient or intuitive ways to initiate payments through legacy systems (such as the ability to accept card payments through a device that connects to a phone). In other cases, the underlying payment system through which payments are made is new (such as the ability to pay someone instantly with virtual currency through a distributed ledger system).

It does matter how you pay; however, the part that matters—from a legal perspective—is not the means of initiation (i.e., payment via mobile app) or infrastructure (i.e., blockchain), but rather who is providing the payment service to the payor and payee and the characteristics of the payment service.

This article’s focus is how payment-system and consumer-protection laws apply (or do not apply) to some of the new ways to pay. It should be noted that there are other important legal and regulatory frameworks that apply to payments, such as financial privacy, cyber and information security, Bank Secrecy Act/anti-money laundering, and economic sanctions, all of which are beyond the scope of this article.

The Legal Framework for Payments

One’s legal rights and responsibilities as a payor or payee for noncash payments are determined by payment-system laws—statutory, regulatory, and contractual. For example, if a payor instructs payment for $100, but through error or fraud the payee is instead paid $1,000, payment-system laws will determine who among the various parties to the payment takes the loss for the extra $900 received by the payee. When consumers are a payor or payee, certain statutory and regulatory consumer-protection laws may also apply to the payment.

Payment-System Laws

With respect to payment-system laws, it should come as no surprise that different laws apply to different types of payments. At the state level, the Uniform Commercial Code (UCC) Articles 3 and 4 serve as the foundational laws for checks, and UCC Article 4A establishes the laws for wholesale wire transfers. These state laws generally may be supplemented or varied by agreement of the parties involved, or by clearinghouse or funds transfer system rule. For example, banks and image clearinghouses generally adopt the Electronic Check Clearing House Organization Rules (ECCHO Rules) to modify and supplement rights and responsibilities under the UCC to address issues unique to the interbank exchange of check images. Note, however, that the ability to vary the UCC by agreement or by clearinghouse or funds transfer system rule is not unlimited. For one thing, the UCC obligation to act in good faith may not be waived.

There is no statutory framework that serves as the basis for exchange of electronic debits through the Automated Clearing House (ACH) system, although commercial credits fall under UCC 4A. Banks rely on the Operating Rules of the National Automated Clearing House Association (NACHA), as adopted into ACH operator rules, both to establish the framework for the debits and to supplement the UCC 4A framework for commercial credits.

It is important to note that the scope of the laws and rules governing traditional noncash payment mechanisms—funds transfers, ACH, and checks—includes bank customers and banks, but does not necessarily contemplate or apply to nonbanks that serve as intermediaries to payors and payees or payments that are made through nonbank networks. Thus, the funds transfer process, under article 4A and the Federal Reserve’s Regulation J, begins with an instruction by an originator to its bank to pay or to cause another bank to pay a beneficiary, and the funds transfer ends when a bank for the beneficiary accepts an instruction to pay its customer. Likewise, the check collection process under article 4 and the Federal Reserve’s Regulations J and CC begins when an item is deposited with a depository bank, and typically ends when the payor bank pays the item. Similarly, under NACHA’s rules, an ACH payment begins with an authorization provided by a customer of a bank, is initiated to an ACH operator by a sending bank, and ends when the receiving bank has received and settled for the payment.

As further discussed below, this means that payment-system laws will not completely address—or may not address at all—issues that may arise for payors and payees whose payments do not begin and end at a bank.

Consumer-Protection Laws

With respect to consumer-protection laws, the primary federal laws in the payments area are: (i) the Electronic Fund Transfer Act (EFTA) and its implementing regulation, Regulation E, for consumer payments made via debit cards, ACH, payroll cards, prepaid accounts, and other consumer electronic funds transfers (discussed further below); and (ii) the Truth in Lending Act (TILA) and its implementing regulation, Regulation Z, for consumer payments via credit cards. These federal laws and regulations establish certain baseline consumer protections, such as disclosures, periodic statements, and most relevant to this article, limitation of liability for unauthorized payments and error-resolution requirements. These consumer protections generally cannot be varied by agreement.

Historically, the payments laws and consumer-protection laws described above provide mutually exclusive legal frameworks governing consumer funds transfers. In particular, the scope of article 4A by its own terms (Section 4A-108) generally excludes from its coverage funds transfers, any part of which is governed by EFTA. In turn, EFTA and Regulation E govern consumer funds transfers—specifically, “electronic fund transfers,” which include essentially any electronic transfer of funds to or from a consumer account, but excludes funds transfers sent by a financial institution on behalf of a consumer through a wholesale payment system (that is, a funds transfer system that is not designed primarily to transfer funds on behalf of consumers), such as a wire transfer system—as a result, those transfers would be covered by article 4A. In recent years, however, most state legislatures have taken steps to amend article 4A to permit some overlap with EFTA with respect to certain remittance transfers that became covered by EFTA and Regulation E as a result of the Dodd Frank Act.

In addition, federal consumer-protection laws historically were tied to payments made to or from consumer accounts held at banks. However, Regulation E’s remittance-transfer provisions apply to remittance-transfer providers that are both banks and nonbanks. Similarly, the Consumer Financial Protection Bureau (CFPB) finalized a new rule in early October that applies Regulation E’s disclosure, periodic statement, limitation of liability, and error-resolution requirements to prepaid accounts, regardless of whether the prepaid account is held by a bank or a nonbank. Specifically, the revised regulation defines a prepaid account to include a variety of payment products, including general purpose prepaid cards and nonbank payment services, such as digital wallets and payment networks, that involve an account that is either issued on a prepaid basis or capable of holding consumer funds. The new provisions become effective April 1, 2018 (although the CFPB also recently announced its decision to revisit certain substantive issues in the rule), and will cover many, but not all, nonbank payment services. Among the payment services that will fall outside the rule are those that only facilitate payments, but do not require consumers to have accounts with the service provider.

For payment services provided by nonbanks that fall outside the CFPB’s prepaid rule and remittance transfer rule, a consumer’s rights and responsibilities as a payor or payee primarily will be determined by the contractual terms that apply to the payment service. However, the consumer may have Regulation E protections for parts of a nonbank payment if the nonbank payment involves funds transfers to or from the consumer’s bank or prepaid account.

Some Examples

The scenarios below illustrate how a payor’s legal rights and responsibilities may vary depending upon whose payment service the payor uses.

Hypothetical 1: Person-to-Person Payment

CoolPay is a nonbank payment service that provides CoolPay accounts to its users and enables them to send funds to each other through its service. CoolPay makes payments in two ways. If a payor-user has funds in his or her CoolPay account, CoolPay will pay the payee through a book transfer: i.e., a debit entry to the payor’s CoolPay account and a credit entry to the payee’s Cool-Pay account. If a payor-user does not have funds in his or her account, CoolPay will initiate an ACH debit to the payor-user’s bank account and then credit the payee-user’s CoolPay account once CoolPay’s bank account is credited for the ACH debit it sent to the payor-user’s bank account.

Jane and George are CoolPay users. Jane uses CoolPay to send George $100 for his birthday. Although Jane is a CoolPay user, she does not keep funds in her CoolPay account. Hence, to effectuate the payment, CoolPay instructs its bank, Bank A, to send an ACH debit for $100 to Jane’s bank, Bank B. Once Bank A receives settlement from Bank B for the ACH debit, it credits CoolPay’s bank account. CoolPay then credits George’s CoolPay account for $100. What if CoolPay makes a mistake and credits Ted’s CoolPay account rather than George’s?

Given that CoolPay provides a payment service that enables consumers to hold funds in CoolPay accounts, CoolPay will be subject to the new prepaid account requirements of Regulation E, including its disclosure and error-resolution requirements, when it goes into effect. The rule will require CoolPay to: (i) disclose to Jane that she has error-resolution rights; and (ii) investigate the error upon timely notice from Jane that her bank account has been debited, but that George has not received his birthday money. CoolPay generally will be required to investigate and determine whether an error occurred within 10 days of Jane’s notice. If CoolPay determines that an error occurred, it must correct the error within one business day of such determination.

Note that, until the CFPB’s prepaid rule is effective, Jane’s ability to seek redress from CoolPay will be determined by the terms and conditions governing Jane’s use of the CoolPay service or possibly her state’s money transmission laws. It should further be noted that, due to the fact that the debit to Jane’s bank account was in the correct amount, it is unlikely that Jane could have sought redress from her bank for CoolPay’s error because the debit was authorized, in the correct amount, and her bank made no error is transmitting the funds to CoolPay’s account with Bank A.

It is also the case that, if CoolPay acted as only a payment facilitator and did not hold consumer funds in CoolPay accounts, the CFPB’s prepaid rule will not be applicable to Jane’s payment. She would again look to the terms and conditions of CoolPay’s service and her state’s money transmission laws for redress.

Hypothetical 2: Business-to-Business Payment

Company A and Company B are CoolPay users. Company A instructs CoolPay to pay Company B $10,000 via transfer from Company A’s CoolPay account to Company B’s CoolPay account. Company A has sufficient funds credited to its CoolPay account to pay for the transfer without the need to debit Company A’s bank account. Hence, CoolPay debits Company A’s CoolPay account for $10,000. However, CoolPay erroneously credits Company C’s CoolPay account rather than Company B’s CoolPay account.

If CoolPay were a bank, this type of error would be an error in execution. Under article 4A, if Company A’s bank paid a party other than the beneficiary Company A identified in its payment instruction, Company A would be entitled to a refund under article 4A’s money-back guarantee provisions for the amount of the payment. Company A’s bank could seek to recover the amount from Company C, but it would be required to refund Company A regardless of whether it does so. Under article 4A, the bank would not be permitted to vary its obligation to refund Company A by agreement.

In the absence of article 4A, the rights of Company A and CoolPay will be governed by the terms and conditions of CoolPay’s service, other agreements among the parties, and common law. In addition, if CoolPay’s terms are not favorable to Company A, it may find itself in court arguing by analogy to article 4A that CoolPay must provide a refund. If Company A is unable to recover from CoolPay, it may also be able to recover from Company C under CoolPay’s terms or common-law theories, but Company C, its jurisdiction, and a number of other factors will be completely unknown to Company A.

Hypothetical 3: Business-to-Business Payment with Distributed Ledger

Let us add a variation to the previous two examples where CoolPay provided payment services to the payor and payee: What if instead it is simply banks providing those services? Does it matter if those banks, in turn, choose to use a fundamentally new infrastructure, such as blockchain, to settle with each other?

Suppose Company A wishes to pay Company B $10,000 for products that it purchased. Company A has an account with Bank A, and Company B has an account with Bank B. Company A opts to make that $10,000 payment by a funds transfer from its account at Bank A to Company B’s account at Bank B. The funds transfer begins with a debit to Company A’s account on Bank A’s books (funds are withdrawn from the payor’s account), and ends with a credit to Company B’s account on Bank B’s books (funds are deposited into the payee’s account).

Suppose, however, that Bank A and Bank B do not have a direct relationship with each other that enables Bank A to credit an account it holds for Bank B, or for Bank B to debit an account it holds for Bank A. Instead, they choose to use blockchain technology—CoolChain—to clear and settle payment from Bank A to Bank B in real time on their own books. A detailed description of how the banks may use blockchain technology in this way is provided in a March 2016 article by Jessie Cheng and Benjamin Geva. In essence, blockchain technology allows banks with no direct relationship to establish trust and coordinate their actions to settle with each other.

Does the fact that the banks in the funds transfer opt to use CoolChain, rather than a traditional funds transfer system like CHIPS or Fedwire, to transact with each other in this way mean that the payment is outside the scope of article 4A? Not necessarily. Article 4A focuses on the type of entities involved, not the means by which they transact with each other. The primary focus of article 4A is the “funds transfer,” the transfer of bank credit from the payor to the payee. The hypothetical above—where Company A transmits an instruction to its bank, Bank A, to pay or cause another bank to pay Company B—falls within article 4A’s definition of “funds transfer” in section 4A-104. This remains so even where Bank A and Bank B happen to choose to use CoolChain or any other blockchain technology to settle with each other. That transfer is still a series of transactions, beginning with Company A’s payment order (Company A’s instructions to Bank A to pay or cause another bank, like Bank B, to pay a fixed amount of money to Company B) made for the purpose of making payment to Company B, the beneficiary of the order. Thus, Bank A’s and Bank B’s choice to use CoolChain to settle with each other would not remove the transfer from the ambit of article 4A.

Although article 4A can be read to apply to a funds transfer involving blockchain rails as a general matter, the application of the technology varies from blockchain to blockchain, and each implementation must be analyzed to determine whether or precisely how certain of its concepts map onto an article 4A framework. Thus, might the legacy article 4A concepts of “funds transfer system” apply to a network of banks that all use CoolChain and together agree to a certain set of payment rules governing their interbank rights and obligations? As described above, one could interpret section 4A-105(a)(5)’s definition of “funds transfer system” and its official commentary to say “yes,” even though the official commentary has not been updated to specifically recognize emerging systems that fundamentally differ from legacy payment rails. The same may not be true of another blockchain rail.

Conclusion

The robust competition for payment services in the United States offers consumers and businesses many ways to pay. However, the legal framework that applies to payments, and that ultimately determines the rights and responsibilities of consumers and businesses when they make and receive payments, is dependent upon a combination of whether the payments begin and end at a bank and, for consumers, the characteristics of the payment service.

In an April 2016 article in Business Law Today, we provided a primer on foreign investment regulation in Canada, an important issue in Canadian cross-border M&A transactions. Foreign investment primarily is regulated through the Investment Canada Act (ICA) and its regulations (although some sectors like banking have separate rules, and other statutes regulating foreign investment may also apply). In the ensuing year, a number of significant changes have occurred or have been announced by the Canadian federal government and are addressed below. It should be noted that this article discusses the ICA and its regulations generally and does not discuss a number of exceptions and nuances affecting its application, including the regime applicable to investments by foreign state-owned enterprises. All currency conversions in this article are made as of March 28, 2017.

Review Thresholds

As explained in the April 2016 article, under the ICA, the acquisition of control of a Canadian business by a non‐Canadian triggers either a (usually pre-closing) review or a (usually post-closing) notification process. The review process generally is triggered if the value of the Canadian business exceeds an applicable threshold, which can vary on a number of factors.

As part of its 2016 Fall Economic Statement, other than for investments by foreign state-owned (or influenced) enterprises (SOEs), the Canadian government committed to increasing the threshold applicable to a direct acquisition of a Canadian business by nationals of World Trade Organization (WTO) member states, which would include a U.S. company ultimately controlled by U.S. nationals. This threshold for review has changed significantly over the last few years, shifting even more transactions into the notification process and thereby reducing ICA compliance costs. In March 2015, this threshold was changed, from one based on the book value of assets of the Canadian business, to a threshold based on the “enterprise value” of the Canadian business, and a planned increase schedule was set out. In its 2016 Fall Economic Statement and again in its 2017 budget, the Canadian government committed to increasing this threshold even more quickly than originally planned, as shown in the table below.

1. Upon enactment of budget implementation legislation, anticipated in the spring or fall of 2017.
2. On a date to be determined (likely January 1, 2019).

The Canadian government also is in the process of implementing the recently negotiated Canada and European Union (EU) Comprehensive Economic and Trade Agreement (CETA), which will increase the threshold for nationals of EU member states. Once in force, CETA will increase the enterprise threshold for nationals of EU member states to C$1.5 billion (approximately US$1.12 billion). A number of countries, including the United States and Mexico, have trade agreements with Canada that contain most-favored-nation protection, with the result that nationals of these countries will also benefit from this substantially increased enterprise value threshold. The legislation in Canada to implement the CETA currently is expected to be in force as early as late June 2017.

An indirect acquisition of a Canadian business (i.e., through the acquisition of its foreign corporate parent) by nationals of WTO-member states, including the United States, with limited exceptions, are exempt from review.

An important exception to these rules on direct and indirect acquisitions remains where the Canadian business is engaged, even if only partially, in the activities of a “cultural business.” A direct acquisition of a cultural business continues to be subject to review where the book value of the Canadian business’ assets exceeds C$5 million (approximately US$3.7 million), and an indirect acquisition of a cultural business continues to be subject to review where the book value of such assets exceeds C$50 million (approximately US$37 million), although in the case of the latter, the review may be done post-transaction and therefore is not an impediment to closing.

Some Clarity on National Security Review

As explained in the April 2016 article, the national security review process allows the Canadian government to review investments where it has “reasonable grounds to believe” that the investment “could be injurious to national security.” Any investment in Canada by a non-Canadian investor can trigger this process regardless of: (i) whether it is reviewable or notifiable according to the rules above; (ii) whether by a U.S. or other investor; (iii) whether it is for the establishment of a new Canadian business, the acquisition of control of a Canadian business, or the acquisition of a minority interest in a Canadian business; and (iv) the dollar value of the transaction. This means that a minority investment in a Canadian business, regardless of its size, could trigger a national security review. This process is, to a certain extent, the Canadian equivalent to the Committee on Foreign Investment in the United States (CFIUS) regulations.

The concept of “could be injurious to national security” is not defined in the ICA or its regulations and, until recently, the Canadian government did not provide any guidance on what it considered “could be injurious to national security” (other than certain statistics on the frequency and outcomes of national security reviews). On December 19, 2016, the Canadian government delivered on a promise, made in the previously noted 2016 Fall Economic Statement, to make the national security review process more transparent by publishing Guidelines on the National Security Review of Investments (the Guidelines), which identify the following nine, nonexhaustive factors that will be taken into account in determining whether foreign investments could be injurious to national security: (i) the potential effects of the investment on Canada’s defense capabilities and interests; (ii) the potential effects of the investment on the transfer of sensitive technology or know-how outside of Canada; (iii) the involvement in the research, manufacture, or sale of goods/technology relating to certain controlled goods noted in the Defence Production Act, including firearms, military training equipment, certain types of aircraft, weaponry and defense systems, etc.; (iv) the potential impact of the investment on the security of Canada’s critical infrastructure, meaning the processes, systems, facilities, technologies, networks, assets, and services essential to the health, safety, security, or economic well-being of Canadians and the effective functioning of government; (v) the potential impact of the investment on the supply of critical goods and services to Canadians, or the supply of goods and services to the Canadian government; (vi) the potential of the investment to enable foreign surveillance or espionage; (vii) the potential of the investment to hinder current or future intelligence or law enforcement operations; (viii) the potential impact of the investment on Canada’s international interests, including foreign relationships; and (ix) the potential of the investment to involve or facilitate the activities of illicit actors, such as terrorists, terrorist organizations, or organized crime.

The Canadian government’s 2017 budget also announced an intention to require the publication of an annual report on the administration of the ICA’s national security.

The Guidelines also provide recommendations for dealing with national security. For example, the ICA contains no formal preclearance mechanism, which is a significant distinction between the Canadian national security regime and the CFIUS regime. To address this issue, the Guidelines recommend that foreign investors file their ICA notifications “early” and prior to the deadlines set out by statute, even though this is not required by law, particularly in cases where the assessment factors described above may be present. By doing such a filing on a preclosing basis and waiting for 45 days to elapse following the filing of such notification, if no action is taken, the investor can proceed with closing knowing that the period within which a national security review could be ordered has expired. Note, however, that this “early filing option” is not available unless an investment triggers a notification (or economic review) requirement. Where no notification (or review) is required (for example, the acquisition of minority interest in a Canadian business where there is no acquisition of control by the non-Canadian investor within the meaning of the ICA), the 45-day period for triggering the national review process runs from implementation of the investment, which precludes the early filing option for obtaining comfort. Nevertheless, early engagement with the government may still be beneficial in securing meaningful comfort from the government. Such engagement allows the government an opportunity to examine the investment and to ask questions of the investor, which, even absent explicit pronouncement from the government, may allow the investor to make meaningful inferences about the government’s assessment of whether the investment would be injurious to national security.

Conclusion

The proposed change to the ICA’s enterprise value thresholds will result in fewer transactions subject to review, and the Guidelines provide additional clarity on national security review. Understanding the ICA’s regulation of foreign investment is important because sanctions can include fines and even a reversal of the transaction (although the authors are not aware of this remedy ever having been used by the Canadian government). It is also important to consult with a Canadian legal advisor, given that many other federal and provincial laws can affect the implementation of an M&A transaction.

Until the 1930s, securities purchasers looked solely to state securities laws—so-called Blue Sky Laws—for protection against securities fraud. That all changed after the Crash of 1929, when the federal securities laws were enacted and came to dominate the field in the ensuing decades. But state securities laws have made a bit of comeback in recent years, and an April 2017 decision out of a California federal court may continue to fuel their rise. Colman v. Theranos, Inc. The Theranos court found that indirect purchasers of securities—those who invest in a fund that in turn purchases securities from a company—can sue that company. The decision raises a number of important questions for both issuers of securities—especially large private companies—and the many funds that buy directly into them.

A brief review of the facts will set the stage. Theranos is a privately held life sciences company recently thrust into the national spotlight over questions about the legitimacy of its business. Plaintiffs in the case had invested money in two different private funds expressly formed to invest in the company. One fund acquired stock directly from Theranos; the other acquired its stock on the secondary market. Plaintiffs’ purchases came amid a publicity campaign about Theranos that, allegedly, was designed to raise capital from private investors, including plaintiffs. After news broke questioning the viability of Theranos’s technology, the indirect purchaser plaintiffs sued the company for fraud, asserting securities claims under various provisions of California law.

Ruling on Theranos’s motion to dismiss, Magistrate Judge Nathanael Cousins of the Northern District of California held that the indirect purchasers had standing to sue under California law. In pertinent part, the California provisions at issue make it unlawful for “a broker-dealer or other person selling or offering” a security to willfully make, “directly or indirectly,” a false or misleading statement “for the purpose of inducing the purchase or sale of such security.” Unlike most of the federal securities laws, notably Section 10(b), this statute does not require a plaintiff to prove actual reliance; rather, a plaintiff need only prove that defendant intended the plaintiff to rely on his statement. And, now, if the Theranos court’s ruling is accepted by other courts, the statute also will not require “privity,” or a buy-sell relationship, between indirect purchasers and the issuing company. Defendants unsuccessfully pressed the court to impose such a requirement, but the court disagreed, noting the statute “focuses on the actions of the seller of the securities, not the relationship between seller and buyer.”

So, did the court get it right? The answer is both yes and no, with a bit of history explaining why. The California statute at issue was modeled after and closely resembles Section 9 of the Securities Act of 1934, which was specifically aimed at prohibiting the manipulative market conduct prevalent in the 1920s. As numerous state and federal courts have noted, including those in California, “market manipulation” is a term of art that covers some artifice or scheme where a defendant enters the market and alters the natural forces of supply and demand. Some of that fraudulent conduct—such as a “wash sale,” where the defendant buys and sells from himself to create the appearance of demand, or a “matched order,” where he buys and sells to co-conspirators for similar purposes—involves trading that occurs solely between one or more co-conspirators. The court is thus right that privity is not universally required; if it were, a defendant trading solely with himself or his scheming confederates could never be liable.

But the court’s analysis failed to see the full picture. Like Section 9, the California statute at issue was never intended to reach false or misleading oral or written statements like those Theranos made to the market. Rather, it is focused on specific schemes, in the market, that artificially alter the natural forces of supply and demand. Nowhere is Theranos alleged to have engaged in any such conduct. The result, then, is to allow an indirect purchaser to repackage a traditional misstatements case—which does require privity under California law—into a manipulative conduct case that does not. Courts have rejected this strategy for years.

The consequences of this approach are potentially far reaching for private companies and the funds that invest in them. For private companies, the decision poses concerns about raising money from institutional investors and publicly traded companies, which have become a significant source of financing. The court’s ruling could give disappointed investors in those entities standing to sue the private companies in which they invest. Since the universe of those investors under the reasoning of Theranos is much broader than those who participate in private offerings—and since those investors may only be able to rely on general statements in the public domain—the court’s ruling raises the possibility that retail investors could sue private companies without ever having directly invested in them.

For private funds that invest in private companies, the decision also raises a number of serious questions, especially as to who controls claims that belong to the fund. For instance, what recourse, if any, does a fund and its other investors have if they believe a lawsuit is frivolous or would distract management and thereby harm their investment? Without an express waiver of the indirect purchasers’ claims, it would seem very little. And would an investor further down the investment chain, say in a fund-of-funds, also have standing to bring a claim against the private company? The court seemed to take comfort that the universe of potential plaintiffs was limited to those the company “intended” to defraud. But drawing the line based on something so subjective provides little comfort to companies and the funds that invest in them.

It is worth emphasizing that there are ways to read the court’s ruling as limited to its unique set of facts. The funds at issue were set up for the express purpose of investing in Theranos stock, not to invest in multiple securities. What’s more, Theranos has been accused of misrepresenting the viability of its business as a whole, something different in kind and degree from an allegedly misleading statement about a discrete event or fact. Nor is it clear that the indirect purchasers had been provided any documents upon which to base their indirect investment in Theranos.

If limited to these facts, the court’s decision could be understood. But if future courts look beyond the facts to the general proposition for which Theranos stands—that indirect purchasers may sue a private company for plain vanilla securities fraud without having to prove privity—the prominence of state securities laws like those in California may only grow.

We begin with ULLCA, because the answer to the delineation question appears straightforward under the uniform act. This column quotes from ULLCA (2013), text and comments, but the analysis applies equally to ULLCA (2006), sometimes informally referred to as “RULLCA” or “Re-ULLCA,” and also to ULLCA (1996), the first uniform LLC act.

ULLCA (2013), Section 105(c)(6) states that, while an operating agreement may not “eliminate the contractual obligation of good faith and fair dealing under Section 409(d),” the agreement “may prescribe the standards, if not manifestly unreasonable, by which the performance of the obligation is to be measured.” The official comment provides several examples, including this one:

EXAMPLE: The operating agreement of a manager-managed LLC gives the manager “sole discretion” to make various decisions. The agreement further provides: “Whenever this agreement requires or permits a manager to make a decision that has the potential to benefit one class of members to the detriment of another class, the manager complies with Section 409(d) of [this act] if the manager makes the decision with:

a. the honest belief that the decision:

i. serves the best interests of the LLC; or
ii. at least does not injure or otherwise disserve those interests; and

b. the reasonable belief that the decision breaches no member’s rights under this agreement.”

This provision “prescribes[s] the standards by which the performance of the [Section 409(d)] obligation is to be measured.”

Under Delaware law, the delineation question requires a different and more complicated analysis. The conceptual answer is “not possible,” but the practical answer is “can do.” Under Delaware law, the implied covenant acts as a special type of “gap filler,” a process of interpolation implied by law: “An implied covenant claim … [asks] what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.” Gerber v. Enter. Prods. Holdings, LLC, 67 A.3d 400, 418 (Del. 2013) (quotation marks and citations omitted).

By its nature, this approach is invariable. The law supplies the gap-filling methodology, which no agreement has the power to change. For instance, an operating agreement may not provide that “a manager’s act in any manner pertaining to this agreement satisfies the implied covenant of good faith and fair dealing if the person asserting a breach of the implied covenant had at the time of contracting reason to know that the agreement could reasonably be interpreted to authorize the act.”

However, a Delaware operating or partnership agreement can reign in the implied covenant by avoiding gaps. Consider the above example from the ULLCA comments, revised as follows:

Whenever this agreement requires or permits a manager to make a decision that has the potential to benefit one class of members to the detriment of another class, the manager complies with Section 409(d) of [this act] the manager’s decision is binding and breaches no duty to the company or its members, if the manager makes the decision with:

a. the honest belief that the decision:

i. serves the best interests of the LLC; or
ii. at least does not injure or otherwise disserve those interests; and

c. the reasonable belief that the decision breaches no member’s rights under this agreement.”

Although “[n]o contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency,” Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005, at *11 (Del. Ch. June 20, 2014) (internal quotations and citations omitted), opportunistic conduct brings Delaware’s implied covenant into play. The ULLCA example as revised leaves scant, if any, room for such conduct. Thus, while under Delaware law “safe harbor” provisions cannot be upheld, in the language of ULLCA (2013) § 105(c)(6), as “prescrib[ing] the standards …by which the performance of the obligation [of good faith and fair dealing] is to be measured,” safe harbor provisions can render the implied covenant inapposite if carefully drafted and sensibly invoked.

For example, in the author’s opinion, it was not sensible to rely on a Special Approval valuation process that had ignored two assets of the company, which were arguably quite substantial. Gerber v. Enter. Prod. Holdings, LLC, 67 A.3d 400, 422–23 (Del. 2013).

Care is also required when an operating or partnership agreement imposes an express requirement of “good faith.” Left undefined, the phrase is a minefield for parties and a godsend for litigators—as exemplified in Policemen’s Annuity and Benefit Fund v. DV Realty Advisors LLC (“Policemen’s Annuity”). The case arose from a limited partnership agreement that permitted the limited partners to remove the general partner:

without Cause by an affirmative vote or consent of the Limited Partners holding in excess of 75% of the [Limited] Partnership Interests then held by all Limited Partners; provided that consenting Limited Partners in good faith determine that such removal is necessary for the best interest of the [Limited] Partnership.

The agreement did not, however, define the term. Policemen’s Annuity No. CIV.A. 7204-VCN, 2012 WL 3548206 at *12-13 (Del. Ch. Aug. 16, 2012).

Both the Chancery Court and Delaware Supreme Court addressed the definitional omission, but each used a different approach and reached a different definitional conclusion. The Chancery Court, 2012 WL 3548206, at *13, used an a fortiori analysis to resolve the case without actually deciding on a definition:

The conduct of the Limited Partners in this case does not approach the sort of unreasonable conduct that is necessarily undertaken in bad faith. A test is nevertheless required; the Limited Partners’ conduct must be analyzed under some rubric. … The definition prescribed in [Delaware’s Uniform Commercial Code] § 1–201(20) [“honesty in fact and the observance of reasonable commercial standards of fair dealing”] is at least as broad of a definition of good faith as that applied to contracts at common law, and… the Limited Partners can meet the [the broader] definition…. Thus, the Limited Partners necessarily satisfy Delaware’s common law definition of good faith as applied to contracts, which is the definition of good faith that the Court presumes was adopted in [the limited partnership agreement].

The Delaware Supreme Court flatly rejected the lower’s court methodology, substituting a standard far more easily met. Relying on one of its own decisions, the court held that the limited partners’ “determination will be considered to be in good faith unless the Limited Partners went ‘so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.’” DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101, 110 (Del. 2013) (quoting Brinckerhoff v. Enbridge Energy Co., Inc., 67 A.3d 369, 373 (Del.2013)).

An Oregon case provides another example. U.S. Genes v. Vial, 923 P.2d 1322 (Ore. App. 1996) concerned a contract that expressly required the parties “to engage in good faith and in fair dealing with respect to the other at all times during the term of this agreement.” The contract did not define the “good faith and … fair dealing,” and the trial court decided “to treat the express good faith provision in the contract as equivalent to the covenant of good faith and fair dealing that is implied in every contract.” The Oregon Court of Appeals reversed, stating that that decision was “[t]he source of the court’s error” and holding that the “express and implied covenants of good faith cannot be equated.”

That holding makes good sense; equating the express with the implied would render the express term surplus. However, half a page further in the decision, the appellate court interpreted the express term according to one scholar’s famous gloss on the implied covenant.

The moral of these stories is clear—never use the phrase “good faith” in an operating or partnership agreement without carefully defining the term.

Kevin Johnson spent nearly 20 years in the banking and financial services industry, so when he went back to law school, he knew exactly what kind of law he wanted to practice and where he wanted to work. He’s now an attorney in the Administrative Law Division of the National Credit Union Administration, with a focus on privacy law. Prior to this, he worked as a banking consultant and served as the Financial Services Director of the Federal Reserve Bank of Atlanta in the Birmingham branch.

He’s been very involved with the ABA, serving as the National Chair of the ABA Law Student Division, for which he received the ABA Law Student Division Gold Key Award, in honor of his high degree of service, dedication and leadership.

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For many years, you worked in the banking and financial services industry as a consultant. And, prior to that with the Federal Reserve Bank of Atlanta as a Financial Service Director. What prompted you to go back to school and get a law degree?

I originally worked for commercial banks in various capacities. And, after a number of years I decided to take an opportunity with the Federal Reserve Bank. One of the things that led me to seek a law degree was the fact that I was responsible for operations at the Fed that correlated directly to a number of banking laws and regulations. I found myself always consulting the regulations that guided the Fed in its operations and its philosophical approach to banking and financial services. After a number of years of this, I thought: if you can’t beat them, you might as well join them.

During law school, you worked as an intern at the National Credit Union Administration. Why did you choose this government entity and how were you able to secure a position at such a well-known agency?

It actually came about while I was at an ABA meeting. Someone suggested to me that I apply to the NCUA, which I promptly did. I received a call while I was in class in law school, and they offered me the opportunity to fly up to D.C. and spend the summer working as the only legal intern that year.

What did you like about it, because after law school, you accepted a full-time position at that agency?

I was in my element. I focused my entire law degree and my career on banking and financial services, because I knew that’s what I wanted to do. My intent was always to go back to a financial institution regulator. On my list I had the Fed, the NCUA, the Consumer Financial Protection Bureau, and the FDIC. The NCUA happened to be the one that gave me the opportunity when I came up here for the summer. They gave me lots of very meaningful work. I developed serious relationships with my colleagues, I felt comfortable here, and I was treated as a valued member of the team. That had a lot to do with my making the decision to come back.

You’re currently an attorney in the Office of General Counsel, with a focus on privacy law. Can you expand on what you’re doing in this area of law?

For all federal executive agencies, certain laws and regulations exist in regards to how we collect, maintain, share, protect, and destroy the information that we collect from the public. As you can imagine, a lot of that data is extremely sensitive, from Social Security numbers to banking information, all of the different categories of personally, identifiable information.

I serve my agency as a privacy attorney, helping to build and maintain an effective and efficient privacy program that allows us to continue collecting this information, but also doing so in a way that is compliant with the laws and the regs. And that it’s protected from the increased cyber threats that exist in our environment today.

The crux of my work is basically helping to maintain the privacy program and make sure that we’re compliant with the Privacy Act of 1974, the E-Government Act of 2002, and the whole host of other Office of Management and Budget guidance, presidential directives, and executive orders.

It feels like this would be a constantly shifting landscape. Is that right?

That’s absolutely right. When I started in privacy, our agency as well as the other financial institution regulators, were coming off the financial crisis that kicked off the recession. I was asked if I wanted to become involved with the privacy side of things. I jumped at the chance, because I had already developed a keen interest in privacy, and privacy-related issues. Little did I know that it was going to take off the way it has. It has led to so many different opportunities and a wonderful learning experience.

Prior to being in the administrative law division, you served as a trial attorney at NCUA. What kind of cases did you handle?

I spent a little more than a year in enforcement litigation before I switched over to the admin. law and the privacy area. While I was in enforcement and litigation, I mostly dealt with issues such as financial services prohibitions. Basically that involves working with individuals who, for whatever reason, our agency felt were no longer fit to serve in this particular industry. If you look at our website, and if you filter through the correspondence that comes out of this agency, we regularly report on individuals who, for whatever reason, whether it was wrongdoing or convictions of a certain type, can no longer serve in the financial services industry. I also worked with conservatorships of failing or failed credit unions. I also did some work with the fraud hotline, chasing down issues that came to us, people reporting different things that go on in the credit union system that need our attention.

How has your background in finance helped you as an attorney?

It helped me hit the ground running. It was also one of the major factors that contributed to me being hired at NCUA. The folks here didn’t have to train me on certain aspects of financial services because not only did I have the knowledge, but I had been involved in many issues that we face. As a result, I was able to contribute to the team at a higher level at a much faster pace.

You worked at the Federal Reserve in Atlanta, including serving as the Director of Operations. What stands out for you from that experience?

The leadership aspect of my career blossomed there. It gave me a better understanding of how to lead people, how to lead through change and adversity, how to lead during times when some very important decisions have to be made. I developed and I solidified my management style there. It was a difficult environment to lead in, but at the same time, very rewarding.

What advice would you give to someone who has to lead during a challenging time?

The main thing I took away was that each member of my team is an individual, and different things motivate different people. Before leadership at the Fed, I’d used a blanket approach. I handled everybody pretty much the same way. I didn’t take the time out to really understand or tap into the individuality of each member of my team. At the Fed, I started getting to know each person, understanding what motivates each individual, treating each individual in a way that’s beneficial to both the organization and to that person. I was able to get much better results using that approach.

What advice would you give to a young attorney who’s just starting out?

I’m currently mentoring a number of young attorneys. Figure out what your interests are. The quicker you narrow your desired areas of practice, the better off you’ll be, because you’ll be able to focus on developing the expertise in whatever those areas of interest happen to be.

Is it a matter of trying different things?

I don’t know if it is as much trying different things as it is knowing yourself and knowing what makes you tick. My advice comes more from an introspective approach. Know what you’re interested in, know what things make you tick, what things excite you, and then, project outward from that point.

You’ve been very involved with the ABA, including serving as the National Chair of the ABA Law Student Division. What made you want to get involved and how have you benefited?

Before I went back to law school, I realized, of course, that I had been out of school for a while. I considered myself a nontraditional student. So, I was apprehensive about going back to law school after having been out of school for so long. I did some research on the organizations that provided resources to help students like me to reacclimate themselves to full-time study. I came across this organization called the Council on Legal Education Opportunity (CLEO). They take in students who are accepted to law school and they start building a foundation, before you start school.

I attended a program in Atlanta, and was taught legal writing, and reading and analyzing cases, how to organize your materials, and how to read statutes. It was excellent. When I got back to Birmingham after that particular program, I did some research because I was so impressed. I found out that the American Bar Association is one of the major benefactors of CLEO.

From there, I started researching the ABA and, lo and behold, I found out it’s one of the largest professional organizations in the world. I knew I needed to get involved. Then I found out they had a law student division. I made my decision to get involved with the ABA before I even enrolled in law school.

As soon as I enrolled at the University Alabama School of Law, I paid my $25 fee, and I became a member of the ABA as a law student. From that point, I got involved anyway I could as a student. I participated in conference calls. I participated in opportunities to help draft comment letters on certain banking regulations. At that time I was, of course, a member of the Banking Law Committee. I assisted with a lot of those things, and it was just very beneficial for me to work with and to correspond with attorneys who were actually doing what I aspired to do.

Did it help you stay motivated during law school because you saw what was out there?

Absolutely. When I got the opportunity to apply for a CLEO scholarship, sponsored by the ABA Business Law Section, I jumped at the chance. I won the scholarship. Basically, this scholarship provided an opportunity for me to attend the Spring Meeting, where I was assigned two mentors. That’s where I transitioned into hyperdrive, if you will, as far as being involved in the ABA.

You’ve received many awards. Is there one that stands out for you?

Probably the most meaningful is the Gold Key Award from the Law Student Division after I served my year as Chair. That was a really, really huge honor.

What do you do for fun?

My wife and I have five beautiful children. They range in age from 11 all the way down to two and half. We have two-and-a-half-year old twins, so they are my hobby. I do have a son who is a golfer, so I spend a lot of time playing golf and shuttling him around to his golfing activities and tournaments. I did my undergraduate work at University of South Carolina, in Columbia, South Carolina, and I attended law school at the University of Alabama School of Law in Tuscaloosa, Alabama, so there are a lot of SEC sports that happen around our household, centered around those two programs.

Anything else you’d like to add?

My involvement in the American Bar Association has paid off for me in an infinite number of ways. From colleagues and the relationships I’ve developed to the meaningful work that we’ve done within our section and within the association as a whole. I’ve enjoyed the opportunities to mentor other students who are eager to learn and eager to navigate the legal industry. I would recommend it to anyone.

Thank you so much!