Ten Rules Every Lawyer—and Client—Should Know about Taxes on Legal Settlements

Posted on April 27, 2017 by - Uncategorized

Lawyers and clients resolve disputes all the time, usually with an exchange of money and a release. Almost any time money changes hands, there are tax issues for both sides, coming up in a surprising number of ways. Perhaps your car was rear-ended while stopped at a red light, your contractor did shoddy work on your condo, you were unfairly fired, or someone did you wrong and, as a result, you are collecting a settlement payment or judgment. As it relates to taxes, the first question in any of these situations is whether the settlement payment or judgment is taxable income, and the answer usually is “yes.” The tax treatment in these situations can vary enormously, however, depending on how you were damaged, how the case was resolved, how payment was made, how IRS Forms 1099 were issued, and other variables. Here are 10 rules lawyers and clients should know about the taxation of settlements.

1. Settlements and Judgments Are Taxed the Same

The same tax rules apply whether you are paid to settle a case (even if your dispute only reached the letter-writing phase) or win a judgment. Despite this similarity, however, you will almost always have more flexibility to reduce taxes if a case settles rather than goes to judgment. If you are audited, you must show what the case was about, and what you were seeking in your claims. Consider the settlement agreement, the complaint, how payments were made to resolve the case, IRS Forms 1099 (or W-2), etc. You can influence how your recovery is taxed by how you deal with these issues.

2. Taxes Depend on the “Origin of the Claim”

Settlements and judgments are taxed according to the matter for which the plaintiff was seeking recovery (the origin of the claim). If you are suing a competing business for lost profits, a settlement or judgment will be considered lost profits taxed as ordinary income. If you are laid off at work and sue for discrimination seeking wages and severance, you will be taxed on your settlement or judgment as having received wages.

In fact, your former employer probably will withhold income and employment taxes on all (or part of) your settlement, even if you have not worked there for years. On the other hand, if you sue for damage to your condo by a negligent building contractor, your damages usually will not be considered income. Instead, the recovery may be treated as a reduction in the purchase price of the condo. That favorable rule means you might have no tax to pay on the money you collect. These rules are full of exceptions and nuances, however, so be careful. Perhaps the biggest exception of all applies to recoveries for personal physical injuries (see rule 3).

3. Recoveries for Personal Physical Injuries and Physical Sickness Are Tax-Free

This is a really important rule that causes almost unending confusion with lawyers and their clients. If you sue for personal physical injuries resulting from, for example, a slip and fall or car accident, your compensatory damages should be tax-free. That may seem odd if, because if you could not work after your injuries, you are seeking lost wages. However, a specific section of the tax code—section 104—shields damages for personal physical injuries and physical sickness.

Note the “physical” requirement. Before 1996, “personal” injury damages included emotional distress, defamation, and many other legal injuries and were tax-free. Since 1996, however, your injury also must be “physical” to give rise to tax-free money. Unfortunately, neither the IRS nor Congress has made clear what that means. The IRS has determined generally that you must have visible harm (cuts or bruises) for your injuries to be “physical.” This observable bodily harm standard generally means that, if you sue for intentional infliction of emotional distress, your recovery is taxed.

Likewise, if you sue your employer for sexual harassment involving rude comments or even fondling, that also is not physical enough for the IRS. Some courts have disagreed, however, and the U.S. Tax Court in particular has allowed some employment lawsuits complete or partial tax-free treatment where the employee developed a physical sickness from the employer’s conduct or where a pre-existing illness was exacerbated. Taxpayers routinely argue in U.S. Tax Court that their damages are sufficiently physical to be tax-free, and although standards are getting a little easier, the IRS usually wins these cases. In many cases a tax-savvy settlement agreement could have improved the plaintiff’s tax chances.

4. Symptoms of Emotional Distress Are Not “Physical”

Tax law draws a distinction between money you receive for physical symptoms of emotional distress (like headaches and stomachaches) and physical injuries or sickness. Here again, these lines are not clear. For example, if in settling an employment dispute, suppose that you receive an extra $50,000 because your employer gave you an ulcer. Is an ulcer considered “physical” or is it merely a symptom of your emotional distress?

Many plaintiffs end up taking aggressive positions on their tax returns by claiming that damages of this nature are tax-free. Yet that can be a losing battle if the defendant issues an IRS Form 1099 for the entire settlement. That means it can behoove you to try to come to an agreement with the defendant about the tax issues, and there is nothing improper about doing so. There are wide variations in tax reporting and multiple players are often involved in litigation (e.g., the parties, their insurance companies, and their attorneys); thus, neglecting to nail all this down in the settlement agreement can be foolish. You may have to pay for outside tax experts, but you will almost always save considerable money later by spending a little at this critical moment. Otherwise, you might end up surprised with Forms 1099 you receive the year after your case settles. At that point, you will not have a choice about reporting the payments on your tax return.

5. Medical Expenses Are Tax-Free

Even if your injuries are purely emotional, payments for medical expenses are tax-free, and what constitutes “medical expenses” is surprisingly liberal. For example, payments to a psychiatrist or counselor qualify, as do payments to a chiropractor or physical therapist. Many nontraditional treatments count as well.

However, if you have previously deducted the medical expenses and are reimbursed when your suit settles in a subsequent year, you may have to pay tax on them. Blame the “tax benefit” rule, which provides that, if you previously claimed a deduction for an amount that produced a tax benefit to you (meaning it reduced the amount of tax you paid), you must pay tax on that amount if you recover it in a subsequent year. The opposite is also true. If you deducted an amount in a previous year, and that deduction produced no tax benefit to you, then you can exclude the recovery of that amount in a later year from your gross income.

6. Allocating Damages Can Save Taxes

Most legal disputes involve multiple issues, but even if your dispute relates to one course of conduct, there is a good chance the total settlement amount will involve multiple categories of damages. It usually is best for the plaintiff and defendant to agree on what is paid and its tax treatment. Such agreements are not binding on the IRS or the courts in later tax disputes, but they are rarely ignored. As a practical matter, what the parties put down in the agreement often is followed.

For all of these reasons, it is more realistic—and more likely to be respected by the IRS and other taxing authorities—if you divide up the total and allocate it across multiple categories. If you are settling an employment suit, there might be some wages (with withholding of taxes and reported on a Form W-2); some nonwage emotional distress damages (taxable, but not wages, so reported on a Form 1099); some reimbursed business expenses (usually nontaxable, unless the employee had deducted them); some pension or fringe benefit payments (usually nontaxable); and so on. There may even be some payment allocable to personal physical injuries or physical sickness (nontaxable, so no Form 1099), although this subject is controversial (see rules 3 and 4).

7. Look for Capital Gain Instead of Ordinary Income

Outside the realm of suits for physical injuries or physical sickness, just about everything is income; however, that does not answer the question of how it will be taxed. If your suit is about damage to your house or your factory, the resulting settlement may be treated as capital gain. Long-term capital gain is taxed at a lower rate (15 percent or 20 percent, plus the 3.8% Obamacare tax, not 39.6 percent) and is therefore much better than ordinary income.

Apart from the tax-rate preference, your tax basis may be relevant as well. This generally is your original purchase price, increased by any improvements you have made and decreased by depreciation, if any. In some cases, your settlement may be treated as a recovery of basis, not income.

A good example is harm to a capital asset, such as your house or your factory. If the defendant damaged it and you collect damages, you may be able to simply reduce your basis rather than report gain. Some settlements are treated like sales; therefore, again, you may be able to claim your basis. In fact, there are many circumstances in which the ordinary income versus capital gain distinction can be raised, so be sensitive to it. For example, some patent cases can produce capital gain, not ordinary income. The tax rate spread can be nearly 20 percent.

8. Attorney’s Fees Can Be a Trap

Whether you pay your attorney hourly or on a contingent-fee basis, legal fees will impact your net recovery and your taxes. If you are the plaintiff and use a contingent-fee lawyer, you usually will be treated (for tax purposes) as receiving 100 percent of the money recovered by you and your attorney. This is so even if the defendant pays your lawyer the contingent fee directly.

If your case is fully nontaxable (e.g., an auto accident in which you are physically injured), that should cause no tax problems. Yet if your recovery is taxable, the type of deduction you can claim for the legal fees can vary materially. This trap occurs frequently. Suppose you settle a suit for intentional infliction of emotional distress against your neighbor for $100,000, and your lawyer keeps 40 percent, or $40,000.

You might think that you would have $60,000 of income. Instead, you will have $100,000 of income, followed by a $40,000 miscellaneous itemized deduction. That means you will be subject to numerous limitations that can whittle your deduction down to nothing. For alternative minimum tax (AMT) purposes, you get no tax deduction for the fees. That is why many clients say they are paying tax on money (the attorney’s fees) they never received.

Notably, not all attorney’s fees face such harsh tax treatment. If the lawsuit concerns the plaintiff’s trade or business, the legal fees are a business expense. Those legal fees are “above the line” (a better deduction). Moreover, if your case involves claims against your employer, or involves certain whistleblower claims, there is an above-the-line deduction for legal fees. That means you deduct those legal fees before you reach the adjusted gross income (AGI) line on the front of your 1040. An above-the-line deduction prevents the problems related to miscellaneous itemized deductions taken after your AGI has been calculated. Outside of employment and certain whistleblower claims or claims involving your trade or business, however, be careful: there are sometimes ways of circumventing these attorney’s fees rules, but you need sophisticated tax help before your case settles to do it.

9. Punitive Damages and Interest Are Always Taxable

Punitive damages and interest are always taxable, even if your injuries are 100 percent physical. Suppose you are injured in a car crash and receive $50,000 in compensatory damages and $5 million in punitive damages. The $50,000 is tax-free, but the $5 million is fully taxable. Moreover, you might have trouble deducting your attorney’s fees (see rule 8).

The same occurs with interest. You might receive a tax-free settlement or judgment, but prejudgment or postjudgment interest is always taxable. As with punitive damages, taxable interest can produce attorney’s fees deduction problems. These rules can make it more attractive (from a tax viewpoint) to settle your case rather than have it go to judgment.

Return to the situation above, in which you receive $50,000 in compensatory (tax-free) damages, plus $5 million in punitive damages. Can you settle instead for $2 million that is all tax-free? It depends (among other things) on whether the judgment is final or on appeal. It also depends on what issues are up on appeal. The facts and procedural posture of your case are important. In some cases, you can be much better off, from a tax viewpoint, taking less money.

10. It Pays to Consider the Defense

Plaintiffs generally are much more worried about tax planning than defendants. Nevertheless, consider the defendant’s perspective as well. A defendant paying a settlement or judgment will always want to deduct it. If the defendant is engaged in a trade or business, doing so rarely will be questioned, given that litigation is a cost of doing business. Even punitive damages are tax deductible by businesses. Only certain government fines cannot be deducted, and even then defendants can sometimes find a way if the fine is in some way compensatory.

Despite these broad deduction rules for businesses, not everyone is so lucky. If the suit is related to investments, the deduction could be restricted to only investment income or face other limitations. If the suit is purely personal, the defendant may get no deduction at all. In some cases, that can extend to attorney’s fees as well.

Defendants can also run up against questions about whether an amount can be immediately deducted or must be capitalized. For example, if a buyer and seller of real estate are embroiled in a dispute, any resulting settlement payment may need to be treated as part of the purchase price and capitalized, not deducted.

Conclusion

Nearly every piece of litigation eventually sprouts tax issues. It is tempting to just bring your dispute to an end and let the tax chips fall where they may. Whether you are a plaintiff, a defendant, or counsel for one, that can be a mistake. Before you resolve the case and sign, consider the tax aspects. Tax withholding, reporting, and tax language that might help you are all worth addressing. You will almost always have to consider these issues at tax return time the following year. You often save yourself money by considering taxes earlier.

Private Planes, Investors, and NASDAQ Rules: Delaware Supreme Court Gives Guidance on Director Independence

Posted on April 27, 2017 by - Uncategorized

Under Delaware law, as under federal law, a corporate stockholder may assert a cause of action derivatively on behalf of a corporation for harms caused to the corporation by its directors and officers. However, a stockholder’s right to bring such a derivative action conflicts with a board of directors’ right to manage the business and affairs of a corporation. Therefore, a stockholder in a Delaware corporation who wishes to bring suit derivatively on behalf of a corporation must either make a demand on the corporation’s board of directors to bring the suit or be prepared to explain in the complaint why such a demand would be futile. Under Delaware Court of Chancery Rule 23.1, a derivative complaint must allege “with particularity” the plaintiff’s efforts to obtain the desired action from the board or must allege, also “with particularity,” “the reasons for the plaintiff’s failure to obtain the action or for not making the effort.” In most cases, the complaint sets forth the plaintiff’s reasons “for not making the effort,” usually alleging that demand on the board would be futile because a majority of the board members were either interested in the challenged transaction or lacked the required independence from an interested party. A complaint that fails to allege such “demand futility” with particularity will be dismissed under Rule 23.1.

A director who participates on both sides of the challenged transaction, or who obtains a benefit not shared with all stockholders, is interested in the transaction. A director who is financially “beholden to” an interested person, or who has a relationship with an interested person that would affect the director’s ability to exercise independent judgment, lacks independence. Demand on the board is excused, and a stockholder may bring suit derivatively, when a majority of the board members are either interested or lack independence. Many Delaware cases have focused on the types of relationships that render directors not independent.

In a recent case, Sandys v. Pincus, 2016 Del. LEXIS 627 (Del. Dec. 5, 2016), the Delaware Supreme Court reversed the Delaware Court of Chancery’s dismissal of a derivative suit based on failure to plead demand futility with particularity. The Court of Chancery found that the facts alleged in the complaint were insufficient to show that a majority of the members of the corporation’s board were either interested in the challenged transaction or lacked independence from an interested person. Four of the five members of the Delaware Supreme Court, sitting en banc, disagreed. The majority opinion, authored by Chief Justice Leo E. Strine, Jr., further defines the types of relationships that can render directors not independent.

In addition to discussing the Delaware Supreme Court’s opinion in Sandys v. Pincus, this article will refer to off-the-cuff remarks made by Chief Justice Strine at the Securities Regulation Institute in Coronado, California, on January 23, 2017, regarding Sandys v. Pincus and, more generally, the problems of director independence under Delaware law.

Summary of Facts

The complaint in Sandys v. Pincus alleged that several top managers and directors of Zynga, Inc. traded on inside information, selling 20.3 million shares of Zynga stock at $12 per share, for a total of $236.7 million, shortly before an earnings announcement disclosed information that caused the market price to drop 9.6 percent to $8.52 per share. The complaint also alleged that the insiders were aware at the time of the sale of additional negative information that, when disclosed three months later, caused Zynga’s market price to drop to $3.18 per share, for a total decline of 73.5 percent from the $12 sale price. The complaint asserted claims for breach of fiduciary duty against the insiders who participated in the sale and the directors who approved the sale.

The defendants included Mark Pincus, who was the former CEO, chairman, and controlling stockholder of Zynga, holding 61 percent of the company’s voting power. At the time the complaint was filed, the Zynga board of directors was composed of nine directors, two of whom, Pincus and defendant Reid Hoffman, had participated in the challenged transaction. Another, Don Mattrick, was Zynga’s CEO.

Based on the allegations in the complaint, the Court of Chancery found that at least five of Zynga’s directors—a majority of the board—were not interested in the transaction and were independent of Pincus. The Delaware Supreme Court disagreed as to the independence of three of those five: Ellen Simonoff, William Gordon, and John Doerr. The court found that, in addition to Pincus and Hoffman, who were interested in the transaction, Mattrick (the CEO), was not independent because Pincus, as the controlling stockholder, controlled Mattrick’s livelihood. Therefore, a majority of six of the nine board members were either interested (Pincus and Hoffman) or lacked independence from Pincus (Mattrick, Simonoff, Gordon, and Doerr), demand was excused as futile, and the complaint should not have been dismissed.

Director Simonoff Was Not Independent Because of Co-Ownership of an Airplane With Pincus

The complaint alleged that director Ellen Simonoff, together with her husband, had “an existing business relationship with defendant Pincus as co-owners of a private airplane.” The Delaware Supreme Court found that “the most likely inference” from that alleged fact was that there was “an extremely close, personal bond between Pincus and Simonoff, and between their families.” The court accepted the plaintiff’s argument that “owning an airplane together is not a common thing” and that such co-ownership “suggests that the Pincus and Simonoff families are extremely close to each other and are among each other’s most important and intimate friends.” The court determined that co-ownership of an airplane “is suggestive of the type of very close personal relationship that, like family ties, one would expect to heavily influence a human’s ability to exercise impartial judgment.” The court maintained that the elevated pleading standard in the demand excusal context—“with particularity”—“does not require a plaintiff to plead a detailed calendar of social interaction to prove that directors have a very substantial personal relationship rendering them unable to act independently of each other.” The court thus concluded that the alleged facts were sufficient to support an inference that Simonoff was not independent of Pincus.

Directors Gordon And Doerr Were Not Independent Because of “Mutually Beneficial Business Relations” With Pincus

The complaint alleged that two other directors, William Gordon and John Doerr, were partners at Kleiner Perkins Caufield & Byers, an investment firm that controlled 9.2 percent of Zynga’s equity. Kleiner Perkins also invested in a company cofounded by Pincus’s wife. In addition, Kleiner Perkins and defendant Hoffman (who participated in the challenged transaction along with Pincus) coinvested in another company, Shopkick, Inc., and Hoffman served on Shopkick’s board with another Kleiner Perkins partner. The court accepted the plaintiff’s argument that “Gordon and Doerr have a mutually beneficial network of ongoing business relations with Pincus and Hoffman that they are not likely to risk by causing Zynga to sue them,” and rejected the defendants’ argument that “the relationships among these directors flowed all in one direction and that it is Pincus who is likely beholden to Gordon, Doerr, and Kleiner Perkins for financing.” The court determined that, “precisely because of the importance of a mutually beneficial ongoing business relationship, it is reasonable to expect that sort of relationship might have a material effect on the parties’ ability to act adversely toward each other.”

Gordon and Doerr Were Not Considered Independent under NASDAQ Listing Rules

The court also emphasized the fact that Zynga did not identify Gordon and Doerr as independent directors under the NASDAQ listing rules, although “Zynga did not disclose why its board made this determination.” Although the Delaware standard for director independence “does not perfectly marry with the standards of the stock exchange in all cases,” the NASDAQ criteria “are relevant under Delaware law and likely influenced by our law.” The court listed the relationships that automatically preclude a finding of independence under the NASDAQ rules, concluding that the “bottom line” is that “a director is not independent if she has a ‘relationship which, in the opinion of the Company’s board of directors, would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.’” The court determined that Delaware law “is based on the sensible intuition that deference ought to be given to the business judgment of directors whose interests are aligned with those of the company’s stockholders.” Thus, when a board of directors has determined that one of its members has a relationship that would interfere with her judgment in carrying out her responsibilities generally—even more so in the “high-salience context” of Rule 23.1, where the determination of independence “can short-circuit a merits determination of a fiduciary duty claim”—courts should exercise an “understandable skepticism.”

Thus, given their alleged relationship with Pincus and Hoffman and the fact that they were not identified as independent under the NASDAQ rules, the Delaware Supreme Court concluded that Gordon and Doerr lacked independence for purposes of demand excusal.

Plaintiff Failed To Investigate the Directors’ Independence before Filing Suit

A recurring theme in the Sandys v. Pincus opinion is the plaintiff’s failure to conduct an adequate presuit investigation into the independence of the Zynga board of directors from the company’s controlling stockholder (Pincus). Although the plaintiff did exercise his right as a stockholder to seek books and records from the company regarding the challenged transaction, he did not seek books and records “bearing on the independence of the board.” The court determined that the “tools at hand” for drafting a complaint include not only traditional books-and-records demands, but “the tool provided by the company whose name has become a verb—or another internet search engine.” If the plaintiff had “Googled” the defendants, “he likely would have discovered more information about Simonoff’s relationship with Pincus.” The court noted that, although “an internet search will only have utility if it generates information of a reliable nature,” the court “can take judicial notice that internet searches can generate articles in reputable newspapers and journals, postings on official company websites, and information on university websites that can be the source of reliable information.” The court determined that the plaintiff’s “lack of diligence put the Court of Chancery in a compromised and unfair position . . . and the plaintiff is fortunate that his failure to do a pre-suit investigation has not resulted in dismissal.”

Justice Valihura’s Dissent Emphasizes the Presumption of Director Independence

In an unusual move, Justice Karen Valihura lodged a written dissent to the court’s ruling. She disagreed with the majority on the independence of directors Simonoff, Gordon, and Doerr. In her view, the plaintiff failed to allege facts showing the materiality of Simonoff’s co-ownership of the airplane or of Gordon’s and Doerr’s business relationships with Pincus and Hoffman. She emphasized that, in the demand-futility context, directors are presumed independent and that plaintiffs have the burden to plead facts “with particularity” showing that the alleged relationships were of a “bias-producing” nature.

As to Simonoff, she noted that the complaint alleged only a business relationship between Simonoffs and Pincus and that the only reference to a “close friendship” appeared in an unverified brief that could not be considered on a motion to dismiss based on the pleadings. Quoting Beam v. Stewart, 845 A.2d 1040, 1050 (Del. 2004), she determined that, “a reasonable inference cannot be made that a particular friendship raises a reasonable doubt ‘without specific factual allegations to support such a conclusion.’” In Beam, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of a complaint that contained allegations that a director was a “longtime personal friend” or had a “longstanding personal relationship” with the controlling stockholder, Martha Stewart.

As to Gordon and Doerr, and Zynga’s failure to identify them as independent directors under NASDAQ rules, Justice Valihura reasoned that it is “not difficult to come up with a scenario where a director might be deemed ‘non-independent’ under the NASDAQ rules, or NYSE rules, yet deemed independent for demand futility purposes,” for example, if the designation were due to a relationship with the corporation or an executive other than the controlling stockholder. Given the plaintiff’s pleading burden and failure to explain why Gordon and Doerr were identified as not independent for NASDAQ purposes, Justice Valihura did not believe that the plaintiff was entitled to an inference that Gordon and Doerr were not independent for demand-futility purposes.

Finally, Justice Valihura noted that, “internet searches likely are not, in most cases, an adequate substitute for [books and records] demands made pursuant to 8 Del. C. § 220,” and that the majority “never identifies what information likely would have been discovered.” She noted that, on motions to dismiss, courts are “stuck with the limited factual allegations made by the plaintiff,” and that courts may not take judicial notice of facts outside the pleading unless they are not “subject to reasonable dispute,” and the parties are “given prior notice and an opportunity to challenge judicial notice of that fact.”

Chief Justice Strine’s “Off the Cuff” Comments

On January 23, 2017, Chief Justice Strine, the author of the Sandys v. Pincus opinion, took part in a “conversation” at the Securities Regulation Institute in Coronado, California, where he discussed issues raised by the opinion along with other issues of director independence.

The Chief Justice stated the view that some personal relationships are akin to family relationships and urged courts and boards of directors to “dig in” and not just “check the box” on exchange independence standards. He distinguished cases in which directors serve on other boards together or attend weddings (as in the Delaware Supreme Court’s 2004 Stewart case), which may signal nothing more than a social or economic circle or peer group. Rather, he asked, who owns a plane together? Co-owning an airplane or a boat is “a big deal.” The Chief Justice stressed that boards should give advance consideration to the likelihood of litigation—it happens to every public company—and think, “who are our really independent directors”—the individuals who could be trusted to make a decision about whether to sue a fellow board member.

In addition, the Chief Justice said that, when a deal is anticipated, it is important for a board to switch from routine, “short-form” minutes to “long-form” minutes, and that the board should flag the change and state why it is being made. Boards that launch without explanation into long-form minutes do not look credible because the minutes are “lumpy”—too much on x and nothing on y. That is why short-form, but thoughtful, “contextual” minutes are best and should be maintained in most situations. When there is a reason to start including more detail, the board should state so and state why. According to the Los Angeles-San Francisco Daily Journal, the Chief Justice suggested that it might even be wise to record key meetings to ensure that events are recalled accurately. “I’d much rather have a tape recording of the meeting . . . than to have somebody doing bad minutes or taking bad notes,” Strine said.

According to the Daily Journal, the Chief Justice also urged corporate attorneys to step in while boards are formed to head off director conflicts that can be raised in derivative lawsuits. He said that attorneys must be willing to probe deeply into relationships among directors through their own external research and direct questioning of potential board members. “Uncomfortable questions need to be asked,” Strine said.

Key Takeaways

Beware of “Mutually Beneficial Business Relations” Between Directors and Controlling Stockholders

Traditionally, a director lacks independence from an interested person if the director is “beholden to” the interested person. Under Sandys v. Pincus, the reverse may be true; a director may lack independence because the interested person is beholden to the director. The allegation that the interested person has an obligation to the director can lead to an inference of “mutually beneficial business relations” such that the director is deemed unable to exercise independent judgment and is disabled from considering a presuit demand for board action against the interested person. The key takeaway is that corporate counsel must consider obligations flowing in both directions, and not just obligations that otherwise independent directors owe to controlling stockholders.

Beware of Co-Ownership of Significant Assets Between Directors and Controlling Stockholders

Under Sandys v. Pincus, co-ownership of a significant asset, such as a private airplane or a boat, whether for a business purpose or otherwise, can lead to an inference that a close personal relationship akin to family exists, and that a director in such a relationship is not independent for purposes of demand excusal. The key takeaway is that corporate counsel should inquire about and investigate the existence of co-owned assets in determining whether a board of directors has a majority of truly independent directors.

Directors Who Are Not Independent under Exchange Rules Are Unlikely To Be Found Independent for Demand-Excusal Purposes

The Delaware Supreme Court did not go so far as to say that a director who is not independent under NASDAQ or other exchange rules is per se not independent for demand-excusal purposes, but Sandys v. Pincus strongly suggests that it is unwise to assume otherwise. Under Sandys, a company’s board should consider disclosing the reasons for its determination that a director is not independent under exchange rules, and should be prepared to explain why such a director should be considered independent for demand-excusal purposes. Although plaintiffs have the burden of pleading particular facts that create a reasonable doubt regarding independence, the mere fact that a director is not independent under exchange rules may be sufficient to meet that burden in future cases.

Plaintiffs’ Lawyers Should Seek Books and Records Related To Board Independence

In Sandys, the plaintiff conducted a presuit investigation by seeking corporate books and records related to the challenged transaction. At that time, a majority of the board members had participated in the challenged transaction, so a majority of the board was interested and unable to consider a demand to sue themselves. The plaintiff, assuming that demand was futile under those circumstances, did not seek books and records regarding board independence. However, the composition of the board changed before the complaint was filed so that only two of the nine board members who would have considered a demand at that time—the so-called demand board—had participated in the transaction. As a result, it was a “close call” whether the board was disabled, and the plaintiff was “fortunate” that the dismissal of his complaint under Rule 23.1 was reversed on appeal. The key takeaway for plaintiffs’ lawyers is that they should always seek information about board independence when demanding books and records in prederivative-suit investigations.

Plaintiffs’ Lawyers Should Always “Google” the Members of the Demand Board

In Sandys, the court scolded the plaintiff for his “cursory” presuit investigation into board independence, insisting that the plaintiff “likely would have discovered more information” if he had conducted an Internet search of reliable sources. The court determined that it could “take judicial notice” that such resources “can be the source of reliable information.” Many derivative and class-action complaints over the years have quoted newspaper and magazine articles in alleging corporate wrongdoing. The Delaware Supreme Court suggests in Sandys that plaintiffs can also rely on reputable Internet sources in pleading demand futility.

Authenticating Digital Evidence at Trial

Posted on April 27, 2017 by - Uncategorized

In this digital age, social media, texts, and a variety of other forms of technology have increasingly become evidence, or sought as evidence, in a wide sundry of litigation. How do you ensure that this evidence comes in at trial? This issue can prove daunting to newer practitioners as well as more seasoned practitioners who may not be as knowledgeable as to how to introduce into evidence e-mails, texts, or Facebook posts. Although it may appear more complicated at first glance, the short answer is simple: authentication. As with all other types of evidence, digital evidence must be authenticated in order to be properly introduced at trial. However, authenticating digital evidence can pose some interesting challenges.

As an initial matter, the proffered evidence must first be determined to be relevant. The test for determining relevancy is Federal Rule of Evidence (FRE) 401, which provides: “Evidence is relevant if: (a) it has any tendency to make a fact more or less probable than it would be without the evidence; and (b) the fact is of consequence in determining the action.” Once the evidence is determined to be relevant, then it must be determined to be authentic.

The authentication standard is the same regardless of whether the evidence is digital or in a more traditional form—that is, FRE 901(a) requires the party proffering the evidence to demonstrate that the evidence is what it is claimed to be. FRE 901(b) sets forth examples of evidence that satisfy the general requirements of FRE 901(a), including, but not limited to, the testimony of a witness with knowledge under FRE 901(b)(1), distinctive characteristics of the item under FRE 901(b)(4), or a comparison by an expert witness under FRE 901(b)(3).

E-mails are now commonly offered as evidence at trial. After first demonstrating that the evidence is relevant pursuant to FRE 401, the attorney proffering this evidence must establish authenticity: Was the e-mail sent to and from the persons as indicated on the e-mail? Here, a witness with personal knowledge may testify as to the e-mail’s authenticity, which typically is the author of the e-mail or a witness who saw the proffered e-mail drafted and/or received by the person the proponent claims drafted/received the e-mail. In addition, if the e-mail has been produced in response to a sufficiently descriptive document request, the production of the e-mail in response may constitute a statement of party-opponent and found to be authenticated under FRE 801(d)(2).

Texts are also becoming increasingly offered as evidence at trial. Typically, evidence of texts is obtained in one of two forms: (1) as screen shots; or (2) as photographs of the text messages. Whether a screen shot or a photograph, it is important that the screen with the text message, the name and/or phone number of the person sending the text message, and the date and time the message was sent are clearly displayed. Text messages can be authenticated by the testimony of a witness with knowledge or by distinctive characteristics of the item, including circumstantial evidence such as the author’s screen name or monikers, customary use of emoji or emoticons, the author’s known phone number, the reference to facts that are specific to the author, or reference to facts that only the author and a small number of other individuals may know.

Social media networks such as Facebook, Linked-In, and the like are now ubiquitous; consequently, social media posts have increasingly become evidence at trial. However, authenticating a social media post generally is more difficult than an e-mail or a text. For example, it is insufficient to simply show that a post was made on a particular person’s webpage; it is generally too easy to create a Facebook page or the like under someone else’s name. In addition, an individual could have gained access to someone else’s social media account. To properly introduce evidence of a social media post at trial, you must first have a printout (or download, if a video) of the webpage that depicts the social media post you seek to introduce as evidence, and the person who printed or downloaded the post must testify that the printouts accurately reflected what was on his or her screen when it was printed or downloaded.

Once that is established, the social media post must be authenticated. This can be done in several ways. Direct witness testimony can be obtained by the purported creator of the post, from someone who saw the post being created, and/or from someone who communicated with the alleged creator of the post through that particular social media network. Testimony can be obtained from the social media network to establish that the alleged creator of the post had exclusive access to the originating computer and the social media account. The subscriber report can also be subpoenaed from the social media network, which can identify all posts made and received as well as any comments, “likes,” “shares,” photographs, etc. As with e-mails and texts, circumstantial evidence may also be used for authentication pursuant to FRE 901(b)(4) if, for example, the post contains references or information relating to family members, a significant other, or co-workers; the writing style of the posts or comments is in the same style (i.e., slang, abbreviations, nicknames, and/or use of emoji/emoticons) the purported author uses; or there are private details about the author’s life or details that are not widely known that are indicated in the post. Finally, do not overlook the option of having the author of the social media post authenticate the post and testify regarding the post in his or her deposition.

In sum, authentication is key to getting digital evidence such as e-mails, texts, and social media posts admitted into evidence, but proper authentication can be a significant hurdle, and this often is a fact-driven issue that will vary from case-to-case.

The Defend Trade Secrets Act: One Year Later

Posted on April 27, 2017 by - Uncategorized

Introduction

The Defend Trade Secrets Act of 2016 (DTSA) was signed into law by former President Obama and became effective on May 11, 2016, amid much fanfare. At the time of its passage, the law was described as the “most significant expansion” of federal law in intellectual property since the Lanham Act in 1946. The DTSA provided a federal cause of action for trade secret misappropriation. In addition, it provided for a specialized seizure remedy, as well as an immunity provision designed to protect employees who might disclose trade secrets when allegedly reporting violations of the law.

The DTSA’s impact over the past year has been limited. Although the DTSA has made it easier for trade secret litigants to establish federal jurisdiction and thus get into federal court, there have been no sweeping changes in trade secret litigation. To date, federal courts do not appear enamored by the extra case load, and nearly all of the federal court decisions have continued to predominantly rely on pre-existing state and federal law and remedies. Despite the widespread publicity, both the seizure remedy and the immunity provision have had extremely minimal application and impact to date. See Bradford K. Newman & Esther Cheng, Federal Trade Secrets Protection: Law Would Create More Problems than It Solves, Daily J., Apr. 28, 2016.

This article provides an overview of the recent developments in DTSA trade secret litigation over the course of the past year. For more detailed information, please refer to the “Employee Mobility, Restrictive Covenants, and Trade Secrets Chapter” of Recent Developments in Business and Corporate Litigation, which was released in April 2017.

Creating a Federal Cause of Action

The DTSA creates the first federal civil cause of action and suite of statutory remedies for the misappropriation of trade secrets in the United States and provides a single uniform cause of action for trade secret misappropriation across the states. Prior to its enactment, as a civil matter, trade secret misappropriation claims (as opposed to Computer Fraud and Abuse Act claims pursuant to 18 U.S.C. § 1030) were governed exclusively by state laws. (Although most states have enacted the Uniform Trade Secrets Act (UTSA), there are still two outliers that protect trade secrets under unique state statutes or common law: New York and North Carolina.) Plaintiffs who sued for trade secret misappropriation in different states faced some longstanding and well-understood differences in legal standards and procedural requirements. The DTSA was purportedly intended to create a uniform body of federal trade secret law while establishing jurisdiction for claims brought pursuant to the DTSA in the federal courts.

On its face, however, the DTSA does not pre-empt state law, meaning that a party can file suit under the DTSA in federal court and plead a state law claim arising out of the same facts. In practice, this means that the DTSA’s primary function to date has been to create a path for plaintiffs to litigate what historically were essentially state law trade secret claims in federal court.

The DTSA cause of action is similar to those brought pursuant to the UTSA. The DTSA at 18 U.S.C. § 1836(b)(1) allows a plaintiff to bring a civil action for misappropriation of a trade secret only if the “trade secret is related to a product or service used in, or intended for use in, foreign or interstate commerce”—an easy showing in today’s world. Under the DTSA at section 1836(b)(3)(B)(5), “misappropriation” is defined much like it is under the UTSA and means: (a) acquisition by a person who knows (or has reason to know) the trade secret was acquired by improper means; or (b) disclosure or use of the trade secret by a person who used “improper means” to acquire the trade secret or had certain knowledge. Notably, the term “improper means” does not include reverse engineering or independent derivation under section 1836(b)(3)(B)(6).

Monetary and Injunctive Relief

Under section 1836(b)(3)(B) of the DTSA, a party can recover injunctive relief, monetary damages, and attorney’s fees. A discussion of injunctive relief follows. (To date, no court has reached the damages stage of a DTSA case, and thus, monetary relief is not addressed in this article.)

Injunctive relief is permitted under section 1836 (b)(3)(A)(i) of the DTSA to prevent any actual or threatened misappropriation on terms “the court deems reasonable.” To prevent plaintiffs from pursuing inevitable disclosure claims and claims aimed at restraining employee mobility, section 1836 (b)(3)(A)(i)(I) provides that injunctive relief may only be issued if it does not “prevent a person from entering into an employment relationship,” and if the “conditions placed on such employment” are “based on evidence of threatened misappropriation and not merely on the information the person knows.” In addition, under section 1836 (b)(3)(A)(i)(II), the injunctive relief ordered must not conflict with any applicable state laws. Injunctive relief is also available under section 1836(b)(3)(A)(ii) if affirmative actions are required to protect the trade secret and the court determines it is appropriate. At a high level, experienced practitioners will recognize there is little about this standard that could be deemed novel under the Federal Rules of Civil Procedure or state corollaries.

Since the enactment of the DTSA, federal courts have not hesitated to grant injunctive relief based solely on existing state and federal law that predates the DTSA. Frequently, the analysis focuses on traditional application of the Federal Rules of Civil Procedure’s injunctive relief provision and either ignores the existence of the DTSA claim in the complaint, or analyzes the dual state-law/DTSA basis for a traditional injunction in tandem.

For example, in Henry Schein, Inc. v. Cook, No. 16-CV-03166-JST, 2016 WL 3418537 (N.D. Cal. Jun. 22, 2016), the court granted a motion for preliminary injunction after finding, inter alia, that Henry Schein, Inc. had established a likelihood of success on its claims of trade secrets misappropriation brought under both the DTSA and California Uniform Trade Secrets Act (“CUTSA”). In making this decision, the court analyzed both the DTSA and CUTSA claims simultaneously.

Similarly, in Engility Corp. v. Daniels, No. 16-CV-2473-WJM-MEH, 2016 WL 7034976, at *10 (D. Colo. Dec. 2, 2016), the Colorado district court granted a preliminary injunction under both the DTSA and the Colorado Uniform Trade Secrets Act. Notably, as part of the preliminary injunction in Engility Corp., the court enjoined Daniels and his new company from competing for certain business for a period of one year. The court noted that, although the DTSA prohibits injunctions that “conflict with an applicable State law prohibiting restraints on the practice of a lawful profession, trade, or business,” such as Colorado’s statutory restrictions on noncompete provisions, the injunction was necessary to prevent Daniels and his new company from taking advantage of trade secrets in their possession and therefore fell within an exception to Colorado’s statutory noncompete restrictions. The court did not separately analyze the proprietary of the injunction under the Colorado Uniform Trade Secrets Act, merely concluding that, despite its less specific provision regarding injunctive relief, it “probably has the same sorts of restrictions as the DTSA.”

In Panera, LLC v. Nettles, No. 4:16-CV-1181-JAR, 2016 WL 4124114, at *4 (E.D. Mo. Aug. 3, 2016), Panera LLC, a restaurant chain, moved for a temporary restraining order against Michael Nettles, a former employee, and his new employer, Papa John’s International, Inc., in the Eastern District of Missouri under both the Missouri Uniform Trade Secrets Act (MUTSA) and the DTSA. The court granted the motion based on the MUTSA claim and declined to analyze the DTSA claim in the context of a footnote, which pointed out that, “although the Court’s analysis has focused on Panera’s Missouri trade secrets claim, an analysis under the Defend Trade Secrets Act would likely reach a similar conclusion.”

Finally, in Earthbound Corp. v. MiTek USA, Inc., C16-1150 RSM, 2016 WL 4418013, at *11 (W.D. Wash. Aug. 19, 2016), a Washington district court also granted a temporary restraining order under both Washington state law and the DTSA based on strong circumstantial evidence of defendant’s misappropriation of confidential and trade secret information about Earthbound’s current and prospective customers, pending projects, bids, pricing, product design, and other elements of its business, which would lead to irreparable harm if not enjoined.

The takeaway in the year following the DTSA’s enactment is that, although the DTSA provides a new basis for federal court jurisdiction, absent extraordinary circumstances, practitioners should expect federal judges to analyze injunctive requests largely according to traditional notions of what is required for such relief.

Ex Parte Civil Seizures

One of the most widely publicized features of the DTSA is section 1836(b)(3)(d), which permits trade secrets misappropriation plaintiffs to request, on an ex parte basis, seizure of the alleged trade secrets before giving any notice to the defendant. Specifically, this provision provides at section 1836(b)(2)(A)(i) that “only in extraordinary circumstances” may the court issue an order “providing for the seizure of property necessary to prevent the propagation or dissemination of the trade secret that is the subject of the action.” To order an ex parte seizure, the court must find under section 1836(b)(2)(A)(ii)(IV)–(VIII) that: (1) the plaintiff is likely to succeed on the merits; and (2) if notice were provided, the defendant would likely “destroy, move, hide, or otherwise make such matter inaccessible.” The court must then find under section 1836(b)(2)(A)(ii)(III) that the harm in denying the ex parte application “outweighs the harm to the legitimate interests of the person against whom seizure would be ordered” and “substantially outweighs the harm to any third parties who may be harmed by such seizure.” To avail themselves of this relief, applicants cannot have publicized the requested seizure under section 1836(b)(2)(A)(ii)(VIII).

Federal Courts Are Extremely Hesitant to Grant a Request for the Seizure Remedy

On a nationwide basis, federal courts generally have limited relief under the DTSA to what was already available under the Federal Rules of Civil Procedure and developed state law. For example, in OOO Brunswick Rail Mgmt. v. Sultanov, No. 5:17-cv-00017, 2017 WL 67119, *2–3 (N.D. Cal., Jan. 6, 2017), the court declined to issue a seizure order against Sultanov, a former employee accused of trade secret misappropriation, to seize the company-issued laptop and mobile phone in his possession, despite finding that the plaintiff had satisfied the requirements for a temporary restraining order (i.e., a likelihood of success on the merits of its trade secret claims and irreparable harm in the absence of injunctive relief). The court cited the DTSA’s requirement that seizure orders may be issued only if other forms of equitable relief would be inadequate. It then found that, in this case, such a remedy was “unnecessary” because the court would order Sultanov to deliver the devices to the court at the time of the hearing without accessing or modifying them in the interim.

Similarly, in Magnesita Refractories Co. v. Mishra, 2017 WL 365619 (N.D. Ind. Jan. 25, 2017), the court noted that the DTSA’s seizure provision did not apply because the existing relief, an ex parte temporary restraining order authorizing the seizure of the defendant’s personal laptop computer, was sufficient. The court had ordered the seizure under the traditional temporary restraining order provision in Federal Rule of Civil Procedure 65 after it was shown that there was a “strong likelihood that [Mishra, the former employee] was conspiring to steal [the employer’s] trade secrets contained in the laptop.” The court rejected Mishra’s argument that he was denied the due process provided under DTSA’s seizure provision and denied his motion to vacate the temporary restraining order.

As of the publication of this article, a federal court has granted a request for the seizure remedy in a published decision only in a single, extraordinary circumstance. In Mission Capital Advisors, LLC v. Romaka, No. 16-civ-5878 (S.D.N.Y. July 29, 2016), the District Court for the Southern District of New York ordered a seizure against a defendant, Romaka, only after the defendant first violated a temporary restraining order. Romaka was a former employee of a commercial real estate company and had downloaded contact lists from his former employer without authorization. He then falsely represented that he had deleted this data. In reality, Romaka simply changed the file names and failed to comply with the existing temporary restraining order. As a result, the court granted an order allowing for the seizure of the contact lists, but because only the customer lists had been described with sufficient particularity, the court denied such a request for all other confidential information.

The Future Impact of the Seizure Provision

The early headline from a nationwide review of the initial DTSA cases is an emerging trend by federal courts to look warily on requests to issue DTSA seizure remedies in routine cases where traditional remedies would suffice. Courts are giving great deference to the statutory phrase “extraordinary circumstances” and refraining from finding as much in most cases, despite allegations typically included in the complaint to the contrary.

Should courts become more inclined to grant the seizure order provided under the DTSA, this remedy would prove effective for trade secret owners who seek to immediately enjoin trade secret misappropriators in the most extreme cases from using and disclosing their trade secrets or, for example, from fleeing the country. On the other hand, the seizure provision may also subject over-eager plaintiffs to substantial damages. In addition, although the seizure provision contains a long list of substantive requirements, an emphasis on confidentiality, and procedural safeguards, until the federal trial and appellate courts provide further guidance in the form of published decisions, there is certainly potential for this provision of the DTSA to lead to exploitive tactics, particularly by plaintiffs bringing misappropriation claims based on anticompetitive motives. This scenario could lead to the “potential for abuse of this provision by ‘trade secret trolls’ and larger companies seeking to use the DTSA for competitive advantage against smaller players.” See Bradford K. Newman & Esther Cheng, Federal Trade Secrets Protection: Law Would Create More Problems than It Solves, Daily J., Apr. 28, 2016. It might also lead to the seizure of company trade secrets by competitors who never should have had access rights to those secrets in the first place. Fortunately, as noted, courts seem to favor a conservative approach, faithful to the statutory text of the seizure provision, signaling the bench’s acknowledgement that it will indeed take “extraordinary circumstances” not found in the commonplace to-and-fro of trade secret litigation.

The Employee Immunity Provision

Another notable provision of the DTSA is its public policy immunity provision at 18 U.S.C. § 1833(b), which offers immunity from liability for the confidential disclosure of a trade secret to a government official or an attorney in order to report a violation of the law. The immunity provision at section 1833(b)(1) protects individual employees from civil or criminal liability for the disclosure of a trade secret that: (a) is made “in confidence to a federal, state, or local government official, either directly or indirectly, or to an attorney” and solely for “the purpose of reporting or investigating a suspected violation of law”; or (b) is made in a complaint or document “filed in a lawsuit or other proceeding” so long as the filing is made under seal. This provision also allows for the use of trade secret information in an anti-retaliation lawsuit. Specifically, if an employee files a lawsuit for retaliation by the employer for “reporting a suspected violation of law,” then the employee is permitted under section 1833(b)(2) to disclose the trade secret to his or her attorney and use the trade secret information in the court proceeding so long as the trade secrets are filed under seal and not disclosed, except pursuant to a court order.

Under the immunity provision at section 1833(b)(3)(A), an affirmative duty is placed on employers to provide notice of the provision in “any contract or agreement with an employee that governs the use of a trade secret or other confidential information.” An employer can also comply with a notice requirement under section 1833(b)(3)(B) by providing a “cross-reference” to a policy given to the relevant employees. The cross-reference can be an amendment to the contract, which informs the employee of the existence of the immunity provision and “sets forth the employer’s reporting policy for a suspected violation of law.” Failure to comply with the notice requirement prevents an employer from recovering exemplary damages or attorney’s fees in an action against the employee under the DTSA.

No court has so far sanctioned an employee’s actions under the DTSA’s immunity provision; thus, this provision has had minimal impact. Bradford K. Newman, Protecting Intellectual Property Law in the Age of Employee Mobility (American Law Media 2014); 2017 updates at §12-7. In Unum Grp. v. Loftus, No. 4:16-CV-40154-TSH, 2016 WL 7115967 (D. Mass. Dec. 6, 2016), a Massachusetts federal court considered and rejected the argument of Loftus, a former employee of Unum Group, based on the DTSA immunity provision, that Unum Group’s trade secrets misappropriation claims should be dismissed because he took documents containing trade secrets to pursue legal action against the plaintiff for alleged unlawful activities. The court found Loftus’ contentions that his actions were immune under the DTSA unpersuasive because there was nothing in the record to support this affirmative defense at the motion-to-dismiss stage of litigation because discovery had not yet been conducted to determine the significance of the documents taken or their contents, it was not ascertainable from the complaint whether the former employee used, was using, or planned to use those documents for any purpose other than investigating potential violation of law, and no whistleblower suit had been filed. As such, the court found that Loftus’ actions were simply impermissible “self-help discovery” and ordered the return of the documents.

Despite the limited case law to date, the DTSA’s immunity provision likely will be raised repeatedly and thus become the subject of scrutiny by the federal trial courts, given that it is anticipated that employees accused of trade secret theft will continue to invoke this provision as part of their defense. For example, when a company discovers evidence that an employee secretly downloaded trade secrets in connection with exiting the company and files suit under the DTSA, the accused will likely claim that they took the trade secrets for the purpose of providing them to their attorney as part of an “investigation” into suspected violation of some law. Given that this defense is not available under the UTSA, and many states in fact specifically outlaw such “self-help” remedies, hedging against this defense may be one of many reasons why a DTSA plaintiff would also want to bring a claim under the UTSA.

Future Implications of the Defend Trade Secrets Act

At this point, apart from conferring federal jurisdiction over most of the trade secret claims, which would heretofore be governed exclusively by state law, and absent diversity jurisdiction, would be litigated solely in state courts, the DTSA in practice has been something less than a “seismic event.” Federal courts have correctly credited the statutory language that prohibits the seizure remedy absent “extraordinary circumstances,” which, despite being pled in every complaint, is rarely present. In addition, although practitioners should expect to see the employee immunity provision invoked on an increasing basis, it will require unique circumstances to get any traction as well.

Are there any action items in light of the DTSA that companies can employ to strengthen their trade secret protections? The answer is most certainly “yes.” Companies should have qualified counsel review policies and agreements to ensure they contain the language required under the DTSA in order to recoup attorney’s fees in the case where an employee unsuccessfully invokes the DTSA’s immunity provision. Beyond that, companies should continually be assessing and improving how they protect their most valuable confidential employee from insider (employee) threats, including devising and utilizing a high-risk departure program designed to safeguard the most valuable trade secrets upon the departure of key executives.

Finally, given that the DTSA does provide for a seizure remedy, in all cases where a company is faced with a DTSA claim, it is essential to conduct a privileged review of immediate measures to employ in order to minimize the ongoing threat to a third party’s trade secrets (if any) and, thus, decrease the likelihood of a seizure remedy granted.

Conducting Business with Tribes in the Aftermath of the Dollar General Supreme Court Split: What You and Your Clients Need to Know

Posted on April 27, 2017 by - Uncategorized

Introduction

With the U.S. Supreme Court’s 4–4 split in Dollar Gen. Corp. v. Mississippi Band of Choctaw Indians, 136 S. Ct. 2159 (2016), tribal members and nonmember individuals and businesses are left to wonder who really wins in this tie. The split decision provided no written opinion and operates as an affirmation of the Fifth Circuit’s decision upholding the jurisdiction of the Mississippi Band of Choctaw tribal court over tort claims brought by a member of the Choctaw tribe against a corporation doing business on reservation land. This decision serves as a significant reminder that anyone doing business on tribal lands must be cognizant that tribal court jurisdiction likely may apply over any disputes that arise.

Overview of Tribal Jurisdiction

Over 30 years ago, the U.S. Supreme Court created two exceptions to the general rule that Indian tribes cannot exercise civil jurisdiction over nonmembers in Montana v. United States, 450 U.S. 544, 565–66 (1981). The first of the two Montana exceptions, also known as the “consensual relationship” exception, establishes that a tribe may regulate the activities of nonmembers entering consensual relationships with the tribe or members thereof through “commercial dealing, contracts, leases, or other arrangements.” Methods of such regulation include “taxation, licensing, or other means.”

Despite this evident pronouncement that tribal courts may, under certain circumstances, exercise jurisdiction over nonmembers, approximately 20 years after the Montana decision, the Supreme Court itself recognized that tribal courts had yet to exercise jurisdiction over a nonmember defendant in any context whatsoever, leaving many to question for two decades whether, and under what circumstances, nonmembers may be subject to tribal court jurisdiction. See generally Nevada v. Hicks, 533 U.S. 353 (2001) (finding Montana’s proscriptions to fall short of dispositive in the case “when weighed against the State’s interest in pursuing off-reservation violations of its laws.”).

Dollar General’s Procedural Posture

The factual background of Dollar General sounds in tort. Dolgencorp operates a Dollar General store on the Choctaw reservation in Mississippi, located on land held by the United States in trust on behalf of the Mississippi Band of Choctaw Indians (the Tribe). The Dollar General store is operated pursuant to a lease agreement with the Tribe and a business license issued by the Tribe to Dolgencorp. Dolgencorp, Inc. v. Mississippi Band of Choctaw Indians, 746 F.3d 167, 169 (5th Cir. 2014). The Tribe conducts the Youth Opportunity Program (YOP), a project which places young members of the Tribe in short-term, unpaid positions—similar to internships—for educational and training purposes. The manager of the Dollar General store, Dale Townsend (Townsend), agreed to participate in this program. Townsend was not a member of the Tribe. Thereafter, the YOP program placed a 13-year-old tribal member (Doe) at the store. Doe later accused Townsend of sexual molestation.

In January 2005, Doe filed suit against Townsend and Dolgencorp in the Choctaw tribal court, alleging that Dolgencorp was vicariously liable for Townsend’s actions and asserting the store negligently hired, trained, or supervised Townsend. Doe further claimed the assault caused severe mental trauma, seeking “actual and punitive damages in a sum not less than 2.5 million dollars.”

Townsend and Dolgencorp filed motions in tribal court seeking to dismiss Doe’s claims for lack of subject matter jurisdiction—both of which were denied. The parties appealed to the Choctaw Supreme Court, which upheld the denials based on a Montana-based analysis and found subject matter jurisdiction applicable over both defendants. Dolgencorp and Townsend then filed a new action in the U.S. District Court for the Southern District of Mississippi against the tribal defendants, alleging that the tribal court lacked jurisdiction over them and seeking to enjoin the prosecution of Doe’s tribal court suit.

The crux of the Dollar General case revolves around interpreting the meaning and implications of the Supreme Court’s decision in Plains Commerce Bank v. Long Family Land & Cattle Co., 554 U.S. 316 (2008). Unfortunately, for clarity’s sake, the Supreme Court resolved that case on other grounds, though it originally granted certiorari to decide whether Montana’s undefined “other means” language included adjudicating civil tort claims in tribal court.

In Plains Commerce, a bank that sold land to tribal members sought to avoid tribal court jurisdiction in the wake of the transaction. The court decided via a fractured 5-4 vote in favor of finding the bank not subject to the lawsuit filed in tribal court, despite having entered into a consensual agreement with tribal members. The court found that tribes lack inherent authority to regulate the sale of non-Indian land, regardless of the form of regulation, thus failing to apply and analyze in any meaningful manner Montana’s first exception.

In Dollar General, Dolgencorp claimed that the Plains Commerce decision narrowed the first Montana exception. Specifically, for tribal jurisdiction to apply, the party seeking to establish jurisdiction must show that: (1) the nontribal entity or individual agreed to a consensual relationship; and (2) the relationship impacts to some degree tribal self-government or internal relations.

Dolgencorp asserted that, because the consensual relationship between Dolgencorp, Townsend, and the tribal parties does not implicate tribal self-governance or internal relations, tribal jurisdiction could not be asserted. Dolgencorp further argued that “tribal sovereignty is subordinate to Congressional authority as a practical matter, and inconsistent with federal concepts of sovereignty.”

The tribal defendants countered that Plains Commerce did not alter the Montana exceptions in any manner, and that a plain showing of a consensual relationship between the tribe and nontribal parties supports a finding of consent to tribal jurisdiction. The Tribe also relied on a contract with Dollar General that “explicitly bound” the corporation to tribal court, arguing further that a sexual assault case addressed tribal health and welfare and thus was clearly subject to tribal jurisdiction.

The Mississippi District Court in Dollar General agreed with the tribal defendants’ arguments in favor of jurisdiction and granted summary judgment in their favor. Dolgencorp Inc. v. Mississippi Band of Choctaw Indians, 846 F. Supp. 2d 646, 653–654 (S.D. Miss. 2011) (“In the court’s opinion, defendants have the better of this argument. Montana identified nonmembers’ consensual relationships with tribes and their members, which involve conduct on the reservation (and particularly on Indian trust land), as a circumstance that warrants tribal civil jurisdiction over matters arising from those relationships.”). The court refused to read any narrowing of Montana’s exception through the Plains Commerce decision and subsequent jurisprudence.

Dolgencorp challenged the district court’s determination that Montana’s consensual relationship exception had been met. However, the Fifth Circuit Court of Appeals affirmed the district court’s decision. In doing so, the court held that Doe was essentially an unpaid intern, unquestionably creating a consensual relationship of commercial nature. Dolgencorp, Inc. v. Mississippi Band of Choctaw Indians, 746 F.3d 167, 173 (5th Cir. 2014) (“In essence, a tribe that has agreed to place a minor tribe member as an unpaid intern in a business located on tribal land on a reservation is attempting to regulate the safety of the child’s workplace. Simply put, the tribe is protecting its own children on its own land. It is surely within the tribe’s regulatory authority to insist that a child working for a local business not be sexually assaulted by the employees of the business.”).

It is important to note that the Fifth Circuit did not establish a commercial relationship as a prerequisite to the assertion of tribal jurisdiction. By rejecting Dolgencorp’s assertion that Plains Commerce narrowed the Montana exception, the appellate court established a higher-level, more general focus when determining an activity’s impact on the Tribe’s interest in regulating the activity.

Fifth Circuit Judge Smith wrote a biting dissent, emphasizing that: (i) Montana’s narrow exception applies only when the conduct questioned is encompassed under a tribe’s authority to “protect tribal self-government or to control internal relations”; and (ii) even if this initial barrier had been met, the nexus between Dolgencorp’s participation in the YOP and the full body of Indian tort law was too weak to permit tribal jurisdiction over Dolgencorp. Judge Smith opined that Dolgencorp could not have anticipated that its consensual relationship with Doe via the YOP program would subject it to any and all tort claims actionable under tribal law; thus, an insufficient nexus existed to satisfy Montana’s first exception. He postured that this first exception “envisages discrete regulations consented to ex ante; the majority, to the contrary, upholds an unprecedented after-the-fact imposition of an entire body of tort law based on Dolgencorp’s participation in a brief, unpaid internship program.”

The Supreme Court’s Dollar General Split

The Supreme Court granted a petition for a writ of certiorari to Dollar General and its parent company, Dolgencorp (together, Dolgencorp), to evaluate whether Dolgencorp could be brought under tribal jurisdiction to adjudicate civil tort claims against nonmembers under the first exception enumerated in Montana. See generally Dollar General, 136 U.S. at 2159. The tribal court approached the Supreme Court’s review with unlikely odds, having won only two Supreme Court cases involving tribal interests, compared to nine losses, since 2005. In addition to its wide recognition as a pro-business bench, the Supreme Court itself acknowledged in 2001 that it had never found a tribal court to have jurisdiction against nonmembers under the first Montana exception.

The Tribe, however, did have some support. For example, although the Supreme Court had never held as such, the Fifth Circuit pointed out that, in its view, every circuit court to address whether tribal courts may exercise jurisdiction over tort claims against nonmembers under Montana’s first exception have held or assumed that they may validly do so. Dolgencorp, Inc., 746 F.3d at 173 n.3. Additionally, the Department of Justice (DOJ) filed an amicus brief in support of the Tribe’s positions and supported the Fifth Circuit’s decision that the Tribe had jurisdiction over Doe’s tort claims because it has the ability to regulate conduct occurring on tribal land, irrespective of Montana’s rule or exceptions. Brief for the United States as Amicus Curiae, Dollar General Corp. v. Mississippi Band of Choctaw Indians, 2015 WL 2228553, at 9–10 (U.S.).

On June 23, 2016, the Supreme Court issued its Dollar General ruling, with a 4–4 split decision, affirming the decision of the Fifth Circuit and upholding tribal court jurisdiction over Doe’s tort claims against Dolgencorp. Because of the tie, no written opinion was issued by the court; thus, the decision does not operate as direct precedent outside of the Fifth Circuit (which includes Mississippi, Louisiana, and Texas). Nevertheless, this does provide persuasive precedent for other jurisdictions and “affirms the longstanding legal principle that tribal courts have civil jurisdiction over non-Indian conduct arising from consensual relations on Indian reservations.” Indeed, with the Dollar General decision, the Supreme Court voted three out of three times in favor of upholding tribal sovereignty in major Indian law cases in 2016, including Nebraska v. Parker, 136 S. Ct. 1072 (2016) and U.S. v. Bryant, 136 S. Ct. 1954 (2016). Both Bryant and Dollar General dealt with tribal courts’ ability to protect tribal members from domestic violence and sexual assault.

Notwithstanding the Supreme Court decision, much uncertainty remains as to the scope of tribal jurisdiction over nonmember individuals and organizations conducting business on tribal land. This uncertainty carries the ability to adversely impact both tribes and their business partners. One result of this jurisdictional uncertainty is the potential withdrawal of businesses from operating and transacting on tribal land. For tribal communities “in which unemployment is already high and access to commercial services (like low-cost merchandise stores) is low,” this may be a very real negative consequence of continuing jurisdictional uncertainty. Petition for Writ of Certiorari, Dollar General Corp. v. The Mississippi Band of Choctaw Indians, 2014 WL 2704006, at 17 (U.S.).

Conclusion

The Supreme Court’s decision is quite impactful on business relationships between tribes and companies and individuals seeking to do business with tribes. Dolgencorp’s petition for a writ of certiorari even anticipated the serious implications of the Supreme Court’s future decision, noting that it affects “tens of thousands of nonmember corporations and individuals who do business on tribal reservations.” Dollar General serves to solidify tribal courts’ jurisdiction and ability to protect members from intentional torts committed within the context of an employer/employee relationship when the business is located within tribal land. Because Indian tribes “generally [do not] have criminal jurisdiction over non-Indians,” this affirmation of a tribe’s ability to seek a civil remedy serves as “the only deterrent to unlawful actions committed by non-Indians who are working or doing business on the reservation.” The suit will now continue in tribal court for a hearing on its merits.

As a result of Dollar General, businesses simply must be aware that any disputes arising on tribal lands may be subject to tribal court jurisdiction, and they should familiarize themselves with the court’s rules and procedures.

Recent Developments in Business and Corporate Litigation 2017

Posted on April 27, 2017 by - Uncategorized

The Business and Corporate Litigation Committee is pleased to present its annual mini-theme issue of Business Law Today. The breadth of business litigation faced by today’s companies is staggering. So, too, is the attendant cost and risk. The Business and Corporate Litigation Committee (BCLC) is the home within the ABA Business Law Section (BLS) for lawyers, in-house counsel, judges, and law students interested in dispute resolution, including litigation, arbitration, and mediation for business clients, as well as substantive issues for business litigators. Our members from around the United States and beyond are approximately 2,000 strong, making the BCLC one of the ten largest committees in the BLS. We have approximately 35 subcommittees in which you can develop your knowledge, connections, and leadership.

To join our growing committee, any BLS member may join the BCLC for free here. Many of our members have found an opportunity to flourish as authors, to show their expertise in particular areas of the law. For example, the BCLC has, for numerous years, authored the indispensable Recent Developments in Business and Corporate Litigation (formerly the Annual Review). The 2017 edition contains 19 chapters authored by over 150 committee members. This single volume—which you can purchase here—is divided into five parts:

  1. Litigation and Dispute Resolution Practice
  2. Civil Business Claims
  3. Business Associations Law
  4. Employment & Labor Law
  5. Finance & Securities Litigation & Arbitration

Committee members regularly write articles for the Section’s Business Law Today publication, as evidenced by this mini-theme issue. These articles represent hot legal topics including (1) the Defend Trade Secrets Act; (2) conducting business on Native American lands after the Supreme Court decision in Dollar General; (3) recent developments in the Delaware Supreme Court on director independence; and (4) authenticating digital evidence at trial. In addition, the BCLC has its own newsletter—The Network—which offers further writing opportunities for committee members.

The BCLC takes great pride in its quality programming and special events. The committee participates actively in the BLS Spring, Annual, and Fall Meetings, and it typically presents 11 CLE programs annually. BCLC regularly presents non-CLE programs and special events, such as the Tips from the Trial Bench program, the Woman Business and Commercial Advocates Reception, and the Annual Pro Bono and Public Service Project. Our popular committee dinners held at each meeting are regularly co-sponsored by the Judges’ Initiative Committee and ADR Committee.

If you missed the Section Spring Meeting in New Orleans, please join us at the Section Annual Meeting in Chicago on September 14–16. The benefits of the BCLC are many, and your experience can be tailored to your individual practice and needs. We are an inclusive and collaborative group—please check out the BCLC webpage here. I hope to see you soon at a future meeting!

From the Uniform Law Commission: In the World of Alternative Entities What Does “Good Faith” Mean?

Posted on March 23, 2017 by - Uncategorized

With this issue, in cooperation with the Uniform Law Conference, we initiate a column on the law of incorporated entities, principally, limited liability companies The column will appear every other month and discuss issues as they develop around the country.

***

Over the past several decades, “good faith” has become increasingly important in the law of business organizations. The phrase appears five times in the newest version of the Uniform Limited Liability Company Act (ULLCA (2013)), more than 40 times in the official comments, and has similar importance in the newest versions of the uniform general and limited partnership acts. The phrase also has fundamental importance in the Delaware law of “alternative entities” (discussed below) and was central cases clarifying the reach of liability-limiting charter provisions under Delaware corporate law’s famous section 102(b)(7).

One might think, therefore, that “good faith” can be defined easily or, at least, definitively. But the term is polysemous, a chameleon whose meaning changes dramatically depending on the context. Depending on context and on jurisdiction, the term indicates a test that is either entirely subjective or has both subjective and objective aspects. In one context, the objective standard is a very lax duty of care reclassified as part of the duly of loyalty. In another context, the word “objective” has a meaning radically different from the “reasonableness” concept typically associated with an “objective” test.

This column concerns the law of limited liability companies and partnerships, where the most important context for “good faith” is the implied contractual obligation (or covenant) of good faith and fair dealing. The obligation, which is not a fiduciary duty, originated in the common law of contracts but in recent has years developed its own, special character as applied to operating and partnership agreements.

The goal of this column is to explain how LLC and partnership law understand and apply the implied contractual covenant. We start where the obligation originated, consider briefly the codification provided in the Uniform Commercial Code (UCC), and then address the special character reflected in Delaware law and the newest versions of the uniform LLC and partnership acts.

Under the common law of contracts, the obligation of “good faith and fair dealing” is an implied and inescapable term of every agreement. Per the Restatement (Second) of Contracts, § 201, “Every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” The official comments suggest that a complete definition is impossible—the duty “excludes a variety of types of conduct characterized as involving ‘bad faith’ because they violate community standards of decency, fairness or reasonableness,” but “[a] complete catalogue of types of bad faith is impossible.”

This type of impossibility is a boon to litigators and a bane for transactional lawyers. “Good faith,” as codified by the Uniform Commercial Code (UCC), is little better. Under UCC, § 1-201(20), “‘[g]ood faith’ . . . means honesty in fact and the observance of reasonable commercial standards of fair dealing.” Presumably, the UCC’s concept of usage of trade imparts some content to “reasonable commercial standards of fair dealing.” Nevertheless (and arguably as a result), those standards assess a contract obligor’s conduct from a perspective disconnected from the language of the contract. The results can be startling, as in K.M.C. Co. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985), which used such standards to hold that: (i) a lender’s exercise of its totally discretionary right to call a demand note was objectively unreasonable; and therefore (ii) the lender was liable for the collapse of the borrower’s business.

As will be seen, the uniform acts and Delaware law are more friendly to transactional lawyers (and their clients), although both the ULC and Delaware case law have flirted at least briefly with an objective standard divorced from the words of the parties’ agreement. For example, in Policemen’s Annuity & Benefit Fund of Chicago v. DV Realty Advisors LLC, No. CIV.A. 7204-VCN, 2012 WL 3548206 (Del. Ch. Aug. 16, 2012), the Delaware Court of Chancery considered the implied covenant in the context of a limited partnership agreement which required the limited partners to act “in good faith” if they chose to remove the general partner but did not define good faith. The court decided to “presume that the parties intended to adopt Delaware’s common law definition of good faith as applied to contracts” and then resolved the matter in light of the UCC definition of the implied convent—including that definition’s objective aspect.

On appeal, DV Realty Advisors LLC v. Policemen’s Annuity & Ben. Fund of Chicago, 75 A.3d 101(Del. 2013), the Delaware Supreme Court affirmed the judgment but flatly ended the flirtation: “This Court has never held that the UCC definition of good faith applies to limited partnership agreements.”

Recent Delaware decisions have moved toward greater precision, mooring both “good faith” and “fair dealing” to the words of the parties’ contract. The pivotal case is Gerber v. Enter. Products Holdings, LLC, 67 A.3d 400, 418-19 (Del. 2013) in which the Delaware Supreme Court stated:

“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care . . . It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties’ agreement and its purpose. Likewise, “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose, and terms of the parties’ contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.

Gerber further explained that, because the actual words of the agreement control the application of the implied covenant:

An implied covenant claim . . . looks to the past. It is not a free-floating duty unattached to the underlying legal documents. It does not ask what duty the law should impose on the parties given their relationship at the time of the wrong, but rather what the parties would have agreed to themselves had they considered the issue in their original bargaining positions at the time of contracting.

(Emphasis added.)

At one time, the Uniform Law Commission (ULC) appeared to do more than merely flirt with the vagueness of the common law/UCC approach. In RUPA Section 404(d), a uniform act codified the implied covenant of good faith and fair dealing for the first time. Comment 4 to that section stated:

The meaning of “good faith and fair dealing” is not firmly fixed under present law. “Good faith” clearly suggests a subjective element, while “fair dealing” implies an objective component. It was decided to leave the terms undefined in the Act and allow the courts to develop their meaning based on the experience of real cases.

Having courts “develop” meaning as they go hardly makes for the rule stability that transactional lawyers seek. In 2001, the ULC adopted a new uniform limited partnership act with the same codifying language, ULPA (2001), § 305(b), but the official comment to the provision took a decidedly different approach:

The obligation of good faith and fair dealing is not a fiduciary duty, does not command altruism or self-abnegation, and does not prevent a partner from acting in the partner’s own self-interest. Courts should not use the obligation to change ex post facto the parties’ or this Act’s allocation of risk and power. To the contrary, in light of the nature of a limited partnership, the obligation should be used only to protect agreed-upon arrangements from conduct that is manifestly beyond what a reasonable person could have contemplated when the arrangements were made.

About a decade later, the ULC began a project to harmonize both the language and commentary of uniform unincorporated business entity acts. The uniform general partnership, limited partnership, and limited liability company acts each codify the implied covenant, and the harmonization project changed both the statutory language and the official commentary. All three acts now expressly characterize the implied covenant as “contractual.” And, in their respective official comments, all three acts interweave the 2001 “non-abnegation” language with quotations from the Delaware cases quoted above.

Thus, under both Delaware law and the uniform acts, the implied obligation of good faith and fair dealing is a cautious enterprise, intended only to preserve the fruits of the bargain—as evidenced by the words of the contract—from one party’s lack of prescience and the other party’s desire to exploit that lack. As Vice Chancellor Laster explained in Allen v. El Paso Pipeline GP Co., L.L.C., No. CIV.A. 7520-VCL, 2014 WL 2819005 (Del. Ch. June 20, 2014)

No contract, regardless of how tightly or precisely drafted it may be, can wholly account for every possible contingency. Even the most skilled and sophisticated parties will necessarily fail to address a future state of the world . . . because contracting is costly and human knowledge imperfect. . . .

Thus, properly understood and delimited, implied covenant analysis resembles the rule for determining whether a party’s contractual duties are discharged by supervening impracticably. As explained in Restatement (Second) of Contracts § 261, cmt. b (1981): “In order for a supervening event to discharge a duty . . ., the non-occurrence of that event must have been a ‘basic assumption’ on which both parties made the contract.” As for the implied contractual covenant, again in the words of Vice Chancellor Laster in the El Paso case, “parties occasionally have understandings or expectations that were so fundamental that they did not need to negotiate about those expectations.”

Or put another way: both doctrines identify situations or claims that—if contemplated at the time of contracting—would have been deal breakers.

In the next column—“Delineating the Implied Covenant and Providing for ‘Good Faith’”—can an operating or partnership agreement shape the implied covenant, even to the extent of creating safe-harbors? What should never be done when making “good faith” an express requirement?

A Fully Informed and Disinterested Stockholder Vote Cleanses Transactions Tainted by Board Conflicts

Posted on March 23, 2017 by - Uncategorized

Recently, in In re Merge Healthcare Inc., C.A. No. 11388-VCG, 2017 WL 395981 (Del. Ch. Jan. 30, 2017), the Delaware Court of Chancery dismissed a complaint, which alleged that the board of directors of Merge Healthcare, Inc. breached its fiduciary duties in connection with its approval of a merger with IBM, because a majority of the disinterested, fully informed, and uncoerced stockholders of Merge approved the acquisition. The decision is the latest in a series of opinions from the court in the wake of the Delaware Supreme Court’s decision in Corwin v. KKR Financial Holdings LLC, 125 A.3d 304 (Del. 2015) and confirms that, where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve a transaction other than with a controlling stockholder, the business judgment rule will apply absent waste even if the transaction was approved by a conflicted board majority. The decision also helps to clarify some uncertainty created by various decisions of the Court of Chancery as to the effect of Corwin on interested director transactions.

Corwin and Interested Director Transactions

In Corwin, the Delaware Supreme Court held that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.” Because of Corwin’s literal holding, the decision created some uncertainty over whether all transactions subject to the entire fairness standard of review were incapable of being cleansed by a fully informed, uncoerced, and disinterested stockholder vote or whether just controlling stockholder transactions were not capable of being cleansed. Historically, transactions tainted by a conflicted board majority, but not a controlling stockholder, were reviewed under the entire fairness standard of review unless the transaction had been approved by a fully informed and disinterested stockholder vote or a special committee of disinterested and independent directors. The effect of a single cleansing mechanism on controlling stockholder transactions was merely to shift the burden of proof of entire fairness from defendants to plaintiffs because of the inherent coercion deemed present when a controller either stands on both sides of the transaction or extracts personal benefits from the transaction. Thus, there was some reason to believe that not all transactions subject to the entire fairness standard were incapable of being cleansed under Corwin—just transactions subject to the entire fairness standard ab initio because of a controlling stockholder.

Corwin suggested that fully informed, uncoerced, and disinterested stockholder approval of a conflicted board decision should be given cleansing effect, but the issue was not squarely before the court. Specifically, the court did not consider allegations that the entire fairness standard applied to its review of a merger because of a conflicted board majority, but rather whether entire fairness applied to the court’s review because of a controlling stockholder. Nevertheless, the court’s dictum was instructive. The court noted that “[f]or sound policy reasons, Delaware corporate law has long been reluctant to second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder is in their best interests.” In addition, the decision affirmed the Court of Chancery’s holding below, which stated that “even if the plaintiffs had pled facts from which it was reasonably inferable that a majority of [] directors were not independent, the business judgment standard of review still would apply to the merger because it was approved by a majority of the shares held by disinterested stockholders . . . in a vote that was fully informed.”

Subsequently, in City of Miami General Employees v. Comstock, C.A. No. 9980-CB, 2016 WL 4464156 (Del. Ch. Aug. 24, 2016), the Court of Chancery gave cleansing effect to a fully informed, uncoerced stockholder vote approving a merger only after determining that plaintiff failed to allege facts sufficient to establish that a majority of the members of the target’s board of directors were belaboring under disabling conflicts. In this case, the alleged conflicts related to the directors’ purported desire to obtain board seats in the surviving entity and inability to act independently from an interested party. The court ultimately dismissed plaintiff’s claims because the transaction was not subject to entire fairness review and the business judgment presumption applied under Corwin. The fact that the court determined that Corwin’s cleansing effect applied only after concluding that a majority of the members of the board were disinterested and independent suggested that the court did not believe that Corwin’s cleansing effect would have applied if a majority of the members of the board were conflicted.

By contrast, in Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447 (Del. Ch. Aug. 25, 2016), the Court of Chancery stated that “[i]n the absence of a controlling stockholder that extracted personal benefits,” where a majority of a corporation’s fully informed, disinterested, and uncoerced stockholders approve the transaction, the business judgment rule will apply “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Like Comstock, Larkin involved claims that a majority of the members of a target’s board faced disabling conflicts when approving a merger. The alleged conflicts related to certain board members having contemporaneous employment with venture capital firms that held stock in the target corporation and the directors’ expectation of employment with the surviving entity following the merger. In rejecting plaintiffs’ claims and applying Corwin to dismiss plaintiffs’ complaint, the court made clear “that [] proper stockholder approval of [a] transaction [will] cleanse any well-pled allegations that [a] transaction was the product of board-level conflicts that might trigger entire fairness review . . . .”

Consistent with the court’s decision in Larkin, Merge Healthcare clarifies that, with respect to conflicted board transactions, a disinterested, fully informed stockholder vote will have a cleansing effect on the transaction.

Factual Background: In re Merge Healthcare

This case involved the acquisition of Merge Healthcare, Inc. by IBM. Prior to the merger, Merge’s Chairman, Michael Ferro, owned approximately 26 percent of Merge’s outstanding stock through an affiliated fund which also provided consulting services to Merge. As a result of the consulting agreement, Merge would have paid Ferro’s affiliated fund a $15 million cash fee in connection with Merge’s acquisition by IBM but for the fact that Ferro subsequently agreed to waive the fee in exchange for an increase in the offer price. The merger was completed on October 13, 2015. Nearly 80 percent of Merge’s stockholders voted in favor of the merger.

Following closing, plaintiffs brought this action, alleging, among other things, that (i) the Merge board ran an unfair sales process and deprived stockholders of the true value of Merge and (ii) the Merge board breached its duty of disclosure by disseminating materially misleading and incomplete information to the stockholders in connection with the proxy statement filed as part of the merger. Defendants moved to dismiss plaintiffs’ complaint on the basis of the ratifying effect of the Merge stockholder vote.

Parties’ Arguments: In re Merge Healthcare

Plaintiffs argued that the entire fairness standard of review should apply to the merger between Merge and IBM because a majority of the members of Merge’s board were conflicted, and Ferro was a controller. According to plaintiffs, Ferro’s relationships with the other board members, as well as his stock ownership in Merge, allowed him to control Merge and its board. Plaintiffs maintained that Ferro used the merger with IBM to satisfy an urgent need to sell illiquid stock holdings in Merge. Finally, to demonstrate that the merger vote had not been fully informed, plaintiffs alleged various disclosure violations related to the financial analysis performed by Goldman Sachs, Merge’s financial adviser. Specifically, plaintiffs argued that (i) the proxy statement failed to disclose Goldman’s treatment of stock based compensation as a cash expense, (ii) the unlevered free cash flows used by Goldman were not those disclosed in the proxy statement, and (iii) the proxy statement inadequately described the present value of Merge’s net operating losses. In addition, plaintiffs contended that defendants failed to disclose that the true purpose of Ferro’s waiver of the consulting fee was to avoid the creation of a special committee rather than to obtain a price increase from IBM.

In response, the director defendants relied upon the cleansing effect of Corwin, contending that, because the vote of the stockholders approving the merger was fully informed, disinterested, and uncoerced, defendants were entitled to the presumptions of the business judgment rule absent waste.

The Court’s Holdings: In re Merge Healthcare

The court held that the vote of Merge’s stockholders cleansed the transaction, entitling the Merge directors to the presumptions of the business judgment rule under Corwin. In so doing, the court, citing Larkin, held that, in the absence of a controlling stockholder that extracted personal benefits from the transaction, a fully informed, uncoerced, and disinterested stockholder vote results in the application of the business judgment rule “even if the transaction might otherwise have been subject to the entire fairness standard due to conflicts faced by individual directors.” Thus, the court found largely irrelevant the allegations that Merge board members were conflicted and focused on whether Ferro was a controller who extracted personal benefits not shared equally with the minority. The court assumed for purposes of its analysis that Ferro was a controlling stockholder of Merge and found Ferro’s interests were fully aligned with the minority stockholders because of his pro rata treatment in the merger. The court rejected plaintiffs’ claim that Ferro had orchestrated the merger to sell his Merge stock because Ferro had been selling his stock in Merge for the past six years. Additionally, the court emphasized that Ferro’s waiver of the fee under the consulting agreement removed any unique benefit that he might have received in the merger.

Next, the court held that plaintiffs’ disclosure claims arising from Goldman Sachs’ summary of the analysis underlying its fairness opinion failed. Regarding plaintiffs’ contention that the reason for Ferro’s waiver of the fee under the consulting agreement was not disclosed, the court found that disclosure of Ferro’s subjective intent to waive the fee was not required.

Conclusion

The court’s decision in Merge Healthcare highlights the evolution of the court’s jurisprudence under Corwin. Specifically, Merge Healthcare confirms that a fully informed stockholder vote will cleanse a transaction in order to apply the business judgment rule to a board’s decision to approve the transaction even if a majority of the directors are interested in the transaction. Such a holding is not necessarily surprising—prior to Corwin, numerous Court of Chancery decisions held that the business judgment rule applied to a conflicted board’s decision to approve a merger where the stockholder vote approving the transaction was fully informed, disinterested, and uncoerced. Some confusion ensued after the Delaware Supreme Court held in Gantler v. Stephens, 965 A.2d 695 (Del. 2009) that stockholder ratification of a transaction is limited to “circumstances where a fully informed shareholder vote approves director action that does not legally require shareholder approval in order to become legally effective.” However, in Corwin, the Delaware Supreme Court narrowly interpreted Gantler as a decision focused on the common law doctrine of ratification and not on the question of what standard of review applies if a transaction not involving a controller is approved by an informed, voluntary vote of disinterested stockholders. The court’s decision in Merge Healthcare clarifies that, with respect to the approval of interested director transactions by a fully informed, disinterested, and uncoerced stockholder vote, the effect of Corwin was to remove any doubt cast on the cleansing effect of a stockholder vote created by Gantler v. Stephens.

DOJ Releases Under-the-Radar Paper on “Evaluation of Corporate Compliance Programs”

Posted on March 23, 2017 by - Uncategorized

In February 2017 the Department of Justice (DOJ) Fraud Section quietly released a short paper entitled “Evaluation of Corporate Compliance Programs,” which sheds more light on how the Department’s new compliance expert will differentiate effective compliance programs from those that are superficially pretty. In the paper, the Fraud Section reiterates that the factors it considers in deciding whether to investigate, charge or negotiate with a corporation (called the “Filip Factors”) necessarily require a fact-specific assessment. And the topics the Fraud Section considers in conducting its assessment—like tone at the top, third party risk assessments and compliance resources—are not new. Yet, the paper provides an important glimpse into “common questions that we may ask” in evaluating how an individual organization passes muster under the Filip Factors. Many of the “sample questions” highlight where the Fraud Section will press to ferret out those corporations that have simply adopted a check-the-box compliance program, versus those that have embraced compliance as a cultural imperative.

Sample Topics

The paper enumerates 11 sample topics that the Fraud Section “has frequently found relevant in evaluating a corporate compliance program.” Many of these topics appear in the US Sentencing Guidelines, the DOJ and SEC FCPA Guidance from November 2012, and other compliance resources. Nonetheless, their presence here shows their durability as measures by which corporations will be judged. The topics include:

  • Analysis and remediation of underlying misconduct, including root cause analysis of compliance failures and whether similar incidents occurred in the past
  • Senior and middle management words and deeds to convey and model proper behavior
  • Autonomy and resources of compliance function including stature, qualifications and funding
  • Operational integration of compliance policies and procedures into a control framework
  • Risk assessment process and the role of metrics
  • Incentives and disciplinary measures and whether they are effective, consistent, and fairly meted out
  • Continuous improvement, periodic testing, and review

Thematically, the topics convey that a successful compliance program responds and reacts to each compliance failure. Compliance needs to bear the visible support of top—and middle—management and run under the leadership of well-resourced compliance professionals. Compliance does not exist isolated from a company’s day-to-day operations and strategic decision making, but is integrated throughout both.

“Common Questions” To Probe A Company’s Compliance Program

The Fraud Section is careful to note that it “does not use any rigid formula to assess the effectiveness of corporate compliance programs” and that each company’s “risk profile and solutions to reduce its risks warrant particularized evaluation.” Yet, the paper sets forth “common questions” that the Fraud Section may ask in making that individualized determination.

Many of the questions coalesce around three critical avenues to explore whether the company has embedded compliance into its culture: (1) the company’s processes for lessons learned, (2) the effectiveness of its gatekeepers and (3) the integration of compliance into the business.

Processes for lessons learned. These questions probe whether the company is learning from prior compliance mistakes or simply punishing the wrongdoer without seeking and correcting systemic failures. For example:

  • “Were there prior opportunities to detect the misconduct in question, such as audit reports identifying relevant control failures . . . ? What is the company’s analysis of why such opportunities were missed?”
  • “What controls failed or were absent that would have detected or prevented the misconduct? Are they there now?”
  • “Has the company’s investigation been used to identify root causes, system vulnerabilities, and accountability lapses, including among supervisory manager and senior executives?”
  • “What information or metrics has the company collected and used to help detect the type of misconduct in question? How has the information or metrics informed the company’s compliance program?”

Effectiveness of gatekeepers. These questions explore not only stature and skill of compliance personnel and personnel in other control functions in the organization, but also whether reports of misconduct get to the right responders. For example:

  • “What has been the turnover rate for compliance and relevant control function personnel?”
  • “Who reviewed the performance of the compliance function and what was the review process?”
  • “Has the company outsourced all or parts of its compliance functions to an external firm or consultant? . . . How has the effectiveness of the outsourced process been assessed?”
  • “Has there been clear guidance and/or training for the key gatekeepers . . . in the control processes relevant to the misconduct?”
  • “Has the compliance function had full access to reporting and investigative information?”

Integration of compliance into the business. Many of the Fraud Section’s questions attempt to shine on light on whether a company has woven compliance into its day-to-day business, from board room to the floor.

Questions include:

  • “What specific actions have senior leaders and other stakeholders (e.g., business and operational managers, Finance, Procurement, Legal, Human Resources) taken to demonstrate their commitment to compliance . . . ?”
  • “What compliance expertise has been available on the board of directors?”
  • “What role has compliance played in the company’s strategic and operational decisions?”
  • “Have business units/divisions been consulted prior to rolling [new policies and procedures] out?”

These questions suggest that the Fraud Section will continue to press on a key vulnerability that plagues the compliance efforts of many organizations: how to translate a well-designed compliance program into the cultural fabric of the company. And prosecutors will not likely be impressed without demonstrable proof of action at all levels of the organization and across all aspects of its business.

The Delaware Supreme Court Confirms That New Castle County’s Unified Development Code Is Constitutional

Posted on March 23, 2017 by - Uncategorized

Facts and Procedural History

On December 7, 2016, the Delaware Supreme Court sitting en banc heard oral argument in Golf Course Assoc, LLC v. New Castle County. The Delaware Supreme Court agreed with the county and affirmed the Delaware Superior Court’s opinion that New Castle County’s Unified Development Code (UDC) did not violate the U.S. Constitution. Golf Course Assoc, LLC v. New Castle County, 2016 WL 7176721 (Del. Dec. 9, 2016).

In Golf Course Assoc., Toll Brothers, Inc. submitted an application to the New Castle County Department of Land Use and the New Castle County Council to construct a housing development on a golf course near Route 48 (Lancaster Pike) outside of Wilmington, Delaware. In determining whether to accept or reject such a proposal, the department relies on the process outlined in the UDC, a process which is based on the concept of concurrency—whether the infrastructure necessary to support the proposed development exists or will exist by the time the development is complete. The first step in this process is to determine the “carrying capacity” for a proposed development, or how much development the surrounding infrastructure will support. In this case, the main issue was the traffic carrying capacity which, pursuant to the UDC, is determined by a Traffic Impact Study (TIS). Once a TIS has been completed, the developer must provide it to the Delaware Department of Transportation (DelDOT) for its written review and comment. The primary metric for measuring traffic congestion is the Level of Service (LOS) of intersections within the area of influence of the proposed development. The LOS for intersections is calculated by traffic engineers using a standard formula, which considers the number of vehicles and the amount of time spent waiting at an intersection at peak travel times. The proposed development in this case would impact the intersection of Lancaster Pike and Centerville Road.

The TIS prepared in 2010 rated the intersection of Lancaster Pike and Centerville Road as LOS “F” and anticipated that in 2016 the intersection would continue to operate at LOS “F.” DelDOT’s engineering firm, hired to review the TIS, assessed the intersection and determined that in 2010 the LOS rating was a “D” and projected that it would be at LOS “F” in 2016. An “F” rating for 2016 meant that the anticipated congestion at the intersection would exceed the standards allowed by the UDC and that the intersection would be in failure.

Toll Brothers had anticipated that traffic at the intersection would pose a problem to its proposed development and, as a result, designed a remedy to fix the congestion. Toll Brothers’ remedy was estimated to cost $1.1 million. Through negotiations with DelDOT, Toll Brothers offered to pay for this proposed remedy. DelDOT, however, preferred another remedy with an estimated cost of $3.5 million, but was willing to accept Toll Brothers’ $1.1 million as a contribution to DelDOT’s preferred solution.

Based on the traffic congestion issue, the New Castle County Department of Land Use disapproved Toll Brothers’ TIS. Accordingly, Toll Brothers’ record plan could not be filed. At the time the county disapproved the TIS, the statutory time period, including two authorized extensions totaling 180 days, had run and thus Troll Brothers’ record plan was deemed expired.

Following the expiration of its record plan, Toll Brothers appealed the county’s disapproval of the TIS and the resulting expiration of the plan to the New Castle County Board of Adjustments. Among other claims, Toll Brothers argued that an unconstitutional exaction had occurred. The board disagreed with Toll Brothers and dismissed its constitutional challenge. However, raising the unconstitutional exaction issue to the board preserved it for judicial review. The board agreed that pursuant to the UDC the plan had properly expired and that there was no constitutional violation. Toll Brothers subsequently filed an appeal with the New Castle County Superior Court. After briefing and oral argument, Judge Parkins of the Superior Court found in favor of the county, issuing its own well-reasoned opinion. The Superior Court’s decision was then appealed to the Delaware Supreme Court.

Toll Brothers’ Constitutional Claim

Toll Brothers argued before the board, the Superior Court, and the Delaware Supreme Court that the department and board’s rejection of the TIS constituted a violation of its constitutional rights under the “unconstitutional conditions” doctrine found in the Nollan/Dolan/Koontz trilogy of cases. This constitutional challenge involves the Takings Clause of the Fifth Amendment of the U.S. Constitution, made applicable to the states through the Fourteenth Amendment, which provides: “[N]or shall private property be taken for public use, without just compensation.” Dolan v. City of Tigard, 512 U.S. 374, 383-84 (1994) (internal citations omitted).  The public policy behind the Takings Clause is “to bar Government from forcing some people alone to bear public burdens which, in all fairness and justice, should be borne by the public as a whole.” Armstrong v. United States, 364 U.S. 40, 49 (1960).

The Koontz Test

The unconstitutional conditions doctrine was first addressed in a 5–4 decision by the U.S. Supreme Court in Nollan v. California Coastal Commission, where a landowner wanted to tear down his existing beach front house to build a new one. In order to do so, the owner needed to obtain a building permit from the California Coastal Commission. The commission required the landowner to provide a public easement across his property before it would issue a permit. The state argued that this easement was necessary to protect the public’s view of the beach, assist the public in overcoming the “psychological barrier” to using the beach, and prevent congestion on the public beach. The U.S. Supreme Court struck down this requirement as an unconstitutional exaction stating:

[T]he lack of nexus between the condition and the original purpose of the building restriction converts that purpose to something other than wait it was. The purpose then becomes, quite simply, the obtaining of an easement to serve some valid governmental purpose, but without payment of compensation. Whatever may be the outer limits of “legitimate state interest” in the taking and land-use context, this is not one of them. In short, unless the permit condition serves the same governmental purpose as the development ban, the building restriction is not a valid regulation of land use but “an out-and-out plan of extortion.”

Seven years after the U.S. Supreme Court issued its opinion in Nollan, it was asked to clarify the “required degree of connection between the exactions and the projected impact of the proposed development.” Dolan v. City of Tigard, 512 U.S. 374, 386 (1994).  This question was left unanswered in Nollan because the court concluded that the connection did not meet “even the loosest standard.” In another 5–4 decision by the U.S. Supreme Court in Dolan v. City of Tigard, the court adopted a “rough proportionality” test which, while there is “[n]o precise mathematical calculation,” requires that the state demonstrate “some sort of individualized determination that the required dedication is related both in nature and extent to the impact of the proposed development.”

It was not until 2013 that the U.S. Supreme Court would again address this doctrine in Koontz v. St. Johns River Water Mgmt. Dist. 133 S. Ct. 2586, 2593 (2013). In Koontz, in response to the state’s demand for property from a landowner for a Management and Storage of Surface Water permit and a Wetlands Resource Management permit, the landowner refused to transfer the property. Because there had been no actual taking due to the landowner’s refusal, this action raised the question as to whether the Takings Clause was applicable where there had been no actual taking of property. The court in Koontz also addressed the question of whether the Takings Clause was implicated when the State demanded money as opposed to an interest in land. The U.S. Supreme Court, in yet another 5–4 decision, found that under such circumstances the test enumerated in Nollan and Dolan was applicable. Specifically, as to the monetary issue, the court noted that a monetary obligation on a specific piece of land is a sufficient link between the government’s demand and the property to implicate the central concern in Nollan and Dolan, namely that “the risk that the government may use its substantial power and discretion in land-use permitting to pursue governmental ends that lack an essential nexus and rough proportionality to the effects of the proposed new use of the specific property at issue, thereby diminishing without justification the value of the property.” The court further explained that there could be a violation of the Takings Clause even though there was no property of any kind actually taken:

Extortionate demands for property in the land-use permitting context run afoul of the Takings Clause not because they take property but because they impermissibly burden the right not to have property taken without just compensation. As in other unconstitutional conditions cases in which someone refuses to cede a constitutional right in the face of coercive pressures, the impermissible denial of a governmental benefit is a constitutionally cognizable injury.

In Koontz the court made clear that in order to make out a claim for an unconstitutional exaction, there must first be a demand. This point was made most clear by Justice Kagan’s dissenting opinion in Koontz. This dissent provides in pertinent part:

Nollan and Dolan apply only when the government makes a “demand[]” that a landowner turn over property in exchange for a permit. I understand the majority to agree with that proposition: After all, the entire unconstitutional conditions doctrine, as the majority notes, rests on the fear that the government may use its control over benefits (like permits) to “coerc[e]” a person into giving up a constitutional right. A Nollan–Dolan claim therefore depends on a showing of government coercion, not relevant in and ordinary challenge to a permit denial. Before applying Nollan and Dolan, a court must find that the permit denial occurred because the government made a demand of the landowner, which he rebuffed.

Concerns Following Koontz

Following the majority’s opinion in Koontz there was widespread concern that local governments would stop negotiating with, and making suggestions to, developers about how to meet permitting criteria and, that instead would simply deny applications that did not meet municipal standards or improperly accept development plans. This was a concern because collaboration between the developer and local government “is essential to an orderly and efficient system of land use regulation.” Julie A. Tappendorf & Matthew T. DiCianni, The Big Chill?—The Likely Impact of Koontz on the Local Government/Developer Relationship, 30 Touro. L. Rev. 455, 471-72 (2014). Indeed, as part of the development process, local governments and developers often meet and discuss possible negative impacts of the proposed development and ways to mitigate concerns in an attempt to reach an agreement. Commentators have suggested that Koontz prevents these discussions from taking place by providing an additional, unnecessary risk of possible lawsuits based on an unconstitutional exaction theory. Specifically, the suggestion is that if the local government participates in what has become the normal back-and-forth with the developer, at any time during that process the developer could cease talks and file suit claiming a taking based on the unconstitutional exaction doctrine. The local government, therefore, has no incentive to take part in those discussions for fear of being accused of making a demand. This necessarily prevents local governments and land developers from reaching agreements that work for both parties and, in effect, prevents a property owner, like the one in Koontz, from having an “opportunity to amend their applications or discuss mitigation options.”

Another concern resulting from the Koontz decision is that if local governments do decide to partake in discussions with the developers, the developers are incentivized to only offer the “easiest and cheapest mitigation condition” because if that is rejected they can race to the courthouse claiming an unconstitutional exaction. See Michael Farrell, A Heightened Standard for Land Use Permits Redefines the Power Balance Between the Government and Landowners, 3 U. Balt. J. Land & Dev. 71, 74 (2013). The Koontz decision, therefore, places the developer in a stronger negotiation position forcing local governments to accept an unfavorable offer or risk litigation.

Applying the Koontz Test to Toll Brothers’ Claims

In Golf Course Assoc., LLC, the board, Superior Court, and, by extension, the Delaware Supreme Court found that the county never made a demand on Toll Brothers. Specifically, it was noted that there was no evidence in the record indicating that negotiations between the county and Toll Brothers had occurred. In fact, the New Castle County Department of Land Use  asserted that it had no authority to negotiate with Toll Brothers (or other developers for that matter). Instead, the negotiations occurred between Toll Brothers and DelDOT. However, as the court noted, when it comes to traffic, DelDOT plays merely an advisory role. The court held that in order to implicate the constitutional exaction doctrine the county has to negotiate with the developer and not DelDOT. In the absence of such negotiations and, in turn, a demand by the county, Toll Brothers’ Nollan/Dolan/Koontz constitutional exaction claim failed.

The Superior Court properly noted that at most there was a denial of a land use permit which, by itself, was insufficient to amount to a constitutional violation. The Superior Court further clarified that a statutory restriction, evenly applied, does not constitute an unconstitutional exaction under the trilogy. The court held that the exaction “must come in the form of a demand arising from an administrative requirement particular to the requested land use permit,” something that was absent in this case.

Conclusion—The Impact

The Delaware Supreme Court’s decision to affirm the Superior Court’s opinion seemingly addresses many of the concerns discussed by commentators following the Koontz decision. Specifically, the Superior Court’s decision, upheld by the Supreme Court, implies that a local government can negotiate with a developer, and avoid an exaction claim, so long as the negotiations involve a non-binding governmental agency which only has an advisory role. By using such an agency (such as DelDOT in this case), the local government does not have to outright reject a plan that fails to satisfy the governing municipality’s rules. Instead, negotiations can occur and an agreement that works for both parties can be reached between the developer and the governmental agency, which is then ratified by the local government. In addition, the non-binding governmental agency can provide the developer with advice on how to meet the permit requirements without fear of possible litigation. Further, the developer’s incentive to offer the “easiest and cheapest mitigation condition” is taken off the table because if such an offer is rejected by the non-binding governmental agency that, in it of itself, does not constitute an unconstitutional exaction.

The Superior Court and Delaware Supreme Court’s decisions not to needlessly expand the unconstitutional exaction doctrine to applications of zoning and subdivision laws serve several additional key public policy considerations. First, the decision prevents a developer from having a constitutional right to taxpayer-funded level of service improvements for water, sewer, and traffic. Had the Superior Court ruled differently, a developer would have had a constitutional right to infrastructure improvements because the county could not deny the application under concurrency laws without violating the Takings Clause. Second, the Superior Court’s decision prevents the public from bearing the responsibility of funding infrastructure improvements merely because a developer seeks to personally profit from a proposed housing development. Lastly, it prevents government officials from being forced to make frequent ad hoc judgments as to whether certain code requirements constitute an unconstitutional exaction.

Disclosure: The case discussed in the article represents one of only a handful of state appellate courts to have, so far, considered and applied the U.S. Supreme Court’s application of the takings provisions under the Fifth and Fourteenth Amendments to the U.S. Constitution found in the Nollan/Dolan/Koontz trilogy of cases in connection with land use decisions and processes. Municipalities, developers, land owners, and the lawyers representing them will have an interest in seeing the latest application of those U.S. Supreme Court cases to the rejection of a planned residential community substantially impacting traffic/transportation.