A significant question pending under the recently effective Corporate Transparency Act (“CTA”) is whether a limited liability partnership (“LLP”) is a “reporting company” as defined in the CTA and the related “Reporting Regulations.” Classification as a reporting company has the effect of ab initio subjecting the firm to the beneficial ownership information reporting obligations of the CTA and the Reporting Regulations absent, on a firm-by-firm basis, an exemption from those burdens.

As detailed below, in considering the definition of a CTA reporting company with the law addressing how an LLP comes into being, it is clear that an LLP is not a reporting company.

This article begins with a review of the genesis of the LLP from the midst of the savings and loan crisis of the late 1980s and the subsequent progression of the form from bespoke supplements to state adoptions of the Uniform Partnership Act (1914) and the Uniform Partnership Act (1994), and then to the detailed provisions for LLPs set forth in the Revised Uniform Partnership Act (1997). We then turn to the CTA and the Reporting Regulations to review their respective definitions of what is a reporting company, including informal guidance from the Financial Crimes Enforcement Network (“FinCEN”) office of the Department of the Treasury as to the application of the regulatory definition. Turning then to the crux, we review why the LLP does not fall within the scope of either definition of what is a reporting company.

The Rise of the LLP

The venerable general partnership has existed for millennia;^[1] aside from the sole proprietorship, likely it is the oldest organizational form. In the U.S. the common law of partnerships was reduced to statutory form in the Uniform Partnership Act (1914) (“UPA”), shortly thereafter supplemented with the Uniform Limited Partnership Act (1916), the latter providing rules applicable to those partners categorized as “limited partners.” The Uniform Partnership Act (1914) was superseded by the (Revised) Uniform Partnership Act (1994), but Texas’s adoption of the nation’s first LLP provisions in 1992 (which accompanied its initial adoption of an LLC statute) caused the Uniform Law Commissioners to revise the statute again to include LLP provisions as the Revised Uniform Partnership Act (1997) (“RUPA”). This statute has since been renamed the Uniform Partnership Act (1997) (last amended 2013) and Uniform Partnership Act (2024). While all states save Louisiana had adopted the 1914 Act, not all have to date adopted a permutation of the 1997 Act. But by the end of the twentieth century,^[2] all states had engrafted LLP provisions onto whatever general partnership statute the state had.

The most commonly understood characteristic of the general partnership is the rule that each partner is vicariously personally liable for partnership obligations; in popular parlance, partners do not enjoy “limited liability” but rather bear personal exposure to the extent of their assets for the partnership’s debts and obligations.^[3] While today some may look askance at this rule, because the absence of vicarious personal liability for organizational liabilities is the universal rule for other forms of organization, in fact it had important benefits. In a firm in which each owner is liable for the consequences of another’s negligence, there is incentive to oversee tasks and to require cooperative action. “Lone wolf” unilateral actions that could put the firm’s capital (including its reputational assets) and that of its partners’ at risk will not be tolerated, and there is an incentive to train employees and newer partners as a method of risk mitigation. “All for one and one for all” became a successful modus operandi. Well, it was until who the “all” was became unknown.^[4] As professional firms grew to have offices distributed throughout the country with varying levels of sophistication and resultant different risk profiles, the “one” in “one for all” was reduced to this office, or my practice group, or even just me.

The fallout of the Savings and Loan Crisis of the 1980s and early 1990s demonstrated that exposing partners across the country and across practices to personal liability for claims often arising in a distant office^[5] was no longer a viable structure.^[6] Generically, the CPA in Lincoln, Nebraska, who performed scrupulous audit work for local farmers and farm equipment distributors found himself facing bankruptcy when his “partner” in Texas was found to have provided spotty if not actually fraudulent assurance services to a savings and loan. Public institutions including the courts asked, Where were the attorneys and accountants who (with 20/20 hindsight?) should have intervened to protect the public from the scourge of unprincipled lending? Accounting firms paid nine-figure fines^[7] or were outright destroyed,^[8] as were storied law firms.^[9]

Okay, but if not general partnerships, then what? And here there arose the narrow gap between a rock and a hard place. On one side were the regulatory rules that limited professional firms to general partnerships (already rejected due to the personal liability rule) and in some instances professional service corporations (“PSCs”).^[10] While the PSC option afforded limited liability, larger firms could not use the PSC form because of the functional size limitation imposed for S-corporation treatment.^[11] Further, the conversion of an existing partnership into an entity taxed under either Subchapter C or Subchapter S resulted in phantom income because of the (for tax purposes) realization of accounts receivable.^[12] Additional transactional costs would have been incurred in the real costs of drafting and negotiating a shareholder agreement, as well as the intangible costs of referring to copractitioners as “shareholders” and in some cases “directors” rather than the previously employed “partners.” What was needed was a partnership that satisfied the professional regulatory rules as to forms of practice and maintained the preferred tax classification while limiting or abolishing the venerable partnership rules as to partner liability. The LLP arose out of that tension.

The limited liability partnership (“LLP”), which in some states is labeled a “registered limited liability partnership,” is a construct in which a general partnership may via a state notice filing elect to be governed by a different rule as to the vicarious liability of the partners for the partnership’s debts and obligations.^[13] In a classic general partnership, each partner is jointly and severally liable with the partnership and each other partner for the partnership’s debts and obligations.^[14] The LLP is a general partnership that continued the partnership format in that it retained existing management structures and tax treatment as well as the perceived value of identifying the firm’s principals as “partners.” Crucially, because the LLP was a general partnership, it did not run afoul of then-existing rules limiting professional practices to the forms of a general partnership and in certain instances a PSC.

The importance of staying within the confines of a partnership is illustrated by the development of the laws of the Commonwealth of Kentucky governing the permitted forms of an accounting practice. Kentucky’s modern statute governing the accounting practice was adopted in 1946,^[15] it providing in part for the structure of partnerships engaged in accounting.^[16] Then in 1984 the defined term “firm” was added to that act, namely: “‘Firm’ means a sole proprietorship, partnership or professional service corporation or association engaged in the practice of public accountancy.”^[17] The rule remained that an accounting practice could be conducted in the form of a sole proprietorship, a partnership, or a professional service corporation.^[18] In 1990 additional detail was added to the rules governing the composition of partnerships and professional corporations through which accounting was practiced, but they, along with sole proprietorships, remained the only available forms.^[19] Then, in 1994, coincident with the adoption of LLP amendments to Kentucky’s enactment of UPA,^[20] the rules governing accountants were amended. But tellingly, while LLCs were encompassed in the permitted forms, no additional language was added to address LLPs.^[21] That was not an omission but rather a recognition that no new authorization was necessary—accountants could practice as partnerships, and partnerships included the new option of electing into LLP status.^[22]

What distinguished the LLP from the preexisting partnership model is that it jettisoned the no longer desired rule of joint and several vicarious liability among the partners. While there are a variety of distinctions under various state laws, if a partnership makes this notice filing and satisfies the name requirements, the partners qua partners are to one degree or another (the distinction is between so-called “partial” and “full” shield LLPs) not subject to joint and several liability for the partnership’s obligations, but rather enjoy limited liability akin to that enjoyed by shareholders in a corporation.^[23] Some states require that the partnership periodically renew its LLP filing and that in the absence of that renewal it reverts to a traditional general partnership. Nearly all if not all states provide that the partnership that elects LLP status is the same entity that existed before that election was made.^[24]

For purposes of this article, it is important to recognize that aside from the elimination of vicarious liability, LLPs are indistinguishable from other general partnerships in all respects: they are formed by association of two or more persons as co-owners of a business for a profit, and, most importantly in this context, they are formed by this association, not by the filing of a charter or certificate with the state. While the characteristic of vicarious liability of the partners may depend upon the filing of a registration, in the parlance of RUPA a “statement of qualification,” the absence of such a filing does not alter the fact that the partnership exists as a business organization under state law. Further, should the registration expire or be withdrawn, the partnership continues as that same partnership; there is no dissolution or other interruption of its ability to transact business as an ongoing organization.

A last point on the substantive law of LLPs; the frame of reference of comparing “general partnerships” with “limited liability partnerships” is false as they are not two sets; essentially all limited liability partnerships are general partnerships.^[25] The set is general partnerships, and it may be divided into the subsets of (i) general partnerships that have elected to be limited liability partnerships, and (ii) general partnerships that have not elected to be limited liability partnerships.^[26] Graphically, it is not:

but rather:

The CTA Reporting Company

The “gateway” to the CTA is status as a “reporting company”;^[27] a reporting company is obligated to file beneficial ownership information reports (“BOIRs”) with FinCEN’s Beneficial Ownership Secure System (“BOSS”) database through its interface.^[28] Conversely, an organization that is not a reporting company never enters into the range of responsibility to file BOIRs.

What is a reporting company is initially defined in the CTA, namely:

(11) Reporting Company.—The term “reporting company”—

(A) means a corporation, limited liability company, or other similar entity that is—

(i) created by the filing of a document with a secretary of state or a similar office under the law of a State or Indian Tribe[.]^[29]

From that source the Reporting Regulations (unfortunately) modified the definition, defining a “domestic reporting company” as:

1. The term “domestic reporting company” means any entity that is:
   1. A corporation;
   2. A limited liability company; or
   3. Created by the filing of a document with a secretary of state or any similar office under the law of a State or Indian tribe.^[30]

FinCEN/Treasury did itself no favors in modifying the definition of a reporting company in the course of drafting the Reporting Regulations, as it may be read as a reporting company is any of (i) all corporations, (ii) all limited liability companies, and (iii) any other “entity” that is “created” by a secretary of state filing.^[31] FinCEN, in an FAQ, clarified that the interpretation of the Reporting Regulation’s definition of a reporting company is limited to those organizations created by a secretary of state filing and does not extend to every corporation or LLC.^[32]

No state requires a secretary of state or similar filing in order for a general partnership to come into existence.^[33] This rule is elemental in that partnership is a default category; when persons enter into a business relationship that satisfies the terms of what is a partnership, then a partnership comes into being,^[34] unless they elect to structure their relationship in another way such as a corporation or LLC.^[35] There being no secretary of state or similar filing in order to “create” a general partnership, it necessarily follows that a general partnership is not a CTA reporting company, a conclusion FinCEN/Treasury has recognized.^[36]

Against this background is what is apparently only a single statement from FinCEN to the effect that an LLP is a reporting company.^[37] On closer analysis that statement, to the extent it addresses LLPs, is incorrect.

LLPs Are Not Created by a Secretary of State Filing and Therefore Are Not “Reporting Companies”

No business organization is “created” by an election by a partnership to be an LLP. Rather, there was a partnership that was not an LLP, and then there is a partnership that is an LLP, and it may come to pass that there is a partnership that once was but is no longer an LLP; throughout all of those conditions there was a single partnership. That the partnership exists and then elects into LLP status is clear from the statutory language. The Revised Uniform Partnership Act (1997) provides: “[a] partnership may become a limited liability partnership pursuant to this section.”^[38] The partnership exists by agreement of the partners,^[39] and thereafter determines that it will be and makes the filing necessary to be an LLP. Since the partnership existed without the requirement of a state or other filing, and the already existing partnership files a document by which it elects in LLP status, it follows that a partnership is not “created” by the partnership’s filing of that election. This point was addressed in the Official Comments to RUPA § 201 in 1997 when it was observed:

Thus, just as there is no “new” partnership resulting from membership changes, the filing of a statement of qualification does not create a “new” partnership. The filing partnership continues to be the same partnership entity that existed before the filing. Similarly, the amendment or cancellation of a statement of qualification under Section 105(d) or the revocation of a statement of qualification under Section 1003(c) does not terminate the partnership and create a “new” partnership. See Section 1003(d). Accordingly, a partnership remains the same entity regardless of a filing, cancellation, or revocation of a statement of qualification.^[40]

Numerous courts have applied these principles to determine that a partnership that has elected to be an LLP is the same partnership that preceded that election.^[41]

This appreciation of the nature of the LLP is consistent with its roots. Recall that every organizational form is a construct, a combination of characteristics that satisfies a particular need, and as recounted above the “need” was for a structure that was and is a general partnership but with an altered rule of partner vicarious liability. If it was not a general partnership, the structure would have been outside the scope of permissible forms for the professional practices that needed (or at least wanted) the new rule.^[42]

Long before the CTA and the question of its treatment of LLPs, the Permanent Editorial Board for the Uniform Commercial Code (the “PEB”) considered the question of whether the election by a partnership to become an LLP via the filing of a statement of qualification is the formation or organization of an entity, a question of importance in the context of the Uniform Commercial Code because it determines the controlling law.^[43] Finding the election to be an LLP is not the organization of a new venture, the PEB wrote:

It follows that the statement of qualification filed with the State and by which a partnership becomes a limited liability partnership under the 1997 UPA is not a “public organic record” under the 2010 amendments to Article 9. The statement of qualification is not a record filed with the State to “form or organize” the partnership. It is the association of the partners that forms the partnership, not any record publicly filed with the State. Both conceptually and legally, a partnership is formed wholly apart from the filing of a statement of qualification with the State. Because a limited liability partnership is not formed or organized by the filing of a public organic record, it cannot be a “registered organization” under the 2010 amendments to Article 9.^[44]

So the statutory language governing a partnership’s election of LLP status, the cases interpreting that language, the Official Comment to that provision of the Revised Uniform Partnership Act (1997), the comments of leading experts in the field, and the PEB considering the language have all agreed that an LLP is not a separate organization “created” by the election to be an LLP. Against that there is, well, really nothing except FinCEN’s unsupported assertion that LLPs are reporting companies.

It bears noting that the Department of the Treasury, in its own regulations, acknowledges that an LLP is just a type of partnership, stating: “A partnership form of registration is available for two or more individuals who are doing business as a partnership, including a limited liability partnership.”^[45] At the same time other of its regulations, namely those under the customer due diligence requirements, provides that “legal entity customer” means: “a corporation, limited liability company, or other entity that is created by the filing of a public document with a Secretary of State or similar office, a general partnership, and any similar entity formed under the laws of a foreign jurisdiction that opens an account.”^[46] If FinCEN is to be taken at its word, and LLPs are not general partnerships, them an LLP is not a “legal entity customer” for which a bank has customer due diligence obligations; conversely if an LLP is but a subset of general partnerships, they are included. Further, clearly FinCEN knows how to write a regulation (and how to influence the drafting of a statute such as the CTA) to include entities created by a secretary of state filing and general partnerships.

FinCEN has estimated that there may be more than 32 million firms existing on January 1, 2024, that will be classified as reporting companies required to file BOIRs into the BOSS database and interface.^[47] All else being equal, those totals will not include any general partnerships that have elected to be limited liability partnerships. While some may view this treatment of LLPs as exposing a significant gap in the CTA’s coverage, that viewpoint does not alter the reach of the statutory language.

1. See, e.g., Robert Francis Harper, Assyrian and Babylonian Literature 263 (reciting the terms of a contract dated to 2000 BCE) (D. Appleton and Company 1901). ↑

2. It is somewhat disturbing to realize this was already a quarter of a century ago. ↑

3. See Unif. P’ship Act (1914) § 15; see also id. § 18. ↑

4. See also Susan Saab Fortney, Am I My Partner’s Keeper? Peer Review in Law Firms, 66 U. Colo. L. Rev. 329 (1995). ↑

5. See also Michael Orey, The Lessons of Kaye, Scholer: Am I My Partner’s Keeper?, Am. Law., May 1992, at 3, 81. ↑

6. See, e.g., Robert W. Hamilton, Registered Limited Liability Partnerships: Present at the Birth (Nearly), 66 U. Colo. L. Rev. 1065, 1069 (1995); Robert R. Keatinge et al., Limited Liability Partnerships: The Next Step in the Evolution of the Unincorporated Business Organization, 51 Bus. Law. 147 (1995). See also Joseph S. Naylor, Is the Limited Liability Partnership Now the Entity of Choice for Delaware Law Firms?, 24 Del. J. Corp. L. 145 (1999). ↑

7. See, e.g., Robert A. Rosenblatt, Auditor Pays $400 Million for Not Signaling S&L; Crisis, L.A. Times (Nov. 24, 1992) (discussing settlement paid by Ernst & Young). ↑

8. See, e.g., Nancy Rivera Brooks, Laventhol & Horwath to Seek Bankruptcy Shield, Dissolve Firm, L.A. Times (Nov. 21, 1990); see also Frederic M. Stiner, Jr., Bankruptcy of an Accounting Firm: Causes and Consequences of the Laventhol & Horwath Failure, 3 Econ. & Bus. J.: Inquiries & Persps. 1 (2010). ↑

9. See supra note 5, discussing $41 million fine paid by Kaye, Scholer, Fierman, Hays & Handler; Law Firm Reaches S&L Settlement, Chi. Trib. (Apr. 20, 1993) (discussing $51 million settlement paid by Jones Day); see also Susan Saab Fortney, OTS vs. the Bar: Must Attorneys Advise Directors that the Directors Owe a Duty to the Depository Fund?, 12 Ann. Rev. Banking L. 373, 375 nn.9–11 (1993); id. at 376–379; Harris Weinstein, Attorney Liability in the Savings and Loan Crisis, 1993 U. Ill. L. Rev. 53, 53 (reporting that some ninety civil cases had been brought in the preceding four years against “lawyers”); James S. Granelli, Two Firms Settle Lincoln S&L Cases, L.A. Times, Mar. 31, 1992, at A1. ↑

10. Recall that at this point in time LLCs had not yet exploded onto the scene, and even where available, professional regulation likely did not yet sanction the use of that form by professional firms. ↑

11. This statement presupposes that pass-through taxation is “necessary,” a statement more true at that time than it is today with significant narrowing of differentials between Subchapters C, K, and S, especially as to the availability of tax-favored retirement savings plans. From 1982 through 1997, the time period that includes the Savings and Loan Crisis, and the rise of the LLP, S-corporation status was limited to firms with thirty-five or fewer shareholders, greatly reducing the utility of S-corporation classified PSCs for the organization of professional firms. See Subchapter S Revision Act of 1982, Pub. L. 97–354, § 2, 96 Stat. 1669, 1669 (Oct. 19, 1982) (amending Code 1361(b)(1) to provide: “For purposes of the subchapter, the term ‘small business corporation’ means a domestic corporation which is not an ineligible corporation and which does not (A) have more than 35 shareholders . . . .”). The limit was not raised to seventy-five shareholders until 1997, and then it was raised to one hundred shareholders in 2005. See Small Business Job Protection Act of 1996, Pub. L. 104-188, § 1301, 110 Stat. 1755, 1777 (Aug. 20, 1996); American Jobs Creation Act of 2004, Pub. L. 108–357, § 232, 118 Stat. 1418, 1434 (Oct. 22, 2004). See also Richard D. Blau, Bruce N. Lemons & Thomas P. Rohman, S Corporations: Federal Taxation § 3:35 (July 2024 Update) (ebook). ↑

12. See 26 U.S.C. § 357(c)(1); see also Thomas Arden Roha, The Application of Section 357(c) of the Internal Revenue Code to a Section 351 Transfer of Accounts Receivable and Payable, 24 Cath. U.L. Rev. 243 (1975); Bruce G. Perrone, Incorporating a Cash Basis Business: The Problem of Section 357(c), 34 Wash. & Lee L. Rev. 329 (1977). ↑

13. In certain states including Colorado and Delaware a limited partnership may also make this filing, but for purposes of simplicity this discussion is in the context of a general partnership. Whether a limited partnership that elects LLP status, sometimes referred to as a limited liability limited partnership or “LLLP,” presents a different set of challenges in determining whether it is a CTA reporting company. ↑

14. See Unif. P’ship Act (1914) § 15; Rev. Unif. P’ship Act (1997) § 306(a); Colo. Rev. Stat. § 7-64-306(1) (“Except as otherwise provided in this section, all partners are liable jointly and severally for all partnership obligations unless otherwise agreed by the claimant or provided by law.”); Del. Code Ann. tit. 6, § 15-306(a); Ky. Rev. Stat. Ann. § 362.2-306(1). ↑

15. See 1946 Ky. Acts. ch. 210 (S.B. 164); see also id. at § 1 (“This Act may be cited as the ‘Public Accounting Act of 1946.’”). ↑

16. See id. § 5 (certified public accountants); id. § 7 (public accountants); see also id. § 8 (permits to practice public accounting to be issued to “individuals and partnerships”). ↑

17. See Ky. Rev. Stat. Ann. § 325.220(6) as created by 1984 Ky. Acts ch. 117 (H.B. 389). Presumably the “professional service [] association” reference is to partnership associations. ↑

18. See Ky. Rev. Stat. Ann. § 325.300 (repealed 1994). ↑

19. See Ky. Rev. Stat. Ann. § 325.300 as amended by 1990 Ky. Acts ch. 285, §1(6) (repealed 1994). ↑

20. See Ky. Rev. Stat. Ann. § 362.555. Kentucky would not adopt the Revised Uniform Partnership Act (1997) until 2006. ↑

21. See Ky. Rev. Stat. Ann. § 325.220(6) as amended by 1994 Ky. Acts 248 (HB 546) (amended 2018) (new text is underlined and deleted text struck through) (“(6) ‘Firm’ means a sole proprietorship, partnership, professional service corporation, or any other form of business organization association engaged solely in the practice of public accountancy that is not otherwise prohibited from operating by the laws of this Commonwealth and which complies with the provisions of this chapter.”). ↑

22. Through 1992 the American Institute of Certified Public Accountants provided that CPAs could practice as sole proprietorships, as general partnerships, and as professional service corporations. See Keatinge et al., supra note 6 at 158. It was only in 2000 that the Kentucky Supreme Court expressly permitted attorneys to practice as PSCs and (professional) LLCs. See Ky. S. Ct. Rule 3.022 (adopted by Order 99-1, effective Feb. 1, 2000). Looking at Delaware and its rules governing attorneys and the manner in which firms could be organized, through 1995 there were particular rules for professional service corporations (Del. S. Ct. Rule 67, amended effective Jan. 1, 1995), that form having been authorized for attorneys in 1969. See id., Comment. While it does not appear there was a rule particularly addressing legal partnerships, it may well be that they were so ubiquitous it was simply understood they could operate. In 1997 Rule 67 was significantly expanded to address and expressly authorize the use of a variety of forms for the organization of law firms; beyond PSCs, all partnership, limited partnership, and LLC organized firms were recognized. See Del. S. Ct. Rule 67, amended effective May 1, 1997. For our purposes the phrase used with respect to partnerships is most telling, namely “general partnerships, including registered limited liability partnerships.” Id. Were partnerships and LLPs distinct categories, we would have expected the rule of practice of the most business law–savvy court in the country to treat them as distinct (just as PSCs are from partnerships, limited partnerships, and LLCs, etc.) from one another. Instead they are treated as members of the same class. Special thanks to Paul Altman (Richards, Layton & Finger) for his assistance in tracking down this history. ↑

23. See, e.g., Ky. Rev. Stat. Ann. § 362.220(2); id. § 362.555 (a partial shield statute); Rev. Unif. P’ship Act (1997) § 306(c) (full shield); Colo. Rev. Stat. § 7-64-306(3); Del. Code Ann. tit. 6, § 15-306(c); Ala. Code § 10-8A-306(c); Va. Code Ann. § 50-73.96(C). See also Christine Hurt & D. Gordon Smith, Bromberg and Ribstein on Limited Liability Partnerships, the Revised Uniform Partnership Act, and the Uniform Limited Partnership Act (2001) (2nd ed.) § 3.03; id. § 3.13[C]. While this description is sufficient for purposes of this discussion, it is worth noting that affording partners in an LLP “limited liability” required more than just altering the rule of UPA § 15. In addition, there needed to be addressed the obligation of the partners each individually to contribute to the partnership to satisfy its obligations and upon liquidation to contribute to satisfy intrapartnership settling up of accounts between partners. See Unif. P’ship Act (1914) §§ 18(a), 18(b); see also Robert R. Keatinge, The Floggings Will Continue Until Morale Improves: The Supervising Attorney and His or Her Firm, 39 S. Tex. L. Rev. 279 (1998). This was accomplished in the Revised Uniform Partnership Act (1997) by section 306(c) thereto (“A partner is not personally liable, directly or indirectly, by way of contribution or otherwise, for such an obligation solely by reason of being or so acting as a partner. This subsection applies notwithstanding anything inconsistent in the partnership agreement that existed immediately before the vote required to become a limited liability partnership under Section 1001(b).”). ↑

24. See, e.g., Rev. Unif. P’ship Act (1997) § 201(b) (“A limited liability partnership continues to be the same entity that existed before the filing of a statement of qualification under Section 1001.”); Del. Code Ann. tit. 6, § 15-201(b); 805 Ill. Comp. Stat. 206/201(b); Ky. Rev. Stat. Ann. § 362.1-201(2); Va. Code Ann. § 50-73.132(E) (“A partnership that has been registered as a registered limited liability partnership under this chapter is, for all purposes, the same entity that existed before it registered.”). See also Colo. Rev. Stat. § 7-64-202(1) (“A limited liability partnership is for all purposes a partnership.”). ↑

25. The qualification recognizes that in some states a limited partnership may elect LLP status. ↑

26. See also Robert Hillman, Donald Weidner & Allan Donn, The Revised Uniform Partnership Act (2023–24 ed.) at § 201, Authors’ Comment 9(b):

    Limited liability partnerships are often discussed as if they were a separate form of business organization. To the contrary, a limited liability partnership is not a “new” or “separate” form of business organization. Rather, a limited liability partnership is simply a partnership that qualifies for a special limited liability shield. At bottom, a limited liability partnership is either a general partnership or a limited partnership. When it files a statement of qualification, it remains the same business organization but it gets a new liability shield. If it cancels the statement, it simply sets the shield aside. ↑

27. Reporting companies come in two flavors: domestic, being those organized in the U.S. including one of its territories, and “foreign,” being those organized outside the U.S. and its territories. Compare 31 C.F.R. § 1010.380(c)(1)(i) with 31 C.F.R. § 1010.380(c)(1)(ii). This discussion is focused upon LLPs organized in the U.S., so any reference to a “reporting company” should be understood to be a reference to a “domestic reporting company.” ↑

28. For reviews of the Corporate Transparency Act, see, e.g., (i) Allison J. Donovan & Thomas E. Rutledge, The Corporate Transparency Act Is Happening to You and Your Clients: Dealing with the Tsunami, Ky. Bar Ass’n (July 30, 2024), and (ii) Robert R. Keatinge, Anne E. Conaway, Thomas E. Rutledge & Bruce P. Ely, Keatinge and Conaway on Choice of Business Entity, ch. 21 (forthcoming Nov. 2024). ↑

29. See CTA, 31 U.S.C.A. § 5336(a)(11). ↑

30. See 31 C.F.R. § 1010.380(c)(1)(i). Note that each of “State” and “Indian tribe” are defined terms. See 31 C.F.R. § 1010.380(f)(4) (definition of “Indian tribe”); id. § 1010.380(f)(9) (definition of “State”). See also Beneficial Ownership Information: Frequently Asked Questions, FinCEN.gov (hereinafter “FinCEN FAQ”) at FAQ C.7 (Jan. 12, 2024) (discussing “reporting company” status of companies created in a variety of U.S. territories). Important for this discussion is recognition that “created” is not a defined term. ↑

31. See also Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. 59498 at 59589 (Sept. 30, 2022):

    Description of Affected Public:

    Domestic entities that are: (1) corporations; (2) limited liability companies; or (3) created by the filing of a document with a secretary of state or any similar office under the law of a state or Indian tribe, and foreign entities that are: (1) corporations, limited liability companies, or other entities; (2) formed under the law of a foreign country; and (3) registered to do business in any state or Tribal jurisdiction by the filing of a document with a secretary of state or any similar office under the laws of a state or Indian tribe.

    (emphasis added). ↑

32. See FinCEN FAQ C.9 (Apr. 18, 2024); see also Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59538 (“FinCEN . . . notes that the core consideration for the purposes of the CTA’s statutory text and the final rule is whether an ‘entity’ is ‘created’ by the filing of the document with the relevant authority.”); id. (“We emphasize again that the only relevant issue for the purposes of the CTA and the final rule is whether the filing ‘creates’ the entity.”). ↑

33. Intentionally not addressed herein are the laws of any of the Indian tribes or of any of the U.S. territories. ↑

34. See, e.g., Unif. P’ship Act (1914) § 6(1); Rev. Unif. P’ship Act (1997) § 202(a); Del. Code Ann. tit. 6, 15-202(a); Ala. Code § 10A-8A-1.01; Colo. Rev. Stat. § 7-64-202(1) (“Except as otherwise provided in subsection (2) of this section, the association of two or more persons to carry on as co-owners a business for profit forms a partnership, whether or not the persons intend to form a partnership.”); Ky. Rev. Stat. Ann. § 362.175; id. § 362.1-202(1); Va. Code Ann. § 50-73.88(A). See also In re Copeland, 291 B.R. 740 (Bankr. E.D. Tenn. 2003); Flying Phoenix Corp. v. Sinclair, 2024 WYCH 3, 2024 Wyo. Trial Order LEXIS 4 (Wyo. Ch. Apr. 25, 2024) (“A partnership is formed when ‘two or more persons’ associate ‘to carry on as co-owners a business for profit,’ ‘whether or not the persons intended to form a partnership.’ The determinative intent is not the parties’ subjective intent to be characterized (or not characterized) as partners, but their ‘intent to do things that constitute a partnership.’ This means that absent a partnership agreement, or even when the parties express their subjective intent not to form a partnership, the parties may inadvertently create a partnership through their conduct.”) (citations omitted); 1 William Meade Fletcher, Fletcher Cyclopedia of the Law of Private Corporations § 20 (“A partnership is created by mere agreement between the partners. The approval of the state is not necessary.”); 2 John Bouvier, A Law Dictionary, Partnership, 11-§4, at 294 (“Partnerships are created by mere act of the parties; and in this they differ from corporations which require the sanction of state authority, either express or implied.”) (The Lawbook Exchange 2003) (1856). ↑

35. See Unif. P’ship Act. (1914) § 6(2); Rev. Unif. P’ship Act (1997) § 202(b); Del. Code Ann. tit. 6, § 15-202(b); Colo. Rev. Stat. § 7-64-202(1); Ky. Rev. Stat. Ann. § 362.175; id. § 362.1-202(2); Va. Code Ann. § 50-73.88(B). ↑

36. See Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59537:

    In general, FinCEN believes that sole proprietorships, certain types of trusts, and general partnerships in many, if not most, circumstances are not created through the filing of a document with a secretary of state or similar office. In such cases, the sole proprietorship, trust, or general partnership would not be a reporting company under the final rule. ↑

37. See Fin. Crimes Enf’t Network, U.S. Dep’t of the Treasury, Beneficial Ownership Information Reporting Rule Fact Sheet (Sept. 29, 2022):

    FinCEN expects that these definitions mean that reporting companies will include (subject to the applicability of specific exemptions) limited liability partnerships, limited liability limited partnerships, business trusts, and most limited partnerships, in addition to corporations and LLCs, because such entities are generally created by a filing with a secretary of state or similar office.

    (emphasis added).

    In addition, pursuant to section 6502(d) of the Anti-Money Laundering Act of 2020, the U.S. Government Accountability Office is reviewing beneficial ownership requirements for trusts, partnerships, and other legal entities, and has made specific inquiries as to LLPs. Not once, not twice, but thrice in the proposed beneficial ownership information reporting regulations FinCEN referenced LLPs, but it then did not structure a definition of a reporting company that would include LLPs within its scope. See Beneficial Ownership Information Reporting Requirements, 86 Fed. Reg. 69920 at 69938–39 (proposed Dec. 8, 2021) (“In general, FinCEN believes the proposed definition of domestic reporting company would likely include limited liability partnerships, limited liability limited partnerships, business trusts (a/k/a statutory trusts or Massachusetts trusts), and most limited partnerships, in addition to corporations and limited liability companies (LLCs), because such entities appear typically to be created by a filing with a secretary of state or similar office.”); id. at 69946–47 (“In general, FinCEN believes the phrase ‘other similar entity created by the filing of a document with a secretary of state or similar office’ in the context of the definition of ‘domestic reporting company’ would likely include limited liability partnerships, limited liability limited partnerships, business trusts (a/k/a statutory trusts or Massachusetts trusts), and most limited partnerships, because such entities appear typically to be created by a filing with a secretary of state or similar office.”); id. at 69957 (“As noted above, the counts for Q6 may include general partnerships for some jurisdictions which may not be considered reporting companies; however, because they are grouped with limited partnerships and limited liability partnerships in this survey, FinCEN is retaining this number as part of its estimate.”). ↑

38. See Rev. Unif. P’ship Act (1997) § 901(a) (“a partnership may elect the status of a limited liability partnership [by filing a statement of qualification with the state filing officer]”); see also Cal. Corp. Code § 16953(a) (“To become a registered limited liability partnership, a partnership, other than a limited partnership, shall file with the Secretary of State a registration, executed by one or more partners authorized to execute a registration, stating all of the following: . . . .”); Colo. Rev. Stat. § 7-64-1002(1) (“A domestic partnership governed by this article may register as a limited liability partnership . . . .”); 805 Ill. Comp. Stat. 206/1001(a) (“A partnership may become a limited liability partnership pursuant to this Section.”); Ind. Code § 23-4-1-45(a) (“To qualify as a limited liability partnership, a partnership under this chapter must file a registration with the secretary of state in a form determined by the secretary of state that satisfies the following: . . . .”); Ky. Rev. Stat. Ann. § 362.555(1) (“To become and to continue as a registered limited liability partnership, a partnership that is not a limited partnership shall file . . . .”); id. § 362.1-931(1) (“A partnership may become a limited liability partnership pursuant to this section.”); Md. Code Ann., Corps. & Ass’ns § 9A-1001(a) (“A partnership formed in accordance with an agreement governed by the laws of this State may register as a limited liability partnership by filing with the Department a certificate of limited liability partnership which sets forth: . . . .”); Mont. Code Ann. § 35-10-701(1) (“To become a limited liability partnership, a partnership shall file with the secretary of state an application for registration on a form furnished by the secretary of state that indicates an intention to register as a limited liability partnership under this section.”); Va. Code Ann. § 50-73-132(A) (“To become a registered limited liability partnership, a partnership formed under the laws of the Commonwealth shall file with the Commission a statement of registration as a registered limited liability partnership stating: . . . .”); 11 Vt. Stat. Ann. § 3291(a)(1) (“Any lawful partnership may become a limited liability partnership pursuant to this section.”). ↑

39. See supra notes 33 through 35 and accompanying text. ↑

40. See also Hillman, Weidner & Donn, supra note 26. It bears noting that as it is the same partnership both before and after an election into LLP status is made, the election to be an LLP (and likewise the election to be a partnership that is not an LLP that is made when an LLP election lapses) is not a “conversion” as contemplated by certain business organization statutes including those permitting a partnership, LLP or otherwise, to convert into, for example, LLC form. Compare, e.g., Colo. Rev. Stat. § 7-64-1002 and Del. Code Ann. tit. 6, §15-1001 (dealing with registration of general partnerships to change their status to LLPs) with Colo. Rev. Stat. § 7-90-201(a) and Del. Code Ann. tit. 6, § 15-901 (dealing with a conversion of a general partnership into another entity). Thus, FinCEN FAQ C.18 (October 3, 2024), which states, “Where a conversion does result in the creation of a new domestic reporting company, the new domestic reporting company is required to file an initial beneficial ownership information (BOI) report,” does not apply to the change of status whereby a general partnership acquires the status of LLP. ↑

41. See, e.g., Mudge Rose Guthrie Alexander & Ferdon v. Pickett, 11 F. Supp.2d 449, 452 n. 12 (S.D.N.Y. 1998) (commenting in footnote that the New York LLP statute “clearly enunciates that a general partnership that is registered as a RLLP is for all purposes the same entity that existed before registration and continues to be a general partnership under the laws of New York”) (citation omitted); Howard v. Klynveld Peat Marwick Goerdeler, 977 F. Supp. 654, 657 n.1 (S.D.N.Y. 1997), aff’d 173 F.3d 844 (2d Cir. 1999) (upon a partnership electing to become a limited liability partnership, “The partnership was not dissolved and continued without interruption with the same partners, principals, employees, assets, rights, obligations, liabilities and operations as maintained prior to the change. Thus, Peat Marwick LLP is in all respects the successor in interest to Peat Marwick.”); Sasaki v. McKinnon, 707 N.E.2d 9 (Ohio Ct. App. 1997) (“These two entities, E&Y and E&Y LLP are, but for the corporate change to a limited liability partnership designation, the same entities for all practicable intents and purposes.”); Maupin v. Meadow Park Manor, 125 P.3d 611 (Mont. 2005) (LLP is “same entity that existed before the registration”); Ex parte Haynes Downard Andra & Jones, LLP, 924 So. 2d 687, 699 (Ala. 2005) (an LLP “is for all purposes, except as provided in Section 10-8A-306 [not relevant to our inquiry], the same entity that existed before the registration and continues to be a partnership under the laws of this state . . . .” (citing Ala. Code § 10-8A-1001(i)); Riccardi v. Young & Young, LLP, 74 Misc. 3d 911, 915 (N.Y. Cohoes City Ct. 2022) (“An LLP is a general partnership which acquires limited liability characteristics upon registration with the secretary of state.”) (citation omitted). ↑

42. See, e.g., Accounting Firms Reorganize to Limit Liability, L.A. Times (Aug. 2, 1994). Of course it was not just accounting and law firms that adopted the LLP format. See, e.g., Jennifer Wong Suzuki, Limited Liability Partnerships for Firms, AIA California (“With the passage of Assembly Bill 469 (Cardoza) in 1998—one [of] the AIACC’s sponsored pieces of legislation—architects can now join accountants and lawyers in forming limited liability partnerships (LLPs).”). ↑

43. As recounted by the PEB in the first substantive paragraph of the report:

    The location of an organization, as “location” is determined under U.C.C. § 9-307, plays an important role in determining the local law that governs perfection, the effect of perfection or nonperfection, and the priority of a security interest. See U.C.C. § 9-301(1). As a general matter, a “registered organization” is located, as determined under U.C.C. § 9-307(e), in the State under whose laws the organization is organized while an organization that is not a registered organization is considered under U.C.C. § 9-307(b)(2) to be located in the State in which the organization has its place of business.

    See PEB Commentary No. 17, Limited Liability Partnerships under the Choice of Law Rules of Article 9 (June 29, 2012) (footnotes omitted). ↑

44. Id. ↑

45. See 31 C.F.R. § 363.20(c)(2). ↑

46. See 31 C.F.R. § 1010.230(e)(1). ↑

47. According to the release accompanying the Reporting Regulations, “The number of legal entities already in existence in the United States that may need to report information on themselves, their beneficial owners, and their formation or registration agents pursuant to the CTA is in the tens of millions.” See Beneficial Ownership Information Reporting Requirements, 87 Fed. Reg. at 59500 (citation omitted). The footnotes accompanying the quoted language sets forth FinCEN’s estimate “that there will be at least 32.6 million ‘reporting companies’ (entities that meet the core definition of a ‘reporting company’ and are not exempt) in existence when the proposed rule becomes effective.” Id.; see also id. at 59562. That same document goes on to state: “Summing the estimates of both domestic and foreign entities, the total number of existing entities in 2024 that may be subject to the reporting requirements is 36,581,506 and the total number of new companies annually thereafter is 5,616,382.” Id. at 59565 (citation omitted). ↑

This article is Part II in the Many Splendors of Fraud Claims series by Glenn D. West, which explores recent cases that affect drafting practices for avoiding fraud claims in private company M&A.

Delaware has made clear that a standard integration provision has no impact on extra-contractual fraud claims based upon false statements of existing fact; instead what is required to defeat such a claim is a clause clearly disclaiming reliance upon any extra-contractual statements. We saw that requirement in action in Part I of this series.^[1] But what about extra-contractual promissory fraud—that is, fraud premised upon a promise of future performance? Why shouldn’t an ordinary integration clause defeat any fraud claims premised on that extra-contractual promise? After all, the purpose of an integration clause is to bar parol evidence of alleged prior extra-contractual promises and agreements that are not contained in the written agreement.

In Shareholder Representative Services LLC v. Albertsons Companies, Inc.,^[2] the Delaware Court of Chancery held that “[w]hile anti-reliance language is needed to stand as a contractual bar to an extra-contractual fraud claim based on factual misrepresentations, an integration clause alone is sufficient to bar a fraud claim based on expressions of future intent or future promises.”^[3] According to the court, “[a]s distinguished from a claim of extra-contractual fraud based on a statement of fact, the fraud claim based on a ‘future promise’ amounts to an improper attempt to introduce ‘parol evidence that would vary the extant terms in the subsequent integrated writing.’”^[4]

Recently, however, Vice Chancellor Laster, in Trifecta Multimedia Holdings, Inc. v. WCG Clinical Services LLC,^[5] refused to follow the Albertsons decision. While promissory fraud may be based upon extra-contractual promises rather than extra-contractual statements of purported existing fact, it is still an extra-contractual fraud claim, not an effort to introduce an additional covenant into a fully integrated agreement. Indeed, promissory fraud is not a separate species of fraud at all. Promissory fraud actually involves more than a future intention to perform a promise; it involves a false statement of existing fact—the existing fact being the promisor’s existing intention to perform the future promise. Technically, promissory fraud is not based on “future intent” at all; it is based upon the present intent not to perform a future promise.

According to the Restatement (Second) of Torts, “[s]ince a promise necessarily carries with it the implied assertion of an intention to perform[,] it follows that a promise made without such an intention is fraudulent and actionable in deceit.”^[6] And, as Lord Bowen famously said, “the state of a man’s mind is as much a fact as the state of his digestion. . . . A misrepresentation as to the state of a man’s mind [i.e., the present intent to perform a future promise] is, therefore, a misstatement of fact.”^[7]

In Trifecta Multimedia Holdings, there was no disclaimer-of-reliance provision, only an integration clause. And the court ruled in favor of the sellers, who alleged that the buyers never intended to fulfill certain extra-contractual promises made in order to induce them into agreeing to an earnout.

Even more recently, in Fortis Advisors LLC v. Johnson & Johnson,^[8] Vice Chancellor Will also rejected a party’s contention that an integration clause could defeat a promissory fraud claim. While recognizing the existence of prior Delaware authority suggesting otherwise, Vice Chancellor Will held that only “unambiguous anti-reliance language” is effective to defeat any extra-contractual fraud claim.^[9] Vice Chancellor Will also noted that, in the prior cases holding otherwise, “the purported oral misrepresentations” about future promises “conflicted with the terms of the contracts.”^[10] An anti-reliance clause is less relevant when the alleged extra-contractual misrepresentations conflict with express language in a fully integrated contract because “reliance upon an oral representation that is directly contradicted by the express, unambiguous terms of a written agreement between the parties is not justified as a matter of law.”^[11]

Regardless of whether the extra-contractual statements are representations of existing fact or promises of future performance that are alleged to have never been intended to be performed (and therefore constitute representations of existing fact—i.e., the current intention to perform those promises), the only sure way to defeat those claims of extra-contractual fraud based on those statements is through a disclaimer-of-reliance provision.

And just as you cannot simply declare in a fraud definition that extra-contractual fraud is not fraud, the common practice of listing “promissory fraud” as something that is not considered fraud may not actually accomplish the desired result if your disclaimer-of-reliance provision does not affirmatively disclaim reliance on all extra-contractual statements made (whether they purport to be traditional statements of existing fact or future promises that carry with them representations of existing fact).

1. Glenn D. West, Follow the Entire Playbook to Disclaim Reliance Upon Extra-Contractual Statements, Bus. L. Today (Oct. 3, 2024). ↑

2. 2021 WL 2311455 (Del. Ch. June 7, 2021). ↑

3. Id. at *12. ↑

4. Id. (quoting Black Horse Cap., LP v. Xstelos Holdings, Inc., 2014 WL 5025926, at *24 (Del. Ch. Sept. 30, 2014)). See discussion of this case in Glenn D. West, Fraud Based upon Oral Future Promises (Unlike Fraud Based upon Oral Misrepresentations of Fact) Can Be Defeated by a Standard Integration Clause, Weil’s Glob. Priv. Equity Watch (June 21, 2021). ↑

5. 318 A.3d 450 (Del. Ch. 2024). ↑

6. Restatement (Second) of Torts § 530(c) (Am. L. Inst. 1977). ↑

7. Edgington v. Fitzmaurice, [1885] EWCA (Civ) 1 (Eng.). ↑

8. 2024 WL 4048060 (Del. Ch. Sept. 4, 2024). ↑

9. Id. at *46. ↑

10. Id. ↑

11. Mercedes-Benz USA, LLC v. Carduco, Inc., 583 S.W.3d 553, 559 (Tex. 2019); see Glenn D. West, There is No Fraud Without “Justifiable” Reliance: Unambiguous Terms of Written Contract Trump Claims of Fraudulent Inducement Even in the Absence of an Effective Non-Reliance Clause, Weil’s Glob. Priv. Equity Watch (Mar. 7, 2019). ↑

I frequently advise nonprofit clients on various legal issues that arise when an employer decides to separate an underperforming employee. Several variables impact the legal analysis, but, in all cases, I am interested in whether, and to what extent, the underperforming employee’s poor performance has been documented over time. How a client responds to that inquiry shapes my legal advice, sometimes favorably to the employer, and other times not. Quite simply, when an employer wishes to part ways with an underperforming employee, a robust record of performance deficiencies can significantly reduce—and in some instances, virtually extinguish—legal exposure for the employer.

How Do Performance Evaluations Reduce Risk Exposure?

With the exception of the chief executive, nonprofit employees in the United States tend to be employed “at will,” meaning that the employer can terminate them for any reason or no reason, except for an unlawful reason. To be clear, an employer cannot fire an employee for a discriminatory reason (race, sex, religion, sexual orientation, or another protected classification) or a retaliatory reason (taking protected leave, whistleblowing, or another protected activity), even if the employee is “at will.” With that as the basic guiding principle, how does an employer prove that it is taking an adverse action for a lawful reason, and not for a discriminatory or retaliatory reason? Consider the following illustration.

Let’s imagine that a little over a year ago, you hired Susie Slacker as a project manager. Slacker suffers from a chronic back condition, which for the purposes of this hypothetical scenario qualifies as a disability under federal and state law and necessitates that she schedule protected, intermittent leave. She coordinates the leave with your nonprofit’s HR department, and generally, this arrangement is not particularly disruptive to the nonprofit. What is disruptive to the nonprofit, though, is Slacker’s limited work ethic, nonresponsiveness, and lack of attention to detail. Without regret, Slacker chronically shows up late to work and to meetings (if she shows up at all), and her work product is often sloppy, containing numerous errors. Slacker often doesn’t respond to emails for days, or at all. Her colleagues are starting to complain, and you are concerned about Slacker’s member interactions, the quality of her work products, and the nonprofit’s reputation. After enduring these professional shortcomings for a full year, you decide that it is time to part ways with Slacker, and you call me for legal advice.

One of the first things I am going to ask you is this: “Has Slacker’s supervisor addressed the performance deficiencies with Slacker, and if so, how?” What I am hoping to hear is some variation of the following: “Slacker’s supervisor has consistently addressed the various professional shortcomings in accordance with nonprofit policy, first with two informal meetings, followed by a written warning and a performance improvement plan. Would you like to see documentation of those interactions?” When I hear any approximation of this response, any concerns I might otherwise have about legal exposure diminish significantly. Just as often, though, I learn that the performance concerns have not been documented at all, or even worse, that the only written documentation of the employee’s performance memorializes the employee’s positive contributions to the nonprofit over time, while completely ignoring the shortcomings. You need not be an employment lawyer to intuit that this is problematic.

But why? How does a lax performance evaluation implicate employment law? The answer lies at the intersection of employment law and discrimination law. Recall that an employer can terminate an at-will employee for any reason or no reason, but not for an unlawful reason such as discrimination or retaliation. To successfully prevail in a wrongful termination action that is predicated on claims of unlawful discrimination or retaliation, an aggrieved employee must prove that an unlawful motive prompted the termination. Of course, the employer will offer a legitimate business reason for the adverse decision—here, that Slacker underperformed over time—but the employee then gets another opportunity to prove that the purported legitimate reason was, in fact, pretext for discrimination or retaliation. For Slacker’s situation specifically, if there is no documented history of poor performance, she is well positioned to argue that the employer’s true reason for the termination was to punish her for taking protected leave for a qualifying disability. Even if Slacker is not savvy enough to manufacture this claim, an enterprising plaintiff’s attorney knows exactly how to leverage this fact pattern to negotiate a favorable severance package or settlement. Yet, there is no need to ever be in this scenario. Quite simply, documentation of performance deficiencies disincentivizes aggressive litigants, equips the nonprofit with a great deal of leverage, and serves as a compelling defense to any legal dispute that ultimately materializes.

Practical Advice for Supervisory Staff

Written performance evaluations are one of the best defenses an employer can produce in a wrongful termination situation to reduce legal exposure. With that in mind, here is some practical advice for supervisory staff:

1. Ensure that performance expectations are tethered to internal policies that have been communicated to the employee. A fundamental concept in employment law is “notice.” As a matter of fundamental fairness, an employee must be apprised of permissible and impermissible behavior. Typically, employers detail these expectations in employee handbooks, and often, as a best practice, these expectations are reinforced throughout the year, whether in staff trainings, in one-on-one supervisory meetings, or through some other medium. If you have not examined your policies and codes of conduct in a while, consider reviewing them to ensure that the policies as written align with your expectations of employee conduct. Also, make sure that each employee acknowledges that they have received and reviewed these documents as part of the employee onboarding experience, and annually thereafter or when the documents are revised, whichever is sooner.
2. Follow your progressive discipline policy. Most nonprofits describe a progressive discipline policy in an employee handbook (e.g., oral warning, written warning, probation, termination). Follow the policy to a tee. Deviations, no matter how small, may expose the nonprofit to “due process,” contract, tort, or disparate treatment claims.
3. Address poor performance in real time with underperforming employees. When an employee fails to meet expectations, candidly address professional shortcomings with the employee, along with discussing ways that the employee can either cure a discrete performance issue, or if that is not possible, perform better in the future. This puts the employee on notice of poor performance. Just as importantly, when confronted with clear expectations and a path forward, the employee may course correct, which tends to be a more optimal outcome, both financially and otherwise, than commencing a search and onboarding a new employee.
4. Document performance discussions in dated communications. After you meet with the employee to discuss performance deficiencies, document a summary of the conversation in a written format. An email suffices for minor infractions; a written warning on nonprofit letterhead or a formal performance improvement plan might be more appropriate for repeated infractions or more egregious violations (of course, in all instances following your internal policies and procedures, as discussed above). These communications should be dated to formally build a performance record over time. This written trail is particularly important to defend against retaliation lawsuits by showing that a pattern of performance deficiencies predated any protected activities.
5. Be candid. You must be candid in your employee evaluations. Nothing is more frustrating that counseling an employer through an employee separation where all of the underperforming employee’s evaluations specify that the employee “meets expectations.” Favorable evaluations are used as ammunition to show pretext. Using our hypothetical scenario as an example, Slacker’s counsel will address a jury with the following type of argument: “For five years, my client met all company expectations, as evidenced by the five employee evaluations you have as Exhibits A–E. Now, just after my client started taking protected leave, the nonprofit is saying for the very first time that she has not been meeting expectations. Why, then, do the written evaluations speak so favorably of my client? You will need to decide whether this brand-new and undocumented explanation is a cover-up—or what we call a ‘pretext’ for an unlawful action—or whether the nonprofit’s diametrically opposite and undocumented explanation is the truth.” As an employer, you do not want to be in that position (in fact, we would urge you to settle long before ever getting to this point), and there is no reason you ever have to be in this position. A truthful record, built over time and memorialized in writing, can insulate an employer from this kind of exposure.
6. Treat similarly situated employees similarly. Finally, and importantly, you must treat similarly situated employees similarly. Imagine that you decide to part ways with Slacker, but Larry Lackluster—who holds a similar position as a project manager at the nonprofit and has a performance history similar to Slacker’s—is simply given a written warning. You have just positioned the nonprofit for a sex discrimination lawsuit based on disparate treatment. In other words, two similar employees with similar titles, job functions, and performance deficiencies were treated differently, and the only apparent explanation is that Lackluster is a man and Slacker is a woman. As a matter of nondiscrimination and fundamental fairness, you must treat similarly situated employees similarly.

Conclusion

This article distills a complicated legal framework into a few short pages. Of course, many important considerations should inform an employer’s decision and approach when determining whether to separate an employee. Such considerations include the size of the nonprofit organization; federal, state, and local law; the employee’s protected characteristics, if any; employer policies; custom and practice; and much more. Legal counsel can advise on the technical nuances of any or all of these legal implications. Regardless of unique factual and legal circumstances, when separating with an underperforming employee, your nonprofit will be positioned much more favorably if a well-documented, robust performance history corroborates the rationale underlying the legitimate business decision to terminate an employee.

This article is Part I in the Many Splendors of Fraud Claims series by Glenn D. West.

I know that many believe that all that could be written about avoiding fraud claims in private company M&A has been written. However, ABRY Partners V, L.P. v. F & W Acquisition LLC^[1] continues to give birth to additional progeny (in the form of new, recent cases) that require attention and possible modification of drafting practices in response. In a series of articles over the next few weeks, I will address some of these recent additions to the ABRY Partners lineage. We will begin with Labyrinth, Inc. v. Urich.^[2]

Background of the Labyrinth Case

Labyrinth involved a stock purchase agreement (“SPA”) that contained the following relevant provisions:

SPA Section 9.3:

The agreement of the parties that is comprised of this Agreement sets forth the entire agreement and understanding among the parties with respect to the subject matter hereof and supersedes any and all prior agreements, understandings, negotiations and communications, whether oral or written, relating to the subject matter of this Agreement. In the event of any inconsistency between the statements in the body of this Agreement and those in the Ancillary Documents, any Exhibit and the Disclosure Schedules (other than an exception expressly set forth in the Disclosure Schedules), the statements in the body of this Agreement will control.^[3]

SPA Section 4.28:

Except for the representations and warranties contained in Section 3 and this Section 4 (including the related portions of the Disclosure Schedules), none of Seller, the Company or any other Person has made or makes any other express or implied representation or warranty, either written or oral, on behalf of Seller or the Company, including any representation or warranty as to the accuracy or completeness of any information regarding the Company furnished or made available to Buyer and its Representatives[,] or any information, documents or material made available to Buyer in expectation of the transactions contemplated hereby[,] or as to the future revenue, profitability or success of the Company, or any representation or warranty arising from statute or otherwise in law.^[4]

SPA Section 5.27:

Buyer has conducted its own independent investigation, review and analysis of the business, results of operations, prospects, condition (financial or otherwise) or assets of the Company, and acknowledges that it has been provided adequate access to the personnel, properties, assets, premises, books and records, and other documents and data of Seller and the Company for such purpose. Buyer acknowledges and agrees that in making its decision to enter into this Agreement and to consummate the transactions contemplated hereby, none of Seller, the Company or any other Person has made any representation or warranty as to Seller, the Company or this Agreement, except as expressly set forth in Sections 3 and 4 of this Agreement (including the related portions of the Disclosure Schedules).^[5]

Sections 3 and 4 of the SPA apparently contained the representations of the company and the seller, respectively, and section 5 apparently contained representations of the buyer.

Following the closing of the transaction in Labyrinth, the buyer sued the seller for both intra-contractual fraud (i.e., fraud in the representations and warranties set forth in the SPA) and extra-contractual fraud (i.e., fraud allegedly committed outside the specific representations and warranties made in the SPA). The extra-contractual fraud allegations were largely based upon oral assurances allegedly made by the seller that the “key financial performance metrics—fourth quarter collections, profits, and accounts receivable—were all unaffected by Seller’s collection practice disclosures.”^[6]

Understanding the Court’s Ruling: A Multiple-Choice Quiz

Which of the following statements are likely true about the action of the Delaware Court of Chancery in ruling on the seller’s motion to dismiss the extra-contractual fraud counts?

1. The court was unpersuaded that section 9.3 was relevant to the motion to dismiss the extra-contractual fraud claims because it was a mere “integration clause” that “does not operate as a bar to fraud claims, but rather simply . . . limit[s] the scope of the parties’ contractual obligations to those set forth in the written agreement.”^[7]
2. The court was unpersuaded that section 4.28 had any effect to disclaim the buyer’s reliance on extra-contractual statements of the seller because section 4.28 was a statement by the seller “of what [the seller] was and was not representing and warranting”; it was not a statement by the buyer of what the buyer was relying upon.^[8]
3. The court was unpersuaded that section 5.27 was effective as a no-reliance clause because the first sentence of section 5.27 “details all the information that formed Buyer’s own independent analysis of the company, including the extracontractual information Seller provided,”^[9] and the second sentence “does not disclaim reliance on any extracontractual information.”^[10]
4. The court dismissed the extra-contractual fraud claims because no “magic words” are required in Delaware to disclaim reliance upon extra-contractual representations,^[11] and sections 4.28 and 5.27 taken together demonstrate “‘that the Buyer only relied on the representations and warranties in the SPA,’ thereby ‘establish[ing] the universe of information on which that party relied,’ and, together with an integration clause [SPA section 9.3], ‘add[ed] up to a clear anti-reliance clause.’”^[12]

Take a moment to test yourself before reading further.

* * *

“A” is clearly correct. Courts across the country say this all the time. Section 9.3 did not even have any anti-reliance language respecting purported extra-contractual representations; it simply excluded oral agreements from constituting part of the parties’ contract.

“B” is also correct. The old practice (which is still followed by some) of having the seller’s representations include a concluding representation (by the seller) that the seller has not made any representations other than those set forth in the agreement simply does not work. It is technically not a statement of no reliance but instead a statement that no extra-contractual representations were made (i.e., it is a “no-representations” clause rather than a “no-reliance” clause). And even if a statement that “no representations” outside the agreement were made by the seller is deemed sufficient as an effective disclaimer of reliance in Delaware, Delaware has long been insistent that the buyer must make that statement. Here, the seller (section 4), not the buyer, made the statement.^[13]

The better practice, of course, is to make sure that the statement both is a statement of no reliance and is made by the buyer. Indeed, an effective anti-reliance clause requires not only correct language but also correct placement in the agreement. I have even likened the creation of an effective disclaimer of extra-contractual representations to the effective means of “neutralizing” a flesh-eating zombie—it requires a specialized weapon to administer a blow to a precise spot.^[14]

“C” is a little tougher. In Texas (and perhaps other states), section 5.27 would clearly not work because there is no express use of the word rely or reliance. Moreover, simply stating (even from the buyer’s perspective) that no representations have been made is ineffective to defeat extra-contractual fraud in Texas.^[15] Instead, what is required in Texas is a clear statement that the buyer did not rely upon any statements that may have been made (even though the parties agreed that no statements were made). According to the Texas Supreme Court, “[t]here is a significant difference between a party disclaiming its reliance on certain representations, and therefore potentially relinquishing the right to pursue any claim for which reliance is an element, and disclaiming the fact that no other representations were made.”^[16] The former (disclaiming reliance) works, but the latter (disclaiming a fact) does not.

However, in Prairie Capital III, L.P. v. Double E Holding Corp.,^[17] the Delaware Court of Chancery rejected this strict approach requiring specific language disclaiming “reliance.” Instead, the Delaware Court of Chancery declared that “Delaware law does not require magic words.”^[18] Rather, “[l]anguage is sufficiently powerful to reach the same end by multiple means, and drafters can use any of them to identify with sufficient clarity the universe of information on which the contracting parties relied.”^[19] While I never was completely sure of what constituted that other “sufficiently powerful” language,^[20] one might be tempted to view the second sentence of section 5.27 (which is a statement coming from the buyer proclaiming that there are no other representations other than those made by the seller and the company in the agreement) as sufficient, under Delaware law, to define the universe of information upon which the buyer was relying despite the failure to use the words disclaim reliance or did not rely.

But in Labyrinth, Vice Chancellor Zurn stated that the first sentence of section 5.27 “can be read to reflect that Buyer was expressly representing it did rely on extra-contractual information” by stating that the buyer “conducted its own independent investigation” from information that was provided by the seller.^[21] In other words, the first sentence suggests that “Buyer formed a judgment or opinion of ‘the business, results of operations, prospects, condition (financial or otherwise), or assets of the Company’ from what Seller provided, namely ‘the personnel, properties, assets, premises, books and records, and other documents and data of Seller and the Company for such purpose.’”^[22] But then, according to Vice Chancellor Zurn, the second sentence merely “identifies Seller’s representations[;] . . . it [does not] preclude[] Buyer’s reasonable reliance on representations that are not identified.”^[23] Stated differently, in the second sentence, “Buyer did not affirmatively acknowledge any disclaimer by Seller, or otherwise specifically establish the universe of information on which Buyer did or did not rely.”^[24]

The safer course is always to think of Delaware as effectively Texas, and to have the Buyer always expressly disclaim reliance on any extra-contractual statements.^[25]

Now, as to “D.” Vice Chancellor Zurn refused to find that the combination of three ineffective clauses (what Vice Chancellor Zurn called “a standard integration clause [9.3], an independent investigation clause [5.27], and a representation and warranty clause [4.28]”)^[26] somehow collectively constituted an effective disclaimer of reliance. As I long ago warned, while Delaware may claim that there no “magic words” required to effectively create an exclusive universe of contract-based representations and warranties upon which any fraud claim must be premised and thereby eliminate the “dog’s breakfast”^[27] of extra-contractual claims, you should assume there actually are required magic words—and use them.

So, the correct answers are A, B, and C.

The Playbook for Disclaiming Extra-Contractual Fraud Claims

To defeat extra-contractual fraud claims, (a) actual disclaimers of reliance should be used, not simple “no representations” statements; (b) disclaimers of reliance should be properly placed in the acquisition agreement so that they are coming from the point of view of the buyer;^[28] and (c) the disclaimer of reliance should be “robust” (i.e., disclaim reliance on an exhaustive list of things that might be provided or discussed in the lead-up to the execution of the agreement).^[29] And, based on Labyrinth, including an independent investigation provision does not necessarily add anything and may in fact do more harm than good, particularly when it suggests that there was a lot of information provided by the seller upon which the buyer relied.

ABRY Partners and its extensive progeny have provided a “playbook” for effectively disclaiming extra-contractual fraud claims in Delaware. While Prairie Capital may have suggested there were some easy outs from actually reading and applying that playbook strictly, do not fall into that trap. You are expected to have fully read the playbook and found the $100 taped to the last page.^[30]

1. 891 A.2d 1032 (Del. Ch. 2006). ↑

2. 2024 WL 295996 (Del. Ch. 2024). ↑

3. Id. at n.188. ↑

4. Id. at n.190. ↑

5. Id. at *16. ↑

6. Id. at *12 (quoting Complaint at ¶ 80, Metro Commc’n Corp. BVI v. Advanced Mobilecomm Techs. Inc., 854 A.2d 121 (Del Ch. 2024)). ↑

7. Id. (quoting Kronenberg v. Katz, 872 A.2d 586, 592 (Del. Ch. 2004)). ↑

8. Id. (quoting FdG Logistics LLC v. A&R Logistics Holdings, 131 A.3d 842, 860 (Del. Ch. 2016)). ↑

9. Id. at *17. ↑

10. Id. at *18. ↑

11. Prairie Cap. III, L.P. v. Double E Holding Corp., 132 A.3d 35, 51 (Del. Ch. 2015) (see infra note 18 and accompanying text). ↑

12. Labyrinth, 2024 WL 295996, at *18 (quoting Prairie Cap., 132 A.3d at 51). ↑

13. See FdG Logistics, 131 A.3d at 860. ↑

14. Glenn D. West, The Surprising Connection Between an Extra-Contractual Fraud Claim and a Flesh-Eating Zombie, Weil’s Glob. Priv. Equity Watch (Mar. 3, 2016). ↑

15. Italian Cowboy Partners, Ltd. v. Prudential Ins. Co. of Am., 341 S.W.3d 323 (Tex. 2011). ↑

16. Id. at 335 (emphasis in original). ↑

17. 132 A.3d 35. ↑

18. Id. at 51. ↑

19. Id. ↑

20. In Prairie Capital, while not expressly disclaiming reliance on extra-contractual representations, the buyer did state that the buyer “agrees that all [extra-contractual representations] are specifically disclaimed by the [seller].” Id. at 50. This language was obviously not present in section 5.27. In addition, Prairie Capital did not contain the unfortunate first sentence of section 5.27; instead, it simply said that “[t]he Buyer acknowledges that it has conducted to its satisfaction an independent investigation of the financial condition, operations, assets, liabilities and properties of the [seller].” Id. ↑

21. Labyrinth, Inc. v. Urich, 2024 WL 295996, at *17 (Del. Ch. 2024) (quoting Anschutz Corp. v. Brown Robin Cap., 2020 WL 3096744, at *14 (Del. Ch. 2020)) (emphasis in original). ↑

22. Id. (quoting SPA section 5.27). ↑

23. Id. at *18. ↑

24. Id. ↑

25. See Glenn D. West, Avoiding the Other F-Word: An Anti-Reliance Clause Should Actually Disclaim Reliance on Extra-Contractual Representations Even When the Parties Agree that None Were Made, Weil’s Glob. Priv. Equity Watch (Mar. 25, 2019). An example of an “anti-reliance” provision is available in Glenn D. West, Reps and Warranties Redux—A New English Case, An Old Debate Regarding a Distinction with or Without a Difference, Weil’s Glob. Priv. Equity Watch (Aug. 2, 2016). ↑

26. Labyrinth, 2024 WL 295996, at *18. ↑

27. See Glenn D. West, Avoiding a Dog’s Breakfast—Some Timely Reminders of How to Effectively Limit the Universe of Purported Representations upon Which Fraud Claims Can Be Made, Weil’s Glob. Priv. Equity Watch (Aug. 13, 2018). ↑

28. Of course, sellers should insist that the anti-reliance clauses be reciprocal (i.e., sellers should also disclaim reliance upon any extra-contractual representations purportedly made by the buyer), particularly in cases involving earnouts. ↑

29. See West, supra note 27. ↑

30. See Draft Day (Summit Entertainment & Oddlot Entertainment 2014) (Ralph Mowry speaking to Sonny Weaver about Bo Callahan and how Washington checks if their potential players have read the entire playbook). ↑

Artificial intelligence (“AI”) can be defined in several ways. The Oxford English Dictionary definition refers to “software used to perform tasks or produce output previously thought to require human intelligence, esp. by using machine learning to extrapolate from large collections of data.” One broad definition, courtesy of IBM—comprehensive enough to include things as diverse as facial recognition software, smart cars, GPS, legal research tools, and chess programs—is “technology that enables computers and machines to simulate human intelligence and problem-solving capabilities.” From the same source comes a definition of generative AI (“GAI”): “deep-learning models” that compile data “to generate statistically probable outputs when prompted.”^[1]

Amidst the continuous flurry of media coverage, publicity generated by tech companies, notoriety based on so-called “hallucinations,” and sundry other extravagances, practicing lawyers must surely, by now, be aware that use by the legal profession of GAI is evolving rapidly and, as with much other technological innovation in the professions, fraught with peril. Bar regulators in several states—including (in alphabetical order) California, Florida, New Jersey, New York, and Pennsylvania—along with the patent bar have variously issued ethics opinions or guidance on the ethical use of GAI. Webinars, both public and private, proliferate, along with comprehensive courses to educate not only lawyers but the judiciary as well. As recently as August 2024, the ABA Task Force on Law and Artificial Intelligence, created in 2023, issued its first report.

Likewise, the ABA Standing Committee on Ethics & Professional Responsibility has recently (July 29, 2024) weighed in with Formal Opinion 512, Generative Artificial Intelligence Tools (“Formal Op. 512”). This opinion highlights many of the same ethical rules as the other guidance, opinions, and reports, but identifies ethical requirements in a slightly different manner. Even though the approach of Formal Op. 512 is not binding on lawyers, it does offer a useful compilation of ethics guidance keyed to the Model Rules of Professional Conduct.

To be sure, GAI can significantly enhance efficiency in law practice because of the ability of this powerful tool to accomplish in a short timeframe a variety of tasks (e.g., legal research, document review, analysis of contracts and other legal documents) that used to be significantly more time-consuming. This, in turn, can benefit clients by reducing the often astronomical costs of legal services and possibly enhance access to justice by underserved populations.

Yet there are also significant pitfalls. Foremost among these are so-called “hallucinations”—a euphemism for nonexistent or false products of research, exemplified by notorious cases such as Mata v. Avianca, United States v. Michael Cohen, and the even more recent Second Circuit decision in Park v. Kim. Other common ethics hazards include potential breaches of client confidentiality and data privacy and succumbing to having one’s independent professional judgment swayed, if not entirely overborne, by the siren song of GAI work product.

Formal Op. 512 organizes the pertinent legal ethics implications of lawyers using GAI quite well. Here is a synopsis of the topics addressed:

• Competence (Model Rule 1.1): Lawyers must understand the capacity and limitations of GAI and periodically update that understanding.
• Communication (Model Rule 1.4): Formal Op. 512 offers guidance on when, and to what extent, lawyers are required to communicate their use of GAI to clients.
• Fees (Model Rule 1.5): Lawyers may not charge clients for time spent learning a technology to be used for client matters generally, unless a client specifically requests the use of a particular AI tool in a matter, in which case a lawyer may charge for learning how to use that particular tool. A lawyer may consider the cost of GAI to be part of office overhead, or may charge for a portion of an expensive and proprietary GAI tool, or on a per-use basis if appropriate, provided everything is fully explained to the client in advance and informed consent is obtained.
• Confidentiality (Model Rule 1.6): Lawyers are responsible for knowing how GAI uses data and putting in place adequate safeguards to ensure that data processed by GAI is secure and not susceptible to unwitting or unauthorized disclosure to third parties. Formal Op. 512 recommends that lawyers secure clients’ informed consent before using client confidences in GAI tools and opines that boilerplate consent included in engagement letters will not be adequate. The opinion also cautions that use by several lawyers of the same GAI tool may result in inadvertent use and disclosure of client information.
• Meritorious Claims and Contentions (Model Rule 3.1): Lawyers must be on their guard to prevent GAI “hallucinations” from forming the basis of asserting frivolous claims and arguments.
• Candor Toward the Tribunal (Model Rule 3.3 and Model Rule 8.4(c)): Overreliance on or uncritical adoption of GAI can result in making false statements of fact or law to a “tribunal” (which is broadly defined to include not only courts but others acting in an adjudicative capacity, potentially including arbitrators, administrative agencies, and legislative bodies). Duties to the tribunal require lawyers, before submitting materials, to review GAI output, including analysis and citations to authority, and to correct errors, including misstatements of law and fact, any failure to include controlling legal authority, and any misleading arguments.
• Responsibilities of Supervisory Lawyers (Model Rule 5.1): Partners and other lawyers with managerial duties must establish clear policies regarding the permissible use of GAI and supervise lawyer staff to ensure compliance with these policies. In this connection, Formal Op. 512 analogizes to principles in various state ethics opinions relating to cloud computing and outsourcing.^[2]
• Supervising Nonlawyers (Model Rule 5.3): Partners and other lawyers with supervisory responsibilities must make sure that nonlawyers (including those in a law firm as well as third-party contractors or other providers outside the law firm) are adequately trained in the ethical and practical uses of GAI.

Not discussed by Formal Op. 512 but worthy of consideration is another point:

• Bias and Prejudice in Law Practice and in Lateral Hiring (Model Rule 8.4(g)): As more firms routinely grow by lateral hiring, there is the potential for built-in bias or discrimination in any AI used to screen applicants and select from large numbers of résumés those to be interviewed. Lawyers must be careful to monitor the use of AI in hiring and results of such use.

In sum, GenAI, like a word processor or even a proprietary database like LexisNexis or Westlaw, is a tool, not a substitute for the exercise of legal expertise and judgment. Using GAI may streamline or even enhance lawyers in the performance of their tasks, but it does not absolve them of their responsibilities under applicable ethics rules.

1. Forms of AI have been in use by the legal profession, whether lawyers were aware of it or not, for many years now. Examples include Microsoft’s Editor, which checks for spelling and grammar errors; Microsoft Excel; a plug-in for Microsoft Word called Brief Catch, which is designed specifically for lawyers and can identify citation problems and errors that arise exclusively in a legal context; and of course Lexis and Westlaw, which have been using AI to help with searches for federal and state case law, statutes, regulations, and secondary legal sources as well. More recently, Lexis and Westlaw have unveiled GAI services to expedite legal research. ↑

2. See Formal Op. 512 at 11 nn.55–58 (citing, inter alia, Fla. Bar Advisory Op. 12-3 (2013); Iowa State Bar Ass’n Comm. on Ethics & Practice Guidelines Op. 11-01 (2011); Fla. Bar Advisory Op. 24-1). ↑

The Rising Tide of NAV Facilities

Fund finance, the practice of lending to investment funds, is experiencing a significant transformation with the increasing prominence of Net Asset Value (“NAV”) credit facilities. NAV facilities are credit facilities that have availabilities that are based on the net asset value of a fund’s underlying investments. These facilities can have a variety of collateral packages, ranging from a direct lien on the underlying investments, to just being limited to the right to receive distributions and the associated bank accounts, and/or a pledge of the equity interests of the entities that hold the investments.

Secondaries funds (funds that invest in interests in other funds) and especially private credit funds (funds that invest in loans to private companies, which are often backed by private equity funds) have long utilized NAV facilities. However, certain key factors have driven the expansion of NAV facilities into use by private equity and other funds, including the liquidity crunch.

NAVigating a Liquidity Crisis

Today, funds are facing an unprecedented challenge in generating liquidity. This is in contrast to the pre-COVID era, during which the market enjoyed explosive growth of subscription credit facilities as they became a near-universal part of a fund’s capital structure. These facilities—secured by unfunded capital commitments of investors, the general partner’s right to call capital, and the enforcement of those rights—are attractive to lenders due to their extremely low default rates and perceived safety as a product. However, due to the failure of several large participants in the subscription lending market during the banking crisis of 2023, the exit or retreat of other large participants from a significant presence in the market, and tighter capital requirements required by the proposed BASEL III endgame regulatory changes, demand for subscription lines currently outstrips supply.

In addition to the decline in the supply of subscription facilities, today’s challenging market conditions have constrained other traditional sources of liquidity as well. Today, private equity funds are facing the slowest private M&A and IPO market in decades, which has significantly slowed the pace of asset disposition. The lack of exit opportunities is also causing many funds to be cautious in calling capital from limited partners, who have expressed that they are facing their own liquidity crisis due to inflation, geopolitical uncertainty, high interest rates, and the denominator effect (i.e., overweighting of private equity assets as part of an institutional investor’s entire portfolio). The lack of distributions has also contributed to the slowdown in new fundraising opportunities to these same limited partners.

NAV facilities allow the fund to navigate this liquidity challenge by enabling distributions to investors and serve a number of other important purposes, including acquiring new investments, supporting existing investments, and providing working capital. NAV facilities permit the fund managers to continue operating the fund with the view of maximizing the investor return, and avoid the premature and possibly discounted dispositions of assets that may otherwise be required.

Structured Finance Meets NAV Facilities

Today, a private equity fund seeking a NAV facility can access a market of providers familiar with the product and willing to compete for their business. In recent years, as the discourse on these NAV facilities to private equity and other funds has continued, the pool of providers has significantly expanded,^[1] in particular to include insurance companies that are seeking highly rated debt products with an attractive yield. The resulting competition has led to a significant compression of pricing on these NAV facilities, which has further driven up demand and has made the product more accessible to a broader set of managers and funds. At the same time, the addition of insurance companies as new entrants has meant that structures and techniques that facilitate the obtaining of a rating, which were long used in the structured finance market, are gaining ground in fund finance. NAV facilities across various asset classes are increasingly structured using independent credit ratings, tranching, bankruptcy-remote special purpose vehicles, true sale, and non-consolidation techniques.

This mirrors the development that has already undertaken in regular-way NAV facilities in the private credit space, which has already seen a widespread adoption of these techniques to assist in decoupling the creditworthiness of the fund’s assets from that of the fund or sponsor, leading to lower pricing and access to a wider range of financing sources. A similar dynamic is found in the rise of collateralized fund obligations (“CFOs”), a form of securitization of underlying investment fund assets. Typically, the fund interests are transferred to a holding company held by the CFO issuer, which issues both debt (notes) and equity interests, backed by the payments and distributions received by the underlying fund interests.

It remains to be seen whether the high interest from insurance companies in NAV facilities to private funds will be sustained. In particular, the National Association of Insurance Commissioners (“NAIC”) has been actively reviewing the regulatory oversight of private equity and complex assets within the insurance industry. In particular, the NAIC has adopted amendments to statutory accounting reporting requirements to state that CFOs and similar private funds–associated products may no longer automatically be given the regulatory treatment that they were typically given (as “bonds”).

Practical Considerations

Both lenders and fund managers entering the NAV facility space should ensure they have competent advice from counsel familiar with these complicated transactions and the internal infrastructure to implement and maintain these facilities. The initial structuring of these facilities requires a deep understanding of the tax and regulatory considerations for all parties. Asset transfers and pledges require significant diligence and coordinated execution. Maintaining the facilities and associated vehicles as separate from the original owner requires discipline and investor education. Lastly, NAV facilities may require compliance with additional regulatory regimes, including the securitization regulations adopted in the EU and the UK and the asset-backed security and associated risk retention requirements in the US.

In addition, fund managers should be aware of recent discourse on NAV facilities generally. In particular, the Institutional Limited Partners Association (“ILPA”) has recently provided guidance regarding the use of NAV facilities, in particular when the proceeds are used to make distributions to limited partners because such distributions can potentially impact fund performance calculations and the limited partner’s ability to allocate capital. ILPA recommends greater communication between GPs and LPs regarding the use of NAV facilities, and many major NAV lenders note that the vast majority of their NAV facilities are not used for distributions, but rather add-on investments or refinancings of pre-existing debt to the portfolio at a lower cost of capital than might otherwise be available.

The Future of Fund Finance

NAV facilities represent a significant evolution in fund finance, offering new opportunities for both funds and lenders. As the market evolves, it is crucial for participants to gain a thorough understanding of these facilities, including their structures, applications, and potential risks. For fund managers and lenders aiming to navigate economic challenges and seize opportunities, a deep knowledge of these tools—such as fund manager constraints and the motivations of various investor groups—will be essential for creating flexible capital structures and optimizing outcomes in a rapidly changing market. Even though the rise of NAV facilities has been in part driven by the current liquidity crisis and the challenges of the subscription facility market, we expect this market to continue to grow even after these broader market conditions pass, as lenders recognize the attractiveness of the product and fund managers understand NAV facilities to be an additional tool in managing their portfolios and find a broader spectrum of lenders willing to offer the product.

This evolving trend is a key focus of the Fund Finance/Asset Based Lending Subcommittee of the ABA Business Law Section, and this article is based on presentations and discussions by that subcommittee, including those by the Authors and other members of the Subcommittee, including Elizabeth Tabas (Chair of the Subcommittee) of Sidley Austin LLP, Leah Edelboim of Cadwalader, Wickersham and Taft LLP, and Linda Filardi of Flagstar Bank.

1. For example, HSBC Asset Management has recently publicly announced that it is launching a NAV financing strategy. ↑

Stablecoins are cryptocurrencies designed to maintain a steady value by pegging themselves to a reserve asset, typically a fiat currency like the U.S. dollar. However, because many stablecoins have experienced market price fluctuation from their pegged value,^[1] a number of foreign and domestic jurisdictions have passed laws regulating them.^[2] While laws have been passed in the EU and elsewhere, the U.S. does not yet have a comprehensive federal law providing a clear legal framework specific to stablecoins. At the same time, some states have passed applicable laws and issued regulations.^[3] Since stablecoins may be transacted across borders and overseas,^[4] there is a strong interest in considering the interplay of regulation in foreign jurisdictions when formulating a domestic framework. Doing so may reduce regulatory arbitrage and help facilitate cross-border interoperability. This article will examine the existing state of global regulations and distill some common principles that may inform U.S. policymaking on the national level.

Overview of Stablecoins

Stablecoins are cryptocurrencies engineered to maintain a consistent value, typically by pegging themselves to a reserve asset. While many stablecoins are pegged to fiat currency like the U.S. dollar, they can also be linked to commodities or even other cryptocurrencies. The specific mechanism backing each stablecoin is stipulated by its smart contract—the computer code that created it.

Despite aiming to offer the benefits of digital assets without extreme volatility, many stablecoins have experienced market price fluctuations. Nevertheless, the stablecoin market has grown considerably, with fiat-backed stablecoin supply reaching approximately $159 billion in 2024.^[5]

There are four main types of mechanisms aimed at maintaining stablecoin price stability:

1. Fiat-backed stablecoins: Each stablecoin issued has a corresponding unit of currency or cash equivalent held in reserve, often U.S. T-bills, typically held in custody at a depository institution. This method ensures that the stablecoin can be redeemed for its fiat counterpart at a fixed rate. Measured in total market capitalization, fiat-backed stablecoins are by far the largest category of stablecoins.^[6]
2. Commodity-backed stablecoins: The value of each stablecoin is pegged to a specific value of a commodity (i.e., gold or silver), which is held in custody in secure vaults. The stablecoin issuer must hold enough of the commodity to fully back all circulating stablecoins.
3. Crypto-backed stablecoins: Crypto-backed stablecoins are backed by other cryptocurrencies. They may be pegged to the price of the other cryptocurrencies or the price of a fiat currency. These stablecoins are often overcollateralized to account for the volatility of the reserve assets. This means that in order to provide a buffer against market fluctuations, the value of the cryptocurrencies held in reserve exceeds the value of the stablecoins issued.
4. Algorithmic stablecoins: This type of stablecoin does not hold assets in reserve. Instead, an algorithm dynamically adjusts the supply by creating more stablecoins to reduce the price when demand falls or by destroying stablecoins to increase the price when demand rises. In theory, this “stabilizes” the value of the stablecoin relative to the target peg. In practice, these mechanisms have notoriously failed to maintain a stable peg.^[7]

Stablecoins are used for several purposes, including trading and effectuating transactions. Because stablecoins aim to offer price stability, they may be used to facilitate payments, both in the U.S. and across borders. Stablecoins are also an actively traded component of the cryptocurrency markets because they can be readily exchanged for other cryptocurrencies. Since January 2020, the supply of fiat-backed stablecoins has grown from $5 billion to approximately $159 billion.^[8]

European Union (EU)

The EU Markets in Crypto-Assets Regulation (MiCA) was enacted in June 2023 and is slated for full implementation by December 2024 (see timeline below).^[9]

The EU Markets in Crypto-Assets Regulation (MiCA) was enacted in June 2023 and is slated for full implementation by December 2024. Source: Markets in Crypto-Assets Regulation (MiCA), Eur. Sec. & Mkts. Auth. (last visited Sep. 18, 2024).

MiCA establishes a comprehensive regulatory framework to increase the safety and transparency of European digital asset markets.^[10] The provisions of MiCA that are specific to stablecoins went into effect on June 30, 2024. The regulation encompasses several critical components such as licensing requirements for custodians and other crypto-asset service providers, enhanced consumer protections, specific stipulations for stablecoins, and provisions to prevent market abuse.^[11]

MiCA categorizes stablecoins into two distinct types: electronic money tokens (EMTs) and asset-referenced tokens (ARTs).^[12] EMTs are fiat-backed and intended to maintain a stable value relative to a single currency. They are treated similarly to electronic money under existing regulations. Conversely, ARTs are backed by several assets, potentially including multiple currencies, commodities, or financial instruments. This structure theoretically distributes risk but requires stringent oversight due to the varied underlying assets.

Specifically, MiCA designates fiat-backed EMTs as electronic money, requiring that issuers either have or obtain authorization as electronic money institutions (EMIs) or credit institutions (i.e., banks). To become authorized, an issuer must apply with the competent supervisory authority of its home member state. As EMIs, these issuers must adhere to the European Electronic Money Directive and MiCA-specific mandates.^[13] These include the obligation to establish a legal entity within the EU, obtain authorization to operate, and publish a detailed crypto-asset white paper approved by a competent authority.^[14] EMT issuers must maintain liquid reserves equal to the tokens in circulation, ensuring redemption at par value at any moment, even under market stress.^[15] MiCA mandates that a minimum of 30 percent of these funds (or 60 percent in the case of “significant” EMTs)^[16] be held in separate accounts at credit institutions, with the remainder invested in secure, low-risk, highly liquid financial instruments denominated in the same currency as the currency referenced by the EMT. Those liquid financial instruments must have minimal market, credit, and concentration risks.^[17] Additionally, EMT issuers are not permitted to offer interest on these tokens and must implement robust measures for safeguarding reserves, handling customer complaints, and segregating reserve assets.

Issuers of ARTs face similar regulatory requirements, including obtaining authorization from their national competent authority unless the issuer is an authorized credit institution, issues tokens below a €5 million threshold over a twelve-month period, or restricts token sales to qualified investors. ARTs must give holders a perpetual redemption right, meaning that issuers must redeem tokens upon request.^[18] MiCA also imposes strict rules concerning reserve composition, risk management, custody arrangements, governance, disclosure practices, complaints handling, and conflict of interest mitigation.

There are limits on how many ARTs and EMTs denominated in a non-EU currency can be used for exchange within the EU. These limits are expressed as trading volume caps.^[19] This is part of MiCA’s broader aim “to address risks that the wide use of crypto-assets which aim to stabilise their price in relation to a specific asset or a basket of assets (such as ARTs) could pose to financial stability, the smooth operation of payment systems, monetary policy transmission or monetary sovereignty.”^[20]

The European Banking Authority (EBA) is tasked with developing more detailed regulations for both EMTs and ARTs, further refining the governance framework established by MiCA.^[21]

United Kingdom (UK)

In November 2023, the UK’s financial regulatory authorities—the Bank of England, the Financial Conduct Authority (FCA), and the Prudential Regulation Authorit—unveiled proposals for the first phase of a comprehensive regulatory framework for digital assets. This initial phase of the framework addresses fiat-backed stablecoins, defined as those intended to hold a stable value by reference to one or more specific fiat currencies.^[22]

Under this proposed framework, any entity issuing or providing custodial services for fiat-backed stablecoins within the UK must obtain authorization from the FCA and adhere to stringent regulatory standards. These standards include segregating client assets, maintaining robust governance controls, and maintaining meticulous records. Additionally, issuers would be required to back the issued stablecoins with stable and liquid reserves to enable swift customer redemptions, and they would be prohibited from offering interest on these stablecoins.

The framework also categorizes stablecoin-based payments into two types: hybrid and pure. Hybrid transactions involve using a regulated stablecoin to enter or exit a transaction, while pure transactions are conducted entirely on-chain with a single stablecoin. Both types of transactions are subject to at least some aspects of the existing Payment Service Regulations, which will be expanded to encompass features unique to stablecoin transactions. This inclusion ensures that stablecoin users enjoy protections similar to those afforded to traditional payment service users, such as specific disclosures, execution time limits, and a structured process for resolving complaints.^[23]

Phase 1 of the framework does not cover commodity-backed or algorithmic stablecoins, which are slated for consideration under Phase 2 regulations. Additionally, the UK is assessing how to appropriately regulate foreign stablecoins that participate in UK payment systems. The current proposals require that a UK-authorized firm approve such stablecoins as meeting standards equivalent to regulated (i.e., UK-issued) stablecoins. This can be contrasted with the EU approach of requiring stablecoins offered to the EU public to be issued by EU-incorporated entities and subject to local reserve requirements.

United States

While the U.S. lacks comprehensive stablecoin legislation, certain existing regulations apply. At the federal level, stablecoins would be considered convertible virtual currency (CVC) by the Financial Crimes Enforcement Network (FinCEN),^[24] and thus obligations under the Bank Secrecy Act apply. Notably, the issue of whether stablecoins are securities or not is being actively litigated, such as in Securities & Exchange Commission v. Binance Holdings Ltd.^[25]

Significant variation exists in state-level regulation of stablecoins. Across the country, money transmission laws apply to stablecoin-related activities. However, some states, such as New York, offer specific guidance or entire regulatory regimes tailored for stablecoins. New York pioneered the BitLicense in 2015, which operates as a license and charter-based system for digital assets.^[26] Such a license is required to conduct a digital asset business in New York. In June 2022, New York’s Department of Financial Services (NYDFS) released guidance on issuing U.S. dollar–backed stablecoins.^[27] The guidance applies to U.S. dollar–backed stablecoin issuers licensed under a BitLicense or chartered as limited-purpose trust companies under New York banking law. The guidance creates “recommendations or principles” related to redeemability, reserves, and attestation (confirmation of accounting statements). Stablecoin issuers must hold at least a 1:1 ratio of reserves segregated from other assets, and the reserves must be highly liquid.^[28]

Common Principles

Although there are many differences in jurisdictional approaches to stablecoin regulation, some common regulatory principles emerge:

1. Stablecoin issuances require explicit regulatory approval by the appropriate regulator.
2. Reserves must be liquid and stable, ensuring that they can cover all issued stablecoins on a 1:1 basis.
3. Stablecoin payment services must align with existing financial regulations, offering protections akin to traditional currency-based payment systems.^[29]

As interest in stablecoins grows, consideration of regulations in foreign jurisdictions is becoming increasingly crucial to prevent regulatory arbitrage and facilitate cross-border transactions. This will require careful analysis as well as collaboration between foreign jurisdictions and their regulators.

1. USDC and USDT, the two largest U.S. dollar–denominated stablecoins by market cap, have experienced temporary price deviation from their target price of US$1. On March 11, 2023, one day after Silicon Valley Bank failed, the market price of USDC dropped to $0.9715. Historical Snapshot—11 March 2023, CoinMarketCap (Mar. 11, 2023). In March 2020, during the initial COVID-19 pandemic wave, the market price of USDT dropped to $0.9742. Historical Snapshot—18 March 2020, CoinMarketCap (Mar. 18, 2020). ↑

2. Markets in Crypto-Assets Regulation (MiCA), Eur. Sec. & Mkts. Auth. (last visited Aug. 29, 2024). ↑

3. Joseph Jasperse, 50-State Review of Cryptocurrency and Blockchain Regulation, Stevens Ctr. for Innovation in Fin. (2024). ↑

4. Comm. on Payments & Mkt. Infrastructures, Bank for Int’l Settlements, Considerations for the Use of Stablecoin Arrangements in Cross-Border Payments (Oct. 2023). ↑

5. Global Live Cryptocurrency Charts & Market Data, CoinMarketCap (last visited Sep. 19, 2024). ↑

6. Top Stablecoin Tokens by Market Capitalization, CoinMarketCap (last visited Aug. 29, 2024). ↑

7. TerraUSD (UST) was an algorithmic stablecoin designed to maintain a stable price of US$1. It aimed to do so by dynamically adjusting supply in reference to its sister token, a cryptocurrency named LUNA. In May 2022, the price of UST and LUNA collapsed, wiping out $45 billion in value. The founder of UST, Do Kwon, has been found liable for securities fraud, see Sec. & Exch. Comm’n v. Terraform Labs PTE Ltd., and charged with multiple criminal fraud counts, see United States v. Do Hyeong Kwon. ↑

8. Global Live Cryptocurrency Charts & Market Data, supra note 5. ↑

9. Markets in Crypto-Assets Regulation (MiCA), supra note 2. This image may be obtained free of charge through the ESMA website. ESMA does not endorse this publication and in no way is liable for copyright or other intellectual property rights infringements nor for any damages caused to third parties through this publication. ↑

10. Regulation (EU) 2023/1114 of the European Parliament and of the Council of 31 May 2023 on Markets in Crypto-Assets, and Amending Regulations (EU) No 1093/2010 and (EU) No 1095/2010 and Directives 2013/36/EU and (EU) 2019/1937 (Document 32023R1114) [hereinafter MiCA]. ↑

11. Markets in Crypto-Assets Regulation (MiCA), supra note 2. ↑

12. “Tokens” are fungible digital assets that represent value or utility. ↑

13. Eur. Banking Auth., Draft Guidelines on Recovery Plans Under Articles 46 and 55 of the Regulation (EU) 2023/1114 (Nov. 8, 2023) (Consultation Paper EBA/CP/2023/30). ↑

14. Issam Hallak & Rasmus Salén, Eur. Parliamentary Rsch. Serv., Non-EU Countries’ Regulations on Crypto-Assets and Their Potential Implications for the EU (Sept. 2023). ↑

15. Eur. Banking Auth., Draft Regulatory Technical Standards to Specify the Minimum Contents of the Liquidity Management Policy and Procedures under Article 45(7)(b) of Regulation (EU) 2023/1114 (Nov. 8, 2023) (Consultation Paper EBA/CP/2023/26). ↑

16. Article 56(1) refers to the “significance” criteria for ARTs set out in Article 43(1):

    The criteria for classifying asset-referenced tokens as significant asset-referenced tokens shall be the following, as further specified by the delegated acts adopted pursuant to paragraph 11:

    1. the number of holders of the asset-referenced token is larger than 10 million;
    2. the value of the asset-referenced token issued, its market capitalisation or the size of the reserve of assets of the issuer of the asset-referenced token is higher than EUR 5 000 000 000;
    3. the average number and average aggregate value of transactions in that asset-referenced token per day during the relevant period, is higher than 2,5 million transactions and EUR 500 000 000 respectively;
    4. the issuer of the asset-referenced token is a provider of core platform services designated as a gatekeeper in accordance with Regulation (EU) 2022/1925 of the European Parliament and of the Council;
    5. the significance of the activities of the issuer of the asset-referenced token on an international scale, including the use of the asset-referenced token for payments and remittances;
    6. the interconnectedness of the asset-referenced token or its issuers with the financial system;
    7. the fact that the same issuer issues at least one additional asset-referenced token or e-money token, and provides at least one crypto-asset service.

    The 60 percent deposit requirement with credit institutions for significant EMTs is set out in Article 3(2) of the final draft of regulatory technical standards from the European Banking Authority. Eur. Banking Auth., Draft Regulatory Technical Standards to Further Specify the Liquidity Requirements of the Reserve of Assets Under Article 36(4) of Regulation (EU) 2023/1114 (June 13, 2024) (Final Report EBA/RTS/2024/10). ↑

17. Eur. Banking Auth., Draft Regulatory Technical Standards to Specify the Minimum Contents of the Liquidity Management Policy and Procedures, supra note 15. ↑

18. MiCA, supra note 10, art. 16(2). ↑

19. The European Banking Authority published the final draft of its regulatory technical standards in relation to this concept on June 19, 2024. Eur. Banking Auth., Draft Regulatory Technical Standards on the Methodology to Estimate the Number and Value of Transactions Associated to Uses of Asset-Referenced Tokens as a Means of Exchange Under Article 22(6) of Regulation (EU) No 2023/1114 (MiCAR) and of E-Money Tokens (Final Report EBA/RTS/2024/13). ↑

20. Id. at 5 (citing recital 5 of MiCA). ↑

21. Eur. Banking Auth., Markets in Crypto-Assets (last visited Aug. 31, 2024). ↑

22. Fin. Conduct Auth., Regulating Cryptoassets Phase 1: Stablecoins (Nov. 2023) (Discussion Paper DP23/4). ↑

23. Id. ↑

24. FinCEN issued guidance in 2019 and 2014 on how FinCEN’s regulations apply to certain business models involving convertible virtual currencies. See, e.g., FinCEN, Application of FinCEN’s Regulations to Certain Business Models Involving Convertible Virtual Currencies (May 9, 2019) (FIN-2019-G001). ↑

25. Sec. & Exch. Comm’n v. Binance Holdings Ltd., No. 1:23-cv-01599 (D.D.C. June 28, 2024), ECF No. 248. ↑

26. N.Y. Comp. Codes R. & Regs. tit. 23, § 200.1 (2015). ↑

27. Industry Guidance, Adrienne A. Harris, Superintendent of Fin. Servs., N.Y. Dep’t of Fin. Servs., Guidance on the Issuance of U.S. Dollar–Backed Stablecoins (June 8, 2022). ↑

28. The reserves are subject to NYDFS approval and may only be comprised of “U.S. Treasury bills acquired by the Issuer three months or less from their respective maturities”; “Reverse repurchase agreements fully collateralized by U.S. Treasury bills, U.S. Treasury notes, and/or U.S. Treasury bonds on an overnight basis”; “Government money-market funds”; or “Deposit accounts at U.S. state or federally chartered depository institutions.” Id. Issuers must adopt clear redemption policies that allow for timely redemption (not more than two full business days) at par value. Moreover, stablecoin issuers must release public attestations monthly that a third-party accountant verifies. NYDFS issued these requirements as guidance, not rules. However, the guidance states that “[i]ssuers that currently issue U.S. dollar–backed stablecoins under DFS supervision are expected to come into compliance with this Guidance within three months of the date hereof.” Id. ↑

29. Cryptocurrency companies in the U.S. are already subject to all state-based money-service business laws and must register as a money services business (MSB) in any state in which they operate. ↑

I. The Bill of Obligations

A. Introduction

We are challenged today to consider what it means to be a true citizen of our country: to consider our Rights as American citizens in the context of the Bill of Rights and Constitution and our Obligations and Responsibilities to the country and each other as American citizens in the context of what it takes to make our Constitution work.

We hear, read, and say a great deal about our rights as citizens and say, read, and hear much less about our obligations as citizens.

B. The Ten Habits of Good Citizens

In his book The Bill of Obligations: The Ten Habits of Good Citizens, author Richard Haass starts the reader with a discussion of rights and their limits, as well as the importance of addressing citizens’ duties and responsibilities, the performance of which is necessary to support and assure the maintenance, preservation, and enforcement of those rights. Haass then articulates his thoughts on restoring the essentials of good citizenship if we are to avert threats to the future of our country. Those ten habits are:

1. Be Informed. Haass notes that an effective, functional democracy necessitates an informed citizenry, and goes on to ask what is an informed citizenry, and what does it take to be an informed citizen? He highlights an awareness of civics, understanding the fundamentals of how the country functions from a governance and governing perspective, and notes the importance of understanding the world in which the country operates, including both domestic and international challenges. He comments that being informed is essential to casting one’s vote in favor of particular candidates and understanding what those candidates bring to the table from the perspective of experience, judgment, ethics, and trustworthiness, as well as their function in both governing and representing the country. He notes the importance of exercising judgment as to peoples’ opinions and how the uninformed may be subject to being manipulated by misinformation and the intentions of the various people seeking to be part of the governance of the country. Haass notes the plethora of information and newspapers, magazines, television, podcasts, websites, social media, and the other tools used to transmit information and opinions, and he points out that an informed person must be able to choose sources that are significant to being informed and avoiding those aimed at misleading or misinforming an aware citizen. He notes that being informed is essential to one’s ability to hold people accountable for their actions, pronouncements, etc., and that accountability is essential to a functioning democratic country given that the people vote on who is best to lead that country. It is also true that being informed is significant to influencing the views of others who are less informed and still essential to voting practices within a democracy.
2. Get Involved. Haass immediately asserts, with respect to getting involved, that a democracy will depend on the participation of its citizens, and that again, it is essential that these citizens are well informed and capable of exercising their responsibility to act, as well as their responsibility to hold others (particularly elected officials) accountable for their actions. He notes the importance of individual actions to making a difference in the way society performs and how particular individuals, by simple acts, have created changes in policy.
3. Stay Open to Compromise. Haass notes that while on the one hand, compromise can be viewed as a sign of weakness, on the other hand, compromise is essential to the functioning of a democracy so that multiple interests can be addressed and recognized. In many ways, compromise was at the heart of drafting the Constitution and many other achievements of our society from civil rights to other matters of American government interests, as well as our societal interests. Haass comments that while compromise is a value, it’s also important to be able to describe and understand the give-and-take in the process, as well as the ultimate choices made and matters considered in effecting a resolution. Through compromise, he says, one can help the country move beyond stalemate to arrive at action.
4. Remain Civil. Haass notes the importance of civility as a means of overcoming cynicism and bridging disagreements that come in a democracy by exercising respect for various sides. Haass notes that in discussions where there are multiple sides and issues to be resolved, civility is sometimes an essential quality in reaching resolution.
5. Reject Violence. Haass highlights the differences between democracy and democratic governments and authoritarian systems. He notes that in particular, rejecting violence in almost any situation is preferable to using it to achieve any kind of political end, as in a democracy, violence is the antithesis of achieving results that reflect the best interests of the groups involved, etc.
6. Value Norms. Haass notes the importance of observing and respecting norms, mores, and social conventions that form the fabric of a society, as one can’t make laws to cover all situations, nor is a society purely based on laws and their observance, to the exclusion of these other elements that are essential to a society’s viability.
7. Promote the Common Good. Haass notes that the “common good” is critical to the functioning and existence of a democracy. Looking past our own self-interests, it is critical to look at the best collective interests of the country itself for civil and political service.
8. Respect Government Service. While Haass notes that it is very American to be suspicious of government and governmental authority, it is also critical to respect those who provide government service as a social good, who often take less and have a sense of public service that motivates them to do the work they do, which should be respected, and not denigrated.
9. Support the Teaching of Civics. Haass and others have noted the current critical failure of the teaching and knowledge of civics, resulting in a lack of understanding of and commitment to the structure and critical elements of our democracy. Interestingly, in order to become a citizen of the United States, those seeking to immigrate are required to review materials including civics information pertaining to U.S. history and government as part of the naturalization process. (See Section II.) Recently, the American Bar Association’s Task Force for American Democracy and deans of American law schools have stressed the critical importance to our society and its founding principles of improved education with respect to civics and the primacy of the Rule of Law.
10. Put the Country First. Interestingly, Haass notes that governing one’s self, personal character, integrity, and tolerance towards others is essential to the functioning of our democracy. He comments in particular on several situations in which the interests of the country were not put first, but were sacrificed to political objectives, and the damage to the interests of the country and its principles as a whole resulting from that kind of action.

II. The Citizenship Pledge for Newly Naturalized Citizens

A. Introduction

When persons seek to become U.S. citizens, they must obtain an application from U.S. Citizenship and Immigration Services (USCIS), and they must review materials containing civics information pertaining to U.S. history and government in preparation for an interview with a USCIS officer, who may ask ten or more questions from a list of one hundred questions in the materials. Applicants who answer at least six questions correctly and are approved for citizenship are invited to participate in a naturalization ceremony, where the applicants must raise their right hands and swear an Oath of Allegiance. As a new citizen, each person taking the Oath of Allegiance agrees to take on and perform those duties and responsibilities sworn to in the Oath.

B. The Seven Undertakings of Newly Admitted American Citizens

1. In order to become a citizen, each person renounces all allegiance, loyalty and fidelity to any foreign ruler, state, or sovereignty of whom or which such person had once been a subject or citizen. In other words, the applicant renounces all loyalty, citizenship, duties, or obligations to any non-U.S. leader, state, or country.
2. In order to become a citizen, each person promises to bear true faith and allegiance to the Constitution and the laws of the United States, essentially a commitment to the rule of law as an essential element of U.S. citizenship.
3. In order to become a citizen, each person commits to support and defend the U.S. Constitution and the laws of the United States of America against all enemies, foreign and domestic.
4. In order to become a citizen, each person promises to bear arms on behalf of the United States when required by law.
5. In order to become a citizen, each person agrees to perform noncombative services in the Armed Forces of the United States when required by U.S. law.
6. In order to become a citizen, each person agrees to perform work of national importance under civilian direction when required by law.
7. Further, each person taking the Oath swears “under God” that they have agreed to perform the duties and responsibilities in the Oath “freely, without any mental reservation or purpose of evasion.”

“Reflections on Citizenship’s Obligations” by John H. Stout, co-chair of the American Bar Association Business Law Section’s Rule of Law Working Group, is part of a series on the rule of law and its importance for business lawyers created by the Rule of Law Working Group. Read more articles in the series.

Every year, the American Arbitration Association-International Centre for Dispute Resolution (AAA-ICDR) administers thousands of consumer arbitration matters, and, over time, those have grown in variety and sophistication. Disputes involving solar power, sales of electric vehicles, data privacy, emerging technologies like cryptocurrency, and the gig economy now make up a significant portion of filings.

Each area raises new issues, different legal principles may apply, and new types of parties are involved. Arguments over the specific technical aspects of the products have become more common; these disputes can delve into topics ranging from battery performance to SIM swap fraud to the inner workings of web-based advertising. Warranty and terms of use agreements are longer and more sophisticated than ever, and they include arbitration provisions that have been crafted with great care. Historically, consumer cases were considered “simple” matters, but these are not your parents’ consumer cases.

The AAA-ICDR has adapted to these changes by:

• embracing virtual hearings,
• addressing emerging technology disputes, and
• upholding procedural safeguards to help ensure fair and enforceable outcomes.

As the quantity of cases and the stakes in individual cases grow, a fair process has become even more critical.

Consumer claims may arise out of an agreement that applies to thousands or millions of consumers. Although some consumer arbitration clauses contain opt-out provisions, consumers generally do not have much choice about how their dispute will be resolved. When a consumer contract calls for arbitration to be administered by the AAA-ICDR, we require a baseline level of due process protections as set out in the Consumer Due Process Protocol and the Consumer Arbitration Rules. For example, the Protocol and Rules call for:

• a fundamentally fair process,
• at a reasonable cost (not more than $225 to the consumer),
• in a reasonably convenient location,
• before a neutral arbitrator who can allow for discovery necessary for a fundamentally fair process and all remedies that could be available in court.

These procedural safeguards cannot be replaced with a simpler process; otherwise, the AAA-ICDR will not administer the case and any decision of the arbitrator could potentially be subject to vacatur. This is possibly the worst outcome for an arbitration process, because the parties who have spent the time, money, and energy going through the process usually must go through it again to resolve their case. Balancing the considerations of fairness and speed helps ensure that the outcome will withstand further challenges and that parties can move on from the dispute. In 2023, the median time from filing to award for consumer cases administered by the AAA-ICDR was 9.6 months, while it was 35.6 months for cases in US district courts.^[1]

Filing to Award: Consumer arbitration cases filed with the AAA that proceeded to hearing and award in 2023 did so much more quickly compared to US district courts. Source: “2023 Consumer Arbitration Statistics,” AAA-ICDR.

Expert, diverse arbitrators are needed to decide consumer disputes.

It is more important than ever to have arbitrators experienced in consumer law deciding consumer arbitrations. The nuances of consumer claims require arbitrators who are familiar with modern technologies and how people interact with them, as well as the law governing those interactions. Arbitrators who educate themselves and interact with these technologies are more likely to serve the parties and the process better than those arbitrators who rely on an assistant to “work the computer.” A roster of arbitrators should also reflect the diversity of the population served to help ensure fair outcomes. Thirty-nine percent of those on the AAA-ICDR’s consumer roster are women and/or people of color, with 39 percent of appointments going to panelists from that group.^[2]

Transparency about consumer arbitration cases and outcomes is important.

The AAA-ICDR provides information about our cases in several forms. Each quarter, we update our Consumer and Employment Arbitration Statistics Report,^[3] which shows case data for all consumer matters closed within the last five years. This report does not show the consumer party’s name but contains information about the opposing party, arbitrator, and case outcome, as well as other important data. We also maintain a quarterly report on arbitrator demographic data.^[4] Both of these reports are free and available to the public.

In addition to these reports, the AAA-ICDR anonymizes and provides for publication of consumer awards. These awards are available via legal research sites and contain the identity of the arbitrator as well as the text of the award.

Virtual hearings are here to stay and have clear benefits for consumer disputes.

The COVID pandemic shifted much of our lives online, and consumer arbitration was not exempt. Virtual hearings have become the norm in our cases, even as the world has returned to in-person activities.

The popularity of virtual hearings seems to indicate that most parties have grown comfortable presenting their cases via those platforms and that arbitrators are comfortable hearing cases in that manner. Virtual hearings also improve access to justice, allowing parties to attend from a comfortable and familiar location without paying for travel costs, with electronic management of evidence, and with less disruption to their work and family obligations.

Technology will continue to enhance the dispute resolution process for consumers.

Online Dispute Resolution (ODR) could be the future of resolving consumer disputes. Online Dispute Resolution can be used as a step in a dispute resolution program and incorporates both binding and nonbinding processes. Various successful ODR tools already resolve over sixty million cases per year and could serve as the model for new platforms to be implemented on a broader scale.^[5]

Artificial intelligence is already impacting dispute resolution, with new tools and services appearing frequently. Parties can build a clause with the AAA-ICDR’s ClauseBuilderAI, edit drafts and analyze documents with GenAI tools like ChatGPT or Claude, and make use of AI transcription services for their hearings. While some AI tools are priced for mid-sized or large law firms, the capabilities of more widely available platforms continue to increase while the cost remains relatively low for an individual subscription. Free platforms also continue to advance, potentially increasing access to justice.

Consumer arbitration has evolved significantly, reflecting the complexities and technological advancements of modern disputes. The AAA-ICDR’s adaptation to these changes, through the embrace of virtual hearings, addressing of emerging technology disputes, and upholding of procedural safeguards, helps to ensure a fair and efficient process. With the growing importance of an expert and diverse group of arbitrators, transparency in case outcomes, and the integration of technology such as ODR and AI tools, the future of consumer arbitration is poised to offer even greater accessibility and effectiveness. These advancements not only uphold the fundamental principles of fairness and due process but also enhance the efficiency and adaptability of the arbitration system, ultimately benefiting all parties involved.

1. “2023 Consumer Arbitration Statistics,” AAA-ICDR, accessed September 18, 2024. ↑

2. Id. ↑

3. “2024 Q1 Consumer and Employment Arbitration Statistics Report,” AAA-ICDR, accessed September 18, 2024. Note: The link to this source begins a spreadsheet download. ↑

4. “2024 Q1 Arbitrator Demographic Data,” AAA-ICDR, accessed September 18, 2024. ↑

5. “About Us,” ODR.com, accessed September 18, 2024. ↑

Introduction

There has been a growing interest in the acquisition and sale of telehealth providers. While the COVID-19 pandemic may have laid the foundation, a recent wave of success for online compounding pharmacies producing weight loss drugs has enhanced the interest in telehealth companies. Such telehealth companies are focusing on “diseases du jour,” some of which have drawn negative attention from lawmakers over their potentially misleading advertising and prescribing practices. Given the recent interest by the Criminal Division of the Department of Justice in compliance-related due diligence, private equity and venture capital companies interested in telehealth companies must ensure that they perform adequate due diligence prior to the purchase of the company, have an adequate and appropriate compliance plan and, if appropriate, voluntarily self-disclose any misconduct they become aware of to avoid criminal charges.

The potential sale of a telehealth company involves the review of a variety of legal and regulatory considerations relating to privacy, practice of medicine, and marketing. This article briefly discusses each of the above in the context of state and Drug Enforcement Agency requirements, Federal Trade Commission expectations, and Food and Drug Administration recommendations. Finally, we review recent telemedicine-related enforcement actions by the Department of Justice.

State Requirements

Telehealth laws can vary from state to state. States may differ on licensing requirements, supervision requirements, distance limitations, the type of technology that must be used, the types of services that are allowed, minimum staffing requirements, recordkeeping requirements, inspections, and more.

It is also important to note that telehealth is a broad category that can involve different types of providers. For example, some companies that provide medications might be using telehealth not only for prescribers to evaluate and prescribe medicines but also for pharmacists to actually dispense the drugs from a variety of locations (telepharmacy). Therefore, review of state licenses for each type of provider and telehealth service provided is key.

Privacy Laws

As one would expect, the storage and sharing of data raises important privacy and security considerations that must be considered while developing a compliant telehealth program. At the federal level, telehealth companies must comply with the Health Insurance Portability and Accountability Act (HIPAA) and its implementing regulations. There are also a variety of relevant state-level privacy requirements, including some specific to health privacy such as California’s Confidentiality of Medical Information Act or the Washington My Health My Data Act. It is important to note that while some state privacy laws may generally apply to medical information privacy, others target specific disease states such as Pennsylvania’s Confidentiality of HIV-Related Information Act (also known as Act 148). Act 148 generally prohibits the sharing of an individual’s HIV-related information without written permission.

Practice of Medicine

The practice of medicine is also regulated on a state-by-state basis. Telehealth companies must ensure that they comply with the varying requirements of states. One particular concern is that telehealth companies that operate in multiple states must consider whether their physicians need to be licensed in different states. For example, Florida requires out-of-state telehealth providers to register.

Disease-Specific Considerations

While telehealth providers must follow general rules related to telemedicine, certain states have disease-specific considerations, such as additional requirements imposed on providers treating obesity. For example, the Florida Commercial Weight-Loss Practices Act has specific body mass index requirements, additional informed consent rules and specific follow up care concerns. Alternatively, Virginia requires a physical examination to prescribe controlled substances for weight reduction or control, which limits the extent and scope of telehealth services.

Federal Requirements

Telehealth has recently been in the news because of companies making unvalidated claims and inappropriate sale of controlled substances. For example, as discussed below, the Drug Enforcement Administration (DEA), along with the Department of Justice, has targeted certain telehealth companies due to their noncompliant sale of controlled substances. To avoid future noncompliance, in 2023 the DEA and the Department of Health and Human Services proposed rules for prescribing controlled medications using telehealth options.

Additional telemedicine flexibilities regarding prescription of controlled medications were put in place during the COVID-19 pandemic but are currently set to expire at the end of 2024. There has been significant discussion about extending many of these flexibilities, and the DEA has been intently listening. For example, it arranged a public listening session on September 12 and 13, 2023, in addition to receiving over 38,000 comments. Despite the uncertainty, telehealth companies have continued with the prescription of controlled substances, which has brought on additional scrutiny from the Department of Justice.

Advertising Requirements

Federal Trade Commission (FTC)

The FTC works to ensure that all marketing materials are truthful and not misleading. This is generally broadly interpreted and enforced. In the context of telehealth, this could include the regulation of advertising and marketing; the use of endorsements, influencers, and reviews; online advertising and marketing; and making health claims. Companies should also pay attention to guidance specific to particular health claims. In fact, given the number of companies now focusing on weight loss, the FTC even put out a reference guide on making weight loss claims. It is worth noting that the Commission can penalize a noncompliant company as much as $50,120 per violation.

Food and Drug Administration (FDA)

While the FTC does have jurisdiction over the promotion of pharmaceutical products, the FDA primarily regulates drug manufacturers to ensure that their products are neither adulterated nor misbranded and are safe and efficacious. Accordingly, if done appropriately, the FDA should not be involved in claims being made by telepharmacy companies. However, there is a growing interest in having the FDA, primarily through the Office of Prescription Drug Promotion, regulate unsupported claims related to prescription drugs.

Telepharmacy and telemedicine companies selling compounded drugs and making drug-like claims for compounded products generally believe that they are safe from FDA scrutiny since the FDA primarily targets manufacturers of pharmaceuticals. However, it is important to note that the FDA has exerted jurisdiction over healthcare providers who are making claims about products for unapproved uses.

Enforcement

Companies and individuals using deceptive marketing in connection with telehealth are subject not only to regulatory oversight, but also civil and criminal penalties.

In July 2022 the Department of Justice (DOJ) announced criminal charges against thirty-six defendants, including a telemedicine company executive and clinical laboratory executives, for more than $1.2 billion in alleged fraudulent schemes involving telemedicine. In one of the cases, an operator of several clinical laboratories “was charged in connection with a scheme to pay over $16 million in kickbacks to marketers who, in turn, paid kickbacks to telemedicine companies and call centers in exchange for doctors’ orders.”

In 2023, Joelson Viveros faced criminal charges related to his allegedly investing in and assisted with a kickback scheme regarding a network of pharmacies that operated a call center. At this call center, telemarketers persuaded Medicare beneficiaries to accept prescriptions for expensive medications that they neither needed nor wanted. Viveros allegedly obtained signed prescriptions by paying kickbacks to two telemedicine companies.

In 2023 executives and owners of DMERx, an internet-based platform for doctors’ orders, were also indicted. The indictments included the CEO prior to a corporate acquisition and the CEO and vice president of the company that operated it after the acquisition. Defendants were allegedly paid for connecting pharmacies, durable medical equipment suppliers, and marketers to telemedicine companies that “would accept illegal kickbacks and bribes in exchange for orders that were transmitted using the DMERx platform.” Allegedly, the prescriptions were not medically necessary and were based on a brief telephone call with the alleged patient or no interaction at all. 

In another case, David Antonio Becerril, a medical doctor, was indicted in connection with a scheme in which he allegedly signed more than 2,800 fraudulent orders for genetic tests and medical for patients he was not treating and had never spoken to. The indictment alleged that telemarketers obtained beneficiary information and prepared fraudulent orders that Becerril signed with an average of less than forty seconds of review, and few or no orders were denied. In some cases, braces were approved for patients whose relevant limbs had already been amputated. 

In May 2024, the DOJ charged a Long Island woman in connection with allegedly selling misbranded and adulterated weight loss drugs, including Ozempic. The defendant allegedly obtained the weight loss drugs from Central and South America and then posted dozens of videos advertising and selling the drugs.

Conclusion

As described above, investors in telehealth companies are exposed to significant risks ranging from lack of appropriate registration of providers, to privacy concerns, to inappropriate promotion. As previously discussed, the DOJ continues to target healthcare fraud and requires compliance oversight prior to and after an M&A transaction. Failure to have adequate compliance programs exposes acquirers to significant liability not only from the FDA, but also the DOJ, FTC, DEA, state regulators, and more.