Learn more at the meeting of the ABA Business Law Section’s Legal Analytics Committee in Washington, D.C. from 8:00 a.m. to 10:00 a.m. on September 13th.

“Software is eating the world,” renowned venture capitalist Marc Andreessen observed in 2011. “Over the next 10 years, I expect many more industries to be disrupted.” Sure enough, an important theme in the decade-long, post-recession economic expansion has been “disruption,” with nimble, venture-backed upstarts upending mature industries, from real estate to retail and finance.

One sector, however, has proven largely resilient to Silicon Valley’s Schumpeterian narrative. Years of “lackluster” investment in legal technology, or LegalTech, have led to the “conventional wisdom” that investors have “no interest” in the space. However, a growing confluence of factors—adoption by industry leaders, a maturing innovation ecosystem, and increasingly available venture funding—suggest that LegalTech may finally be nearing its long-sought inflection point.

Over the last decade, venture capital activity has expanded, paralleling the growth of the rapidly-scaling companies VC investment supports. As shown below, in 2018, U.S. VC firms invested over $136 billion—up fivefold from 2009—across nearly 10,000 transactions. Average transaction values rose to almost $14 million in 2018, double the 2014 figure. 

A well-documented theme has been data-driven optimization of mature industries that have historically underutilized technology—e.g., transportation, office rentals and television. More recently, financial services—a complex, competitive and intricately-regulated industry—has seen a surge of activity.  According to CB Insights data, in 2018, global FinTech investment exceeded $40 billion; the sector boasts 39 “unicorns,” which are companies valued at over one billion-dollars each; collectively they are worth $147.4 billion.

In contrast, for myriad reasons, LegalTech investment volume and performance “as a whole, has been more-or-less disappointing.” To put that in perspective, between 2009 and 2019, the global LegalTech sector (as defined below) raised an aggregate $8.9 billion—about $400 million less than the $9.3 billion Uber raised in a single January 2018 round.

Estimates of LegalTech’s market size and investment trends vary considerably based on how one defines the space, which encompasses a broad range of products and services across the legal value chain, including analytics, research, case management and marketplaces. The analysis below aims to provide a macro view of global investment trends in LegalTech and, correspondingly, uses an intentionally broad definition, encompassing companies applying technology to law as well as compliance.[1] 

In 2010, investors expressed growing interest in LegalTech, committing $700 million to the space, more than double 2009 investment levels. However, a relatively slow adoption curve—particularly compared to other sectors—disappointed the market, largely muting activity between 2011 and 2016.  

Somewhat ironically, the drop-off in LegalTech investment coincided almost perfectly with the “tipping point” in LegalTech company formation around 2010 and 2011, shown below at left. Growth was particularly robust in data-intensive sub-sectors, such as legal analytics and document automation, which have been buttressed by development of essential technologies like machine learning, AI, and natural language processing. At the same time, as shown below at right, LegalTech exits—overwhelmingly through M&A (in blue) rather than IPOs (in orange)—have been steadily increasing. 2018 saw nearly 200 liquidity events and 2019 is well on track to exceed that.

LegalTech Company Formation	Investment Exits (Global)

Venture capital investment in LegalTech renewed in 2017, and 2019 is on track to be a record year for both investments and exits. Past ebbs notwithstanding, the confluence of a large total addressable market, increasing demand, a growing value proposition, and favorable venture markets provide powerful tailwinds to support the sustainability of LegalTech investment.

First, LegalTech has the potential to disrupt significant parts of a large and profitable space, thus far largely untouched by technology. In 2016, U.S. legal service revenues totaled $437 billion; average AMLaw100 margins typically exceed 40%. At the same time, the sector chronically underinvests in technology—spending, by some measures, ten times less than financial firms—thus remaining “persistently stuck in the 90s.” Together, these conditions suggest a particularly target-rich environment for disrupters across large parts of the legal value chain.

Second, LegalTech is benefitting from a robust, secular shift in demand. This has been particularly notable in the B2B space, with forward-thinking law firms embracing technology as a logical competitive advantage. The pressure to maintain margins in a highly competitive environment is also likely to encourage investment in efficiency enhancements. Correspondingly, law firms have started LegalTech innovation labs, venture capital arms, and development partnerships.

Third, technological innovation and business model maturation have increased LegalTech’s value proposition in both the B2B and B2C spaces. For instance, on the B2C side, innovative companies like Atrium provide viable substitutes for legal services; on the B2B end, platforms like Clio help optimize firm operations. This maturation has benefitted considerably from a growing legal innovation ecosystem, which includes law firms, along with in-house legal departments—e.g., Liberty Mutual’s “legal tech transformation”—and research hubs, like Georgia State’s Legal Analytics and Innovation Initiative.

Finally, venture market dynamics appear favorable for continued LegalTech investment. VC firms have raised increasingly large funds and as a result have record ‘dry powder’ available. At the same time, perception of the LegalTech space has been materially ‘de-risked’ following high-profile transactions by blue-chip investors, like Andreessen and Y-Combinator. Furthermore, the final chart below illustrates that LegalTech is still very much in its early innings, with 85% of investments at the seed or Series A stages and over 50% under $1 million. This nascency highlights LegalTech’s largely untapped potential for disruptive impact as well as outsized returns.

LegalTech Investment Summary – Stage & Amount Raised

[1] Analysis based on Crunchbase Insights’ database.  Methodologically, data set aggregates the following seven categories of legal and compliance-focused start-up companies: (i) internet Software & Services – legal; (ii) Internet Software & Services – compliance; (iii) Software (non-internet/mobile) – legal software; (iv) Software (non-internet/mobile) – compliance software; (v) mobile software & services, specific sub-industries – legal; (vi) mobile software & services, specific sub-industries – compliance; and (vii) Business products & services – legal services.

From the intersection of the gig economy, faster payments technology, and legislators’ failure to address the dearth of small-dollar credit options, there has emerged a new type of payment product that gives workers immediate access to their wages even if their next payday isn’t scheduled for another week or more. These products go by a number of names—wages-on-demand, advance wage payment, earned income access, wage-based and work-based advances—but all make it possible to deliver payments within minutes of a worker’s request. Studies tells us that many people live paycheck to paycheck, would not be able to cover an unanticipated expense of a few hundred dollars, and lack access to credit at reasonable rates. For these workers, immediate access to wages that have been earned but are not due to be paid can be an important benefit. Immediate access products are also popular with “gig workers” who drive for rideshare companies, deliver food and groceries, or perform other piecework tasks and who want to be paid immediately at the end of their shift.

At first glance these products may seem simple and straight forward, but they are in fact complex financial products that raise a number of novel legal issues. Because there are so many different business models in the marketplace, discerning the legal and operational framework of a particular service can be challenging. Without such information, business lawyers may have difficulty assessing the legal risks these new products posed to workers and employers. This article describes how these products work and identifies several potential legal issues that employers and financial institutions should be evaluate before participating in one of these programs.

How Do Wage Advance Products Work?

Wages advance products fall into two broad business models: direct-to-consumer and employer-integrated. In the direct-to-consumer model, the worker interacts directly with the provider who collects work history and other information from the consumer. The provider funds the advance and recoups it by debiting the worker’s bank account on the next payday. In the employer-integrated model, the employer markets the program to its workers and shares information on hours worked with the provider. The employer may also fund the advance and may assist in the collecting the advance through payroll deduction. Some programs charge a monthly “participation” fee while others assess a fee for each transaction. Frequently, there are multiple options for how quickly the employee may receive the advance, with the slower payment method (one to two days) having a lower or no fee and the faster payment method (a few minutes) being more expensive. The employee usually pays the fees but some providers allow the employer to subsidize some or all of the cost. There are a number of variations on these models, and providers describe their products in different ways. Some characterize the service as providing an advance of wages already earned, others as the purchase of an asset (future wages), and others as an assignment of wages. Employees and employers should review the details of any services they are considering to determine exactly what legal rights and obligations they are taking on.

Are Wage Advance Products An Extension of Credit?

A fundamental question raised by wage advance companies is whether the advances being provided are in fact loans governed by the federal Truth in Lending Act (TILA) or state lending laws. Some proponents of wage advance products argue that they are not forms of credit because they don’t charge interest (although they may charge fees or accept “tips”) or because there is no recourse against the employee except the wage deduction. One theory is that the use of a single payroll deduction as opposed to debiting a consumer’s a bank account prevents the provider from being deemed a “creditor” under TILA regulations. Critics of wage advance programs view them as an updated form of payday lending. Opponents are especially concerned about models in which the worker authorizes the provider to debit her bank account because such automatic withdrawals often lead to overdrafts which can subject the consumer to additional bank fees and penalties.

In its recent payday lending rule, the federal Consumer Financial Protection Bureau (CFPB) acknowledged that some wage advance services may not be providing a loan. CFPB states that there is a “plausible” argument that there is no extension of credit when an employer allows an employee to draw accrued wages ahead of a scheduled payday and then later reduces the employee’s wage payment by the amount drawn. The strength of the argument is increased when the employer does not reserve any recourse to recover the advance other than through payroll deduction. Unfortunately, the Bureau failed to provide more detailed guidance on how to determine which business models are covered by the lending rules and which are not. For wage advance products that do involve the provision of credit and thus are subject to the rule, CFPB carved out exemptions for services that meet certain requirements.

Even if a particular wage advance service is not a lender under federal rules, it may still be subject to regulation at the state level. The New York Department of Financial Services (NYDFS) recently announced a multistate investigation of allegations of unlawful online lending in the payroll advance industry with a dozen jurisdictions participating. NYDFS says the investigation will focus on whether companies are violating state banking, licensing, payday lending, and other consumer protection laws. The inquiry will look at whether wage advance programs collect usurious or otherwise unlawful interest rates, whether characterized as transaction fees, monthly membership fees, or “tips,” and whether collection practices generate improper overdraft charges for consumers. According to press reports, at least twelve wage advance providers received letters requesting information on their practices. The outcome of this investigation will, we hope, provide much needed clarity on the application of state lending law to the wage advance industry.

State Wage and Hour Issues

Wages-on-demand services must also comply with state wage and hour laws. A key question is whether a payment for hours worked, but for which wages are not due until a future date, should be categorized as a payment of wages earned or an advance of wages. If it is a payment of wages, then the employer has to withhold taxes and other deductions, ensure the funds are transferred via a permissible method of wage payment and potentially provide a detailed wage statement. If, on the other hand, the payment is as an advance of wages, then the employer must comply with wage advance and payroll deduction regulations. For example, in New York, an advance payment that assesses interest or charges a fee does not qualify as a “wage advance” and may not be reclaimed through payroll deduction.

Some business models have the employee assign some or all of their wages to the provider—a practice which may not be valid in all jurisdictions. Wage assignments are prohibited in some states and regulated to varying degrees in others. In California, for example, an assignment of wages to be earned is valid only if it is to pay for the “necessities of life.” Ohio limits the assignment of future wages to paying court-ordered spousal or child support. If the employee is married, a number of states require the spouse’s consent to the assignment. A provider may characterize the wage advance transaction as a sale of an asset in order to avoid the wage assignment issues. In a number of states, however, such a transaction is deemed to be a loan. In Alaska and Florida, for example, the sale of wages, earned or to be earned, is deemed to be a loan secured by an assignment of the wages and the amount the wages exceed the amount paid is deemed to be interest. 

Employers offering payroll cards to their employees should make sure the wage advance product they choose is compatible with their card program. A number of states prohibit the payment of wages to a payroll card that charges a fee for the loading of wages to the account. In these jurisdictions, wage advance products that assess a transaction fee may be problematic. Other states prohibit payroll cards from linking to any form of credit, “including a loan against future pay or a cash advance on future pay.” Employers selecting a wage advance product need to be careful not to create problems for their employees who elect to be paid via payroll card.

California Considers Legislation to Regulate Wage Advance Providers

Given the uncertainty that surrounds wages-on-demand products under state law, some providers have sponsored legislation that would clarify the law in this area. For example, the California legislature is currently considering a bill, SB 472, which would authorize wage advances by qualified providers who register with the state and meet certain bonding and insurance requirements. Qualified providers could provide advances only on a non-recourse basis, be limited in debt collection activities and prohibited from reporting payment history to credit reporting agencies. The National Consumer Law Center (NCLC) initially said it would support the bill if the scope was limited to authorize only products that are integrated with the employer and to exclude any products that directly debit a consumer’s account. NCLC also advocated for tighter restrictions on fees and limits on usage. The legislation was amended in committee but not in the manner NCLC was seeking, and the organization now opposes the initiative. The bill is continuing to move forward in the legislature, but its fate is unclear.

The Future for Wage Advance Services

While wage advance services face some serious legal obstacles, the demand for such products amongst workers is high and employers are motivated to provide these services in order to keep their workforces happy. Business lawyers should expect to see significant legal and regulatory developments related to these products in the next year. The outcome of the pending multistate investigations should contribute to a better understanding of which business models are legally viable. Legislative and regulatory activity should also be expected and may significantly impact the service models available in the market.

Learn more about wage advance products and earn CLE credits at the ABA Business Law Section’s Annual Meeting in Washington, D.C.

Legal Issues Associated With Wages-on-Demand Products

Friday, September 13, 2:00-3:00 pm

Panelists:        Alicia W. Reid, U.S. Bank

                          Abbie Gruwell, National Conference of State Legislatures

                          Stephen T. Middlebrook, Womble Bond Dickinson

Introduction

On June 5, 2019, a Financial Industry Regulatory Authority (FINRA) hearing panel handed down a groundbreaking decision against a registered crowdfunding portal member.[1] The 148-page decision tackled multiple issues of first impression involving crowdfunding portals. Ultimately, the hearing panel expelled the portal member and barred its chief executive for violating the crowdfunding rules of both FINRA and the Securities and Exchange Commission (SEC),[2] but did not rule in favor of FINRA’s Department of Enforcement on all claims. The decision is a must-read for those seeking guidance on crowdfunding regulation, particularly for those seeking to operate as crowdfunding intermediaries under SEC and FINRA funding portal rules.

Crowdfunding Background

Crowdfunding originated as a means of raising capital for charities and small-business projects, where the public (i.e., the “crowd”) could evaluate the merits of a fundraiser’s proposal and decide whether to donate to the charitable cause or contribute small amounts of money to the business idea (usually in exchange for a token of value, such as early access to or discounted products, tickets to a performance, or other perks). Until relatively recently, crowdfunding did not involve the offer of a share in any profits that the fundraiser expected to generate from business activities financed through crowdfunding. This is because any crowdfunding offering involving the offer or sale of securities would trigger the application of costly registration requirements and regulatory obligations under the federal securities laws.

In an effort to give small-business owners and start-ups access to a broader base of capital, Congress in April 2012 enacted Title III of the JOBS Act, which established a regulatory framework for crowdfunding offerings of securities (also referred to as “equity crowdfunding”).[3] By adding Section 4(a)(6) to the Securities Act of 1933 (Securities Act), the JOBS Act created an exemption from registration for internet-based securities offerings by issuers that raise no more than $1 million in aggregate over a 12-month period.[4] This exemption is available only if a crowdfunding securities offering is conducted exclusively through an intermediary. Intermediaries are required under the JOBS Act to be registered with the SEC and FINRA as either a broker-dealer or a “funding portal.”

Section 3(a)(80) of the Securities Exchange Act of 1934 (Exchange Act) defines a funding portal as “any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to [the April 2012 exemption from registration for crowdfunding securities offerings].”[5] Section 3(a)(80) further provides that funding portals are not permitted to: (i) offer investment advice or recommendations; (ii) solicit purchases, sales, or offers to buy the securities displayed on their platforms; (iii) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on their platforms; or (iv) hold, manage, possess, or otherwise handle investor funds or securities.[6]

Pursuant to the JOBS Act, the SEC promulgated Regulation Crowdfunding in October 2015,[7] and FINRA adopted its Funding Portal Rules shortly thereafter in January 2016.[8] FINRA oversees the crowdfunding industry’s adherence to both sets of rules, and, currently regulates nearly 50 funding portals.[9]

SEC and FINRA crowdfunding rules authorize issuers to conduct small offerings exclusively through websites operated by an intermediary funding portal. Through the portal, potential investors can review information about the issuer and the offering and can discuss the offering with other interested investors. If an investor makes an investment commitment, that money is held in escrow. There is a mandatory waiting period before the offering can close, during which investors retain the right to rescind their investment commitment. If the issuer’s target capital raise is reached by the specified target date, the offering is closed and investor funds are released to the issuer. If, however, the target amount is not reached by the target date, then the offering is canceled and all escrowed funds are returned to investors.

Any investor can participate in a crowdfunding offering, subject to two limitations: (1) if an investor’s annual income or net worth is less than $107,000, then, during any 12-month period, they can invest up to the greater of either $2,200 or five percent of the lesser of their annual income or net worth; and (2) if an investor’s annual income and net worth are equal to or more than $107,000, then, during any 12-month period, they can invest up to ten percent of their annual income or net worth, whichever is less, but not to exceed $107,000.[10]

Pursuant to crowdfunding rules and regulations—specifically SEC Crowdfunding Rule 201—issuers are required to publicly disclose on SEC Form C the following information to potential investors: (1) name, legal status, address, and website; (2) names of directors and officers (with business history); (3) names of persons holding 20 percent or more of the outstanding voting equity; (4) business plan; (5) headcount; (6) cap on number of investments; and (7) intended use of offering proceeds.[11] This disclosure must be filed before an offering can open to investors.[12] An issuer must also disclose the type of security offered, the target amount of the offering, and the deadline for reaching the target amount. SEC Form C also requires disclosure of an issuer’s basic financial information, total assets, cash, cash equivalents, accounts receivable, short-term and long-term debt, revenues and sales, costs of goods sold, taxes paid, and net income.

Pursuant to SEC Crowdfunding Rule 400(a), intermediaries must register with the SEC and FINRA as a broker or a funding portal. FINRA Funding Portal Rule 110(a)(10) promulgates five standards used to measure an applicant’s fitness to become a funding portal. These registration standards mandate that the applicant: (1) is neither subject to statutory disqualification under the Exchange Act or subject to pending regulatory action or investigation; (2) has established business relationships with banks, broker dealers, transfer agents, escrow agents, etc.; (3) has a supervisory system in place reasonably designed to achieve compliance with applicable federal securities laws and rules, including FINRA’s Funding Portal Rules; (4) has fully disclosed and provided support for all direct and indirect sources of funding; and (5) has a recordkeeping system that enables it to comply with federal, state, and FINRA recordkeeping requirements.[13]

An intermediary generally provides educational materials on its funding portal platform (i.e., website) that explain the process for investing via a crowdfunding platform, the types of securities being offered by the issuers on the platform, and the risks associated with investing in these types of securities. SEC Crowdfunding Rule 303(a) requires an intermediary to make an issuer’s required disclosures available to the SEC and investors. This includes posting an issuer’s Form C on its funding portal website.[14] Such information must be available on the website for at least 21 days before any securities can be sold.[15]

Although intermediaries involved in a crowdfunding offering are not required to conduct due diligence related to the offering, they do serve a critical gatekeeping function.[16] Under SEC Crowdfunding Rule 301(a), an intermediary must have a “reasonable basis” for believing that an issuer on its platform is in compliance with the various applicable statutory and regulatory requirements.[17] Critically, SEC Crowdfunding Rule 301(c) mandates that an intermediary deny an issuer access to its platform if the intermediary has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.”[18] Should an intermediary become aware of such concerns after granting access to its platform, it must promptly remove and cancel the offering, and return any invested funds.[19]

An intermediary is also responsible for notifying investors when their investment commitments have been received; when material changes are made to the terms of the offering; when changes are made in the company’s ownership; and when an offering closes early. Intermediaries are also subject to the recordkeeping requirements set forth in SEC Crowdfunding Rule 404, which include keeping records of issuers’ SEC filings and notices to investors, and other communications regarding offerings on its platform. All of these records must be available for SEC and FINRA inspection and examination.

FINRA’s Case Against Manuel Fernandez and DreamFunded Marketplace, LLC

Manuel Fernandez established DreamFunded Marketplace, LLC (DFM) in early 2016 and registered DFM with FINRA as a funding portal (the Portal) several months later. As CEO of DFM, Fernandez became an associated person of a funding portal member and was assigned a FINRA Central Registration Depository (CRD) number. Notably, “Fernandez had no experience working in the securities industry, but the applicable rules did not require him to take any classes or training, or to take any licensing or qualifying examination to qualify to operate a funding portal.” [20]

 Between July 2016 and October 2017, DFM served as an intermediary for 15 crowdfunding offerings, two of which closed and released investors’ funds to the issuers. The FINRA hearing panel’s decision in the Fernandez matter focused on three of these offerings:

• Company A, a social networking company with no assets, revenue, or operating history sought initially to offer 100,000 securities with a $10,000 target capital raise and a September 27, 2016, closing date, but ultimately closed early on June 26, 2017 with a $4,000 target.[21]
• Company B, a company hosting a library of short videos about health and well-being, targeted issuing 10,000 securities in an aggregate of $10,000 with a closing date of June 30, 2017, and ultimately closed early on April 14, 2017 after raising and distributing $10,500.[22]
• Company C, which produced a special type of fire hose and harness, sought a $10,000 target capital raise with a target closing date of September 30, 2017, but did not reach its target amount before DFM removed it from the Portal on April 30, 2017.[23]

In October 2016, FINRA conducted ongoing surveillance of DFM and noticed a YouTube video clip showing Fernandez purporting to make an offer to invest $1 million into Company C. Suspecting that the video may have violated SEC Crowdfunding Rule 300(b), which prohibits officers of intermediaries from holding interests in issuers on their platforms, FINRA opened a “for cause” examination of DFM and Fernandez.[24] Thereafter, FINRA issued a series of Rule 8210 requests to Fernandez seeking documents and information relating to the 15 offerings on the the Portal’s website, DFM’s financial records, bank account statements, and investor agreements.[25] FINRA also took on-the-record testimony from Fernandez. As FINRA continued its investigation, it became concerned that Fernandez and DFM might have violated a number of SEC Crowdfunding and FINRA Portal Rules.

On February 23, 2018, Enforcement filed a complaint against Fernandez and DFM alleging ten causes of action.[26] Between September and November 2018, FINRA argued its case in an eight-day, two-session hearing. During the hearing, Fernandez essentially repudiated much of the on-the-record testimony he previously provided to FINRA. The hearing panel characterized Fernandez’s hearing testimony as “evasive, vague, and inconsistent,” contrasting it with the largely credible testimony of FINRA staff and investigators. The panel therefore discredited much of his testimony, noting that it appeared that “very little of Fernandez’s hearing testimony was candid or true.”[27]  

First Cause of Action—Failing to Provide Documents and Information (FINRA Funding Portal Rules 800(a) and 200(a) and FINRA Rule 8210): FINRA Funding Portal Rule 800(a) provides that funding portal members and their associated persons are subject to FINRA Rule 8210, which, among other things, requires compliance with FINRA requests for information and testimony. Throughout the litigation, Fernandez and DFM challenged FINRA’s jurisdiction to issue Rule 8210 requests and bring a disciplinary proceeding. The hearing panel rejected these jurisdictional challenges, determining that while the JOBS Act distinguishes between broker-dealers and funding portals, “it folds funding portals into the existing disciplinary system for broker-dealers,” and therefore grants jurisdiction to FINRA to discipline funding portals as it would broker-dealers.[28] The panel also determined that “[u]nder Funding Portal Rule 100(b)(1), all officers, owners, controlling persons, and employees of a funding portal are associated persons. As the CEO of the Portal, Fernandez was an associated person of a FINRA member who received a CRD number.”[29] Therefore, Fernandez was required to comply with FINRA Rule 8210 requests and was subject to FINRA’s broker-dealer disciplinary procedures.

The panel determined that Fernandez, in his capacity as CEO of the Portal, failed to respond fully and completely to FINRA’s Rule 8210 requests. His conduct violated FINRA Rule 8210, as made applicable to funding portals by Funding Portal Rule 800(a), which requires anyone subject to FINRA’s jurisdiction to provide information orally, in writing, or electronically, and to testify with respect to any matter involved in an investigation, complaint, examination, or proceeding. The panel also found that Fernandez violated FINRA Funding Portal Rule 200(a), the funding portal equivalent of FINRA Rule 2010, which requires industry members to conduct business pursuant to high standards of commercial honor and just and equitable principles of trade.

Under FINRA’s Sanction Guidelines, a bar is standard in situations where an individual fails to respond at all to a Rule 8210 request, as well as for a partial but incomplete response, unless the respondent demonstrates substantial compliance with the request. In determining the appropriate sanctions in this matter, the hearing panel heavily considered Fernandez’s “pattern of disclaiming responsibility,” his false and misleading statements to regulators, and his attempts to delay the investigation using “dubious” medical excuses.[30] These factors outweighed two key mitigating factors: Fernandez’s lack of experience and training (which led to ignorance of his responsibilities), and the minimal investor harm at issue. After concluding that Fernandez and DFM “were proven unfit to continue in the securities industry,”[31] the hearing panel expelled DFM from FINRA membership as a funding portal and barred Fernandez from association with any FINRA funding portal member.

Takeaway: FINRA has jurisdiction over all funding portal members and associated persons. Current and prospective intermediaries need to educate themselves about their obligations under FINRA funding portal rules and must comply with any requests for information and testimony from FINRA.

Second Cause of Action—False or Misleading Issuer Communications (FINRA Funding Portal Rules 200(c)(3) and 200(a) and SEC Regulation Crowdfunding Rule 301(c)(2)): As noted above, SEC Regulation Crowdfunding Rule 301(c)(2) requires an intermediary to deny an issuer access to its platform if it has a “reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection,” or, if the intermediary already granted an issuer access to its platform, to rescind access and return investor funds after it becomes aware of such information.[32]

The panel determined that Fernandez violated SEC Regulation Crowdfunding Rule 301(c)(2) and FINRA Funding Portal Rule 200(a) based on the following facts that were known to him. First, Company A’s Form C filings contained numerous deficiencies, including inconsistencies in ownership information, changes in the number of securities to be sold to investors, and different offering deadline dates. Second, Fernandez was asked by the CEO of Company A to lower the target amount for its offering, close the offering early, and transfer investor funds to his personal bank account. The panel found that these were red flags that would have led a reasonable person to have serious investor protection concerns.[33] Furthermore, instead of terminating Company A’s access to the Portal, cancelling the offering, and returning investors’ money, Fernandez facilitated the transfer of funds to Company A’s CEO. For this misconduct, the panel determined that it would generally suspend the Portal for 30 days and suspend Fernandez for six months and fine him $10,000. However, due to the Portal’s expulsion and Fernandez’s bar for other violations, the panel did not impose these lesser sanctions.[34]

In contrast, the hearing panel dismissed the portion of the Second Cause of Action pertaining to FINRA Funding Portal Rule 200(c)(3). FINRA Funding Portal Rule 200(c)(3) establishes content standards for funding portal communications with investors. These standards include not only communications created by the funding portal, but also communications created by the issuer for the funding portal to provide to investors. A funding portal is not responsible for false or misleading issuer communications that have been prepared solely by the issuer unless the portal is aware of, or has reason to be aware of, the false or misleading statements. In its complaint, Enforcement alleged that Company A’s and Company B’s projections and forecasts were false and misleading, and that Respondents violated FINRA Funding Portal Rule 200(c)(3) by knowingly posting them. The hearing panel disagreed, determining that it was unclear whether the projections and forecasts were in fact misleading, and that Respondents did not have a duty to conduct due diligence on those projections and forecasts.

Takeaway: Although intermediaries are not required to conduct due diligence into issuer projections or forecasts, as gatekeepers they must evaluate information in their possession regarding issuers and offerings and deny issuer access if investor protection concerns are implicated.

Third Cause of Action—False or Misleading Funding Portal Communications (FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a)): FINRA Funding Portal Rule 200(b) prohibits a funding portal from “effect[ing] any transaction in, or induc[ing] the purchase or sale of any security by means of, or by aiding or abetting, any manipulative, deceptive or other fraudulent device or contrivance.”[35] FINRA Funding Portal Rule 200(c)(2)(A) prohibits a funding portal from distributing or making available communications to investors that are false, exaggerated, unwarranted, promissory or misleading; that omit any material fact that, in light of the context of the material presented, should be disclosed in order to prevent the communication from being misleading; that state or imply that FINRA or another self-regulatory organization endorses, indemnifies, or guarantees the portal’s business practices; that predict or project performance; or that make any exaggerated or unwarranted claim, opinion, or forecast.[36] As seen above, communications prepared solely by issuers are exempt from prosecution under Rule 200(c)(2)(A) unless the member portal knows or has reason to know the communications are false or misleading.

Enforcement alleged that Respondents made false and misleading statements, and induced the purchase of a security by engaging in deceptive practices, in violation of FINRA Funding Portal Rules 200(b), 200(c)(2), and 200(a) when Fernandez: (1) posted through social media and on the Portal’s website a video clip of himself striking a purported deal to make a $1 million investment in Company C; and (2) posted information on the Portal regarding (a) the Portal’s issuer due diligence and deal flow screening, and (b) real estate tombstones that created a misleading impression that the real estate deals offered a 10 percent return and were part of the Portal’s crowdfunding business when they were not.

The panel determined that the video clip contained two untrue statements: (1) that Fernandez had invested over $100 million in start-up businesses, and (2) that the $1 million offer by Fernandez to Company C’s CEO was accepted. The panel found that by posting the false and misleading video clip on the Portal’s platform and Fernandez’s social media accounts, the Respondents had intentionally or recklessly engaged in a “deceptive device” in violation of the Funding Portal rules.[37] The panel also determined that Respondents intentionally or recklessly made false statements on the Portal regarding their allegedly vigorous issuer due diligence and screening. Notably, the panel concluded there was “no screening team and Fernandez had no system for evaluating issuers or their offerings.”[38] The panel also determined that Respondents’ posting of real estate tombstones on the Portal was misleading in violation of Rule 200(c), and that all of these actions violated Rule 200(a). The panel concluded that the appropriate sanctions for Respondents’ Rule 200(a) violations were expulsion for DFM and a bar for Fernandez. Noting that the misleading statements about real estate transactions would generally have resulted in the lesser sanction of a Letter of Caution, the panel declined to impose this sanction in light of the myriad other violations.

Takeaway: Funding portal member communications regarding issuers and offerings have the potential to mislead investors and must be carefully vetted by intermediaries prior to publication on funding portal websites.

Fourth Cause of Action—No Reasonable Basis for Believing Issuer Compliance (SEC Regulation Crowdfunding Section 301(a) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(a) provides that an intermediary must have a reasonable basis for believing that a crowdfunding issuer is in compliance with the applicable requirements.[39] An intermediary can rely on an issuer’s representations concerning compliance unless the intermediary has reason to question the veracity of those representations.[40] Enforcement alleged that Respondents violated Rule 301(a) because they had no reasonable basis for believing that either Company A or Company B had complied with their required disclosure obligations. The complaint alleged that (1) Company A falsely claimed in its SEC disclosure that it had provided investors with true and complete financial statements when, in reality, it did not submit financial statements, and (2) Company B both failed to provide a basis for its valuation of its video library—its main asset—and provided to DFM an SEC filing with inconsistencies regarding asset valuation and projections for revenue.

The panel dismissed the Fourth Cause of Action in its entirety and noted that when Company A filed its Form C, it had no operating history and no financial statements to disclose. According to the panel, the absence of a financial statement did not mean that the Respondents failed to comply with SEC Crowdfunding Rule 301(a) or any other rule. The panel also dismissed the claims relating to Company B because funding portals do not have a duty to analyze and evaluate issuers’ projections and forecasts.[41]

Takeaway: Although funding portals are not required to analyze issuers’ projections and forecasts, they must have a reasonable basis for believing that an issuer seeking to offer and sell securities through their platform complies with the requirements in Section 4A(b) of the Securities Act and the related requirements in Regulation Crowdfunding.

Fifth Cause of Action—Failure to Perform Meaningful Background Checks (SEC Regulation Crowdfunding Rule 301(c)(1) and FINRA Funding Portal Rule 200(a)): SEC Regulation Crowdfunding Rule 301(c)(1) requires an intermediary to conduct a background check and review securities enforcement regulatory history for: (1) each issuer whose securities are to be offered through the intermediary; (2) each officer or director (or persons occupying a similar status or performing a similar function); and (3) any beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities.[42] Enforcement alleged that Respondents violated SEC Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a) by failing to perform any meaningful background checks or securities enforcement regulatory history searches on the issuers making offerings on the Portal.

The hearing panel determined that the evidence established that Fernandez failed to conduct the required background checks and failed to review securities enforcement regulatory histories for the Portal’s issuers and parties associated therewith in violation of Regulation Crowdfunding Rule 301(c)(1) and Funding Portal Rule 200(a). For this misconduct, the panel would have suspended the Respondents for 30 days, but in light of the expulsion and bars for the other violations, did not impose these lesser sanctions.[43]

Takeaway: Funding portals must be diligent in conducting background and securities enforcement regulatory history checks on issuers. That diligence must be carefully reviewed by the intermediary before granting issuers funding portal access.

Sixth, Seventh, Eighth and Ninth Causes of Action—Failure to Provide Investors with Notice of Material Changes, Change of Offering Deadlines, Required Information and Completion of Transactions (SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d), 303(f) and FINRA Funding Portal Rule 200(a)): SEC Crowdfunding Rule 304(c)(1) provides that if there is a material change to the terms of an offering or the information provided by the issuer, then the intermediary must give notice of the material change to any investor who has made an investment commitment. The notice must inform the investor that the investment commitment will be canceled unless the investor reconfirms the commitment within five business days of receiving the notice. If an investor fails to do so, then within five business days after that the intermediary must provide notice that the commitment was canceled, the reason for the cancellation, and the amount of money the investor should expect to receive as a refund.[44]

Enforcement alleged in its Sixth Cause of Action that Respondents failed to provide any notices of material change to investors when Company A filed three Form C amendments that included material changes. The panel agreed that the Respondents violated Crowdfunding Rule 304(c)(1) when Company A’s Form C amendment was “marked as containing a material change in the terms of the offering” but Respondents did not notify any investors of such changes.[45] The panel also found that this conduct violated FINRA Funding Portal Rule 200(a).

Next, SEC Crowdfunding Rule 304(b)(2) provides that if an issuer reaches its target offering amount prior to the deadline specified in its offering materials, it may close the offering on an earlier date, as long as the offering is open for a minimum of 21 days. An intermediary is required to provide notice to any potential investors, and any investors who have made investment commitments, informing them of the new offering deadline and their right to cancel their investment commitments for any reason up to 48 hours prior to the new deadline. The new offering deadline must be at least five business days after the notice to investors is provided. The offering cannot close if, at the time of the new offering deadline, the issuer does not meet or exceed the target offering amount.[46]

In the Seventh Cause of Action, Enforcement alleged that Respondents failed to provide notice to investors of early closings for Company A and Company B and of the investors’ rights to cancel their investment commitments. The panel agreed, and determined that the Respondents violated SEC Regulation Crowdfunding Rule 304(b)(2) and FINRA Funding Portal Rule 200(a) by failing to give notice to investors when the offerings of Company A and Company B closed early. According to the panel, “Respondents deprived investors in both offerings of their right to cancel their investment commitments up until 48 hours of the closing.”[47]

SEC Regulation Crowdfunding Rule 303(d) provides that upon receiving an investment commitment, an intermediary must promptly give notice to an investor of the following: (i) the dollar amount of the commitment; (ii) the price of the securities, if known; (iii) the name of the issuer; and (iv) the date and time by which the investor may cancel the investment commitment.[48]

In the Eighth Cause of Action, Enforcement alleged that Respondents, in connection with offerings made by Company A and Company B, failed to provide required information to investors in the notices of investment, including the price of securities and the date and time by which investors could cancel their commitments. The panel determined that Respondents violated SEC Regulation Crowdfunding Rule 303(d) by sending notices to investors in the offerings of Company A and Company B that did not provide any information of the investors’ right to cancel their investment commitments up until a specific date and time, and in doing so, also violated FINRA Funding Portal Rule 200(a).[49]

SEC Regulation Crowdfunding Rule 303(f) requires an intermediary to provide a notification to each investor that contains certain information. The rule requires the following: (i) the date of the transaction; (ii) the type of security that the investor is purchasing; (iii) the identity, price, and number of securities purchased by the investor, along with the total number of securities sold by the issuer in the transaction and the price at which the securities were sold.

In the Ninth Cause of Action, Enforcement alleged that Respondents did not provide investor confirmations when the Company A and Company B offerings closed. The panel reviewed the record and determined that the Respondents violated SEC Crowdfunding Rule 303(f), and thereby FINRA Funding Portal Rule 200(a), by failing to provide investors with confirmation of the Company A and Company B offering closings.[50]

In its sanctions analysis for the sixth, seventh, eighth, and ninth causes of action, the panel aggregated the misconduct because, taken together, the violations of SEC Regulation Crowdfunding Rules 304(c)(1), 304(b)(2), 303(d) and 303(f) represented a “systemic failure to give investors the information to which they were entitled.”[51] For these violations, the panel would have imposed a 30-day suspension on both Fernandez and DFM, but in light of the expulsions and bars, it did not impose these sanctions.

Takeaway: Funding portals have a number of obligations to provide adequate notices to investors, including those regarding material changes to the terms of an offering, early closings, prices of securities, and the date and time by which investors can cancel their commitments. Funding portals must also maintain appropriate systems and procedures to track the occurrence of notice-related events and ensure that investors are provided with timely and proper notices.

Tenth Cause of Action—Supervision (FINRA Funding Portal Rules 300(a) and 200(a) and SEC Regulation Crowdfunding Rule 403(a)): SEC Regulation Crowdfunding Rule 403(a) requires a funding portal to implement written policies and procedures reasonably designed to achieve compliance with applicable laws, regulations, and rules. FINRA Funding Portal Rule 300(a) requires a funding portal member to establish and maintain a system for supervising associated persons that is “reasonably designed” to achieve compliance with securities laws and Funding Portal Rules.[52]

In the Tenth Cause of Action, Enforcement alleged that DFM’s written policies and procedures were not reasonably designed to achieve compliance with applicable rules, regulations and laws because they lacked substance, were not provided to the Portal’s employees, and were rarely referenced or used. The panel determined that Respondents violated SEC Crowdfunding Rule 403(a) and FINRA Funding Portal Rules 300(a) and 200(a) by failing to establish any concrete or practical system for supervising the Portal’s conduct of its business to ensure compliance with legal and regulatory requirements. For this failure, the panel noted that it would have suspended Respondents for 30 days and required them to submit a remediation plan to FINRA for approval and implementation. However, because of the expulsions and bars, the panel did not impose these sanctions.[53]

Takeaway: Funding portal members must maintain adequate written policies and procedures that are reasonably designed to achieve compliance with securities laws and FINRA Funding Portal Rules.

Upon reviewing all of the facts and circumstances in this matter, the panel suggested it had no other choice but to impose stringent sanctions: “Respondents committed numerous violations in a systemic, wholesale compliance breakdown. Fernandez failed to tell FINRA staff the truth prior to the hearing, and he failed to tell the Extended Hearing Panel the truth at the hearing. Fernandez also attempted to shift responsibility for all missteps to others. We have no confidence that in the future, if permitted to continue in the securities industry, Respondents would comply with regulatory requirements or fully and truthfully respond to regulatory inquiries.”[54]

In reaching its decision, the panel noted that it “might hesitate to impose stringent sanctions in other circumstances—as, for example, where a person operating a funding portal makes mistakes from a lack of understanding of the rules, but expresses a sincere desire to correct those mistakes, and develops and implements policies and procedures to avoid mistakes in the future.”[55] The panel also recognized that “[t]o some degree, Respondents’ violations may be partly attributable to the lack of a mechanism for educating and qualifying a person to run a funding portal. Fernandez may not have fully comprehended the applicable rules or the nature and degree of regulatory oversight exercised by the SEC and FINRA.”[56]

Conclusion

In the three years since the SEC’s Crowdfunding and FINRA’s Funding Portal Rules took effect, the use of equity crowdfunding to facilitate capital formation has been relatively modest. Recently, the SEC, in an effort to review and improve its general regulatory framework for securities offerings that are exempt from registration requirements, issued Concept Release on Harmonization of Securities Offering Exemptions.[57] The SEC published the release to solicit comments on possible ways to simplify and improve the exempt offering framework to promote capital formation and expand investment opportunities.

As part of the release, the SEC reported that from the inception of crowdfunding through the end of 2018, a total of 519 crowdfunding offerings have been completed, raising $108.2 million, or an average capital raise of $208,400 per offering.[58] The SEC’s data also indicate that the majority of crowdfunding issuers raised less than the maximum amounts targeted in the original offering documents, with only 29 issuers raising the full $1.07 million allowed by law over 12 months.[59]

The decision against DFM and Fernandez represents the first litigated FINRA enforcement action against a funding portal and serves as important guidance for current and future crowdfunding participants. Despite its seemingly slow start, equity crowdfunding is a powerful tool for small companies and entrepreneurs seeking access to start-up capital. As reflected by the lengthy hearing panel decision in the DFM/Fernandez case, however, SEC and FINRA crowdfunding rules are complex and can easily lead to compliance quandaries for issuers and intermediaries.

[1] Extended Hearing Panel Decision, Dep’t of Enforcement v. DreamFunded Marketplace LLC and Manuel Fernandez, Disciplinary Proceeding No. 2017053428201 Financial Industry Regulatory Auth., Office of Hearing Officers (June 5, 2019), available at https://bit.ly/2XwyeRr (“Extended Hearing Panel Decision”).  This matter has been appealed.  See Adjudication and Decisions, FINRA, https://www.finra.org/rules-guidance/oversight-enforcement/decisions (last visited August 29, 2019).

[2] Hearing Officer McConathy and the Extended Hearing Panel decided it was “necessary to write at length” on this matter because of issues of first impression and the numerous causes of action. Extended Hearing Panel Decision, at 7.

[3] 157 Cong. Rec. S8458 (daily ed. Dec. 8, 2011) (statement of Sen. Jeff Merkley) (“Low-dollar investments from ordinary Americans may help fill the void, providing a new avenue of funding to the small businesses that are the engine of job creation. The Crowdfund Act [Title III of the JOBS Act] would provide startup companies and other small businesses with a new way to raise capital from ordinary investors in a more transparent and regulated marketplace.”), available at https://www.congress.gov/112/crec/2011/12/08/CREC-2011-12-08.pdf; 157 Cong. Rec. H7295-01 (daily ed. Nov. 3, 2011) (statement of Rep. Patrick McHenry) (“[H]ighnet worth individuals can invest in businesses before the average family can. And that small business is limited on the amount of equity stakes they can provide investors and limited in the number of investors they can get. So, clearly, something has to be done to open these capital markets to the average investor[.]”), available at https://www.congress.gov/112/crec/2011/11/03/CREC-2011-11-03.pdf.

[4] Jumpstart Our Business Startups Act [JOBS Act], H.R. 3606, 112th Cong. (2012), Section 302(a) and (b), available at https://www.govinfo.gov/content/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Securities Act Section 4(a)(6) exempts offerings of up to $1 million in a 12-month period, subject to adjustment for inflation required by Section 4A(h) at least once every five years. Accordingly, issuers are currently permitted to raise a maximum aggregate amount of $1.07 million in a 12-month period. 17 C.F.R. § 227.100(a)(1) (2017).

[5] Extended Hearing Panel Decision, supra note 1, at 91; see also Section 3(a)(80) of Exchange Act of 1934, 17 C.F.R. § 227.300(c)(2) Intermediaries (2017), available at https://www.govinfo.gov/content/pkg/CFR-2017-title17-vol3/pdf/CFR-2017-title17-vol3-sec227-300.pdf.

[6] 17 C.F.R. § 227.300(c)(2)(i)-(iv) (2017).

[7] SEC Crowdfunding Rules, 17 C.F.R. § 227.100, et seq. (2015), available at https://www.govinfo.gov/content/pkg/FR-2015-11-16/pdf/2015-28220.pdf.

[8] Self-Regulatory Organizations; Financial Indus. Regulatory Auth., Inc.; Notice of Amendment No. 1 and Order Granting Accelerated Approval to a Proposed Rule Change, as Modified by Amendment No. 1, to Adopt the Funding Portal Rules and Related Forms and Rule 4518, SEC Release No. 34-76970, File No. SR-FINRA-2015, available at https://www.sec.gov/rules/sro/finra/2016/34-76970.pdf; Jumpstart Our Business Startups (JOBS) Act (SEC

Approval of FINRA Funding Portal Rules and Related Forms, FINRA Regulatory Notice 16-06, Effective Jan. 29, 2016), available at https://www.finra.org/sites/default/files/Regulatory-Notice-16-06.pdf.

[9] FINRA, Funding Portals We Regulate (last updated June 17, 2019), available at https://www.finra.org/about/funding-portals-we-regulate.

[10] SEC Crowdfunding Rules, supra note 7, at 100.

[11] Id. at 201.

[12] Id. at 203(a)(1).

[13] FINRA Funding Portal Rule Application, 110(a)(10) Standards for Granting or Denying Application (effective Jan. 29, 2016), available at http://finra.complinet.com/en/display/display_main.html?rbid=2403&element_id=12222.

[14] SEC Crowdfunding Rules supra note 7, at 303(a).

[15] Id. at 303(a)(2).

[16] See, e.g., Section 4A(a)(5) of the Securities Act, implemented through the JOBS Act, stating: “[An intermediary shall] take such measures to reduce the risk of fraud with respect to such transactions, as established by the [SEC] by rule,” available at https://legcounsel.house.gov/Comps/Securities%20Act%20Of%201933.pdf.

[17] SEC Crowdfunding Rules supra note 7, at 301(a).

[18] Id. at 301(c)(2).

[19] Id.

[20] Extended Hearing Panel Decision, supra note 1, at 5.

[21] Id. at 33-34, 42.

[22] Id. at 48, 50.

[23] Id. at 51.

[24] Id. at 6.

[25] Id. at 69.

[26] Id. at 73.

[27] Id. at 77.

[28] Id. at 19.

[29] Id. at 29.

[30] Id. at 140, 141.

[31] Id. at 139.

[32] Id. at 95.

[33] Id. at 109-11.

[34] Id. at 144.

[35] Id. at 114.

[36] Id.

[37] Id. at 116-17.

[38] Id. at 118.

[39] Id. at 120.

[40] SEC Crowdfunding Rules supra note 7, at 301(a).

[41] Extended Hearing Panel Decision, supra note 1, at 123.

[42] Id. at 124.

[43] Id. at 145.

[44] Id. at 128-29.

[45] Id. at 129.

[46] Id. at 129-30.

[47] Id. at 130.

[48] Id.

[49] Id.

[50] Id. at 131.

[51] Id. at 15.

[52] Id. at 132.

[53] Id. at 146.

[54] Id. at 8.

[55] Id.

[56] Id. at. 5.

[57] SEC Concept Release on Harmonization of Securities Offering, Release No. 33-10649 (June 18, 2019, available at https://www.sec.gov/rules/concept/2019/33-10649.pdf.).

[58] Id. at 147-48.

[59] SEC Report to the Commission Regulation Crowdfunding, at 4 (June 18, 2019), available at https://www.sec.gov/files/regulation-crowdfunding-2019_0.pdf.

Prepayment Penalties in Commercial Loan Documents

Contractual prepayment premiums—also called make-whole provisions or prepayment penalties—offer yield protection to a lender in the event a borrower repays its loan prior to its scheduled maturity date. Such provisions are often found in higher-value loans with longer terms, including those offered to distressed companies trying to clean up their balance sheet or restructure debt in an attempt to avoid a bankruptcy filing. Some categorize prepayment premiums as a hedge against the risk of loss of future interest resulting from a borrower’s early payoff, whereas others describe the premium as the price a borrower pays for the autonomy to prepay or refinance its debt. Whichever way you put it, prepayment premiums endeavor to increase predictability for lenders.

Although these provisions are increasingly common in commercial loan agreements and bond indentures, and even more so where the borrower is distressed, that is not to say they are uncontroversial. In many cases, make-whole provisions compensate commercial lenders and bondholders in an amount significantly exceeding that which the name would imply, contemplating returns that often exceed the current fair value of the debt. In addition, because they are more common in larger loans, make-whole amounts are typically quite significant. Indeed, in In re Ultra Petroleum, 913 F.3d 533 (5th Cir. 2019), the value of the make-whole amount and postpetition interest at stake exceeded $380 million.

The Ultra Petroleum Decision

To be clear, the Ultra Petroleum decision is not the first to create uncertainty in the analysis of make-whole provisions under the Bankruptcy Code, and it is true that objectors seeking to avoid make-whole claims enjoyed their choice of several grounds of attack far before the Fifth Circuit’s ruling. For example, make-whole claims had been disallowed as unenforceable under applicable nonbankruptcy law (including based on arguments that the claims were a penalty as opposed to a reasonable and enforceable liquidated damages provision), as unreasonable under section 506(b) of the Bankruptcy Code (with respect to secured claims), or in a handful of cases, as unmatured interest under section 502(b)(2). In fact, prior to Ultra Petroleum, the Second Circuit in In re MPM Silicones, LLC, 874 F.3d 787 (2d Cir. 2017) and the Third Circuit in In re Energy Future Holdings Corporation, 842 F.3d 247 (3d Cir. 2016), had issued completely conflicting opinions on whether the automatic acceleration of debt caused by a bankruptcy filing triggers payment of a make whole.

In the January 2019 decision, the Fifth Circuit, albeit in dicta, sided with the small minority of bankruptcy courts that held that make-whole claims constitute unmatured interest because, in substance, they seek to compensate a lender for future interest payments due to early repayment of debt. Thus, the Ultra Petroleum ruling, which strongly suggests that section 502(b)(2) disallows any claim that is the economic equivalent of unmatured interest, bolsters arguments for the across-the-board disallowance of make-whole claims under the Bankruptcy Code.

The Post-Ultra Petroleum State of the Law

Although the successful recovery of make-whole amounts from a chapter 11 debtor was far from a foregone conclusion even pre-Ultra Petroleum, the decision unquestionably alters what had been at least a somewhat navigable legal landscape, and raises questions about the lending market’s response in the longer term.

The pre-Ultra Petroleum state of the law was marked by specific guidelines set forth in various cases that provided a playbook by which sophisticated bankruptcy counsel could surgically craft loan documents to avoid the pitfalls of make-whole provisions by including carefully bargained-for provisions on choice of law, yield maintenance formulas estimating the damages to lenders resulting from prepayment, and clearly defined conditions to payment, including explicit language indicating the make whole is payable on acceleration. Thus, notwithstanding the existing circuit split, lenders could draft to hedge against these risks and exert their control over borrowers to push for a favorable jurisdiction in the event of bankruptcy.

The ruling will undoubtedly have considerable impact on the allowability of a lender’s make-whole claim in courts within the Fifth Circuit. However, unless and until the Supreme Court offers guidance on how courts should approach the issue, the new, even less predictable landscape of make-whole claims in bankruptcy means significantly more uncertainty for lenders relying on make-whole recoveries. In a realm where lenders already exercise a great deal of control, the uncertainty caused by the ruling, coupled with the typically significant value of the make-whole claims at stake, may result in increased rigidity and tension in chapter 11 negotiations. To compensate for this risk, lenders may also resort to charging higher interest rates and fees on distressed deals, or even opting not to lend to distressed borrowers. Although the ultimate impact of Ultra Petroleum remains to be seen, the line between risky and too risky can be a thin (and expensive) one to tread.

A receivership occurs when a court appoints a third party to exercise independent oversight on specific assets. Although receiverships are commonly involved in real estate transactions, they can also arise when commercial borrowers are in distress, in cases of corporate deadlock, and in the event of litigation where the rights of the parties cannot otherwise be fully protected. In some cases, even for large operating companies, courts have appointed receivers and granted the receivers authority to take complete control of defendant’s business operations, including determining whether to sell or wind-down business affairs.

Contracts, particularly lending agreements, often contain clauses authorizing appointment of a receiver upon default. The question is: how effective are these provisions for operating companies (versus single asset real estate matters in which receivers are often appointed on an ex parte basis[1])? This issue often arises in the context of a contentious relationship in which the borrower refuses to file a bankruptcy case, and commencing an involuntary case is unavailable to the lender. The answer appears to be that although the receivership provision alone is not likely to be determinative as to whether to appoint the receiver, it may be considered by courts as a strong factor in the lender’s favor.

The issue over the effectiveness of a receivership provision was recently tested in The Huntington National Bank v. Sakthi Automotive Group USA, Inc., et al.[2] In Sakthi, Sakthi Automotive Group (Sakthi Automotive), a critical component supplier of automotive parts, defaulted on its loan obligations to Huntington National Bank (the Bank). The Bank sought a preliminary injunction prohibiting Sakthi Automotive from destroying, selling, transferring, or performing other similar acts with respect to the collateral. The Bank also sought the appointment of a receiver with broad powers, including to operate and sell the company pursuant to the terms of the parties’ credit agreement:

Upon the occurrence of an Event of Default and at all times thereafter, the Lender shall be entitled to the immediate appointment of a receiver for all or any part of the Collateral, whether such receivership is incidental to the proposed sale of the Collateral, pursuant to the Uniform Commercial Code or otherwise. Each Loan Party hereby consents to the appointment of such a receiver without notice or bond, to the full extent permitted by applicable statute or law; and waives any and all notices of and defenses to such appointment and agrees not to oppose any application therefor by the Lender, but nothing herein is to be construed to deprive the lender of any other right, remedy, or privilege the Lender may have under law to have a receiver appointed, provided, however, that, the appointment of such receiver shall not impair or in any manner prejudice the rights of the Lender to receive any payments provided for herein. Such receivership shall at the option of the Lender, continue until full payment of all the Obligations.

The court denied the motion for a preliminary injunction, finding, among other things, that the Bank could not establish irreparable harm because its injury could be fully compensated by money damages. However, irreparable harm was not a necessary factor for the court to consider in appointing a receiver; therefore, the Bank’s request to protect its collateral could be accomplished through appointment of a receiver.

In addition to recognizing Sakthi Automotive’s express contractual consent to the appointment of a receiver, the court also considered several factors traditionally applied in federal cases appointing receivers:

1) the existence of a valid claim by the moving party
2) alleged fraudulent conduct
3) imminent devaluation, concealment, or loss of the property
4) inadequate alternative legal remedies (such as money damages)
5) lack of a less drastic equitable remedy
6) whether appointment of a receiver will do more harm than good

As an equitable remedy, case law regarding the appointment of receivers generally suggests the weight of each factor is within the court’s discretion.

In initially considering the contractual provision, the court determined that there was no dispute that at least one default existed under valid contracts. The court found the unambiguous receivership provision to weigh in favor of appointing a receiver but continued to consider the factors referenced above. In so doing, the court determined that the Bank met the first three factors. As to the sixth factor, Sakthi Automotive failed to establish that the receiver will do more harm than good. That left the fourth and fifth factors, and as to these, the court placed great weight on the receivership provision and found that these factors had “little relevance” given the existence of the contractual provision. The fact the court gave “little relevance” to the fourth factor due to the contractual provision is particularly noteworthy in that the court previously determined the Bank could be fully compensated with money damages when denying the preliminary injunction request.

In its motion for reconsideration, Sakthi Automotive challenged only the fraudulent conduct, diminished value, and the “more harm than good” factors—not the factors given “little relevance” in light of the contractual provision. The court denied the reconsideration motion and noted that although there is disagreement about whether a contractual receiver provision is dispositive, in this matter both the contractual provision and the factors outlined in receivership case law favored a receivership in this case. The court entered an order granting the receiver broad operating power over the company assets.

In the end, for operating companies there are numerous reasons why a court may be reluctant to find that a receiver provision coupled with the existence of a default would indisputably lead to appointment of a receiver without proof of additional considerations. However, the existence of the contractual provision may be a strong factor considered and tip the scale in favor of the appointment when weighing the other factors. Indeed, a court may, as it did in Sakthi, determine that certain factors are met by the existence of a contractual provision.

[1] For real estate matters, see generally Uniform Commercial Real Estate Receivership Act, § 6, cmt. 2 (“there is significant recent authority supporting the view that a receivership clause alone provides a sufficient basis to appoint a receiver after the mortgagor’s default.”) (citations omitted). See also Britton v. Green, 325 F.2d 377, 382 (10th Cir. 1963) (holding that a contractual provision involving oil and gas leases was sufficient to appoint a receiver: “By the terms of the mortgage, the mortgagor expressly agreed that in the event of a foreclosure suit, the mortgagee is entitled, ‘as a matter of right,’ to the appointment of a Receiver to take possession and control of, operate, maintain and preserve the mortgaged property. . . .”).

[2] 2:19-cv-10890 (E.D. Mich. 2019). See also PNC Bank, Nat’l Ass’n v. Goyette Mech. Co., 15 F. Supp. 3d 754, 758 (E.D. Mich. 2014) (“the parties’ advance consent to the appointment of a receive (sic) is a strong factor weighing in favor of appointing one.”); Am. Bank & Tr. Co. v. Bond Int’l Ltd., No. 06-CV-0317-CVE-FMH, 2006 U.S. Dist. LEXIS 58361, at *21–*23 (N.D. Okla. Aug. 17, 2006) (unpublished) (appointing a receiver for an operating company’s collateral based on the Tenth Circuit’s approval of a security agreement’s receivership provision in Britton, supra note 1, and case law equitable factors).

Until recently, legal principles surrounding unfairness, deception, and abusiveness have been defined primarily at the federal level, yet with perceived federal retrenchment from consumer protection, states have increasingly taken a hard look at their roles in protecting their citizens from unfair, deceptive, or abusive acts or practices (UDAP/UDAAP). Recent legislative changes in Maryland and Arkansas highlight the different approaches states are taking in how they regulate UDAP/UDAAP and through those changes are choosing to either prioritize consumer protection or protect industry from perceived overreach.

Maryland

On May 15, 2018, Maryland enacted House Bill 1634 and Senate Bill 1068, effective October 1, 2018, which substantively amended the Maryland Consumer Protection Act (the MCPA).[1] Before the amendment, the MCPA generally prohibited “unfair or deceptive trade practices” in addition to prohibiting certain specific practices.[2] The amendments to the MCPA increased the scope of the statute, which now generally prohibits “unfair, abusive or deceptive trade practices.”[3]

The amended MCPA now also specifically provides that violations of the federal Military Lending Act and the federal Servicemembers Civil Relief Act will be considered unfair, abusive, or deceptive trade practices in violation of the MCPA.[4] In addition, the amended MCPA now provides for significantly increased penalties. Before the amendments, the MCPA provided for penalties of up to $1,000 for an initial violation and $2,500 for subsequent violations. These penalties have been increased to $10,000 and $25,000, respectively.[5]

The increased scope of the MCPA aligns with the Consumer Financial Protection Bureau’s authority to pursue enforcement actions related to “unfair, deceptive and abusive acts or practices” under Dodd-Frank. Maryland House Bill 1634 and Maryland Senate Bill 1068 added a new provision to the Miscellaneous Consumer Protection Provisions Title[6] that encourages the Office of the Attorney General and the Commissioner of Financial Regulation to assert their authority to bring actions for “unfair, abusive or deceptive trade practices” under Dodd-Frank. House Bill 1634 and Senate Bill 1068 also added another new provision[7] to the Miscellaneous Consumer Protection Provisions Title that increases appropriations to both the Office of the Attorney General and the Commissioner of Financial Regulation for the purposes of enforcement of financial consumer protection laws. Consumers continue to have a private right of action for both damages and attorney’s fees for violation of the MCPA under its expanded coverage.[8]

Overall, the amendments to the MCPA and the related amendments to the Miscellaneous Consumer Protection Provisions Title favor consumers by increasing the scope of MCPA protections, promoting enforcement of existing standards by state regulators, and increasing the penalty for violations of the consumer protection statutes.

Arkansas

In contrast to Maryland’s efforts to expand consumer protection under the MCPA, Arkansas has taken steps to restrict consumer protection, particularly private rights of action.

The Arkansas Deceptive Trade Practice Act (ADTPA)[9] generally prohibits and makes unlawful “deceptive and unconscionable trade practices.”[10] The ADTPA also designates certain specific practices as unlawful.[11] On April 7, 2017, Arkansas enacted House Bill 1742 (now Act 986), effective August 1, 2017, which substantively amended the ADTPA.

Before the amendment, the ADTPA allowed a private right of action for any “person who suffers actual damage or injury as a result of an offense or violation” of the ADTPA.[12] A claimant could recover actual damages.[13] A successful claim under the ADTPA did not require a showing of monetary damages or reliance on the practice that violated the ADTPA.

The amended ADTPA now limits a private right of action to a person that suffers “an actual financial loss as a result of his or reliance on the use of a practice declared unlawful under [the ADTPA].”[14] The claimant may only recover “his or her actual financial loss proximately caused by the offense or violation, as defined under the [the ADTPA].”[15] The amended ADTPA further provides that “[t]o prevail on a claim brought under Ark. Code Ann. § 4-88-113(f)(1), a claimant must prove individually that he or she suffered an actual financial loss proximately caused by his or her reliance on the use of a practice declared unlawful under [the ADTPA].”[16] The amended ADTPA defines “actual financial loss” as “an ascertainable amount of money that is equal to the difference between the amount paid by a person for goods and services and the actual market value of the goods or services provided.”[17] Accordingly, the amended ADTPA now requires a claimant to show actual monetary damages or injury. Furthermore, a claimant must now also show that the damages or injury were “proximately caused by his or her reliance on the use of a practice declared unlawful under [the ADTPA].”[18]

The Arkansas Court of Appeals found that reliance was not necessarily required for a successful claim under the prior version of the ADTPA.[19] Courts applying Arkansas law have held that the amended ADTPA requirements for showing monetary damages and reliance are therefore substantive in nature and not procedural.[20] Accordingly, the courts have held that these requirements are not retroactive and will not apply to purchases made before August 1, 2017.[21]

The amended ADTPA also now prohibits private class-action claims under the ADTPA, with the exception of claims asserting violations of the Arkansas Constitution, Amendment 89, which provides the maximum interest rates a lender may impose.[22] Before the amendment, the ADTPA did not expressly limit private class-action claims.

Consumer Protection Versus Protection from Frivolous Lawsuits

Maryland and Arkansas demonstrate divergent approaches to consumer protection through application of UDAP/UDAAP statutes. Maryland has adopted an expansive view of what constitutes a violation of the MCPA, going beyond even UDAAP standards derived from the Dodd-Frank Act by codifying MLA and SCRA violations as per se unfair, deceptive, or abusive acts. Coupled with increased funding for enforcement by the Maryland Attorney General and its already robust private right of action, the recent MCPA amendments send a strong message that Maryland will be at the forefront of consumer protection in the coming years.

Arkansas reflects a separate priority: concern that malleable concepts of unfairness and deception may be used to justify frivolous lawsuits and class actions where no monetary injury exists. Similarly, at the federal level, “reliance” is not an element of an unfairness, deception, of abusiveness claim. This additional requirement makes proving an ADTPA violation materially more difficult—even where monetary injury exists, consumers must prove that they understood and relied on a representation to their detriment.[23]

These approaches represent opposite ends of the pro-consumer versus pro-industry approach to state UDAP/UDAAP laws. As consumer protection shifts to states, the current reality for both consumers and industry may be this patchwork approach.

[1]      Md. Code Ann., Com. Law §§ 13-101 et seq.

[2]      Id. §§ 13-303(k), 13-101 et seq.

[3]      Id. § 13-303(k) (emphasis added).

[4]      Id. § 13-301(14)(xxxi), (xxxii).

[5]      Id. § 13-410(a), (b).

[6]      Id. § 14-4103.

[7]      Md. Code Ann., Com. Law § 14-4104.

[8]      Id. § 13-408.

[9] Ark. Code Ann. §§ 4-88-101 et seq.

[10] Id. § 4-88-107.

[11] Id. § 4-88-108.

[12] Id. § 4–88–113.

[13] Id. § 4–88–113.

[14] Id. § 4-88-113(f)(1).

[15] Ark. Code Ann. § 4-88-113(f)(1).

[16] Id. § 4-88-113(f)(2).

[17] Id. § 4-88-102(9).

[18] Id. § 4-88-113(f)(2).

[19] Pleasant v. McDaniel, 550 S.W.3d 8, 12 (Ark. Ct. App. 2018).

[20] See Mounce v. CHSPSC, LLC, 2017 WL 4392048, at *7 (W.D. Ark. Sept. 29, 2017); In re Restasis (Cyclosporine Ophthalmic Emulsion) Antitrust Litigation, 2018 WL 5928143 at *4 (E.D. Ny. Nov. 13, 2018).

[21] Id.

[22] Ark. Code § 4-88-113(f).

[23] The related concept of materiality is presumed under federal deception law. See FTC Policy Statement on Deception (1983).

The law’s definition of “good faith” is often amorphous, fact specific, and difficult to spell out. No doubt, courts and factfinders have grappled with it for centuries. Yet what explains Maryland’s aversion to interpreting it—or acknowledging it—in the “fair consideration” definition in the Uniform Fraudulent Conveyance Act (UFCA)?

New York and Maryland are the only jurisdictions still applying the UFCA (most other states—43 of them—have moved on to the modernized Uniform Fraudulent Transfer Act), and not surprisingly, New York courts have spilled a lot of ink interpreting and articulating the rights of creditors seeking to void fraudulent conveyances. At this point in New York, there is little ambiguity on what good faith means in the constructive fraudulent conveyance context when insolvent businesses are moving money and assets.

Under the constructive fraudulent conveyance statute of the UFCA,

Every conveyance made and every obligation incurred by a person who is or will be rendered insolvent by it is fraudulent as to creditors without regard to his actual intent, if the conveyance is made or the obligation is incurred without a fair consideration.

“Fair consideration” is provided in exchange for property or an obligation if:

(a) In exchange for such property, or obligation, as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied, or

(b) The property, or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property, or obligation obtained.

On a plain reading, the statute permits the avoidance of a transfer as constructively fraudulent even if the debtor receives equivalent value if the plaintiff can prove that the value was not provided in good faith. Striking down such conveyances is permitted regardless of the debtor-transferor’s intent.

In New York, as found in the definition, fair consideration is present when (1) the recipient of the debtor’s property either conveys property in exchange or discharges an antecedent debt; (2) the debtor receives the “fair equivalent” of the property conveyed; and (3) the exchange is undertaken in good faith. See Sharp Int’l Corp. v. State St. Bank & Trust Co. (In re Sharp Int’l Corp.), 403 F.3d 43, 53-54 (2d Cir. 2005). The New York Court of Appeals has identified a few parameters defining “good faith”—an honest belief in the activities in question; no intent to take unconscionable advantage of others; no intent to delay, hinder, or defraud others—and certain circumstances that constitute bad faith as a matter of law; notably, transfers to directors, officers, and shareholders of insolvent corporations in derogation of the rights of general creditors. Farm Stores, Inc. v. School Feeding Corp., 102 A.D.2d 249 (2d Dep’t 1984). Other courts interpreting New York law have interpreted good faith to apply to any transaction between an insolvent corporation and a corporate insider. See Hirsch v. Gersten (In re Centennial Textiles), 220 B.R. 165, 172 (Bankr. S.D.N.Y. 1998) (“under New York law, transfers from an insolvent corporation to an officer, director or major shareholder of that corporation are per se violative of the good faith requirement of DCL § 272 and the fact that the transfer may have been made for a fair equivalent is irrelevant.”); Allen Morris Commercial Real Estate Servs. Co. v. Numismatic Collectors Guild, Inc., No. 90 Civ. 264, 1993 WL 183771, 1993 U.S. Dist. LEXIS 7052, at *28-*30 (S.D.N.Y. May 26, 1993) (“it has been held that transfers from an insolvent corporation to an officer, director and major shareholder of that corporation are per se violative of the good faith requirement of Section 272.”).

Although the fact patterns are often nuanced, it’s undeniable that good faith is of great significance under New York’s UFCA when insolvent businesses are making transfers or entering into transactions with insiders.

Given the robust attention to good faith in New York, it seems safe to assume that the other UFCA jurisdiction—Maryland—might perform a similar test. Or maybe not.

Recently, in United Bank v. Buckingham, 761 F. App’x 185 (4th Cir. 2019), the Fourth Circuit Court of Appeals reversed a decision by the late Judge Roger W. Titus assessing whether fair consideration existed when an insolvent business changed the beneficiary designations on two life insurance policies the company purchased for its CEO.

The judgment creditor bank in the case was owed millions of dollars by the bankrupt debtor business, its CEO, and his wife. Prior to becoming insolvent, the company purchased life insurance policies as an employment benefit to the CEO. Upon the CEO’s death, the company would be reimbursed its premium payments (from the death benefits), and with the beneficiary designated by the CEO receiving the remainder.

After a protracted default by the company, a forbearance agreement between the parties, the CEO diminished by dementia, and his son David appointed guardian, the debtor company’s board approved a sale of the policies. The policies were sold for $110,000—a value determined by the life insurance company pursuant to an IRS formula—to a trust. The trustee of the trust was David, and the beneficiaries were David and his two siblings.

The bank alleged that the transfer of the policies to the trust for only $110,000 was fraudulent because it lacked fair consideration in that the policies were conveyed from the debtor company to the trust despite the fact that the policies were cashed in for $750,000 soon after the sale. The court disagreed with the bank and found that “the $110,000 was a ‘fair equivalent’ for the John Hancock policies.” In short, David—voting for his ill father—and his brother Thomas agreed to transfer the policies from the defunct business to a trust, of which David was both the trustee and a beneficiary, along with his two other siblings, for $110,000 despite evidence that the policies were cashed in for $750,000 after the sale.

The district court’s decision focused solely on fair equivalence and undertook a financial valuation of the policies, ultimately agreeing with David’s position that the policies’ value was $110,000 based on overdue premium payments, negative surrender values, and the fact that the policies were in danger of lapsing and becoming worthless; the policies were also subject to a neutral evaluation from John Hancock based on an IRS-approved formula.

Although the court examined the financial considerations in great detail—and per the “fair equivalent” reference definition—no mention of good faith can be found in the opinion.

In reversing the district court, Judge A. Marvin Quattlebaum, writing for the Fourth Circuit, reversed Judge Titus because there was a genuine factual dispute “concerning the fairness of the consideration” paid for the policies; yet, instead of assessing whether the insolvent business sold the policies for a (1) fair equivalent and (2) in good faith—as the statute requires—the panel held that the trial court had “improperly weighed the evidence” in the defendant’s favor at the summary judgment stage. Indeed, Judge Quattlebaum’s opinion offers no mention of good faith of Maryland’s UFCA (to be fair, he’s not the first to omit it, nor likely the last).

Being on both sides of a transaction is usually a red flag for good faith. See Matter of Bernasconi v. Aeon, LLC, 963 N.Y.S.2d 437 (N.Y. App. Div. 3d Dep’t 2013) (“[W]here . . . a corporate insider participates in both sides of the transfer and the insider controls the transferee, the transfer will be deemed to have been made in bad faith if made to a creditor’s detriment . . . .”) But not here.

Although New York has a robust body of law evaluating good faith and arguably would have denied summary judgment had this case been decided under New York law, the failure of the Buckingham courts to undertake even a minimal good-faith examination of the sale to the trust—and ignore that those voting for the policy would receive the benefits—all raise significant and legitimate doubts as to whether courts are properly interpreting Maryland’s “fair consideration” definition in the UFCA. Although Judge Titus acknowledged Maryland’s deficiency in noting that that there is no dispositive authority as to how to determine fair consideration under specific circumstances, under his and the Fourth Circuit’s interpretation, the “and in good faith” clause may as well have been removed from the “fair consideration” definition found at Md. Code § 15-204. United Bank v. Buckingham, 301 F. Supp. 3d 561 (D. Md. 2018).

Until Maryland’s UFCA “fair consideration” definition is fully interpreted—with at least an acknowledgment to the good-faith clause—creditors may well be advised to seek a nexus to New York law, or a similarly favorable jurisdiction, if they hope to truly enforce their rights.

Since common law, stockholders have enjoyed a qualified right to inspect the corporation’s “books and records” for any “proper purpose”—i.e., a purpose reasonably related to the stockholder’s interests as a stockholder. Codified in state corporation statutes such as section 220 of the Delaware General Corporations Law (DCGL), these stockholder inspection rights were exercised infrequently until the Delaware courts began to encourage stockholders to utilize these “tools at hand” to obtain information necessary to plead demand excusal in derivative actions. As the Delaware Supreme Court noted in the seminal decision of Rales v. Blasband: “Surprisingly, little use has been made of section 220 as an information-gathering tool in the derivative context.” 634 A.2d 927, 935 n.10 (Del. 1993). Over the last 20 years, “Delaware courts have encouraged stockholders to use the ‘tools at hand’ (e.g., Section 220) to gather information before filing complaints that will be subject to heightened pleading standards.” Lavin v. West Corp., 2017 WL 6728702, at *9 (Del. Ch. Dec. 29, 2017). The significant increase in section 220 litigation over the last decade is a testament to the plaintiffs’ bar heeding the Delaware courts’ admonitions.

At the same time that section 220 books and records demands have become commonplace, rapid technological advances have driven the proliferation of the forms of media in which corporate information is kept, including, for instance, e-mails, text messages, and other electronic communications and records not traditionally viewed as a corporation’s “books and records.” The issue is only further complicated by the fact that officers’ and directors’ use of personal computers, smartphones, and personal e-mail accounts potentially renders communications beyond the direct control of the corporations whom the officers and directors serve. Until relatively recently, Delaware courts have been hesitant to compel the production of such “nontraditional” books and records in section 220 litigation, given that the extant jurisprudence dictates that a section 220 summary proceeding is far from coextensive in scope with Rule 34 discovery, and a stockholder is only entitled to those books and records deemed “necessary and essential” to achieving a proper purpose. Typically, board minutes, resolutions, and the like are deemed sufficient because the courts are mindful that a stockholder’s inspection rights must be balanced against the potential for burdensome and abusive “fishing expeditions” that mirror discovery requests in plenary corporate litigation. Nonetheless, as technological advances have expanded the range of media used to conduct business, the law has also evolved regarding access to e-mail, text messages, and other forms of communication as books and records of the corporation. Although still evolving, some general principles have emerged that generally guide when the Delaware courts will permit access to electronic communications in section 220 proceedings.

Who cares? Corporations and their officers and directors absolutely should. Section 220 demands have become virtually a necessary prerequisite to any stockholder derivative action, and the books and records that stockholders receive and use to draft their complaint can be outcome-determinative on a motion to dismiss. Whereas board minutes and more “formal” corporate records will allow little room for “creative interpretation” by the plaintiffs’ bar, the same cannot be said of e-mail communications where plans and decisions are informally deliberated in real time, perhaps satirically or within a context that may not be evident when portrayed with hindsight by counsel whose objective is to prove a breach of fiduciary duty. Although producing e-mails in a books and records case cannot always be avoided, there are steps corporations can take on a clear day to mitigate the risk.

The seminal decision granting access to e-mails is a 2013 nonpublished transcript ruling, Ind. Elec. Workers Pension Tr. Fund IBEW v. Wal–Mart Stores, Inc., 7779–CS, at 97–98 (Del. Ch. May 20, 2013) (Strine, C.), which ironically does not directly address the issue of whether e-mails are corporate records subject to section 220 inspection rights. In Wal-Mart, then-Chancellor Strine ordered the production of private communications between officers and directors concerning an alleged bribery scandal under investigation by the plaintiff. In the process, the issue arose as to whether e-mails and electronic documents created or maintained on personal devices were the appropriate subject of a section 220 demand. The court drew no distinctions between e-mails and documents created by employees upon their personal devices verses those generated within the company’s official systems, concluding that where the documents were created or maintained was not controlling: “In terms of this issue of the home devices . . . if you use your home computer to handle Wal-Mart information, I don’t think that many companies would believe that . . . that makes it their personal information.” Given that the e-mails were deemed corporate records necessary for the plaintiff to conduct its investigation, they were to be produced irrespective of where they were physically created or maintained. Although the unpublished Wal-Mart decision did not directly address when the production of e-mails is appropriate in a section 220 action, its affirmance on appeal was routinely cited by the plaintiffs’ bar for that principle.

The issue arose again in Chammas v. Navlink, Inc., 2016 WL 767714 (Del.Ch. 2016), a case involving a director’s demand for books and records pursuant to the more expansive rights that directors have as compared to stockholders. In Chammas, the director plaintiff sought to “investigate whether ‘the other members of the Board and management are excluding them from board business and related communications,’ including emails prior to Board meetings and alleged Secret Meetings.” Consistent with Wal-Mart, Vice Chancellor Noble first observed that whether a document or communication is stored on the company’s servers is “not necessarily determinative of whether it constitutes a book or record of the company.” More important, the court concluded, is whether the book or record must be “in the possession or control of the corporation.” Second, recognizing the importance of burden considerations in the section 220 context, the court disclaimed that although its “holding is not to be interpreted as a blanket prohibition against inspection of private communications among directors, subjecting Section 220 proceedings to such broad requests, even by directors, runs contrary to the ‘summary nature of a Section 220 proceeding.’” Finally, the court observed that the books and records of the company are “those that affect the corporation’s rights, duties, and obligations . . . .” The court’s ultimate rejection of the demand for e-mails turned on the insufficiency of the plaintiff’s evidence of wrongdoing to warrant their production: “Mere suspicions of pre-meeting collusion among board members or board members and management, in the context of a Section 220 action, is insufficient to compel the production of private communications between such officers and directors . . . .”

The same year Chammas was decided, Vice Chancellor Laster analyzed whether e-mails may be within the scope of books and records obtainable pursuant to section 220. In Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752 (Del. Ch. 2016), a stockholder sought to investigate the hiring of Yahoo’s chief operating officer, and in that connection sought e-mails from the company’s CEO. The court began its analysis by categorically rejecting the argument that e-mails are per se beyond section 220’s scope. Vice Chancellor Laster observed the evolution of corporate record-keeping and the modern reality that virtually all books and records are now kept electronically: “Limiting ‘books and records’ to physical documents ‘could cause Section 220 to become obsolete or ineffective.’” The court then relied upon Wal-Mart to reject the argument that the company’s search for documents would be limited to the company’s devices, as opposed to a custodian’s personal device, holding that “a corporate record retains its character regardless of the medium used to create it.” As for the test to determine whether e-mails must be produced, the court limited itself to a single consideration: “As with other categories of documents subject to production under Section 220, what matters is whether the record is essential and sufficient to satisfy the stockholder’s proper purpose, not its source.”

A few years later in Schnatter v. Papa John’s International, Inc., 2019 WL 194634 (Del. Ch. 2019), Chancellor Bouchard addressed the test suggested in Chammas as to whether e-mails (or any documents) are deemed books and records of the company—i.e., whether they are “those that affect the corporation’s rights, duties, and obligations . . . .” The defendant in Papa John’s resisted production of e-mails between directors discussing former director Schnatter, citing Chammas and claiming that “Schnatter is just curious about what his fellow fiduciaries were saying about him.” The court rejected the argument because the scope of documents ordered to be produced would be limited to those related to the plaintiff’s proper purpose, thus satisfying the standard. Commenting further, Chancellor Bouchard then effectively agreed with Vice Chancellor Laster’s reasoning for producing e-mails as articulated in Yahoo, albeit qualified by consideration of the additional costs inherent in producing electronic communications:

A further word is in order regarding emails and text messages from personal accounts and devices. The reality of today’s world is that people communicate in many more ways than ever before, aided by technological advances that are convenient and efficient to use. Although some methods of communication (e.g., text messages) present greater challenges for collection and review than others, and thus may impose more expense on the company to produce, the utility of Section 220 as a means of investigating mismanagement would be undermined if the court categorically were to rule out the need to produce communications in these formats.

Citing then-Chancellor Strine’s decision in Wal-mart, the court held that “if the custodians identified here . . . used personal accounts and devices to communicate about changing the Company’s relationship with Schnatter, they should expect to provide that information to the Company.” Expressly disclaiming the promulgation of any bright-line rule, Chancellor Bouchard grounded the analysis in “balanc[ing] the need for the information sought against the burdens of production and the availability of the information from other sources, as the statute contemplates.”

If there were any question about whether e-mails are properly within the scope of section 220 demands, the Delaware Supreme Court resolved it in KT4 Partners LLC v. Palantir Technologies Inc., 203 A.2d 738 (Del. 2018). In Palantir, after a potential sale of the company fell through because Palantir allegedly thwarted the deal and KT$ sought information pursuant to its far-reaching rights under an “Investors Rights Agreement,” Palantir allegedly amended the agreement to curtail KT4’s rights. KT4 made a demand to inspect Palantir’s books and records under section 220 of the DGCL for the purpose of investigating “fraud, mismanagement, abuse and breach of fiduciary duty.” Palantir rejected the demand, and KT4 commenced a section 220 action in the Delaware Court of Chancery. Following trial, Vice Chancellor Slights held that KT4 had shown a proper purpose of investigating potential wrongdoing in multiple areas, including Palantir’s amendment of the Investors’ Rights Agreement in ways that “eviscerated” KT4’s contractual information rights after KT4 sought to exercise those rights. The court specifically held that KT4 was entitled to “all books and records relating to” the amendments to the Investors’ Rights Agreement. After the parties were unable to agree on whether the books and records to be produced were to include e-mails, the court issued a final order that excluded e-mails from the documents that Palantir would be required to produce. The court reasoned in part that e-mails were not essential to fulfill KT4’s stated investigative purpose, based on the (mistaken) understanding that Palantir possessed and would produce formal board-level documents relating to the amendments of the Investors’ Rights Agreement, rendering a further production of e-mail unnecessary for KT4’s purpose. 

KT4 appealed the Court of Chancery’s ruling. Importantly, on appeal, Palantir conceded that other than the amendments to the Investors’ Rights Agreement themselves, responsive nonemail documents did not exist, and that e-mails related to the amendments did exist. The Delaware Supreme Court held that the e-mails plaintiff sought were necessary and essential to investigating the alleged wrongdoing because the defendant admitted other, more traditional forms of books and records did not exist. Insofar as being required to produce e-mails was concerned, the Supreme Court viewed Palantir’s obligation as a self-inflicted wound. As the Supreme Court made clear, “if a company observes traditional formalities, such as documenting its actions through board minutes, resolutions and official letters, it will likely be able to satisfy a Section 220 petitioner’s needs solely by producing those books and records.” The court conversely cautioned that “if a respondent in a § 220 action conducts formal corporate business without documenting its actions in minutes and board resolutions or other formal means, but maintains its records of the key communications only in emails, the respondent has no one to blame but itself for making the production of those emails necessary.” 

* * *

The foregoing cases illustrate several principles inherent in any analysis of whether electronic communications will be ordered produced in section 220 litigation. First, electronic communications are deemed corporate records that may be ordered in section 220 proceedings, but only to the extent that they are “necessary and essential” to the plaintiff’s investigation. Second, whether or not the electronic communications reside on the corporation’s servers or personal devices, if they are necessary and essential to the plaintiff’s investigation, they may subject to an order compelling production. Third, although e-mails may be ordered to be produced in section 220 litigation, the cost and burden of such a production will weigh considerably in the court’s final determination. And finally, Palantir serves as an admonition to corporate boards and their counsel to be mindful to observe corporate formalities and appropriately document board meetings and actions through minutes, resolutions, and other official materials, and avoid conducting “formal corporate business . . . through informal electronic communications.” Absent proper recordkeeping and formal documentation of the board’s decisions, there is risk that a corporate respondent in a section 220 action may be ordered to produce e-mails as “necessary and essential” to satisfying a stockholder’s books and records demand.

Mr. Blanchard is a partner at Morgan, Lewis & Bockius LLP. He represents clients in all facets of shareholder litigation, class actions, securities enforcement matters, investigations, and business disputes. The views expressed by the author are his alone and are not the views of Morgan Lewis or the firms’ clients. This article is for information purposes only and does not constitute legal advice.

The following is excerpted from Chapter 16 of Law of Artificial Intelligence and Smart Machines: Understanding A.I. and the Legal Impact.

Robots, and autonomous vehicles (AVs) in particular, act in the physical world.  Accidents involving these systems are inevitable.  Some of these accidents will cause catastrophic injury for those involved in the accident.  Even worse, if a defect or cyber attack could compromise every instance of a particular robot or an entire network, fleet, or industry, the defect or attack could cause widespread simultaneous accidents throughout the country or even the world.  Imagine, for instance, a future in which regional transportation centers in metropolitan centers control the dispatch and navigation of AVs in the region.  Imagine further that a sudden defect causes all the AVs under control of the system to crash all at once in a major metropolitan area like New York.  The impact of such an event in terms of harm, property damage, injury, and deaths could easily exceed an event like the attacks on September 11, 2001.

In 2012, I had the opportunity to speak at the Driverless Car Summit presented by the Association of Unmanned Vehicle Systems International.  The conference organizers polled the audience which, although admittedly unscientific, did provide a data point about industry views on product liability.  One polling question asked attendees to identify the chief obstacle to the deployment of AVs, and the top answer was “legal issues.”  The proceedings of the conference identified this issue as well.[1]  Although the poll did not break down the issues among compliance and liability, I suspect that liability is the larger perceived issue.  Indeed, some people have identified product liability suits are an existential threat to autonomous driving.[2]

In the worst-case scenario for the industry, manufacturers could face numerous suits that force some of them to exit the robotics market and cause others to decide not to enter the market in the first place.  They could perceive that the sales are not worth the risk.  Such an outcome could be tragic if it results in manufacturers not bringing otherwise life-saving and socially beneficial robots to the market.  Manufacturers, however, can implement practices to minimize the likelihood, frequency, and magnitude of accidents, and thereby control the risk of liability.  By implementing these practices, manufacturers can maintain the profitability they would need to offer robots in the market.

Managing the Risk of Robot Product Liability

Given the large human and financial consequences of defective products, manufacturers seek to manage the risk of product liability litigation and costly recalls.  What can a robot, AV, or AI system manufacturer do to reduce the likelihood of company-ending product liability litigation?  Most importantly, if manufacturers can proactively prevent defects and resulting accidents from occurring in the first place, they can prevent the need to defend product liability claims.  Planning for improved safety can enable manufacturers to make safer products that are less likely to cause accidents and trigger product suits.

Of course, accidents may occur anyway and with any widely-deployed robot, AV, or AI system, a manufacturer can foresee that accidents are inevitable.  Nonetheless, a proactive approach to risk management would permit a manufacturer to put itself in the best position possible to prevail in product liability cases based on the inevitable accidents.  A proactive approach to design safety means that the manufacturer takes the steps today to implement a commitment to safety, which will minimize its risk from future suits.  History shows that juror anger fuels outsize verdicts.  If a proactive manufacturer takes the concrete and effective steps to implement a commitment to safety, it will be able to tell a future jury why its products were safe and how it truly cared about safety.  Such actions will place the manufacturer in the best possible light when, despite all these safety measures, an accident does occur.

Making the commitment to safety upfront is crucial.  As one commentator stated, “The most effective way for [counsel for] a corporate defendant to reduce anger toward his or her client is to show all the ways that the client went beyond what was required by the law
or industry practice.”[3]  Going beyond minimum standards is important because, first, juries may look at minimum standards skeptically, thinking that the industry set the bar too low.  Moreover, juries expect that manufacturers know more about their product than any ordinary “reasonable person,” which is the standard for judging a defendant in a negligence action.  Juries expect more from manufacturers.  “A successful defense can also be supported by walking jurors through the relevant manufacturing or decision-making process, showing all of the testing, checking, and follow-up actions that were included.  Jurors who have no familiarity with complex business processes are often impressed with all of the thought that went into the process and all of the precautions that were taken.”[4]  The most important thing to a jury is that the manufacturer tried hard to do the right thing.[5]  Accordingly, a manufacturer that goes above and beyond minimum industry standards is in the best position to minimize the likelihood of juror anger and minimize possible product liability risk.

Any proactive approach to product safety should begin with a thorough risk analysis.  A risk analysis would look at the types of problems that could arise with a product, how likely these problems could occur, and the likely frequency and impact of these problems.  After completing this analysis, a manufacturer can analyze its robot or AI product design in light of the risks.  It can change design and engineering practices to address potential issues and prioritize risk mitigation measures based on what it sees as the most significant risks.  In implementing this risk management process, a manufacturer may obtain guidance from a number of standards relevant to robots and AI systems.  In the field of AVs, examples include:

• ISO 31000 “Risk management – Guidelines” (regarding the risk management process).
• Software development guidelines from the Motor Industry Software Reliability Association.
• IEC 61508 Functional safety of electrical/electronic/programmable electronic safety-related systems (safety standard for electronic systems and software).
• ISO 26262 family of “Functional Safety” standards implementing IEC 61508 for the functional safety of electronic systems and software for autos.

Adherence to international standards may not insulate a manufacturer from liability, whether in front of a jury or as a matter of law.  Nonetheless, following international standards increases the credibility of a manufacturer’s risk management program.  Also, following standards helps a manufacturer create a framework of controls for its risk management process.  Such a framework would make implementation and assessment easier.  Therefore, organizing a risk management program based on the methods specified in international standards provides an important basis for defending later product liability litigation.

In addition to adhering to international standards, insurance will play an important role in managing robot and AI product liability risk.  Insurance functions to shift product liability risk to insurance carriers.  In exchange for paying a premium, a manufacturer’s insurance carriers will defend and indemnify manufacturers for losses and pay for settlements or judgments to resolve third party claims.  The insurance industry is in the early stages of understanding robot and AI risk and creating coverage that effectively manages risk.[6]  As businesses and consumers deploy robots and AI systems more broadly, insurers will create insurance programs for third party accident and liability risks.  Some of those risks may include privacy and security breaches.  One barrier to effective insurance programs is the lack of loss experience data to assist in the underwriting process.  To start writing policies for given robots or AI systems, however, insurance carriers are likely to look at analogous conventional products.[7]  In the short run, manufacturers may need to tailor-make insurance coverage with bespoke policies that fit their risk profiles.  Over time, carriers will enter the market and create standard policies, reducing premium costs over the longer run.

Beyond the most immediate internal safe design steps and insurance programs, manufacturers of a given type of robot or AI system may be able to act jointly to mitigate risk to the entire industry sector (subject to possible antitrust issues involving joint action).  For instance, they may work on safety and information security standards to promote safe practices within the industry sector.  Trade groups and purchasing consortia can help manufacturers promote the safety among component manufacturers.  Finally, an industry sector may want to create and maintain information sharing groups to develop and promote safety practices among industry participants.

During the design process, effective records and information management (RIM) will help a manufacturer document and evidence its commitment to safety.  Documents generated contemporaneously with the design process can memorialize a manufacturer’s safety program and the steps it takes to fulfill its commitment to safety.  In any product liability suit, a witness could certainly testify about the manufacturer’s safety program.  Nonetheless, without corroborating contemporaneously recorded documentation, there is a risk that the jury would find any such testimony to be self-serving and thus disbelieve it.  In this vein, wholesale destruction of all design documents of a certain age may be as bad as retaining too many documents.  Archiving the right documents in preparation of future litigation will help the business defend itself in the future.  Effective RIM may win cases, while poor RIM may lose cases.

Finally, some pre-litigation strategies may further reduce product liability risks.  For example, manufacturers can work with jury consultants to advise the manufacturer in the defense of a product liability case.  They can focus on ways the manufacturer can place its safety program in the best light to avoid impressions that would anger a jury.  Moreover, a manufacturer may want to create a network of defense experts familiar with their robotics or AI technologies.  These experts can help educate jurors about various engineering, information technology, and safety considerations.  Further, attorneys representing AI and robotics manufacturers may work within existing bar groups or form new ones to share specialized knowledge, sample briefs, case developments, and other information helpful to the defense of product liability cases.

[1] E.g., Autonomous Solutions Inc., 5 Key Takeaways From AUVSI’s Driverless Car Summit 2012 (Jul. 12, 2012) (“Some of the largest obstacles to autonomous consumer vehicles are the legalities.”).  Reports from Lloyd’s of London and the University of Texas listed product liability as among the top obstacles for AVs.  Lloyd’s, Autonomous Vehicles Handing Over Control:  Opportunities and Risks for Insurance 8 (2014) [hereinafter, “Lloyd’s Paper”]; University of Texas, Autonomous Vehicles in Texas 5 (2014).

[2] See, e.g., Tim Worstall, When Should Your Driverless Car From Google Be Allowed To Kill You?, Forbes, Jun. 18, 2014 (“the worst outcome would be that said liability isn’t sorted out so that we never do get the mass manufacturing and adoption of driverless cars”), http://www.forbes.com/sites/timworstall/2014/06/18/when-should-your-driverless-car-from-google-be-allowed-to-kill-you/.

[3] Robert D. Minick & Dorothy K. Kagehiro, Understanding Juror Emotions:  Anger Management in the Courtroom, For the Defense, July 2004, at 2 (emphasis added), http://www.krollontrack.com/publications/tg_forthedefense_robertminick-dorothyhagehiro070104.pdf.

[4] Id.

[5] See id.

[6] See generally Lloyd’s Paper, supra note 1.

[7] Cf. David Beyer et al., Risk Product Liability Trends, Triggers, and Insurance in Commercial Aerial Robots 20 (Apr. 5, 2014) (describing the development of insurance coverage for drones), available at http://robots.law.miami.edu/2014/wp-content/uploads/2013/06/Beyer-Dulo-Townsley-and-Wu_Unmanned-Systems-Liability-and-Insurance-Trends_WE-ROBOT-2014-Conference.pdf.