This article is Part II of the Musings on Contracts series by Glenn D. West, which explores the unique contract law issues the author has been contemplating, some focused on the specifics of M&A practice, and some just random.
In a Delaware Court of Chancery decision earlier this year, Labyrinth, Inc. v. Urich,[1] Vice Chancellor Zurn likened the not-uncommon busted cross-reference in a stock purchase agreement (“SPA”) to the misunderstood orders that led to the disastrous Charge of the Light Brigade during the Crimean War in 1854.
Lord Raglan’s order was to “advance rapidly to the front—follow the enemy and try to prevent the enemy carrying away the guns.”[2] But which front and what guns? From Lord Raglan’s vantage point high on the cliffs above the battle, his orders were perfectly clear. He could see the “captured guns” that he wanted recaptured being carried away by the enemy nearby. However, from the vantage point of the recipient of the orders, Lord Lucan, the only guns that he could see were at the end of the long valley in a fortified position. And, thus, “[i]nto the valley of Death [r]ode the six hundred.”[3]
According to Vice Chancellor Zurn, the SPA in dispute in Labyrinth was “rife with blunders and omissions.”[4] Using as a cautionary tale the bad decision made by Lord Lucan in hastily interpreting an ambiguous order, Vice Chancellor Zurn refused to choose between “two reasonable interpretations . . . [and] just charge on.”[5] Instead of resolving the matter on a motion to dismiss, the matter must now be resolved through an expensive trial, with a full “factual inquiry to determine the parties’ intent.”[6]
And what were these “blunders and omissions”? Well, there were really only two significant ones, and they both involved “contractual signals to nonexistent provisions”[7]—that is, busted cross-references.
The Busted Cross-References in Labyrinth
The first busted cross-reference involved the signature block for an individual party to the agreement. In that signature block, there was a reference to “Section 7.5” as being one of only two sections of the SPA to which the signatory was agreeing to be bound. The problem was that there was no Section 7.5 in the agreement. There was a Section 6.7.5, which seemed pretty clearly to be the section that the agreement intended to reference. However, Vice Chancellor Zurn concluded:
Perhaps the parties meant Section 7.5 to be Section 6.7.5; perhaps the parties intended something entirely different. The ambiguity, while perhaps so minor as to be a typo, requires a greater factual inquiry to determine the parties’ intent. It is here that I refrain from charging “forward” with the “Light Brigade.”[8]
The second busted cross-reference was even more problematic.
The exclusive remedy provision (Section 8.9) read as follows:
Subject to Section 10.12, the parties acknowledge and agree that their sole and exclusive remedy with respect to any and all claims for any breach of any representation, warranty, covenant, agreement or obligation set forth herein or otherwise relating to the subject matter of this Agreement, shall be pursuant to the indemnification provisions set forth in this Section 8. In furtherance of the foregoing, except with respect to Section 10.12, each party hereby waives, to the fullest extent permitted under Law, any and all rights, claims and causes of action for any breach of any representation, warranty, covenant, agreement or obligation set forth herein or otherwise relating to the subject matter of this Agreement it may have against the other parties hereto and their Affiliates and each of their respective Representatives arising under or based upon any Law, except pursuant to the indemnification provisions set forth in this Section 8. Nothing in this Section 8.9 shall limit any Person’s right to seek and obtain any equitable relief to which any Person shall be entitled pursuant to Section 10.12.[9]
The plaintiffs were seeking injunctive relief to prevent violations of certain of the post-closing covenants set forth in the SPA. Once again, however, the provision referred to a section that did not exist—there was no Section 10.12. Instead, there was a Section 9.12, which provided as follows:
Each of the parties acknowledges and agrees that the other parties would be damaged irreparably in the event that any of the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached or violated. Accordingly, each of the parties covenants and agrees that, without posting bond or similar undertaking, each of the other parties shall be entitled to an injunction or injunctions to prevent breaches or violations of the provisions of this Agreement and to the remedy of specific performance of this Agreement and the terms and provisions hereof in any action, suit or proceeding instituted in any court as specified in Section 9.8 having jurisdiction over the parties and the subject matter, in addition to any other remedy to which such party may be entitled, at law or in equity. Each party further covenants and agrees that, in the event of any action, suit or proceeding for specific performance in respect of such breach or violation, it shall not assert that a remedy at law would be adequate.[10]
So, again, Vice Chancellor Zurn was faced with a busted cross-reference. While she thought it likely that the reference to Section 10.12 was intended to be a reference to Section 9.12, and that the blunder had probably resulted from a section of the agreement being deleted at some point, she could not conclude so at the motion to dismiss stage: “I will not yet say the SPA precludes injunctive relief, but without greater factual confidence, neither will I say the SPA permits it.”[11]
Say What You Mean and Mean What You Say
Obviously, more care should have been taken in checking these cross-references before finalizing the SPA. But here are a few tricks that could have helped (other than using Word’s auto cross-reference feature, which may or may not always be reliable). First, if you ever need to delete a section, just delete the text of the section (not the section number itself) and replace the deleted text with “[intentionally deleted]”—then nothing like the 10.12 becoming 9.12 could happen. Second, I always bolded or underlined cross-references; it makes them easier to spot when you are proofing. And last, I always included parenthetical section titles with my cross-references. Thus, even if I left off the “6” in 6.7.5, if the section title was “Noncompetition Agreement,” it would probably be easy enough for the court to see the obvious intent if the reference to Section 7.5 was stated as “Section 7.5 (Noncompetition Agreement).”
Some may think this is all hyper-technical silliness. But such is the life you have chosen. The objective theory of contracts requires that courts determine what parties intended by their contracts from the words used in them. Courts assume that what you meant by your contract is what the contract actually says. So, make sure that your contract actually says what you mean. Words matter, and cross-references matter.
From large language models like ChatGPT to image generation tools like DALL-E, artificial intelligence (“AI”) has undeniably become part of the public consciousness—providing utility, amusement, and commercial opportunities for individuals and companies alike. Amid their popularity for creating text based on user prompts in fun and novel ways, AI chatbots have also proven useful as quasi search engines—scraping and synthesizing vast quantities of data to respond to a variety of inquiries and requests in a clear and concise manner.
This functionality blurs the line between traditional search engines, such as Google or Yahoo, which typically provide links to websites, and content creators—raising questions about the nature of information retrieval and synthesis. Such a shift in functionality has elicited scrutiny about whether these tools might be considered “information content providers” under section 230 of the Communications Decency Act (“Section 230”),[1] the federal law that (in relevant part) governs the moderation of online content by interactive computer service providers and immunizes them from most lawsuits based on third-party content. As a result of this evolution, providers of AI technology, particularly AI search engines, may find themselves potentially exposed to greater liability than their Internet-age predecessors.
The Emergence of a New Type of Generative AI
Technology companies and users alike are increasingly recognizing and embracing generative AI’s capabilities in the search space. Google quickly capitalized on its search engine prowess and unveiled an “AI Overviews” feature, which now sits atop many Google search queries.[2] And just recently, OpenAI opened its “SearchGPT” for closed beta testing, launching it as “a temporary prototype of new AI search features that give you fast and timely answers with clear and relevant sources.”[3]
By way of illustration, when a user types a prompt into Google such as “what is the role of a lawyer?” a traditional search would simply generate a list of links to informative third-party websites with relevant information. Today, Google AI Overviews will generate a narrative answer above that list; in one search of the example prompt by the authors, it explained, “Lawyers, also known as attorneys, counselors, or counsel, are licensed professionals who advise and represent clients in legal matters. Their role is to provide legal counsel and advocacy for individuals, businesses, and government organizations.” An accompanying quasi-footnote link points readers to its source material (in this example, the ABA website[4]).
Under the hood, both Google’s AI Overviews and OpenAI’s SearchGPT operate on similar principles: They use large language models to process and synthesize information from web searches they perform. These models are already trained on diverse Internet content, including not only reputable sources but also user-generated content and potentially unreliable information. When a query is received, the AI rapidly scans its knowledge base and retrieves relevant, up-to-date information from the Internet or relevant index of consistently updated Internet data. The AI then identifies the most relevant details and generates a response using its language model, which predicts the most probable text based on the query and all information available to it at the moment of execution. Oftentimes, the same prompt will result in a different response, which is generally true of generative AIs due to their use of stochastic optimization algorithms. These algorithms incorporate controlled randomness into the process of generating answers for problems that rely on probabilities.
However, this process is not infallible. AI models can sometimes conflate facts from different sources, misinterpret context, place too much weight on a particular source to the detriment of others, or fail to distinguish between reliable and unreliable information. These possibilities in the context of search engine functionality can lead to the propagation of misinformation, ranging from harmless misconceptions to potentially dangerous advice, all presented with the same air of authority as accurate information. Examples have cropped up since AI Overviews was unveiled by Google in July that have subsequently caused the feature’s incorporation to be partially rolled back by the company.[5] For example, after a user complained that their car’s blinker wasn’t making an indicator noise, AI Overviews suggested the user change their blinker fluid. The problem with this advice? Blinker fluid doesn’t exist and is an inside joke among car connoisseurs.[6] Further, these systems may occasionally “hallucinate”—generating plausible-sounding but entirely fabricated information—especially when dealing with queries outside their training data or when attempting to bridge gaps in their knowledge.
But the potential for harm goes further than bad advice about car maintenance. Generative AI search engines also risk the proliferation of defamatory content by responding to a user’s query with misleading or blatantly false characterizations of real people. By way of illustration, one anecdote reported that in response to a query about cheating in chess, Google’s AI Overviews produced a response stating that chess grandmaster Hans Niemann had admitted to cheating by using an engine or chess-playing AI when playing against the world’s top chess player, Magnus Carlsen.[7] The problem? Niemann hadn’t admitted to cheating against Carlsen, and in fact had vociferously denied any wrongdoing, including filing a $100 million lawsuit against those who had accused him of cheating.[8] The misleading response from Google AI Overviews was likely paraphrased from statements made by Niemann about prior online games when he was much younger. But given the predictive mechanics of Google Overviews’s AI, that context was absent from the response.
When an AI search engine promulgates inaccurate, misleading, or tortious content, who should be liable for the fallout? Google’s AI Overviews and OpenAI’s SearchGPT present unique challenges to the traditional understanding of online platforms’ roles and responsibilities. These search-integrated AI tools operate on a spectrum between traditional search engines and creative content producers. Unlike standard AI chatbots, which primarily generate responses based on preloaded training data, or traditional search engines that merely display preexisting information, these tools actively retrieve, synthesize, and produce content using information from the Internet in real time. This real-time integration of web content allows these AI search tools to create new, synthesized content from multiple sources.
As a result, these tools are increasingly taking on the role of a content creator rather than a neutral platform. This shift may have implications for the platforms’ legal liability, as it poses the question: Are providers of these AI services akin to a publisher, acting as a neutral conduit for information, or are they more analogous to an author, exercising discretion, albeit algorithmically, to generate unique content? As we explore Section 230 of the Communications Decency Act and its implications, this distinction will be crucial in understanding the potential legal challenges these new AI tools may face, and the consequences for consumers harmed by their content.
Background on Section 230
Section 230 was enacted at the beginning of the Internet’s social media era to encourage innovation by protecting interactive computer service providers from liability stemming from tortious content posted by third parties on their platforms. Under Section 230, the provider will be liable only if it “contribute[s] materially” to the alleged unlawfulness published on the platform.[9] Section 230’s protections apply specifically when the provider “merely provides third parties with neutral tools to create web content.”[10]
These standards have been applied to protect interactive computer service providers from liability for the publication of tortious content on their platforms. For example, in Blumenthal v. Drudge, the District Court for the District of Columbia dismissed the plaintiff’s defamation claim against AOL for its publication of an allegedly defamatory Internet article written by codefendant Matt Drudge.[11] The Court concluded that AOL’s role in disseminating the article (providing the Internet service platform upon which the article was published) fell under Section 230’s protective umbrella. The Court explained that, in enacting the statute, Congress “opted not to hold interactive computer services liable for their failure to edit, withhold or restrict access to offensive material disseminated through their medium.”[12] Because AOL had not authored the article, but instead only served as an intermediary for the allegedly injurious message, the Court concluded that the Internet service provider was immune under Section 230.
Neutral Intermediary or Content Contributor: Where Will Generative AI Land?
Against this backdrop, it becomes evident that generative AI search engines do not fit squarely within the existing legal framework, as they potentially occupy the roles of Internet platform and content creator simultaneously. On the one hand, a service like Google AI Overviews isn’t authoring articles in the traditional sense. But on the other hand, Google AI Overviews does more than merely provide a medium through which information can be funneled. How courts view that activity will be critical for whether generative AI search engines fit within the limitations of Section 230 immunity.
The case of Fair Housing Council of San Fernando Valley v. Roommates.com, LLC, illustrates how courts have assessed the “contributor” versus “neutral tool” dichotomy for Section 230 immunity purposes. In that case, the Court held that the website operated by the defendant had not acted as a neutral tool when the website did not “merely provide a framework that could be utilized for proper or improper purposes” but instead was directly involved in “developing the discriminatory [content].”[13] Specifically, the defendant “designed its [website’s] search and email systems to limit [roommate] listings available to subscribers based on sex, sexual orientation and presence of children,” and “selected the criteria used to hide listings.”[14] The Court reasoned that “a website operator who edits in a manner that contributes to the alleged illegality . . . is directly involved in the alleged illegality and thus not immune” under Section 230.[15]
By contrast, in O’Kroley v. Fastcase, Inc., the Sixth Circuit Court of Appeals held that Section 230 barred a defamation lawsuit against Google’s presentation of its search results.[16] In that case, the plaintiff argued that based upon the manner in which its search results were displayed, “Google did more than merely display third-party content” and was instead “responsible” for the “creation or development” of the content.[17] The Court disagreed, noting that although Google “performed some automated editorial acts on the content, such as removing spaces and altering font,” its alterations did not “materially contribute” to the allegedly harmful content given that “Google did not add” anything to the displayed text.[18]
Here, the functionality of Google AI Overviews functionality is arguably more akin to the Roommates platform than Google’s display of search results in O’Kroley. AI Overviews collects and curates preexisting information authored by other sources, synthesizing it to form a narrative response that is (in theory) directly responsive to the user’s query. In this regard, Google AI Overviews is analogous to an academic researcher reporting on preexisting literature in a review article. While the individual studies cited aren’t the researcher’s original work, the synthesis, analysis, and presentation of that information constitute a valuable and original contribution in the form of an academic survey. Similarly, AI Overviews’s curation and synthesis of information, while based on existing sources, results in a unique product that reflects its own algorithmically “analytical” process.
Because of the way generative AI works, even when there are independent sources of information being used to generate Google AI Overviews’s narrative answer, the response is promulgated by Google, rather than the independent sources themselves. While one might argue that AI Overviews is deciding which third-party content to include or exclude—similar to traditional search engines—AI Overviews’s role goes beyond that of an editor. In other words, Google isn’t merely a conduit for other sources of information or simply filtering which content to display; Google is serving as the speaker—essentially paraphrasing the information provided by the independent sources and sometimes doing so imperfectly. Simply put, Google’s editorial role is more substantive than merely changing the font or adding ellipses.
The following example illustrates Google AI Overviews’s editorial functionality, and how it can take seemingly innocuous content on the Internet and edit it to convey a message that could pose harm to the public. In May, Google AI Overviews went viral for suggesting its users ingest one serving of rock per day since, according to AI Overviews, rocks are “a vital source of minerals and vitamins that are important for digestive health”: “Dr. Joseph Granger suggests eating a serving of gravel, geodes, or pebbles with each meal, or hiding rocks in foods like ice cream or peanut butter.”[19] Google’s cited source was ResFrac Corporation, a hydraulic fracturing simulation software company, which had reposted[20] an article by The Onion,[21] a well-known satirical news organization that publishes fictional, humorous articles parodying current events and societal issues. Pictured in the Onion article was an advisor to ResFrac, explained ResFrac in its repost.
Authors’ reproduction of a Google AI Overviews response about eating geodes.
But much was left out by Google AI Overviews, including the important contextual clues that would tip a reader off to the satirical nature of the original content. For instance, the article states that sedimentary supplements “could range in size from a handful of dust to a medium-sized 5-pound cobblestone,” and that rocks should be hidden “inside different foods, like peanut butter or ice cream” to mask the texture. So, while the original content was lifted from the ResFrac post and properly cited, the meaning and intent were substantially altered in a way that goes beyond a neutral publisher’s alteration (e.g., changing font or adding punctuation). Google AI Overviews is unambiguously advocating for rock consumption—a position that, if adhered to, could undoubtedly cause real harm. If applied, Section 230’s umbrella of immunity would allow Google AI Overviews to escape liability for harm caused by its dissemination of this nonsensical position.
The Potential Repercussions of Section 230 Application to New AI Search Engines
Under traditional Section 230 principles, the plaintiff may be barred from suing interactive computer service providers for tortious speech but nevertheless can seek to recover from the original creator of the harmful content. For example, in the Drudge case discussed above, the plaintiff was barred from suing AOL but was permitted to continue the case against the original author of the defamatory article. Articulating this principle, the Fourth Circuit has opined that Section 230 immunity does not mean “that the original culpable party who posts [tortious content] would escape accountability.”[22]
But no such parallel accountability exists in the generative AI search engine context. Simply put, there may not be an “original creator” to take the blame for the publication of harmful content. Consider the example of AI Overviews recommending eating rocks discussed above. The Onion’s original article was published as, and intended to be, purely satirical. Indeed, when ResFrac reposted the article, there was no indication that it was intended to be taken literally or was being provided as medical advice. Neither The Onion nor ResFrac was negligent or reckless in publishing the article, and the article’s language only became potentially harmful when reframed and relied upon, without proper context, by Google AI Overviews. In other words, the “original creator” would not be the tortfeasor—AI Overviews would be. If applying Section 230 immunity, a plaintiff harmed by Google AI Overviews’s advocacy for rock consumption would be left without recourse.
Similarly, in the context of defamation, a plaintiff harmed by a libelous generative AI search engine result would be left without recourse. Generally, to bring a cause of action for defamation, the plaintiff must establish the following: (1) a false statement purporting to be fact; (2) publication or communication of that statement to a third person; (3) fault amounting to at least negligence; and (4) damages or some harm caused to the reputation of the person or entity who was the subject of the statement.[23] But how can a plaintiff allege negligence or an intent to defame when the original publications from which the defamatory search result were taken were not defamatory in the first place? In the chess player example discussed above, the available information online was only defamatory when it was taken out of context and mischaracterized by the generative AI search engine. Thus, the original speakers—i.e., the sources from which the search engine pulled its information—were neither negligent nor intentionally defamatory in publishing the content. As a result, a defamed plaintiff would be unable to establish the elements of their case against the “original speaker.”
These scenarios further highlight why generative AI search engines don’t fit neatly within the existing Section 230 framework, and the legal principles underlying the statutory framework.
A recent and tragic case out of the Third Circuit Court of Appeals illustrates the serious harm that algorithmically generated content can cause, and the way in which courts are attempting to grapple with the issue of accountability. In Anderson v. TikTok, Inc., at issue was the question of whether TikTok could rely on Section 230 immunity to dismiss a lawsuit brought by the estate of a child who accidentally died while performing a TikTok trend known as the “Blackout Challenge.”[24] Videos depicting the challenge were shown to the child via the TikTok “For You Page” or “FYP”—a feature of the app that relies on algorithmic curation to recommend a “tailored compilation of videos” to the user based on data about their interests and characteristics.[25] The plaintiff argued that TikTok should be held liable for recommending and promoting Blackout Challenge videos to minors’ FYP through its algorithm.[26]
The Third Circuit agreed with the plaintiff, concluding that TikTok’s algorithmic recommendations via the FYP constituted “expressive activity” not immunized under Section 230.[27] The Court explained that because the TikTok algorithm “‘[d]ecid[ed] on the third-party speech that [was] included in or excluded from a compilation—and then organiz[ed] and present[ed] the included items’ on users’ FYPs,” the recommendation was the “first-party speech” of TikTok.[28] Simply put, because TikTok’s algorithm curated an individualized FYP for each user, the platform served not merely as conduit for third-party information, but instead, created unique, expressive content.
Although the case did not involve a generative AI search engine like Google AI Overviews, the Third Circuit’s analysis is instructive as to the way in which courts may apply traditional Section 230 jurisprudence to algorithmically generated content. Indeed, the Third Circuit’s reasoning is easily extendable to the content generated by generative AI search engines that, like the FYP generated by TikTok, curate unique content in response to user activity.
Conclusion
Given its characteristics and capabilities, AI search engines such as Google AI Overviews should be categorized as “material contributors” rather than “neutral tools” under the Section 230 analytical framework. We reach this conclusion given that generative AI search engines actively synthesize information from multiple real-time sources, determine relevance and importance of such information, and generate new content that goes beyond mere aggregation and indifferent publication. Under such circumstances, the technology functions far more like an academic curating and paraphrasing her research findings than a neutral message board or conduit for information. This nuanced characterization may seem slight but could have meaningful implications for both developers of AI technology and those who may be harmed by it.
If the opposite conclusion is reached, and Section 230 immunity applies, those who are harmed by AI-generated search results would be left with little to no recourse. Unlike traditional Section 230 immunity, which leaves the door open for recovery from the original tortious speaker, the potential harm caused by AI search engine results can typically be traced back to only one source—the AI algorithm itself. It’s easy to imagine a world in which Google AI Overviews produces a search result that’s missing context or mischaracterizes the original content in a manner that is either negligent or defamatory. But with Section 230 immunity, AI companies would face no consequences for irresponsible development of their models and injured plaintiffs would have no “original speaker” to blame for their injuries. This lack of accountability could lead to proliferation of misinformation and harmful or defamatory content, as companies prioritize speed and efficiency over safety.
On the other hand, if generative AI search engines aren’t protected under Section 230, the AI ecosystem may become more restrained. It’s important to remember that the primary motivation behind the passage of Section 230 was to “preserve the vibrant and competitive free market that presently exists for the Internet”—i.e., to ensure that innovation would not be stifled by the fear of liability.[29] These principles are equally, if not more applicable, in the context of AI. AI companies might feel pressured to rein in their advancements to avoid content creator liability while the ongoing AI arms race incentivizes them to push those boundaries.
The tension between innovation and legal liability is exacerbated by the absence of comprehensive AI regulation clearly defining the contours and applicability of Section 230 immunity in the context of generative AI. This dearth of regulation may remain the status quo for the foreseeable future, as congressional attempts to regulate AI have largely fallen flat in recent years. There have been two notable, but unsuccessful, efforts to address the issue posed by generative AI with regard to Section 230 immunity. In March 2023, Senator Marco Rubio introduced legislation to amend Section 230.[30] The proposed legislation would classify platforms that amplify information using an algorithm as “content providers” with respect to the information they promulgate via AI. This amendment would impose liability on those platforms for the content amplified algorithmically or by some other automated processes. In June 2023, Senator Josh Hawley introduced a bill that would waive immunity under Section 230 for claims and charges related to generative artificial intelligence, which was defined to mean “an artificial intelligence system that is capable of generating novel text, video, images, audio, and other media based on prompts or other forms of data provided by a person.”[31] Both bills died in the Committee on Commerce, Science, and Transportation. And although the Biden administration issued an executive order addressing the federal regulation of AI, the action did nothing to answer the question of whether Section 230 immunity should be applied to content generated by AI.[32]
Given these circumstances, it seems likely that courts, rather than legislators, will take the lead in defining the limits of Section 230’s applicability to generative AI technology. Leaving such a complex task to judges and lawyers—most of whom are likely not technological experts in artificial intelligence—may lead to unpredictable, undesirable, and inconsistent results. For example, while the Third Circuit may view algorithmic curation as “expressive activity,” courts in other parts of the country may adopt a different approach, resulting in a patchwork of protection for those harmed by tortious content generated and promulgated by artificial intelligence.
Generative AI search engines highlight the need for a more nuanced approach to online content regulation in a world where generative AI exists. These tools challenge our traditional understanding of content creation and distribution, with their ability to synthesize and generate novel content from multiple sources under the guise of unlimited information access and apparent expertise. Without appropriate legislation or regulation that balances innovation and liability, we risk creating an AI landscape that neither companies nor individuals can navigate safely or effectively.
Goddard v. Google, Inc., 640 F.Supp.2d 1193,1196 (N.D. Cal. 2009) (under Section 230, a website will be liable only if it “contribute[s] materially” to the alleged unlawfulness, not when it “merely provides third parties with neutral tools to create web content”); Fair Housing Council of San Fernando Valley v. Roommates.com, LLC, 521 F.3d 1157, 1172 (9th Cir. 2008) (explaining that Section 230 immunity applies when “the website operator [is] merely a passive conduit” for the publication of the allegedly defamatory content). ↑
116 F.4th 180 (3d Cir. 2024). According to the Court’s opinion, the “Blackout Challenge” encouraged users “to choke themselves with belts, purse strings, or anything similar until passing out.” Id. at 182. ↑
This article is Part I of the Musings on Contracts series by Glenn D. West, which explores the unique contract law issues the author has been contemplating, some focused on the specifics of M&A practice, and some just random.
Golfers the world over are familiar with the famous “Arnold Palmer”—not just the actual human golfer but also the drink consisting of half tea and half lemonade. AriZona Beverages has been selling its “Big Can” of “Arnold Palmer” drinks (as well as its many other flavors of iced tea) prepriced for retail at just 99 cents per can since 1998. How has the company done that? Well, according to a recent trial court decision out of the New York Supreme Court of Nassau County, AriZona Beverages USA, LLC v. Evercore, Inc.,[1] part of the secret has been that it has been able to ensure “that [it is] supplied with [its] requirements of beverage cans by reliable suppliers at the contracted price.”[2] Those “Big Cans” are critical, and there are apparently only two suppliers of those cans west of the Mississippi: Ball Corporation and VoBev, LLC.
The Evercore decision arose out of a
special proceeding . . . seeking narrow pre-action discovery of the identity of the entities and/or individuals who [AriZona Beverages] claim[s] have aided and abetted and conspired with EVERCORE to tortiously interfere with the supply of Big Cans (and other size cans) to [AriZona Beverages] and tortiously induce VoBev, LLC to breach its March 2023 Can Supply and Production Agreement with [AriZona Beverages].[3]
The case highlights the potential consequences of violating a confidentiality obligation in a target’s material contract as part of the target’s sales process.
Case Background
Evercore was the investment banker for VoBev in connection with a potential sale of VoBev, and, as “is common in the industry, EVERCORE hosted an electronic data room to facilitate due diligence by a third party (‘Party A’) on VoBev.”[4] One of the documents uploaded to that data room was the March 2023 Can Supply and Production Agreement between AriZona Beverages and VoBev (“Can Supply Agreement”). The Can Supply Agreement apparently contained confidentiality obligations that prohibited disclosure of its terms to a third party without AriZona Beverages’ approval.
AriZona Beverages was concerned that Party A may have been Ball Corporation, which AriZona Beverages believed was trying to acquire VoBev and then seek to terminate the Can Supply Agreement. AriZona Beverages had been separately involved in arbitration proceedings with Ball Corporation concerning the alleged undersupply of cans by Ball Corporation pursuant to a supply agreement between AriZona Beverages and a company that Ball Corporation had previously acquired (and, in fact, AriZona Beverages had prevailed in that arbitration and obtained a judgment against Ball Corporation for more than $14.5 million, with additional potential disputes still to come).[5] In addition, AriZona Beverages apparently was informed that a purported representative of Ball Corporation had been seen at VoBev’s plant with a copy of the confidential information memorandum related to VoBev’s proposed sale in hand. According to AriZona Beverages,
if [AriZona Beverages] [is] unable to obtain the Big Cans under the Can Supply Agreement [it] will suffer millions in damages and Ball [Corporation] will gain leverage over the supply “. . . especially if VoBev is sold to Ball and/or Ball causes VoBev to terminate its Supply Can Agreement with [AriZona Beverages] as part of any transaction.”[6]
Evercore claimed that, even though it was in control of the data room, it was not permitted to reveal the name of Party A, or anyone else who may have had access to the data room, because of the terms of a nondisclosure agreement (“NDA”) that was entered into between VoBev and each party that was given access to the data room, including Party A. One would assume that the NDA permitted disclosure of otherwise confidential information, like the names of the parties seeking data room access, if it was required by virtue of a court order.
Court Ruling
The court found that AriZona Beverages had “brought forth sufficient information to confirm that the Can Supply Agreement is crucial to [AriZona Beverages’] business and the breach of the requirement of non disclosure permitting other part(ies) to obtain confidential and proprietary information must be addressed through the disclosure sought herein.”[7] In addition, the court specifically found that the acts complained of by AriZona Beverages “could conceivably form the basis of a cause of action including, but not limited to, tortious interference with contract.”[8]
Accordingly, the court ordered Evercore “to disclose the identity of each entity or individual to whom it provided access to the data room . . . [or] supplied a copy of the Can Supply Agreement or otherwise disclosed its terms.”[9]
And this seems like a straightforward holding. Uploading the Can Supply Agreement to the data room would appear to constitute a violation of most confidentiality obligations regarding the disclosure of an agreement’s terms. As such, AriZona Beverages is presumably entitled to know who had access to that data room to access how it may have been damaged by that apparent violation. The fact that Evercore may have separately been under a confidentiality agreement with the bidders not to disclose their names was irrelevant to AriZona Beverages’ claim related to the violation of the Can Supply Agreement’s confidentiality obligations.
The situation that arose in Evercore should serve as a reminder that sell-side diligence in readying a company for sale is as important as buy-side diligence. Violating a confidentiality obligation in a material contract of the target could have serious consequences. Indeed, in an English case decided a few years ago, Kason Kek-Gardner Ltd. v. Process Components Ltd.,[10] the disclosure of a target’s intellectual property license agreement to a potential buyer, in violation of the license’s confidentiality obligation, was deemed sufficient to permit the counterparty to terminate the target’s license.
Practical Considerations
But wait, some may say: How exactly can you disclose the terms of a material contract of a target to a potential buyer, which understandably needs to know those terms if it is to acquire the target, when those terms are specifically prohibited from being disclosed to any third party without the consent of the counterparty? Well, obviously, you can seek the counterparty’s consent to such disclosure—but what if that is not practical or is inopportune given the need to disclose the terms when it still may not be clear that any sale will actually occur?
If the potential buyer enters into an NDA promising not to disclose anything it learned about the target during due diligence, isn’t that a sufficient safeguard to avoid violating the underlying confidentiality obligation in the target agreement? The answer seems to be no. We all learned long ago that when you agree with a friend to keep something in confidence, disclosing that confidence to another friend who promises not to further disclose the confidence is still a violation of your original agreement to keep that confidence.
It remains to be seen whether AriZona Beverages was actually damaged by the alleged violation of the Can Supply Agreement’s confidentiality agreement. But regardless, there are no easy solutions to how to address confidentiality obligations in a target’s material agreements when setting up a data room on the sell side, or even in preparing the confidential information memorandum—but these confidentiality obligations do need to be addressed. Unless there is an actual exception to the material contract’s confidentiality obligation that permits disclosure in connection with a potential sale of the target, one should not assume that one will be implied,[11] particularly if one of the potential buyers is a competitor to the target or to one of the counterparties to the target’s confidential, material agreements.
No. 608480/2024 (Sup. Ct., Nassau Cnty,. Aug. 27, 2024). ↑
[2017] EWCA (Civ) 2132, at paras. 56–61. The license agreement specifically provided that the agreement could be terminated by either party “immediately by written notice to the other in the event of . . . any material [non-remediable] breach by the other party of any of its obligations under the Agreement.” And a “breach of the confidentiality obligations under clause 10” was deemed to “constitute[] a non-remediable material breach.” Id. at para. 48. ↑
Id. at paras. 49–55. This suggests that there needs to be more care in the initial drafting of these important portfolio company contracts. Just as an unconsidered anti-assignment or change of control provision in a target’s material contract could constitute an “exit blocker,” a confidentiality provision in that target’s material contract, with no exemptions that permit limited disclosure in connection with a potential sale, could also end up being an “exit blocker.” For those unfamiliar with the term, exit blocker is an expression used in the private equity industry to describe a provision contained within a material contract of a portfolio company that effectively makes a sale of that portfolio company extremely difficult without obtaining the consent of the counterparty to that material contract. ↑
The process of creating a privilege log has evolved significantly over the past few decades. As former U.S. Magistrate Judge Andrew J. Peck remarked,
When I got on the bench in 1995, the privilege logs in a typical case [were] two to three pages, maybe 50–100 entries. Now the privilege logs are like little novels, and there may be 10,000 or more entries. That is very expensive and is often useless to the other side in figuring out what is or isn’t privileged.[1]
His observation highlights the critical need for well-crafted, efficient privilege logs that serve the needs of all parties in litigation without becoming burdensome or unclear. This article will outline the federal rules guiding privilege logs, explore the different types of privilege logs, and provide best practices to create comprehensive and manageable logs.
Federal Rules Guiding Privilege Logs
The Federal Rules of Civil Procedure (“FRCP”) do not use the term privilege log or otherwise spell out procedures for logging privileged documents. Instead, FRCP 26(b)(5)(A)(ii) requires parties who withhold documents on the grounds of privilege to provide sufficient detail about those documents so the opposing party can assess the privilege claim. Specifically, the rule states that the withholding party must “describe the nature” of the documents, communications, or tangible things withheld “in a manner that, without revealing information itself privileged or protected, will enable other parties to assess the claim.”
Types of Privilege Logs
The absence of strict procedural guidance leaves much room for interpretation, prompting the emergence of various types of privilege logs tailored to different legal contexts.
A. Traditional Privilege Logs
The traditional privilege log is the most detailed and burdensome form. It requires a line-by-line description of each document, including the author, recipients, date, and a description of the subject matter sufficient to explain the claim of privilege. Traditional logs are often time-consuming and expensive to produce, particularly in large-scale litigation involving thousands of documents. Despite their complexity, they provide the most thorough level of detail, making them common in high-stakes litigation.
B. Metadata Privilege Logs
A metadata log simplifies the process by providing only the metadata extracted from withheld documents—such as date, author, recipients, file type, and document title—without including a narrative description.[2] These logs streamline the process by automating much of the data entry, reducing time and costs. However, the lack of a detailed narrative can leave privilege claims vulnerable to challenges, particularly when more context is needed to substantiate the privilege.
C. Categorical Privilege Logs
Categorical logs group documents into broad categories based on shared characteristics (e.g., all emails between specific parties during a certain date range). Instead of providing a line-by-line description, the log assigns a common description of privilege to an entire group of documents.[3] This method is particularly useful in large-scale litigation and is often negotiated between parties to reduce the burden of creating a traditional log. While categorical logs are efficient, they can be problematic if the descriptions lack sufficient detail to justify the privilege.
Best Practices for Creating an Effective Privilege Log
Given the varying complexity and scope of privilege logs, attorneys should follow several best practices to ensure that their logs meet the legal requirements and facilitate smooth litigation.
1. Negotiate Privilege Log Requirements Early
To avoid disputes down the line, it is critical for parties to meet and confer to come to a mutual decision on privilege log requirements at the beginning of discovery. Ideally, this will take the form of a written document such as an electronically stored information (“ESI”) agreement or privilege review protocol. Procedures for privilege review and parameters for privilege logs can also be incorporated into broader e-discovery protocol documents. Documenting the privilege review process early puts the parties in a better position to provide and receive the information needed to properly assess privilege claims for a particular matter. This collaborative decision can also help prevent misunderstandings and costly discovery disputes later in the litigation process.
2. Check Local Rules
While many courts leave the issue to the parties, some have significant privilege log requirements. Some jurisdictions have local rules that dictate the format or content of privilege logs, so it is important for counsel to learn these requirements early in the litigation process. For example, New York State courts strongly promote categorical logs through local rules.[4] Tailoring your privilege log to meet local court requirements ensures compliance and reduces the risk of objections.
3. Choose the Right Type of Privilege Log
The parties should decide whether to use a traditional, metadata, or categorical privilege log, depending on the case’s complexity and the volume of documents.
4. Agree on Required Fields for the Privilege Log
To comply with FRCP 26(b)(5)(A)(ii), the log must contain sufficient information to allow the receiving party to understand the basis for the claim. Agreement should be reached on which fields to include in a privilege log. At a minimum, the log should contain the date of the document, the author and recipients, the privilege asserted, and a brief description of the privileged content. In addition to these basic fields, parties should consider including more specific details based on the scope and complexity of the case, such as document type, document Bates number or unique identifier, and purpose of the communication.
5. Include Clear Descriptions of Privilege
Clearly denoting the basis for the privilege is essential. In addition to the attorney-client privilege and work-product doctrine, be prepared to discuss and include other relevant privileges, such as common interest, doctor-patient, accountant-client, and priest-penitent privileges, depending on the case and jurisdiction. Accurate privilege descriptions reduce the likelihood of challenges and ensure that the withheld information is properly protected.
6. Establish Date Ranges
Parties should agree on a relevant date range for logging privileged documents. Typically, attorney-client communications postdating the filing of the complaint are not logged unless the case involves ongoing conduct relevant to the claims. Establishing clear parameters around which communications must be logged can significantly reduce the burden on both parties.
7. Consider Redaction Instead of Withholding
Redacting privileged content, particularly in email strings—instead of withholding entire documents—can preserve context and reduce disputes. Often, the author, recipients, and dates of emails are not privileged. By redacting, it preserves so-called parent-child relationships, and the face of the document provides most of what one would otherwise have to log, save for the nature of the privilege asserted. Whether redaction is an appropriate aspect of a privilege review process depends on the facts and circumstances of each case.
8. Assess Attachments Separately
Attachments to privileged emails are not automatically privileged. Each attachment must be independently assessed for privilege claims. Failing to do so can result in nonprivileged documents being improperly withheld, leading to challenges.
9. Utilize Name Normalization
Normalization refers to writing a person’s name the same way each time it appears on the log. This normalization reduces confusion and makes it easier for the opposing party to review the log. For instance, all variations of “John Smith” (e.g., “J. Smith,” “[email protected]”) should be standardized to a single format throughout the log.
10. Be Transparent with Third-Party Communications
When third parties are involved in communications, assess whether disclosure to those third parties waives privilege. Privilege claims involving third-party recipients are frequently challenged, so proactively identifying these parties can help prevent future disputes.
11. Coordinate the Timing of Production
Privilege logs are typically produced after the final document production. Agreeing to a specific deadline, such as thirty to sixty days after production, can prevent unnecessary administrative burdens and ensure completeness. Rolling logs are administratively inefficient as there may be corrections, omissions, or documents that need to be clawed back.
Conclusion
Preparing a privilege log is a fundamental aspect of the discovery process in litigation. While there is no one-size-fits-all approach, understanding the numerous considerations can help attorneys create effective and compliant logs.
Disclaimer: The content is intended for general informational purposes only and should not be construed as legal advice. If you require legal or professional advice, please contact an attorney.
In the realm of corporate restructuring, the parties, attorneys, and judges typically have a singular focus on dollars: maximizing recoveries for creditors and the equitable distribution of assets. But is bankruptcy really all about the bottom line? And does focusing solely on financial outcomes limit our understanding of corporate responsibility? We have had occasion twice (most recently in a virtual Earth Day panel[1]) to explore these questions alongside colleagues in the insolvency world, and we lay out some of our discussion in written form below.
Bankruptcy professionals know that insolvency situations are not always about the bottom line. Consider the following list of recent, high-profile cases where noneconomic concerns were the focus of attention:
Purdue Pharma: The infamous opioid manufacturer’s bankruptcy proceedings spotlighted public health and accountability, both retrospectively and prospectively.
The Diocese Cases, Boy Scouts of America, and USA Gymnastics: These proceedings involved claims of sexual abuse and failure of oversight, the obligations of religious and charitable organizations, and the need for transparency, responsibility, and reform.
The Weinstein Company: This case illustrated the interplay between corporate governance and accountability in light of longstanding, prebankruptcy allegations of abuse and misconduct.
Alex Jones/Free Speech Systems: The controversial Internet personality’s bankruptcy raised thorny questions about accountability for the spread of misinformation and whether bankruptcy should be an occasion for maximizing value or preventing further harm.
FTX: Here, the role of government regulators loomed large, with scholars questioning whether the government overstepped its role by forcing FTX into bankruptcy prematurely.[2]
These examples (and others too numerous to list) force us to acknowledge that bankruptcy proceedings often extend beyond financial recovery.[3] As a result, we should, at a minimum, consider the social and ethical ramifications of corporate missteps.
It’s Not All Mass Torts and Bad Actors
To be clear, the bigger picture goes beyond bad actors. Bankruptcy proceedings also encompass noneconomic concerns when enterprises committed to “doing good while doing well,” especially nonprofit entities and benefit corporations, end up in bankruptcy court.
The leadership of many for-profit entities now commit their endeavors to profit-making through the lens of Corporate Social Responsibility (CSR) and Environmental, Social, and Governance (ESG) metrics.
CSR is a collective term covering corporate citizenship and all aspects of nonfinancially focused corporate initiatives. Historically, the term has almost exclusively been used to describe optional corporate activities that generate positive goodwill, such as employee volunteer programs and charitable contributions. At its core, CSR refers to a company’s commitment to ethical behavior and contributions to economic development while improving the quality of life for employees, their families, local communities, and society at large.
ESG, on the other hand, is focused more on risk management and less on voluntary programs. The term “ESG” was coined in 2004 in a UN Global Compact report,[4] and the goal of ESG was to manage the nonfinancial risks and opportunities inherent in a company’s day-to-day activities. The three pillars within an ESG framework are as follows:
The Environmental Pillar: What impact (positive or negative) does the company have on the environment? Considerations include environmental risks and opportunities, reducing carbon footprint, and opportunities related to the use and development of clean energy.
The Social Pillar: What impact does the company have on society generally? Considerations include labor relations, human rights, safety, community impact, product integrity, privacy, and employee morale.
The Governance Pillar: How is the company run? Considerations include board and senior management diversity, board independence, executive compensation, reporting and disclosure, and internal controls (e.g., related to bribery, corruption, political contribution policies, and cybersecurity).
Similarly, we see more focus on noneconomic concerns with benefit corporations,[5] a type of legal entity with a statutory mandate to balance the pursuit of profit against a general or specific “public benefit,” which could be generating a positive impact on society, the environment, or local workers. Unlike their nonprofit cousins, however, benefit corporations can distribute profits to shareholders. Notable examples include Patagonia, Warby Parker, and Allbirds.
Plainly, the expectation for businesses to act responsibly has escalated. Customers, employees, investors, and other stakeholders increasingly expect it and often demand it. While some may disagree, we think those business principles should continue through insolvency and should remain no less important inside bankruptcy than they are outside it. Of course, we recognize the challenge in shifting even the slightest focus toward noneconomic concerns when that shift may naturally reduce the current focus on maximizing value for creditors. But perhaps that is the wrong way to look at this problem.
Rethinking What We Mean When We Maximize “Value”
Instead, perhaps we should rethink what bankruptcy professionals mean when we say we maximize “value.” Traditionally, the principal role of a trustee, debtor in possession, or creditors’ committee in bankruptcy has been to maximize monetary value. And indeed, bankruptcy’s “turn to market value” over the last several decades, as Professors Roe and Simkovic have helpfully sketched out,[6] has had a positive effect on our industry, with chapter 11 cases moving more quickly and efficiently. But that is no reason to turn a blind eye to broader questions of reputational value, community impact, and long-term sustainability.
In bankruptcy, these issues can manifest through various channels:
Stakeholder Engagement: Ensuring that all stakeholders are considered in restructuring plans, from employees facing job loss to victims seeking accountability.
Reputation Management: Maintaining an organization’s reputation in the wake of bankruptcy, which can be profoundly affected by its actions and commitments to social responsibilities.
Long-Term Sustainability: Considering how the business can not only emerge from bankruptcy but do so in a manner that positions it for sustainable, ethical growth in the future.
Committees and Conflicts
Even so, bankruptcy professionals must be careful to operate within their role, with a keen eye for potential conflicts. When monetary recovery and nonmonetary values diverge, some creditors may focus primarily on financial returns, while others may push for recognition of nonmonetary benefits—such as regulatory relief, enhanced corporate governance, or more robust reporting practices.
One of us has pointed out that the Bankruptcy Code already authorizes courts to appoint committee members for their unique perspectives, or to appoint a special committee, like a benefit committee.[7] Beyond that, we may want to get creative. In certain cases, out-of-the-money (OOM) committees could play an enhanced role, offering a critical voice for stakeholder interests that extend beyond financial recovery.
Conclusion
In most bankruptcy cases, noneconomic concerns are ancillary or subordinate considerations. Yet, they are integral to the ethical landscape of corporate responsibility. With the new wave of interest in hybrid models, this approach to corporate governance will increasingly spill over into the insolvency world. Balancing the demands of creditors with the interests of multiple stakeholders presents a complex challenge, but one that can ultimately lead to more sustainable and responsible corporate practices. With this shift, bankruptcy professionals and courts will be compelled to consider how best to integrate CSR and ESG principles into the fabric of their practices. Only through this lens can we hope to redefine what “value” or “success” means in the context of corporate restructuring.
This is a question worth exploring as we strive to create a more ethically grounded and socially responsible business insolvency environment.
See Jonathan C. Lipson & David A. Skeel, FTX’d: Conflicting Public and Private Interests in Chapter 11, 77 Stan. L. Rev. (forthcoming 2025). ↑
For example, Professors Pamela Foohey and Christopher Odinet analyze in depth how debtors can use bankruptcy as a “tool for silencing.” Pamela Foohey & Christopher K. Odinet, Silencing Litigation Through Bankruptcy, 109 Va. L. Rev. 1261 (2023). ↑
For a discussion of how benefit corporations might deviate from the typical path through bankruptcy, see Christopher D. Hampson, Bankruptcy & the Benefit Corporation, 96 Am. Bankr. L.J. 93 (2022). ↑
The MAC Cup II law student M&A negotiation competition has launched! Sixty-four student teams from forty-six schools across the US and Canada are squaring off in multiple qualifying rounds to join the “Final Four” in-person championship in Laguna Beach, California, and to win awards for best agreement mark-ups, all while learning to advocate their (made-up) clients’ positions.
The ABA Business Law Section’s M&A Committee launched the inaugural MAC Cup last year, with Nada Abousena and Grace Baer of American University taking top honors in front of the membership of the M&A Committee and a panel of invited judges. The M&A Committee has expanded this year’s MAC Cup to include more teams, more negotiations, and more awards, with continued access for students to M&A practitioners and professional M&A resources, promising to make the MAC Cup the premier hands-on transactional learning experience for law students with a passion for M&A.
“We’re giving law school students opportunities to learn about and apply M&A negotiation skills, like the litigation opportunities they get during the more traditional moot court,” said Mike O’Bryan, immediate past chair of the M&A Committee. “We want students to think about M&A as a significant part of their legal careers and to develop some practical skills to get them started.”
Nada Abousena and Grace Baer of American University Washington College of Law, coached by David Albin, won the inaugural MAC Cup in January 2024. Photo by Baldemar Fierro.
Building on Past Success
This year’s participation figures highlight the growing importance and reach of the competition.
“This year, we had eighty-nine applications,” said Thaddeus Chase, a member of the M&A Committee subcommittee that runs the MAC Cup. “This represents a 75 percent increase in submissions. And our targets will be even more aggressive for MAC Cup III.”
Other members of the MAC Cup subcommittee are O’Bryan, Wilson Chu, Glenn West, Tom Romer, Caroline Shinkle, and Sacha Jamal. All are members of the M&A Committee and practicing M&A attorneys, though Romer recently left the practice to form Dexterity, a digital negotiation platform designed for M&A (and now hosting the MAC Cup documents). Curtis Anderson, a professor at BYU Law School and former practicing outside and in-house M&A counsel, also is on the subcommittee and brings experience in organizing law school competitions.
“This year, by expanding the field, we’ve provided more students/law schools the opportunity to gain experience from the competition and the chance to compete,” said Chase. “It allows for more students to become connected and build a network across law schools and the M&A Committee. We’ve also built in the wrinkle that students may need to switch sides (i.e., from Buyer to Seller or from Seller to Buyer) with a week’s notice—we think this pushes students to think critically and drives home the point that the best outcome for a deal is usually somewhere in the middle (not everyone wins every point/issue).”
Learning New Skills
What do students learn?
M&A concepts; critical thinking; understanding the meaning of a “win” in M&A transactions; and the knowledge that this competition is not done in isolation: students can leverage the advice, guidance, and support of participating legal practitioners.
“The synergy between the law students and our members (whether as judges or coaches) is really dynamic and reflects the M&A Committee’s commitment to provide practical training to a new generation of M&A lawyers,” said Caroline Shinkle, a subcommittee member who has witnessed the excitement and rewards of this competition.
“Without a doubt, there is a level of seriousness that permeates student participation,” said Shinkle. “And yet this seriousness is tempered by the excitement created by the coaches and judges—generating a level of interaction rarely seen at this level.”
2024’s winners were announced at the M&A Committee’s annual meeting in Laguna Beach after facing off in a mock negotiation in front of attendees. Photo by Baldemar Fierro.
The Challenge of a Competitive Path
For students to make the “Final Four” is an indication of their hard work and negotiation skills—but also the strategic planning and coping skills needed to survive all phases of the competition.
The MAC Cup II schedule is intense:
Initial issues list and Acquisition Agreement mark-up due: October 21, 2024
First Open Round: October 26–27, 2024 (virtual)
Second round issues list and Acquisition Agreement mark-up due: October 30, 2024
Second Open Round: November 2–3, 2024 (virtual)
Elite 8 Quarterfinal Negotiation Matches: January 25, 2024 (virtual)
Semifinals: January 30, 2025 (in person), Laguna Beach, California
Finals: January 31, 2025 (in person), Laguna Beach, California
Opportunities for Lawyers
The competition provides opportunities for M&A practitioners to work with the students as judges or coaches. For the MAC Cup II, while the qualifying rounds are completed, lawyers still can act as judges in the virtual “Elite Eight” or the in-person “Final Four” rounds in January—if you’re interested, contact Thaddeus Chase (at [email protected]). In the longer run, there also will be opportunities for lawyers to recruit competitors and to coach or judge in next year’s MAC Cup III.
“At each stage, from initial issue spotting through final negotiations, students benefit from the legal talents of M&A Committee members who serve as judges and coaches,” said Romer.
Wendy Li and Alexis Brugger of University of Pennsylvania Carey Law School, who took second place in 2024, were coached by Debra Gatison Hatter. Photo by Baldemar Fierro.
Line Up to Be a Part of MAC Cup II
An impressive list of sponsors has already lined up to be part of MAC Cup II: M&A supporting companies Thomson Reuters, Hotshot, and Dexterity, and law firms Sullivan & Cromwell, Ropes & Gray, McDermott Will & Emery, Freshfields, Goodwin, Morrison Foerster, and Morris James. And the list is only getting longer!
“The sponsors have recognized that transactional skills have been sadly lacking in law student graduates. We’re changing that with the opportunities provided by the MAC Cup,” said Wilson Chu, former M&A Committee chair. “The transactional skills learned by students are invaluable.”
As the excitement leading up to the Laguna championship heats up, it has been proven, once again, that the BLS M&A Committee is at the forefront in its commitment to improving the knowledge and skills of law students throughout the nation.
Contractual covenants not to compete, or “noncompetes,” restrict “a man’s natural right to follow any trade or profession anywhere he pleases and in any lawful manner.”[1] Delaware courts “frown on or disfavor restrictive covenants,” particularly in employment contracts, but such provisions have historically been enforced.[2] While the applicable standard has remained nominally consistent, recent case law suggests that these provisions are being scrutinized more closely.
The Reasonableness Test
Delaware courts “do not mechanically enforce or deny noncompetes but closely scrutinize[] them as restrictive of trade.”[3] A noncompete will be enforced only if it “(1) [is] reasonable in geographic scope and temporal duration, (2) advance[s] a legitimate economic interest of the party seeking its enforcement, and (3) survive[s] a balancing of the equities.”[4]
These requirements must be reviewed “holistically and in context.”[5] As Vice Chancellor Laster explained,
[a] court must not tick through individual features of a restriction in isolation, because features work together synergistically. For example, “a court must consider how the temporal and geographic restrictions operate together” because the “two dimensions necessarily interact.” A covenant that restricts employment in a similar industry for two years might be reasonable if it only applies within a single town or county, and vice versa. All else equal, a longer restrictive covenant will be more reasonable if geographically tempered, and a broader restrictive covenant will be more reasonable if temporally tailored.[6]
When a noncompete is entered into in connection with the sale of a business, the court must still evaluate its reasonableness, but the “inquiry is less searching than if the covenant had been contained in an employment contract.”[7]
The fact-intensive nature of this inquiry does not lend itself to bright-line tests; however, the case law has revealed some common themes.
Geographic Scope
“[T]he reasonableness of a covenant’s scope is not determined by reference to physical distances, but by reference to the area in which a covenantee has an interest the covenants are designed to protect.”[8] Courts have found noncompetes to be reasonable when limited to the areas where a company does business.[9] Provisions that apply beyond the company’s area of operations, have worldwide or nationwide application, or include the company’s affiliates or subsidiaries have been heavily criticized.[10]
While nationwide or worldwide restrictions are often considered overbroad, courts have enforced them when they are entered into in connection with the sale of a business.[11]
A lack of geographical restrictions is unusual, but it does not render the restriction unenforceable per se.[12] If the other aspects are reasonable, Delaware courts may still enforce the noncompete.[13]
Duration
As a general matter, the longer a restrictive covenant applies, the narrower its geographic and subject matter scope must be.[14] Delaware law does not provide a specific reasonable duration. Noncompetes lasting two years are the most commonly approved.[15] However, Delaware courts have found that restrictions lasting one year and three years were reasonable.[16]
In Ainslie v. Cantor Fitzgerald, Limited Partnership, the Delaware Court of Chancery found that a four-year noncompete contained in a partnership agreement was unreasonable, but it suggested that such a duration may be “in the range of reasonable” if the scope of the restriction were appropriately narrowed.[17]
Delaware courts have upheld longer durations when the provision arises in connection with the sale of a business or stock.[18]
Legitimate Economic Interest
Like the other aspects of this analysis, the existence of a legitimate economic interest is highly fact intensive. In evaluating the alleged economic interest, courts have considered a variety of factors, including (i) the employee’s exposure to confidential information, proprietary technology, and other trade secrets; (ii) the level of training and skill that was required to perform the work; and (iii) the employee’s general role with the company.[19]
The specificity of the applicable language is also important. Vague terms such as similar to or substantially the same as when referring to the company’s business have been found to be too vague to demonstrate a legitimate economic interest.[20] Noncompetes prohibiting conduct that directly competes with, or is similar to, the business of the company, and only the company, have been found to be enforceable.[21]
Finally, the breadth of the restriction is also considered. As the court in Fortiline, Inc. v. McCall held, a broader restriction requires a broader legitimate interest. Noncompetes that cover a company’s affiliates or that broadly define a company’s business have been routinely rejected as not being “tailored to the employee’s role while employed.”[22]
Delaware courts have held that protecting a company’s goodwill, confidential information, customer base, and/or competitive advantage gained through the employee’s efforts may each be a legitimate economic interest.[23] The identity of a company’s referral sources may be protectable provided that those sources are not transient in the industry.[24] A company’s desire to prevent its employees from working directly for its clients (known as disintermediation) may constitute a legitimate economic interest in appropriate circumstances.[25]
However, courts have rejected claims that a noncompete was necessary when the interests being protected were “vague and everyday concern[s],”[26] including that (i) the employee was generally “responsible for many . . . customer relationships,”[27] or involved in “finding deals and fostering relationships” with customers;[28] (ii) the employee would be able to use the technical expertise or general industry knowledge they gained while employed by the company against it;[29] and (iii) the employee could use an important certification the company paid for them to get against it.[30]
Balancing of the Equities
Finally, Delaware courts balance the company’s interest in preventing competition with the harm that would befall the employee if the covenant were enforced.
The recent case law suggests that this balance focuses on an employee’s ability to earn a living and the role the employee played in the company. Given Delaware’s concern for employees’ well-being, it is not surprising that courts have been critical of provisions that will prevent a person from earning a living.[31] The role that the employee had with the company is also an important factor. Given the typically disparate bargaining power between a company and its employees, noncompetes with lower-level employees are routinely rejected as unreasonable. However, Delaware courts have been less critical of provisions applying to senior executives who received significant compensation or who were critical to the negotiation of the transaction that led to the creation of the noncompete.[32]
The “Blue Pencil” Rule
As a court of equity, the Delaware Court of Chancery in the past has revised the scope and/or duration of a noncompete.[33] But this process, known as using a “blue pencil,” has been criticized and rarely applied in recent years. As Vice Chancellor Laster explained in Sunder Energy, LLC v. Jackson,
revising an overbroad restrictive covenant creates a no-lose situation for employers because businesses can draft the covenant as broadly as possible, confident that the scope of the restriction will chill some individuals from departing. If someone does challenge the provision, then the worst case is that the court will blue-pencil its scope so it is acceptable. It also enables employers to extract benefits at the expense of employees by including unenforceable restrictions in their agreements.[34]
In Labyrinth, Inc. v. Ulrich, the court denied a motion to dismiss because, even though the ten-year-long restrictive covenant was overbroad in several ways, the fact that the employee was personally and deeply involved in negotiating the covenant in connection with the sale of his business “may conceivably present a rare instance where equity and public policy might require blue penciling.”[35]
Contractual Provisions Regarding Reasonableness
The “reasonableness” analysis cannot be avoided via contractual provisions. Companies may attempt to contract around the reasonableness requirement by including provisions pursuant to which the employee (i) agrees that the restrictions are reasonable, (ii) waives any defense that they are not, and (iii) agrees that a court may modify the provision if it is deemed unreasonable as drafted. However, Delaware courts have repeatedly held that such provisions are ineffective and do not relieve the court of its obligation to determine the reasonableness of the provision.[36]
“Forfeiture for Competition” Provisions Recently Upheld
As the Delaware Supreme Court recently explained in Cantor Fitzgerald, Limited Partnership v. Ainslie, so-called “forfeiture for competition” provisions are not evaluated for “reasonableness.”[37] Forfeiture for competition provisions are contract provisions that relieve the company of obligations to pay an employee deferred financial benefits if the employee breaches a noncompetition provision in the contract. As the Delaware Supreme Court held in Cantor, such provisions “stand on different footing” than noncompetes because they do not “limit a [person’s] ability to compete or otherwise obtain employment.”[38] Unlike noncompetes, forfeiture for competition provisions are “a condition precedent that excuses [the company] from its duty to [make future payments] if the [employee] fail[s] to satisfy a condition to which they agreed to be bound in order to receive a deferred financial benefit.”[39] As a result, forfeiture for competition provisions are not reviewed for reasonableness but rather enjoy the “court’s deference on equal footing with any other bargained-for-term” in a contract.[40]
Statutory Limitations
Even if the provision satisfies the reasonableness standard, Delaware law prohibits the use of noncompetes in some narrow circumstances. By way of example, noncompetes between physicians that restrict the physician’s right to practice medicine in a particular area or for a particular time period are void (although provisions requiring the payment of money damages for a breach of such provision are enforceable).[41]
Other states have gone even further than Delaware and enacted statutes prohibiting or strictly limiting the enforceability of such provisions.[42]
The FTC’s Effort to Ban the Use of Noncompetes
Earlier this year, the Federal Trade Commission (“FTC”) issued a final rule (“Final Rule”) that, subject to certain specific exceptions, made it a violation of section 5 of the Federal Trade Commission Act for employers to enter into new noncompete agreements with workers of any level on or after September 4, 2024 (“Effective Date”).[43] However, the Final Rule was barred from taking effect, and its future is uncertain.
Under the Final Rule, noncompetes in effect on the Effective Date are only enforceable against employees considered to be “Senior Executives”—that is, those in a “policy-making position” who meet or exceed a minimum compensation requirement.[44] If an employee does not qualify as a Senior Executive, existing noncompetes are no longer enforceable. The Final Rule imposes strict time limits for companies to notify non–Senior Executives of that change.
While the Final Rule is a broad prohibition, there are several limitations and exceptions. First, it only applies to noncompetition provisions in employment contracts; it does not apply to noncompetes entered into in connection with the bona fide sale of a business or a franchise. Second, it does not prohibit causes of action for breaches of a noncompete that occurred prior to the Effective Date. Finally, enforcement of a noncompete does not violate the Final Rule if the company has a good-faith basis to believe that the Final Rule does not apply to that situation.
The Final Rule did not go into effect on September 4, 2024, as expected. On August 20, 2024, Judge Ada Brown of the U.S. District Court for the Northern District of Texas issued a permanent injunction setting aside the Final Rule and declaring that it “shall not be enforced or otherwise take effect on September 4, 2024, or thereafter.”[45] Litigation regarding enforceability of the Final Rule is ongoing. Therefore, it remains possible that the Final Rule, or some modified version thereof, may still become law.
In sum, while Delaware is a contractarian state that defers to people’s right to privately order their affairs, that deference is tempered when a contract restricts a person’s ability to work. Noncompete agreements (unlike forfeiture for competition provisions) are judged by a “reasonableness” standard. Reasonableness, however, does not lend itself to a bright-line test, but requires analysis of several interrelated considerations—the agreement’s geographic scope and duration, the existence of a legitimate economic interest, and a balancing of the equities. While no one factor is determinative, Delaware courts have issued some guideposts (discussed above) and made it clear the concept is so important that parties cannot contract around the inquiry and that courts are hesitant to change an otherwise unenforceable contract. The time may come that the FTC’s final rule goes into effect and companies are prohibited from entering into noncompetes altogether. However, until then business leaders and legal practitioners must ensure that noncompetes are “reasonable” if they are to be enforced under Delaware law.
Labyrinth, Inc. v. Ulrich, 2024 Del. Ch. LEXIS 78, at *52 (Del. Ch. Jan. 26, 2024). ↑
TriState Courier & Carriage, Inc. v. Berryman, 2004 Del. Ch. LEXIS 43, at *41 (Del. Ch. Apr. 15, 2004). ↑
Weichert Co. of Pa. v. Young, 2007 Del. Ch. LEXIS 170, at *12 (Del. Ch. Dec. 7, 2007). ↑
See, e.g., id. (twenty-five miles from the company’s main operations); TriState Courier & Carriage, 2004 Del. Ch. LEXIS 43, at *43 (anywhere the company operated or has operated for the previous three years); All Pro Maids, Inc. v. Layton, 2004 Del. Ch. LEXIS 116, at *17–18 (Del. Ch. Aug. 9, 2004) (limited to the specific zip codes where the majority of the company’s clients are located); Kan-Di-Ki, LLC v. Suer, 2015 Del. Ch. LEXIS 191, at *69 (Del Ch. July 22, 2015) (the twenty-three states the company operated in); COPI of Del., Inc. v. Kelly, 1996 Del. Ch. LEXIS 136, at *12 (Del. Ch. Oct. 25, 1996) (within twenty miles of the company’s operations). ↑
See, e.g., Fortiline, Inc. v. McCall, 2024 Del. Ch. LEXIS 317, at *9–10 (Del. Ch. Sept. 5, 2024) (finding a noncompete unreasonable because it applied at least nationwide); Hub Grp., Inc. v. Knoll, 2024 Del. Ch. LEXIS 250, at *23 (Del. Ch. July 18, 2024) (finding a noncompete unreasonable because it applied to the contiguous United States and potentially Canada, Mexico, and India, including geographic locations that the employee had no responsibility for); Labyrinth, Inc. v. Ulrich, 2024 Del. Ch. LEXIS 78, at *52 (Del. Ch. Jan. 26, 2024) (a noncompete was overbroad because it spanned the areas in which both the company and its affiliates operated); Sunder Energy, 305 A.3d at 754–56 (rejecting a noncompete that applied to forty-six states when the employee only operated in Texas); Centurion Serv. Grp., LLC v. Wilensky, 2023 Del. Ch. LEXIS 354, at *8–10 (Del. Ch. Aug. 31, 2023) (finding a noncompete was unreasonable because it applied to any “area” in the United States or abroad in which the company was operating or was planning to operate); Intertek Testing Servs. NA, Inc. v. Eastman, 2023 Del. Ch. LEXIS 66, at *8 (Del. Ch. Mar. 16, 2023) (a restrictive covenant applying anywhere in the world was overbroad because the company operated primarily in Texas); Kodiak Bldg. Partners, LLC v. Adams, 2022 Del. Ch. LEXIS 288, at *18–20 (Del. Ch. Oct. 6, 2022) (rejecting a noncompete that included the states of Idaho and Washington and anywhere within one hundred miles of any other location served by the company or its affiliates); FP UC Holdings, LLC v. Hamilton, 2020 Del. Ch. LEXIS 110, at *15–17 (Del. Ch. Mar. 27, 2020) (rejecting a provision applying anywhere in the United States the company operates or may operate). ↑
See, e.g., Centurion Serv. Grp., 2023 Del. Ch. LEXIS 354, at *10 (“[T]his Court has enforced non-competes with a nationwide scope, but only in instances where the competing party agrees, in connection with the sale of a business, to stand down from competing in the relevant industry anywhere for a stated period of time after the sale.”); see also Brace Indus. Contracting, Inc. v. Peterson Enters., Inc., 2015 Del. Ch. LEXIS 229, at *7 (Del. Ch. Aug. 28, 2015) (a restriction covering the entire United States and Canada was appropriate in connection with the sale of a business because the entity that was sold did business worldwide); O’Leary v. Telecom Res. Serv., LLC, 2011 Del. Super. LEXIS 36, at *1 (Del. Super. Jan. 14, 2011) (upholding a nationwide restrictive covenant entered into in connection with the sale of a business because the business operated across the nation). ↑
See Del. Express Shuttle v. Older, 2002 Del. Ch. LEXIS 124, at *45 (Del. Ch. Oct. 23, 2002). ↑
See, e.g., id. at *41–51 (enforcing a three-year noncompete that lacked a geographical restriction because it was expressly negotiated by the parties immediately before it went into effect and the restricted territory was implicitly limited to places the company could and did serve from its Newark, Delaware, facility); Rsch. & Trading Corp. v. Pfuhl, 1992 Del. Ch. LEXIS 234, at *12 (Del. Ch. Nov. 18, 1992) (enforcing a one-year noncompete that lacked a geographical limitation because the company enjoyed widespread goodwill and the relief sought was narrow in scope). ↑
See, e.g., Weichert Co. of Pa. v. Young, 2007 Del. Ch. LEXIS 170 (Del. Ch. Dec. 7, 2007); All Pro Maids, Inc. v. Layton, 2004 Del. Ch. LEXIS 116 (Del. Ch. Aug. 9, 2004); TriState Courier & Carriage, Inc. v. Berryman, 2004 Del. Ch. LEXIS 43 (Del. Ch. Apr. 15, 2004); Del. Express Shuttle, 2002 Del. Ch. LEXIS 124; COPI of Del., Inc. v. Kelly, 1996 Del. Ch. LEXIS 136 (Del. Ch. Oct. 25, 1996). ↑
See RHIS, Inc. v. Boyce, 2001 Del. Ch. LEXIS 118, at *23–24 (Del. Ch. Sept. 26, 2001) (upholding a one-year restriction); Rsch. & Trading Corp., 1992 Del. Ch. LEXIS 234, at *31 (upholding a one-year restriction); Faw, Casson & Co. v. Cranston, 375 A.2d 463, 469 (Del. Ch. 1977) (a three year noncompete was reasonable but only to the extent it applied in northern Delaware). But see Fortiline, Inc. v. McCall, 2024 Del. Ch. LEXIS 317, at *2, *10 (Del. Ch. Sept. 5, 2024) (holding that a one-year noncompete was overbroad); Del. Express Shuttle, 2002 Del. Ch. LEXIS 124, at *54 (a three-year noncompete was unreasonable). ↑
Ainslie v. Cantor Fitzgerald, Ltd. P’ship, 2023 Del. Ch. LEXIS 22, *41 (Del. Ch. June 4, 2023), rev’d on other grounds, Cantor Fitzgerald, Ltd. P’ship v. Ainslie, 312 A.3d 674 (Del. 2024). ↑
See, e.g., Kan-Di-Ki, LLC v. Suer, 2015 Del. Ch. LEXIS 191 (Del Ch. July 22, 2015) (upholding a five-year noncompete covering twenty-three states entered into in connection with the sale of the company); O’Leary v. Telecom Res. Serv., LLC, 2011 Del. Super LEXIS 36 (Del. Super. Jan. 14, 2011) (upholding a four-year noncompete covering the entire United States entered into in connection with the sale of the company); Hough Assocs. v. Hill, 2007 Del. Ch. LEXIS 5 (Del. Ch. Jan. 17, 2007) (upholding a noncompete in a stock purchase agreement that applied for five years following the date of the agreement or three years after the employee left the company, with a geographic scope of fifty miles). But see Labyrinth, Inc. v. Ulrich, 2024 Del. Ch. LEXIS 78 (Del. Ch. Jan. 26, 2024) (rejecting a ten-year noncompete contained in a stock purchase agreement). ↑
See Elite Cleaning Co. v. Capel, 2006 Del. Ch. LEXIS 1105, at *26–27 (Del. Ch. June 2, 2006). ↑
Hub Grp., Inc. v. Knoll, 2024 Del. Ch. LEXIS 250, at *25 (Del. Ch. July 18, 2024); Del. Express Shuttle, 2002 Del. Ch. LEXIS 124, at *48–50; Norton Petroleum Corp. v. Cameron, 1998 Del. Ch. LEXIS 32, at *12 (Del. Ch. Mar. 5, 1998). ↑
See, e.g., Gener8, LLC v. Castanon, 2023 Del. Ch. LEXIS 380 (Del. Ch. Sept. 29, 2023); Lyons Inc. Agency Inc. v. Wilson, 2018 Del. Ch. LEXIS 317, at *15 (Del. Ch. Sept. 28, 2018); Kan-Di-Ki, 2015 Del. Ch. LEXIS 191; TriState Courier & Carriage, Inc. v. Berryman, 2004 Del. Ch. LEXIS 43,*43 (Del. Ch. Apr. 15, 2004); All Pro Maids, Inc. v. Layton, 2004 Del. Ch. LEXIS 116 (Del. Ch. Aug. 9, 2004); COPI of Del., Inc. v. Kelly, 1996 Del. Ch. LEXIS 136 (Del. Ch. Oct. 25, 1996); Faw, Casson & Co., 375 A.2d at 468–69. ↑
Fortiline, Inc. v. McCall, 2024 Del. Ch. LEXIS 317, at *7 (Del. Ch. Sept. 5, 2024); see alsoLabyrinth, 2024 Del. Ch. LEXIS 78, at *53–54; Sunder Energy, LLC v. Jackson, 305 A.3d 723, 753 (Del. Ch. 2023); Centurion Serv. Grp., LLC v. Wilensky, 2023 Del. Ch. LEXIS 354, at *8–10 (Del. Ch. Aug. 31, 2023); Frontline Techs. Parent, LLC v. Murphy, 2023 Del. Ch. LEXIS 336 (Del. Ch. Aug. 23, 2023); Kodiak Bldg. Partners, LLC v. Adams, 2022 Del. Ch. LEXIS 288, at *18–19 (Del. Ch. Oct. 6, 2022) (rejecting a provision applying to the business of the company and its affiliates). ↑
See Fortiline, 2024 Del. Ch. LEXIS 317, at *6; Rsch. & Trading Corp. v. Pfuhl, 1992 Del. Ch. LEXIS 234, at *12 (Del. Ch. Nov. 18, 1992).↑
RHIS, Inc. v. Boyce, 2001 Del. Ch. LEXIS 118, at *20–21 (Del. Ch. Sept. 26, 2001). ↑
Elite Cleaning Co. v. Capel, 2006 Del. Ch LEXIS 105, at *23–24 (Del. Ch. June 2, 2006). ↑
Hub Grp., Inc. v. Knoll, 2024 Del. Ch. LEXIS 250, at *30 (Del. Ch. July 18, 2024); Centurion Serv. Grp., 2023 Del. Ch. LEXIS 354, at *10–11. ↑
Sunder Energy, LLC v. Jackson, 305 A.3d 723, 757–58 (Del. Ch. 2023) (finding a provision was unenforceable because, among other things, it barred the employee from participating in any business that sells to any homeowner in any states where Sunder did business . . . [meaning the employee] could not take a job at a Best Buy . . . or a McDonalds”); Centurion Serv. Grp., 2023 Del. Ch. LEXIS 354 (criticizing the impact of the provision on the employee’s ability to work). ↑
See, e.g., Labyrinth, Inc. v. Ulrich, 2024 Del. Ch. LEXIS 78, at *52 (Del. Ch. Jan. 26, 2024); Sunder Energy, 305 A.3d at 753. ↑
See, e.g., Del. Express Shuttle, Inc. v. Older, 2002 Del. Ch. LEXIS 124 (Del. Ch. Oct. 23, 2002) (adjusting the duration of a noncompete from three years to two years); Faw, Casson & Co. v. Cranston, 375 A.2d 463, 468–69 (Del. Ch. 1977) (revising the geographic reach of a noncompete). ↑
See e.g., Ainslie v. Cantor Fitzgerald, L.P., 2023 Del. Ch. LEXIS 22, at *36, rev’d on other grounds, Cantor Fitzgerald, Ltd. P’ship v. Ainslie, 312 A.3d 674 (Del. 2024) (“[T]he fact Plaintiffs signed an agreement stipulating to its own reasonableness does not insulate that agreement from a reasonableness review under Delaware law.”); Kodiak Bldg. Partners, LLC v. Adams, 2022 Del. Ch. LEXIS 288, at *8 (Del. Ch. Oct. 6, 2022) (“[L]anguage stating its restrictive covenants are reasonable, and waiving a defense that they are not, does not preclude this Court from performing the reasonableness analysis our law mandates.”). ↑
Del. Code tit. 6, § 2707 (2024); see alsoDel. Code tit. 6, § 4914 (prohibiting the use of noncompetes in motor vehicle franchise agreements); Del. Code tit. 24, § 4109 (2023) (prohibiting a requirement that a home inspector trainee be required to execute a noncompete with a supervising inspector). ↑
See, e.g., Ala. Code § 8-1-190(a) (2015); Cal. Bus. & Prof. Code §§ 16600 et seq. (2024); and Neb. Rev. Stat. § 59-1603 (2024). ↑
Following the regional bank crisis in March of 2023,[1] many businesses started to review their treasury-management procedures for cash deposits out of safety concerns in the event of an insolvency of their depository bank. The reviews brought new attention to deposit programs designed to maximize access to insurance coverage provided by the Federal Deposit Insurance Corporation (“FDIC”) for deposits larger than the current $250,000 standard maximum deposit insurance limit per account at a depository bank. This article focuses on the IntraFi Cash Service of IntraFi LLC (“IntraFi”) as an example of such a program. The article will respond to frequently asked questions about how the IntraFi program works and how the depositors and their lenders are protected in the program.
How Does the IntraFi Program Work?
When placing funds on behalf of a customer through the IntraFi program, the customer’s relationship institution, which may be a bank, broker-dealer, or other eligible financial institution (“Relationship Institution”), and the customer enter into a deposit placement agreement (“DPA”) and a custodial agreement with the Relationship Institution as the custodian. The DPA states that the Relationship Institution will act as the customer’s agent in placing deposits. The custodial agreement further authorizes the Relationship Institution to maintain a custodial account[2] for the customer for the purpose of crediting the deposits placed through the program.
The Relationship Institution, in turn, will have entered into a Participating Institution Agreement with IntraFi and a sub-custody agreement (“Sub-Custody Agreement”) with a large money-center bank as a sub-custodian (“Sub-Custodian”) for the IntraFi program. The funds the Relationship Institution places for the customer are then, as described below, deposited with various FDIC-insured deposit-taking financial institutions (“Destination Institutions”) that enter into Participating Institution Agreements with IntraFi and are eligible to receive funds through the IntraFi program.
The placements are in amounts and pursuant to arrangements that make the funds eligible for deposit insurance provided by the FDIC ($250,000 per owner, per Destination Institution for each account ownership category). Specifically, the benefits of that insurance for the deposits at the Destination Institutions may be passed on to the customer under the “pass-through” rules established by the FDIC, which enable funds deposited by a custodian on behalf of the customer to be insured as if the customer had made the deposit with the Destination Institution itself.[3] Notably, customers can instruct the Relationship Institution not to deposit funds with certain Destination Institutions where the customer already maintains accounts, so as not to exceed coverage limits at that insured bank. The IntraFi program allows depositors to access millions in aggregate FDIC insurance across network banks.
The Sub-Custodian acts under the Sub-Custody Agreement as an intermediary to have the funds deposited with the Destination Institutions. The funds are then placed into deposit accounts at each Destination Institution, with the deposit accounts being in the name of the Sub-Custodian at the Destination Institution.
The Relationship Institution, the Destination Institutions, and the Sub-Custodian maintain appropriate books and records. These books and records, when considered together, reflect that the customer is the ultimate beneficiary of the funds placed in a deposit account at the relevant Destination Institution. Each deposit is recorded (a) on the records of the Destination Institution, in the name of the Sub-Custodian as the Relationship Institution’s sub-custodian; (b) on the records of the Sub-Custodian, in the Relationship Institution’s name as the customer’s custodian (showing that the Sub-Custodian is holding any claims with respect to the funds against the Destination Institution for the benefit of the Relationship Institution); and (c) on the records of the Relationship Institution, in the customer’s name (showing that the Relationship Institution is holding its claims with respect to the funds against the Sub-Custodian for the benefit of the customer).
In addition, under the DPA, the Relationship Institution agrees with the customer that it is acting as a “securities intermediary” under Article 8 of the UCC with respect to the custodial account established for the customer and that it will treat as “financial assets” under Article 8 of the UCC all of the Relationship Institution’s rights against the Sub-Custodian with respect to the deposit accounts placed by the Sub-Custodian. Financial asset means, among other things, “any property that is held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under [Article 8].”[4] The custodial account is a “securities account” under the UCC. Once the rights to payment with respect to the deposit accounts are financial assets credited to the custodial account, the customer acquires a security entitlement to them, which is a combination of contractual rights against the Relationship Institution, as securities intermediary, and a property interest in the financial assets. The customer’s rights include obtaining payments and distributions on the financial assets, exercising rights with respect to those financial assets, changing the form of holding of those financial assets, and causing the Relationship Institution to comply with entitlement orders to transfer or redeem those financial assets.[5]
How Is the Customer Protected in the Event of Insolvency of the Relationship Institution?
As noted above, the claims against the Sub-Custodian are credited to the customer’s account and treated as financial assets, giving the customer security entitlements against the Relationship Institution. Under Article 8, financial assets so credited, with exceptions not relevant here, are not property of the Relationship Institution and are not subject to the claims of the Relationship Institution’s creditors. As a result, the financial assets—the claims of the Relationship Institution against the Sub-Custodian—would not be included in the insolvency estate of the Relationship Institution. Practically, in most cases when a Relationship Institution has failed, its deposits and the custodial account have been assumed by another Relationship Institution, and business has continued as usual.
How Is the Customer Protected in the Event of Insolvency of the Sub-Custodian?
Similarly, under the Sub-Custody Agreement, the parties agree that the Sub-Custodian is acting as a securities intermediary and that the claims of the Sub-Custodian against the Destination Institutions are treated as financial assets under Article 8. Accordingly, such claims against the Destination Institutions are treated as security entitlements of the Relationship Institution against the Sub-Custodian. As with the Relationship Institution, financial assets, with exceptions not relevant here, are not property of the Sub-Custodian, are not subject to the claims of the Sub-Custodian’s creditors, and would not be included in the insolvency estate of the Sub-Custodian.
How Is the Customer Protected against the Exercise of Setoff by the Sub-Custodian in Case the Sub-Custodian Has an Unrelated Claim against the Relationship Institution?
The only contractual right of setoff that the Sub-Custodian has under the Sub-Custody Agreement against the Relationship Institution is for certain limited charges due to the Sub-Custodian as compensation in the Sub-Custody Agreement.
The Sub-Custodian would likely not have a noncontractual common-law right of setoff against the funds placed with it under the IntraFi program for amounts owed to the Sub-Custodian unrelated to the IntraFi program. Under the common law of most states, noncontractual common-law setoff is permitted only when the debts owed are “mutual.”[6] Mutuality requires that both parties be acting in the same capacity. Under the Sub-Custody Agreement, though, the Sub-Custodian is acting as a securities intermediary under Article 8 for the ultimate benefit of customers of the Relationship Institution. The Sub-Custodian would likely be acting in a different capacity as a creditor of the Relationship Institution for amounts owed unrelated to the IntraFi program. (The analysis would be similar if the Destination Institution were to consider exercising a setoff right for unrelated claims against the Sub-Custodian.)
How Does a Lender to the Customer Obtain a Perfected Security Interest in the Customer’s Rights to Payment under the IntraFi Program with the Desired Priority?
The lender’s security agreement needs to reasonably identify the collateral. The collateral description in a security agreement may refer to security entitlements or investment property, which is the generic UCC Article 9 category into which security entitlements fall. Alternatively, the collateral description could be even more specific while using one of those terms, such as “all of the debtor’s right, title, or interest in security entitlements to financial assets consisting of rights to payment under the IntraFi program maintained by [the Relationship Institution] for the benefit of the debtor, and the proceeds thereof.”
The security interest may be perfected by the lender filing in the appropriate UCC filing office a properly completed UCC financing statement against the customer and indicating as the collateral the security entitlement or investment property or a more specific description of the security entitlement or investment property using those terms, and the proceeds thereof.
The security interest granted by the customer may also be perfected by the Relationship Institution obtaining “control” of the security entitlements. If the lender is also the Relationship Institution, the lender obtains control automatically because the Relationship Institution is the customer’s securities intermediary. If the lender is not the Relationship Institution, the lender should enter into a securities account control agreement with the Relationship Institution and the customer, which will require the Relationship Institution to follow, without further consent of the customer, the entitlement orders of the lender, rather than the customer, under certain circumstances. If the lender perfects the security interest by control, there is no need for the lender to file a financing statement against the customer to perfect the lender’s security interest in the customer’s rights to payment under the IntraFi program.
Perfection of the lender’s security interest by control is the preferable method of perfection for the lender.[7] A security interest in a security entitlement or investment property perfected by control will have priority over a security interest in the same collateral perfected by the filing of a financing statement. This is the case even if the perfection of the security interest by control occurred after the filing of the financing statement and even if the secured party perfected by control knew of the financing statement filing.
Additional Considerations
Notably, the DPA provides that the customer has the right to dismiss the Relationship Institution as custodian and request that any of the funds placed for the benefit of the customer with a Destination Institution be retitled by the Destination Institution in the name of the customer directly. This process has the effect of unwinding the securities account held by the Relationship Institution and the Relationship Institution ceasing its role as a securities intermediary with respect to the funds.
If the customer exercises this right and the funds are so retitled, (a) there would no longer be a security entitlement with respect to the customer’s right to payment of the funds, and (b) the Relationship Institution’s security interest with respect to the right to the funds would no longer be perfected by control or may not be entitled to the priority afforded by control. The Relationship Institution may then need to take any additional steps necessary to preserve the perfection and priority of the security interest. As a result, a Relationship Institution that is also a lender may wish to include a provision in its credit documents providing that the customer shall postpone the exercise of its rights under the DPA while any obligations under the credit documents are outstanding or while the Relationship Institution has any obligation to extend credit under the credit documents. A third-party lender will want to address this issue in its account control agreement with the customer and the Relationship Institution.
Concluding Comments
This article provides only a brief summary of the IntraFi program and does so as an example of similar programs. It does not respond to all questions that may arise under these types of FDIC insurance maximization programs and is not a substitute for a careful review of the documentation for each program.
The custodial account will be a securities account for purposes of Article 8 of the Uniform Commercial Code (“UCC”), which is an account to which securities or other financial assets may be credited. The crediting of the deposit to the custodial account does not in and of itself render the deposit a security for purposes of federal securities laws. ↑
This article is Part IV in the Many Splendors of Fraud Claims series by Glenn D. West, which explores recent cases that affect drafting practices for avoiding fraud claims in private company M&A.
In Delaware, as in most states,
any person or entity that is alleged to have knowingly participated in the making of a fraudulent misrepresentation can be liable for that misrepresentation to the same extent as the person or entity that actually makes the misrepresentation; and the persons or entities potentially liable can include affiliates of the entity making the representation, as well as the human officers and owners of that entity or its affiliates, to the extent they knowingly cause or permit that entity to make a fraudulent misrepresentation.[1]
This concept applies to both intra-contractual and extra-contractual fraud claims.
Importantly, however, ABRY PartnersV, L.P. v. F & W Acquisition LLC[2] and its progeny permit (1) extra-contractual fraud to be taken off the table for both parties and nonparties to an agreement, through a properly worded disclaimer-of-reliance provision (to which the nonparties are made third-party beneficiaries); (2) liability for intra-contractual fraud to be limited to deliberate or knowing falsehoods stated in the express representations and warranties contained in the written agreement only, through an exclusive remedy provision (to which the nonparties are made third-party beneficiaries); and (3) the elimination of liability, through an exclusive remedy and nonrecourse provision, for parties and nonparties from “reckless, grossly negligent, negligent, or innocent misrepresentations of fact”[3] in a purchase agreement (all of which are potential states of mind supporting tort-based claims, including, potentially, common-law or equitable fraud).
What no contractual provision can accomplish, however, whether it is an exclusive remedy provision or a nonrecourse provision, is the elimination of liability of either a party or a nonparty for knowingly making or causing another person to make a deliberately false statement in a purchase agreement. I have written about this several times,[4] but it appears that deal lawyers continue to negotiate fraud definitions and nonrecourse provisions as if nonparties could avoid liability for deliberate and knowing participation in the conveyance of falsehoods in the express representations in a purchase agreement.
Matrix Parent: Deficient Fraud Definition
Fraud is frequently defined with the aim of purportedly limiting liability for fraud to only the party that is actually making the representations and warranties in the purchase agreement. An example of this approach is the following definition of Fraud from the recent Delaware Superior Court decision Matrix Parent, Inc. v. Audax Management Company, LLC:[5]
[“Fraud” means] intentional and knowing common law fraud under Delaware law in the representations and warranties set forth in this Agreement, any Contribution Agreement and the certificates delivered pursuant to Section 2.02(f)(i) and Section 2.03(d)(i). A claim for Fraud may only be made against the Party committing such Fraud. “Fraud” does not include equitable fraud, constructive fraud, promissory fraud, unfair dealings fraud, unjust enrichment, or any torts (including fraud) or other claim based on negligence or recklessness (including based on constructive knowledge or negligent misrepresentation) or any other equitable claim.[6]
But as noted by Aveanna Healthcare, LLC v. Epic/Freedom, LLC,[7] one of ABRY Partners’ many progeny, “if a seller ‘knew that the company’s contractual representations were false,’ the seller cannot ‘insulate’ itself from contractual fraud by hiding behind the company’s representations.”[8] In other words, it does not matter who technically made the representations—it matters who participated in their making or in causing them to be made.
And just as nonparties cannot hide behind the party that technically made the contractual representations, you cannot use a nonrecourse provision to exonerate nonparties from their participation in the conveyance of intentional lies in a written purchase agreement either. Nonrecourse provisions are not permitted to go so far—any attempt to do so is famously considered “too much dynamite.”[9]
Matrix Parent not only rejected the effort of defendants to limit Fraud, as it was defined, to just the parties to the purchase agreement, but also rejected the reliance upon a very broadly worded nonrecourse clause to exonerate nonparties who were alleged to have knowingly participated in intentional intra-contractual fraud. The court further rejected a very explicit provision that actually had the parties waiving “any claim against any Non-Recourse Party for conspiracy, aiding or abetting or other theory of liability.”[10] According to the court, “under Delaware law, the terms of a fraudulently procured contract [even though limited to claims based ‘solely on the falsity of express contractual representations’] cannot exempt from liability entities that were knowingly complicit in the fraud, including entities that aided, abetted, or conspired to commit such fraud.”[11] And, similar to the holding in Online Healthnow, Inc. v. CIP OCL Investments, LLC,[12] “[b]ecause Plaintiff has well pled that [a non-recourse party] did, in fact, know of and facilitate the fraudulent misrepresentations in the SPA . . . [the non-recourse party] cannot invoke the non-recourse provision to avoid liability under ABRY Partners and its progeny.”[13]
Crafting an Agreement with the Matrix Parent Decision in Mind
So, knowing this, you can easily agree as a seller to carve out intentional inter-contractual fraud from the nonrecourse clause, and define Fraud by reference to “Persons” rather than “Parties.”
The July 15, 2024, Merger Agreement governing Perdoceo Education Corporation’s $135 million acquisition of University of St. Augustine for Health Sciences, LLC, contains an example of a Fraud definition that appears to understand that you cannot limit intentional intra-contractual common-law fraud to just the party actually making those representations:
“Fraud” means actual and intentional common law fraud under Delaware law with respect to the representations and warranties set forth in this Agreement (including Article V or Article VI), any of the Related Documents, or any certificate delivered pursuant to this Agreement or any of the Related Documents. For the avoidance of doubt, (a) the term “Fraud” does not include any claim for equitable fraud, promissory fraud, or unfair dealings fraud, or any claim for fraud or misrepresentation based on negligence or recklessness and (b) only a Person who had actual knowledge of or knowingly and intentionally participated in such Fraud shall be responsible for such Fraud and only to a Person who actually relied on such representations and warranties and was actually damaged or harmed by such Fraud.[14]
Keep in mind that clause (b) does not actually do anything that the law of Delaware doesn’t already do, but sometimes saying it out loud helps the other side—and it’s sleeves off the seller’s vest to acknowledge that nonparties can be liable for the knowing participation in the conveyance of falsehoods in the express representations and warranties set forth in an acquisition agreement.
Section 5 of the Securities Act of 1933 (“Securities Act”) prohibits the offer or sale of unregistered securities, absent an exemption. However, Section 4(a)(1) of the Securities Act explicitly states that the prohibition in Section 5 only applies to transactions by an issuer, underwriter, or dealer.[1]
The Securities and Exchange Commission (“SEC”) has been relatively undaunted by that limitation. Through a long series of SEC enforcement actions, appellate courts have expanded the plain language of Section 4(a)(1) by developing the “necessary participant” doctrine, widening the scope of the “issuer, underwriter, or dealer” language to hold defendants liable when they have been a “necessary participant” in the offer and sale of alleged unregistered securities. In an SEC enforcement action dating back to 1941, SEC v. Chinese Consolidated Benevolent Ass’n, the U.S. Court of Appeals for the Second Circuit found that a person not directly engaged in transferring title of the security nevertheless can be held liable under Section 5 if that person “engaged in steps necessary to the distribution of [unregistered] security issues.”[2] The Second Circuit’s interpretation is judge-made law that departs from the plain language of the statute.
This article explores the advent and evolution of the “necessary participant” doctrine and discusses some of the dangers of expanding the plain language of Section 4(a)(1).
Section 4(a)(1): The “Ordinary Trading” Exemption
Section 5 of the Securities Act makes it unlawful, directly or indirectly, to publicly offer or sell unregistered securities, unless the offering is covered by an exemption.[3] Several potential exemptions are available to market participants, depending upon the nature of the transaction, amount of the offering, and participants involved. One of those exemptions is codified under Section 4(a)(1),[4] sometimes known as the “ordinary trading” exemption, which states that Section 5 does not apply to transactions by any person other than an issuer, underwriter, or dealer.[5]
Underwriter is statutorily defined in Section 2(a)(11) of the Securities Act as
any person who has purchased from an issuer with a view to, or offers or sells for an issuer in connection with, the distribution of any security, or participates or has a direct or indirect participation in any such undertaking, or participates or has a participation in the direct or indirect underwriting of any such undertaking.[6]
For example, an investment bank that has an arrangement with a securities issuer to facilitate the public sale of its securities is typically considered an “underwriter.”
On its face, Section 2(a)(11) defines underwriter broadly enough such that, theoretically, it could be construed to encompass persons other than the traditional investment bank that underwrites a registered securities offering. However, “while the definition is indeed broad, ‘[u]nderwriter’ is not . . . a term of unlimited applicability that includes anyone associated with a given transaction.”[7] Courts have found that “[i]t is crucial to the definition of ‘underwriter’ that any underwriter must participate in the distribution of a security.”[8] This participation notion was expressly contemplated by Congress, which “ma[de] clear that a person merely furnishing an underwriter money to enable him to enter into an underwriting agreement is not an underwriter. . . . The test is one of participation in the underwriting undertaking rather than that of a mere interest in it.”[9] The rationale for subjecting underwriters to potential liability is “because they hold themselves out as professionals who are able to evaluate the financial condition of the issuer,” and “[t]he public relies on their expertise and reasonably expects that they have investigated the offering with which they are involved.”[10]
If a holder of securities is not an issuer, underwriter, or dealer, they may sell their existing securities without registration pursuant to Section 4(a)(1).[11] Section 4(a)(1) was “designed to exempt routine trading transactions with respect to securities already issued”—not necessarily to exempt initial distributions by issuers.[12] Importantly, Section 4(a)(1) exempts transactions, not persons.[13]
SEC v. Chinese Consolidated Benevolent Ass’n
In 1941, the Second Circuit seemingly expanded the statutory limitations of Section 4(a)(1), not only by construing the Section 2(a)(11) definition of underwriter broadly, but by holding that even if a defendant was not an issuer, dealer, or underwriter itself, the Section 4(a)(1) exemption would not apply if the defendant was engaged in “steps necessary” to the distribution of unregistered securities.
In Chinese Consolidated, the SEC sued a New York corporation to enjoin it from using any instruments of interstate commerce or of the mails in attempting or offering to sell or dispose of Chinese government bonds.[14] The defendant was a benevolent association with a membership of 25,000 Chinese individuals. Without any official or contractual relationship with the Chinese government, this New York corporation urged members of Chinese communities in New York, New Jersey, and Connecticut to purchase Chinese government bonds, and offered to accept funds from prospective purchasers and deliver those funds to the Bank of China in New York. Neither the defendant nor its members were ever charged for their activities, and they did not receive any compensation. The SEC sought to enjoin the defendant from disposing of, or attempting to dispose of, these Chinese government bonds, which it alleged were unregistered securities.
The defendant was concededly neither the issuer of the Chinese government bonds nor a dealer. Accordingly, under Section 4(a)(1) of the Securities Act, the defendant would be exempt from registration requirements if it was also not an underwriter, as defined in Section 2(a)(11). The district court indeed found that the defendant was not an underwriter and was therefore exempt because the defendant did not sell or solicit offers to buy the Chinese government bonds for an issuer, as the Section 2(a)(11) definition of underwriter specifies. The district court found that the defendant’s actions in attempting to dispose of the bonds were not for the Chinese government; indeed, there was no contractual arrangement or even understanding with the Chinese government.
The Second Circuit reversed, pointing to the facts that the “defendant solicited the orders, obtained the cash from the purchasers and caused both to be forwarded so as to procure the bonds.”[15] The court noted that “the aim of the Securities Act is to have information available for investors[,] [and] [t]his objective will be defeated if buying orders can be solicited which result in uninformed and improvident purchases.”[16] Ultimately, the court, noting the aim of the Securities Act to furnish the public with adequate information, and the purported aim of the issuer (here, the Chinese government) to promote the distribution of the securities, broadly interpreted the plain language of the definition of underwriter. The court held that “[a]ccordingly the words ‘(sell) for an issuer in connection with the distribution of any security’ ought to be read as covering continual solicitations.”[17] The court ultimately found that the defendant acted as an underwriter in the distribution of unregistered securities.[18]
Crucially, the court went on to find a “further reason” for holding that the defendant’s activity was prohibited.[19] The court noted that Section 4(a)(1) was not intended to exempt distributions by issuers, and that here,
[t]he complete transaction included not only solicitation by the defendant of offers to buy, but the offers themselves, the transmission of the offers and the purchase money through the banks to the Chinese government, the acceptance by that government of the offers and the delivery of the bonds to the purchaser or the defendant as his agent.[20]
The court held that “[e]ven if the defendant is not itself ‘an issuer, underwriter, or dealer’ it was participating in a transaction with an issuer, to wit, the Chinese Government.”[21] The court explained that the Section 4(a)(1) exemption does not “protect those who are engaged in steps necessary to the distribution of security issues.”[22]
In sum, the court found that the defendant’s actions fell under the definition of underwriter under Section 2(a)(11) such that the defendant was liable for its attempts to dispose of the Chinese government bonds without registration; and, significantly, that even if the defendant was not an underwriter, it “engaged in steps necessary to the distribution” of the unregistered securities such that it did not qualify for the Section 4(a)(1) exemption. Thus, the “necessary participant” doctrine was born, making it possible for a defendant to be liable under Section 2(a)(11) even if it is not an issuer, underwriter, or dealer.
The Second Circuit’s Expansion of Necessary Participant
Stemming from Chinese Consolidated in 1941, courts have adopted and expanded the necessary participant language from that case to create myriad other tests that purportedly help explain what a “necessary participant” is—and when a person who is not an issuer, underwriter, or dealer can nevertheless be liable under Section 5.[23]
Perhaps realizing that Chinese Consolidated was unmoored from the statute, the Second Circuit later tried to put the genie back in the bottle, but without actually overturning Chinese Consolidated. In SEC v. Kern, the Second Circuit cited the “steps necessary” language from Chinese Consolidated to hold that “underwriters . . . include any person who is ‘engaged in steps necessary to the distribution of security issues.’”[24] But later, in SEC v. Sourlis, with somewhat cursory analysis, the Second Circuit held that Section 5 liability extends to “those who have ‘engaged in steps necessary to the distribution of [unregistered] security issues’”—quoting and relying on Chinese Consolidated without even mentioning the word underwriter.[25]
District courts within the Second Circuit, springboarding from Chinese Consolidated’s departure from the statutory text, developed the “necessary participant” doctrine by introducing additional considerations beyond the plain language of Section 4(a)(1). Under these cases, defendants may be liable for violating Section 5 even if they do not offer or sell a security, provided that they were a “necessary participant” in the unregistered distribution.[26]
But then how is a court to determine who is a “necessary participant”? As one court frames it, “[t]he ‘necessary participant test . . . essentially asks whether, but for the defendant’s participation, the sale transaction would not have taken place.’”[27] This “but for” formulation significantly expands the range of whom the SEC can sue for Section 5 liability to include anyone or any entity that the SEC asserts had a necessary role in the unregistered securities transaction.
In other words, in an attempt to define limitations on what a “necessary participant” is, courts have articulated a “substantial factor” test—that is, “whether the defendants’ acts were a ‘substantial factor in the sales transaction.’”[28] However, the concept of a “substantial factor” in a securities transaction is as ill-defined as other terms within this discussion.[29]
And as the SEC v. Genovese court pointed out, the “but-for” test raises its own problems. It “would require finding innumerable necessary participants to every unregistered securities offering—everyone who played an intermediate role, no matter how small, in the chain of causation leading to the sale.”[30] Indeed, “[a] strict ‘but-for’ test also is at odds with the Commission’s guidance, which provides that not every individual in the causal chain is a necessary participant.”[31]
Ultimately, in Genovese, the court organized the defendant’s activities into two categories: (1) those showing “direct involvement” in the sale and (2) those “activities ancillary” to the sale.[32] Examples of direct involvement, which implicate substantial participation, include where defendants “directly prepared . . . corporate resolutions and documentation”;[33] “formed entities for use in sale, solicited investments, provided subscription agreements, communicated with buyers and sellers, and directed broker action”;[34] and “found private parties as clients for deals, filed paperwork with regulators, served as president, CEO and director of transfer agency and handled promotion of stock.”[35] In contrast, the Genovese court ultimately found that “activities ancillary” were “too remote from the actual sale to rise to the level of necessary or substantial participation”—creating yet another criterion for considering what “necessary participation” is.[36]
Thus, in the Second Circuit alone, the new category of “necessary participant” created by Chinese Consolidated—explicitly described as being separate from the definition of underwriter in Section 2(a)(11)—has spawned a slew of tests, some of which appear to be attempting to shoehorn the classification back into the underwriter definition, and some of which follow Chinese Consolidated more strictly (and thus follow the statute far more loosely).
Other Circuit Courts’ Interpretation of Necessary Participant
In the wake of Chinese Consolidated, other circuit courts, including the U.S. Courts of Appeals for the Seventh and Ninth Circuits, also adopted a new, atextual “necessary participant” doctrine, often tempered by the “substantial factor” doctrine, to hold that defendants need not be issuers, underwriters, or dealers to be held liable for a Section 5 violation.[37] These courts often recognize the risk that a party whose minimal acts assisted in the unregistered securities distribution could be held liable for registration violations, but they have found that, “in practice, the standards differ little, for no court using the ‘necessary participant’ test has found liable a defendant whose acts were not a substantial factor in the sales transaction.”[38]
In SEC v. Holschuh, the Seventh Circuit formulated the test differently, explicitly finding that persons who were not underwriters may nevertheless be liable on the grounds that the statute refers to the transactions by people, not the people themselves.[39]Holschuh found that the defendant “was a ‘necessary participant’ and ‘substantial factor’ in the unlawful sales transactions,” and thus liable even though not an underwriter.[40] Thus, other circuits have used this “substantial factor” test as well—sometimes articulated somewhat differently from the Second Circuit, but still addressing the concept of a “necessary participant” rather than strictly an issuer, underwriter, or dealer.
Back to the Second Circuit: In re Lehman Brothers
After the adoption of the “but-for” test and “substantial factor” test, which both provided gloss on the “necessary participant” doctrine, the Second Circuit provided further guidance in a 2011 case, In re Lehman Brothers Mortgage-Backed Securities Litigation.[41] There, investors brought putative class actions to hold credit ratings agencies liable under the Securities Act, in part as underwriters. The plaintiffs attempted to argue that Second Circuit precedent construed the term underwriter broadly to include any person who is “engaged in steps necessary to the distribution of security issues.”[42] According to the plaintiffs’ logic, “any persons playing an essential role in a public offering . . . may be liable as underwriters.”[43] The court disagreed, stating that its “prior cases do not hold that anyone taking steps that facilitate the eventual sale of a registered security fits the statutory definition of underwriter.”[44] Rather, the court “stated that ‘underwriter’ references those who take ‘steps necessary to the distribution’ of securities.”[45]
Further elaborating on Chinese Consolidated, Kern, and other Second Circuit progeny, the court clarified that “this precedent cannot be read to expand the definition of underwriter to those who participate only in non-distributional activities that may facilitate securities’ offering by others.”[46] Rather,
the participation must be in the statutorily enumerated distributional activities, not in non-distributional activities that may facilitate the eventual distribution by others. This approach avoids the implausible result of transforming every lawyer, accountant, and other professional whose work is theoretically “necessary” to bringing a security to market into an “underwriter” . . . , a dramatic outcome that Congress provided no sign of intending.[47]
In its elaboration, the court corrected a common misinterpretation of Chinese Consolidated, remarking that “we note that the ‘steps necessary to the distribution’ language relied on by plaintiffs was originally employed by this court [in Chinese Consolidated] to explain a registration exemption, not the underwriter definition.”[48] The court noted, “[W]e stated [in Chinese Consolidated] that ‘[i]t,’ meaning the [4(a)(1)] exemption, ‘does not . . . protect those who are engaged in steps necessary to the distribution of’ securities because it is limited to transactions between individual investors.”[49]
On the one hand, Lehman Brothers clarified that Chinese Consolidated first employed the “steps necessary” language to carve out “necessary participants” from the Section 4(a)(1) exemption. On the other, Lehman Brothers clarified that underwriter references those who take “steps necessary to the distribution” of securities, despite that language not existing in the Section 2(a)(11) statutory definition of underwriter. In doing so, Lehman Brothers reconfirmed the departure from the text first set out in Chinese Consolidated: under these cases, a “necessary participant” is not just a type of underwriter; it’s a new category entirely—one that does not exist in the text of the 1933 Securities Act.[50]
Where to, from Here?
The rationale of the Securities Act was to provide the public accurate and complete information by the people or entities responsible for distributing securities to the public.[51] Yet, despite Congress’s circumscribed application of registration requirements to issuers, dealers, and underwriters, the Second Circuit expanded the group responsible for registration requirements to include “necessary participants” to the distribution of securities, even if they are not underwriters.
That expansion, initiated in a few lines in Chinese Consolidated in 1941 and expounded on over a period of decades by multiple circuit and district courts, stretches the plain language of Section 4(a)(1). Not only can the Section 2(a)(11) definition of underwriter include those who indirectly participate in the distribution of securities (already, arguably, at the outer reaches of Section 2(a)(11)), but even those who are not underwriters may not fall under the Section 4(a)(1) exemption if they are “necessary participants” and take “steps necessary” to the distribution of unregistered securities.
Chinese Consolidated opened the door for a nebulous “necessary participant” to include myriad individuals or entities other than issuers, underwriters, or dealers in the chain of a securities distribution. The Ninth Circuit’s discussion in Murphy raised the concern that “this broader standard could encompass a party whose acts in furtherance of the distribution were de minimis and who should not be held liable for registration violations.”[52]
In the era of digital assets trading over complex and interconnected computer networks, it might be a struggle to draw the appropriate limiting principle on who could be deemed a “necessary participant,” and an expansive interpretation could apply to innumerable persons and entities. No longer are we only concerned with a single newspaper editorial, as Judge Swan pointed to in his Chinese Consolidated dissent, but courts will be asked to consider: Websites that host front ends? Participants in a blockchain network, such as validators, stakers, or decentralized exchanges? Noncustodial wallet providers? Blockchains themselves?
For many (and perhaps all) of these categories, it would make no sense to hold the persons or entities creating or operating these technologies responsible for issuances of unregistered securities—not from a policy point of view, and certainly not under the plain language of the Securities Act. Indeed, given the free-flowing and permissionless nature of the internet and Web 3.0, participants may not even be aware of the role they play in the distribution chain—perhaps they simply publish software on the internet that could be used to ultimately purchase an alleged unregistered security.
Eighty years of case law has developed to suggest that a “necessary participant” is its own category, apart from issuers, underwriters, and dealers. That alone is a departure from the plain text of the Securities Act. Worse, as explained above, district courts have struggled to interpret the “necessary participant” language from Chinese Consolidated to apply some limiting principle, such that underwriter is not too broadly construed to include any person who is engaged in “steps necessary” to the distribution of securities.
Without the “necessary participant” doctrine’s advent in Chinese Consolidated, district courts would merely have to interpret the plain language of Section 4(a)(1) that applies to issuers, underwriters, and dealers—and perhaps Section 2(a)(11)—to determine who would be considered an underwriter. While some of the same analytical tools might be useful, such tools would be used within the context of Section 2(a)(11) and the rest of the underwriter definition, which—in context—might serve to limit some of the more expansive interpretations of which parties may be liable.
Ultimately, the “necessary participant” doctrine as first stated in Chinese Consolidated would be unlikely to survive a strict textualist Supreme Court review. Chinese Consolidated created a new category for liability, even if a person was not an underwriter. A textualist review would likely limit Section 4(a)(1)’s application to its plain language of only issuers, dealers, or underwriters (as defined in Section 2(a)(11)), not issuers, dealers, underwriters, or those who have engaged in “steps necessary” to the distribution of securities, as in Chinese Consolidated.
Further, a textualist review, grounded in the remainder of Section 2(a)(11) (and taking into account the context of that language), would be narrower. For example, such a review would not eliminate the words “for an issuer” from the Section 2(a)(11) definition of underwriter, meaning that an entity with no contractual arrangement or understanding with the issuer likely would not be considered an underwriter. Deeming an individual or entity integral to distributing an alleged security, and thus liable under Section 5, simply because it provides information about or access to that security, despite no relationship or understanding with the issuer, is unmoored from the plain language of Section 5.
Unless the Supreme Court, other courts of appeal not bound by prior circuit law, or Congress weighs in and ends this eighty-year-long (and counting) detour away from the plain statutory language of the Securities Act, the definition of necessary participant, and the myriad considerations that influence what a “necessary participant” is, will remain unclear for individuals and entities operating in the securities industry and beyond.
15 U.S.C. § 77b(a)(11); see Fed. Deposit Ins. Corp. v. Credit Suisse First Bos. Mortg. Sec. Corp., 414 F. Supp. 3d 407, 413 (S.D.N.Y. 2019). ↑
In re Refco, Inc. Sec. Litig., No. 05-cv-8626, 2008 WL 3843343, at *4 (S.D.N.Y. Aug. 14, 2008) (citing Ackerberg v. Johnson, 892 F.2d 1328, 1335 (8th Cir. 1989)). ↑
McFarland v. Memorex Corp., 493 F. Supp. 631, 644 (N.D. Cal. 1980). ↑
Circuit Judge Swan dissented, pointing out that “the majority opinion has construed the statute more broadly than its language will permit.” Id. at 742. In his interpretation, including the defendant within the definition of an underwriter “gives no meaning to the words ‘for an issuer.’” Id. He pointed out that under the majority’s construction, “a single newspaper editorial, published without instigation by the Chinese Government and merely urging the purchase of the bonds in the name of patriotism, would make the newspaper an ‘underwriter,’” and that he “cannot believe the statute should be so interpreted.” Id.↑
See SEC v. N. Am. Rsch. & Dev. Corp., 424 F.2d 63, 82 (2d Cir. 1970) (noting that Chinese Consolidated “make[s] it clear that being an underwriter is not a prerequisite to a finding of violation of Section 5”); SEC v. Culpepper, 270 F.2d 241, 246 (2d Cir. 1959) (“In [Chinese Consolidated] we noted the underlying policy of the [Securities] Act, that of protecting the investing public through the disclosure of adequate information, would be seriously impaired if we held that a dealer must have conventional or contractual privity with the issuer in order to be an ‘underwriter.’”). ↑
425 F.3d 143, 152 (2d Cir. 2005) (citing Chinese Consolidated). Ironically, the citation of Chinese Consolidated’s “steps necessary” language to define underwriter in Kern “was arguably dictum because the transaction in that case unquestionably ‘involved underwriters,’ rendering [Section 4(a)(1)] inapplicable.” In re Lehman Brothers Mortg.-Backed Sec. Litig., 650 F.3d 167, n.7 (2d Cir. 2011). ↑
See SEC v. Mattera, No. 11-cv-8323, 2013 WL 6485949, at *10 (S.D.N.Y. Dec. 9, 2013) (holding that “necessary participants” in unregistered distributions may be liable under Section 5); SEC v. Sason, 433 F. Supp. 3d 496, 513 (S.D.N.Y. 2020). ↑
SEC v. Universal Express, Inc., 475 F. Supp. 2d 412, 422 (S.D.N.Y. 2007) (quoting SEC v. Murphy, 626 F.2d 633, 651–52 (9th Cir. 1980)). ↑
Id. (quoting Murphy, 626 F.2d at 651–52); see also SEC v. Genovese, No. 17-cv-5821, 2021 WL 1164654 (S.D.N.Y. Mar. 26, 2021) (noting that Sason and Mattera qualify the “necessary participant” test “with statements that the defendants’ acts must be a ‘substantial factor in the sales transactions’”). ↑
See SEC v. Elliott, No. 09-cv-7594, 2011 WL 3586454, at *7 (S.D.N.Y. Aug. 11, 2011) (“As for substantial participation, to be sure it is a concept without precise bounds. . . .”). ↑
Id. (quoting In re Owen v. Kane, Exchange Act Release No. 23827, 1986 WL 626043, at *3 (1986) (reinforcing that “not everyone in the chain of intermediaries between a seller of securities and the ultimate buyer is sufficiently involved in the process to make him responsible for an unlawful distribution”). ↑
See, e.g., SEC v. Murphy, 626 F.2d 633, 648 (9th Cir. 1980) (“Although we have rejected Murphy’s exemption argument because he need not be an issuer, underwriter or dealer to be held liable for a § 5 violation, we recognize that Murphy’s role in the transaction must be a significant one before liability will attach.”). ↑
Id.; see also SEC v. CMKM Diamonds, Inc., 729 F.3d 1248, 1255 (9th Cir. 2013) (“Prior to the issuance of a security, numerous persons perform mechanical acts without which there could be no sale. . . . [B]ut these acts nonetheless do not render the defendants sellers” because their “acts must also be a substantial factor in bringing about the transaction.”). ↑
As noted above, in Sourlis, the Second Circuit—after Lehman Brothers—sidestepped the whole morass, simply quoting and relying on Chinese Consolidated without even mentioning the word underwriter. 851 F.3d 139, 143–44 (2d Cir. 2016). ↑
See H.R. Rep. No. 73-85, at 5 (1933) (noting that the Securities Act imposes fiduciary-like responsibilities on “all those responsible for statements upon the face of which the public is solicited to invest its money,” namely, “directors of the issues, its experts, and the underwriters who sponsor the issue”). ↑
