Excessive executive compensation has come under fire in recent years from a range of commentators,[1] including surprising ones like former Chief Justice of the Delaware Supreme Court Leo Strine.[2] Although generous compensation packages may be justifiable in the case of a healthy company, in the case of a distressed company, they are more difficult to defend—economically and legally. For example, bankrupt OxyContin manufacturer Purdue Pharma recently disclosed that it paid its CEO Craig Landau $9 million in the 12 months before filing and doubled his salary in 2018 after hiring a law firm to provide bankruptcy advice.[3] Admittedly, it is not readily apparent that Landau’s compensation is excessive under current market standards. Even so, it is obvious that executives who receive outsized compensation packages and the board members who approve them are prime targets for dissatisfied corporate constituents, such as unpaid creditors, seeking to recoup value. Fraudulent transfer and fiduciary claims are the traditional tools that creditors use to seek recovery of excessive managerial compensation. However, in certain jurisdictions, creditors may also be able to characterize excessive compensation paid to manager-shareholders as disguised and unlawful dividends. As with other features of corporate law, the applicability and contours of the de facto dividend doctrine vary from jurisdiction to jurisdiction.
Sections 170(a) and 174(a) of the Delaware General Corporation Law (DGCL) make a director liable to the corporation, or its creditors in the event of insolvency, for the full amount of any illegal dividend, including those paid while “the corporation’s capital . . . is less than the capital represented by all outstanding shares having a preference upon the distribution of assets.”[4] In Horbal v. Three Rivers Holdings, Inc., minority shareholders in a health maintenance organization (HMO) sued corporate directors for “siphoning off tens of millions of dollars from the HMO in the form of disguised salaries, bonuses and corporate perquisites,” which the plaintiffs asserted were really “de facto dividends.”[5] Judge Chandler rejected plaintiffs’ theory on the ground that “[n]o Delaware court ha[d] ever recast executive compensation as a constructive dividend[.]”[6] Instead, Judge Chandler found that the plaintiffs’ claim implicated “a classic allegation of self-dealing or waste” subject to attack as a violation of the fiduciary duty of loyalty.[7]
Outside of Delaware, however, a number of courts have been willing to recast inordinate executive compensation as de facto, disguised, or constructive dividends,[8] particularly in the case of closely held corporations.[9] These claims may be brought by creditors or minority shareholders and can be framed as tort or statutory claims.[10] For example, in the recent case of Tisch v. Tisch, the Colorado Court of Appeals found that a controlling shareholder’s use of company funds from a family-owned liquor store for the payment of excessive salary, personal credit cards, and unauthorized loans qualified as disguised dividends supporting minority shareholders’ civil theft claim.[11]
From the perspective of an unpaid creditor, there are several potential advantages to recasting inordinate executive compensation as disguised and unlawful dividends, as opposed to pursuing only fiduciary duty or fraudulent transfer claims. First, as opposed to a fraudulent transfer claim, a director who is not a transferee may be held personally liable for authorizing or acceding to the unlawful dividend. In some jurisdictions, a director’s statutory liability for an unlawful dividend may be based upon mere negligence,[12] and the business judgment rule does not provide a defense.[13] Moreover, in certain jurisdictions, a director cannot assert the use of a special committee or exculpation language in a corporate charter as a defense to liability.[14] Additionally, in most jurisdictions, creditors may recover dividends paid while a company is insolvent from a manager-shareholder who received it with knowledge of the company’s insolvency.[15] Although this may be similar to an avoidable transfer claim, fraudulent transfer and preference defenses are unavailable because the statutory unlawful dividend claim is akin to a “strict liability” claim.[16] Finally, statutory unlawful dividend claims may also allow the plaintiff to recover interest from the date of the distribution.[17] Given these potential advantages over fraudulent transfer and fiduciary claims, practitioners advising boards and representing creditors should be aware of the possibility of courts recasting excessive executive compensation as disguised unlawful dividends in certain jurisdictions.
[1] J. William Boone is a partner at James-Bates-Brannan-Groover-LLP in Atlanta, Georgia, and Matthew M. Graham is a shareholder at Stearns Weaver Miller Weissler Alhadeff & Sitterson, P.A. in Miami, Florida.
[2] Leo E. Strine, Jr., Toward Fair and Sustainable Capitalism, Harvard John M. Olin Discussion Paper Series, Discussion Paper No. 1018 (Sept. 2019).
[3] Geoff Mulvihill & Tom Murphy, Purdue Pharma paid CEO $9M in year before bankruptcy, StarTribune, Oct. 30, 2019; Liz O. Baylen, Purdue Pharma workers can get bonuses, but maybe the CEO shouldn’t, judge decides, L.A. Times, Dec. 4, 2019.
[7]Id. at *4; see also Quadrant Structured Prods. Co., Ltd. v. Vertin, 102 A.3d 155, 201 (Del. Ch. 2014).
[8]See, e.g., Tisch v. Tisch, 439 P.3d 89, 105 (Colo. App. 2019); Four Seasons Equip., Inc. v. White (In re White), 429 B.R. 201, 210 (Bankr. S.D. Tex. 2010); Interstate Highway Const., Inc. v. Gigot, 90-1289-K, 1990 WL 235693, at *2 (D. Kan. Dec. 20, 1990); Murphy v. Country House, Inc., 349 N.W.2d 289, 293 (Minn. Ct. App. 1984); Erdman v. Yolles, 233 N.W.2d 667, 669 (Mich. Ct. App. 1975).
[9]See Alaska Plastics, Inc. v. Coppock, 621 P.2d 270, 277 (Ala. 1980).
[10]Compare Interstate Highway Const., Inc., 1990 WL 235693, at *2 (statutory claim by creditor), with Tisch, 439 P.3d at 105 (civil theft claim by minority shareholders).
[13]See In re Musicland Holding Corp., 398 B.R. 761, 785 (Bankr. S.D.N.Y. 2008) (finding that section 174(a) of the DGCL “imposes a form of strict liability without regard to any action or inaction by a particular director” and “the business judgment rule does not apply because the payment of an unlawful dividend is an illegal act”).
[14]See 2 Model Bus. Corp. Act § 8.25 official cmt. (4th ed. 2013 rev.) (stating that “section 8.25(e)(1) generally makes nondelegable the decision whether to authorize or approve distributions, including dividends”); Del. Code tit. 8, § 102(b)(7) (providing that certificate of incorporation may not limit or eliminate a director’s personal liability for unlawful dividends under section 174 of the DGCL).
IRS Forms 1099 match income and Social Security numbers.[1] Most people pay attention to these forms at tax time, but lawyers and clients alike should pay attention to them the rest of the year as well. Failing to report a Form 1099 is guaranteed to give you an IRS tax notice to pay up. These little forms are a major source of information for the IRS. Copies go to state tax authorities, which are useful in collecting state tax revenues.
Lawyers receive and send more Forms 1099 than most people, in part due to tax laws that single them out. Lawyers make good audit subjects because they often handle client funds. They also tend to have significant income. The IRS has a keen interest in the tax treatment of litigation settlements, judgments, and attorney’s fees. Lawyers are singled out for extra Forms 1099. The tax code requires companies making payments to attorneys to report the payments to the IRS on a Form 1099.
Each person engaged in business and making a payment of $600 or more for services must report it on a Form 1099. The rule is cumulative, so whereas one payment of $500 would not trigger the rule, two payments of $500 to a single payee during the year require a Form 1099 for the full $1,000. Lawyers must issue Forms 1099 to expert witnesses, jury consultants, investigators, and even co-counsel where services are performed and the payment is $600 or more.
A notable exception from the normal $600 rule is payments to corporations. Payments made to a corporation for services are generally exempt; however, an exception applies to payments for legal services. Put another way, the rule that payments to lawyers must be the subject of a Form 1099 trumps the rule that payments to corporation need not be. Thus, any payment for services of $600 or more to a lawyer or law firm must be the subject of a Form 1099, and it does not matter if the law firm is a corporation, LLC, LLP, or general partnership, nor does it matter how large or small the law firm may be. A lawyer or law firm paying fees to co-counsel or a referral fee to a lawyer must issue a Form 1099 regardless of how the lawyer or law firm is organized. Plus, any client paying a law firm more than $600 in a year as part of the client’s business must issue a Form 1099. Forms 1099 are generally issued in January of the year after payment. In general, they must be dispatched to the taxpayer and IRS by the last day of January.
Issuing Forms 1099 to Clients
One confusing tax reporting issue for law firms is whether to issue Forms 1099 to clients. Practice varies considerably, and many firms issue the forms routinely; however, most payments to clients do not actually require the forms. Of course, many lawyers receive funds that they pass along to their clients. That means law firms often cut checks to clients for a share of settlement proceeds. Even so, there is rarely a Form 1099 obligation for such payments. Most lawyers receiving a joint settlement check to resolve a client lawsuit are not considered payors. In fact, the settling defendant is considered the payor, not the law firm. Thus, the defendant generally has the obligation to issue the Forms 1099, not the lawyer.
Example 1: Larry Lawyer earns a contingent fee by helping Cathy Client sue her bank. The settlement check is payable jointly to Larry and Cathy. If the bank doesn’t know the Larry/Cathy split, it must issue two Forms 1099 to both Larry and Cathy, each for the full amount. When Larry cuts Cathy a check for her share, he need not issue a form.
Example 2: Consider the same facts as in Example 1, but assume that Larry tells the bank to issue two checks, one to Larry for 40 percent, and the other to Cathy for 60 percent. Here again, Larry has no obligation to issue a form because Cathy is getting paid by the bank. The bank will issue Larry a Form 1099 for his 40 percent. It will issue Cathy a Form 1099 for 100 percent, including the payment to Larry, even though the bank paid Larry directly. Cathy must find a way to deduct the legal fee.
Physical Injury Payments
One important exception to the rules for Forms 1099 applies to payments for personal physical injuries or physical sickness. Think legal settlements for auto accidents and slip-and-fall injuries. Given that such payments for compensatory damages are generally tax-free to the injured person, no Form 1099 is required.
Example 1: Hal Hurt is in a car crash and receives a $1 million settlement. Defendant Motors issues a joint check to Hal and his lawyer Sue Suits. Defendant is not required to issue a Form 1099 to Hal. Defendant must still issue a Form 1099 to Sue for the full $1 million.
Example 2: Same facts, but assume Sue asks for a $600,000 check issued to Hal (without a Form 1099) and a $400,000 check issued to her (with a Form 1099 to Sue for $400,000). Defendant Motors can agree to this request.
Other Payments to Clients
What about a law firm’s refund of legal fees to clients? Must those payments be reported to the client on Form 1099 issued to the client? If the refund is of monies held in the lawyer’s trust account, no Form 1099 is required; however, if the law firm was previously paid and is refunding an amount from the law firm’s own income, a Form 1099 is needed.
Example: Big Law LLP represents Joe Inventor and is holding $50,000 of Joe’s funds in its trust account. Due to a dispute over the quality of Big Law’s services, it agrees to refund $30,000 of Joe’s deposit. No Form 1099 is required because this was Joe’s money. Big Law also agrees to refund $60,000 of the monies Joe paid for fees over the last three years. Big Law is required to issue a Form 1099 for the $60,000 payment.
The primary area where a lawyer must issue a Form 1099 to a client is where the lawyer performs significant oversight and management functions. The tax regulations are not terribly clear exactly what these management and oversight functions are in many cases, but merely being a plaintiff’s lawyer and handling the settlement monies is not enough.
What if the lawyer is beyond merely receiving the money and dividing the lawyer’s and client’s shares? Under IRS regulations, if lawyers take on too big a role and exercise management and oversight of client monies, they become “payors” and as such are required to issue Forms 1099 when they disburse funds.
Joint Checks
IRS regulations contain extensive provisions governing joint checks and how Form 1099 should be issued in such cases. Most of these rules mean that lawyers will be receiving Forms 1099 when their names are on the settlement checks.
Example 1: Dastardly Defendant settles a case and issues a joint check to Clyde Client and Alice Attorney. Dastardly normally must issue one Form 1099 to Clyde for the full amount and one Form 1099 to Alice also for the full amount. This reality may cause Alice to prefer separate checks, one for the client funds, and one to pay the lawyer directly. That way, Alice may only receive a Form 1099 for her fees, not also for her client’s money.
Example 2: This time Dastardly Defendant issues a check for 60 percent of the settlement to Clyde Client and 40 percent to Alice Attorney. Dastardly issues one Form 1099 to Clyde for 100 percent, and one Form 1099 to Alice for 40 percent. So that Clyde doesn’t pay taxes on the fees paid to Alice for which he received a Form 1099, he will try to deduct the 40 percent on his tax return. Beginning in 2018, though, deductions for legal fees are now much more restricted than in the past. There is still an above-the-line deduction for legal fees in employment, civil rights, and whistleblower cases, but beyond that, many legal fees can no longer be deducted.
Seeking to help their clients avoid receiving Forms 1099, some plaintiff lawyers ask the defendant for one check payable to the “Jones Law Firm Trust Account.” Many defendants are willing to issue a single Form 1099 only to the Jones Law Firm in this situation. Technically, however, Treasury Regulations dictate that you should treat this Jones Law Firm Trust Account check just like a joint check payable to lawyer and client. That means two Forms 1099, each in the full amount, are required.
Judgment Calls and Penalties
Requirements to issue Forms 1099 have existed in the tax code and parallel state law for decades. Still, these requirements have become more rigorous in recent years. Penalty enforcement has also become tougher. More and more reporting is now required, and lawyers and law firms face not only the basic rules, but the special rules targeting legal fees.
Lawyers are not always required to issue Forms 1099, especially to clients. Nevertheless, the IRS is unlikely to criticize anyone for issuing more of the ubiquitous little forms. In fact, in the IRS’s view, the more Forms 1099 the better. Perhaps for that reason, it is becoming common for law firms to issue Forms 1099 to clients even where they are not strictly necessary. Defendants usually have this knee-jerk reaction as well—when in doubt issue the forms. Sometimes, though, both lawyers and defendants go overboard and issue the forms when they really should not.
Most penalties for nonintentional failures to file are modest—as small as $270 per form. This penalty for failure to file Forms 1099 is aimed primarily at large-scale failures, such as where a bank fails to issue thousands of the forms to account holders; however, law firms should be careful about these rules, too.
The distribution of the proceeds of a class action, for example, can trigger large-scale issuances of Forms 1099. In addition to the $270-per-failure penalty, the IRS also may try to deny a deduction for the item that should have been reported on a Form 1099. That means if you fail to issue a form for a $100,000 consulting fee, the IRS could claim it is nondeductible. It is usually possible to defeat this kind of draconian penalty, but the severity of the threat still makes it a potent one.
An often-cited technical danger (but generally not a serious risk) is the penalty for intentional violations. A taxpayer who knows that a Form 1099 is required to be issued and nevertheless ignores that obligation is asking for trouble. The IRS can impose a penalty equal to 10 percent of the amount of the payment.
Example: Larry Lawyer makes a $400,000 payment to co-counsel, but Larry fails to issue a required Form 1099 even though his CPA told him he was required to. In addition to other remedies, the IRS may impose a $40,000 penalty.
Although a 10-percent penalty is high, I have never personally seen this penalty imposed. In fact, I wonder how likely it is even to be proposed, unless the taxpayer has a damning memo in his file that he hands the IRS, making clear that he knew of the Form 1099 obligation and ignored it.
IRS Form W-9
Given that Forms 1099 require taxpayer identification numbers, attorneys are commonly asked to supply payors with their own taxpayer identification numbers and those of their clients. Usually such requests come on IRS Form W-9. If an attorney is requested to provide a taxpayer identification number and fails to provide it to a paying party, he or she is subject to a $50 penalty for each failure to supply that information.
The payments to be made to the attorney also may be subject to back-up withholding. As a practical matter, some defendants may refuse to pay over money without the required taxpayer identification numbers, or will seek to pay the money through a court. It is usually not worth fighting over Forms W-9. If you have negotiated for language in the settlement agreement making clear what Forms 1099 will (or will not) be issued, there should usually be no reason to fight over providing Forms W-9.
Conclusion
Receiving Forms 1099 is not particularly fun, but at least it is a reminder to report the payment on your tax return. Even many issuers of Forms 1099 may not especially like the form. Lawyers must pay special attention to these rules, and not just when they are settling cases or closing real estate deals. More than many other businesses and professionals, lawyers are commonly sending and receiving Forms 1099. Clients care a great deal about these rules as well, especially if they receive a big, fat Form 1099 in the mail that they were not expecting.
[1] Robert W. Wood is a tax lawyer with www.WoodLLP.com and the author of numerous tax books including Taxation of Damage Awards & Settlement Payments (www.TaxInstitute.com). This discussion is not intended as legal advice.
In a recent decision, the United States Court of Appeals for the First Circuit (the First Circuit) reversed a lower bankruptcy court decision that absolved a university of fraudulent transfer liability stemming from tuition payments received from a student’s parents.[1] The parents, who pled guilty to orchestrating a Ponzi scheme, were presumed to be insolvent at the time the tuition payments were made.[2] The issue of whether colleges and universities may be sued by bankruptcy trustees to recover tuition payments made by insolvent parents for the benefit of their adult children has divided bankruptcy courts for years.In re Palladino, 942 F. 3d 55 (1st Cir. 2019), marks the first appellate-level decision to address the issue.
From an objective bankruptcy law perspective, the Palladino case was rightly decided by the First Circuit. Indeed, a fundamental goal of bankruptcy is to ensure that similarly situated creditors are treated alike and share equitably in the distribution of debtor assets. To achieve this goal, title 11 of the United States Code (the Bankruptcy Code) grants a bankruptcy trustee (or debtor-in-possession) several important powers. Chief among the trustee’s powers is the ability to “avoid”[4] transfers and/or transactions as set forth in sections 544 through 549 of the Bankruptcy Code. This article will consider issues prevalent in bankruptcy avoidance actions. However, the central focus of the article is on the intersection between the exercise of avoidance powers against colleges and universities and public policy encouraging parental contributions to higher education.
2. TRUSTEE STRONGARM POWERS AND AVOIDANCE ACTIONS IN BANKRUPTCY
Under state fraudulent transfer statutes,[5] a creditor may seek to avoid a transfer made by a debtor to a third party if under the circumstances, the transfer was adverse to such creditor.[6] In avoiding such transfers, applicable state law allows the creditor to “reach-back” to recover payments made as many as six years prior the bankruptcy filing. The Bankruptcy Code in turn allows trustees standing to pursue such transfers under state law “in the shoes” of the harmed creditor. In addition, the Bankruptcy Code provides the trustee with direct substantive avoidance powers, albeit with a reach-back period generally limited to two years.[7]
The Bankruptcy Code empowers bankruptcy trustees to avoid and recover fraudulent transfers, including those attributed to constructive fraud, from the recipient (in this context, the university). As noted by the United States Supreme Court in Central Bank of Washington v. Hume, 128 U.S. 195, 211 (1888), “debtors must be just before they are generous.” Under section 548(a)(1)(B) of the Bankruptcy Code, a transfer is deemed constructively fraudulent where the insolvent debtor makes a payment (or any other transfer of an interest in property) for which the transferee does not provide “reasonably equivalent value” while the debtor is insolvent. Constructively fraudulent transfers are avoidable and recoverable for the benefit of the bankruptcy estate irrespective of whether, and to what extent, the initial transferee received the payments in good faith. Simply put, absent a showing of “value” provided in exchange for the transfers, it does not matter whether the college or university had knowledge of the parent’s insolvency or fraud or otherwise received the tuition payments in good faith.
It is important to note that the Bankruptcy Code (and comparable state law fraudulent transfer statutes) provide for avoidance of both actual and constructive fraud-based transfers and transactions. Under the actual fraud theory of recovery, the trustee may avoid transfers intended to frustrate current or future creditors’ recovery efforts. Section 548(a)(1)(A) of the Bankruptcy Code provides, in pertinent part—
(a)(1)The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted . . . .
The trustee has the burden of establishing intent.[8] To the extent the intent at issue in a case is to defraud, courts are split on whether the standard of proof is by a preponderance of evidence or by clear and convincing evidence.[9]
In the context of avoidance actions brought against colleges and universities to recover tuition payments, the decisional authority most often turns on analysis of constructive fraud claims. In Palladino, for example, the trustee asserted both actual fraud[10] and constructive fraud claims. However, the First Circuit’s Palladino opinion was based primarily on its finding that the debtor parents received no value in exchange for the payments they made for their daughter’s education. There the court reasoned:
The tuition payments here depleted the estate and furnished nothing of direct value to the creditors who are the central concern of the code provisions at issue. The code recognizes five classes of transactions that confer value: (1) the exchange of property; (2) the satisfaction of a present debt; (3) the satisfaction of an antecedent debt; (4) the securing or collateralizing of a present debt; and (5) the granting of security for the purpose of securing an antecedent debt. 11 U.S.C. § 548(d)(2)(A). None are present here, nor are parents under any legal obligation to pay for college tuition for their adult children.
The First Circuit noted that such payments by an insolvent debtor, irrespective of the noble cause, will be undone by bankruptcy rules allowing trustees to claw back transfers. The First Circuit declined to recognize an exception not enacted by Congress via statute. The bankruptcy court, from which the appeal was taken, had found the Palladinos paid their daughter’s tuition because “they believed that a financially self-sufficient daughter offered them an economic benefit” and as such determined value had been provided.[11] Rejecting this analysis, the First Circuit urged that “value” be considered from the perspective of the creditor, for whose benefit fraudulent transfer laws were established, not the debtor parents.
3. DEFENSES
In defending against claw-back actions, colleges and universities should consider and hold the trustee to her burden of establishing each element of the claim. A trustee may challenge a transaction as constructively fraudulent by establishing:
For less than reasonably equivalent value; and the debtor
was insolvent or became insolvent as a result;
was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.[13]
Upending any one of the required elements will defeat a fraudulent transfer claim.
Further, at least one court has ruled that the university would be deemed a mere conduit where funds are first deposited into a student controlled account, albeit managed by the institution; the funds are not withdrawn or otherwise under the dominion of the institution until the student enrolls in courses at the institution, and such funds are refundable if the student withdraws from the institution.[14] In Hamadi, the court determined that the university was shielded from liability under section 550(b)(1) of the Bankruptcy Code, which prohibits trustees from “recovering from an immediate transferee of an initial transferee who ‘takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided[.]’” A key factor in the court’s ruling in favor of the university was that it was deemed an immediate (or subsequent) transferee rather than the initial transferee of the tuition payments. To be clear, the statutory defense is only available to good-faith subsequent transferees.[15] Like the payment structure in Pergament, the shielded University of Connecticut tuition payments came from a student-controlled account funded by the parents and were refundable to the student up until he registered for courses.[16]
4. EXTRAJUDICIAL EFFORTS TO PROTECT EDUCATIONAL INSTITUTIONS
Although the age of majority in most states is 18, society expects and legally presumes that parents will contribute to the higher education costs for children 18 and over. Indeed, as colleges and universities know all too well, a student’s eligibility for need-based financial aid is based on the institution’s “Cost of Attendance” less the “Expected Family Contribution.”[17] The Expected Family Contribution is determined by a federally mandated calculation based on information submitted in the student’s Free Application for Federal Student Aid. As noted by one commentator, “it seems counterintuitive to limit a student’s financial aid award because it is decided his parents can afford to contribute a certain amount to his education and then later call these transfers fraudulent if the parents file for bankruptcy.”[18] Courts have acknowledged this conundrum in ruling on trustee tuition claw-back actions. In In re Oberdick, 490 B.R. at 711–12, the court rejected a trustee’s fraudulent transfer claim after noting the parents testimony that (1) they viewed the college tuition and related educational expenses for their adult children as family obligations, and (2) they were denied state and federal student aid for the adult children because of the “expected family contribution.”
Federal legislators have also recognized the disconnect between federal higher education policy and federal bankruptcy law. In 2015, the Protecting All College Tuition (PACT) Act was introduced by Representative Chris Collins of New York. would be shielded from recovery.[19] The PACT Act of 2015 did not advance out of committee.
5. CONCLUSION
Although Palladino is the first appellate decision to address claw back of tuition payments, it is likely not the last. Unless and until Congress enacts legislation to shield tuition payments from avoidance, colleges, universities, and their counsel must be prepared to defend against fraudulent transfer actions. The strategic offense principle as crystalized in the adage “the best defense is a good offense” comes to mind. As detailed above, some institutions have lodged successful defenses by establishing administrative protocols that distance them (somewhat) from funds received from students’ parents. Others will no doubt be well served to monitor developments in the law and employ a broad-based strategic offense.
[1] Monique D. Hayes is a partner in the law firm Goldstein & McClintock LLLP. She is co-chair of the ABA Business Law Section Young Lawyer Committee and a member of the ABA Business Law Section Business Bankruptcy Committee, serving as co-chair of the Executory Contracts Subcommittee and a member of the Current Developments Task Force.
[2] In 2014, Debtors Steven and Lori Palladino pled guilty to investment fraud in connection with a Ponzi scheme they orchestrated using their family business, Viking Financial Group. Like many Ponzi schemes, the Palladino’s fraud ensnared friends and business associates as well as vulnerable elderly investors. The Palladinos petitioned for chapter 7 bankruptcy relief prior to pleading guilty to the fraud charges. A trustee was appointed to oversee their bankruptcy proceedings. During the bankruptcy case, the trustee uncovered nearly $65,000 in transfers the Palladinos made to Sacred Heart University, Inc. as tuition payments for their legally adult daughter. The bankruptcy trustee sued the university to avoid and recover the tuition payments as fraudulent transfers.
[3]See In re Sterman, 594 B.R. 229 (Bankr. S.D.N.Y. 2018) (finding debtor’s tuition payments on behalf of nondebtor are avoidable and recoverable by a bankruptcy trustee); In re Knight, 2017 WL 4410455 (Bankr. D. Conn. Sept. 29, 2017) (same); Matter of Dunston, 566 B.R. 624 (Bankr. S.D. Ga. 2017) (same); In re Leonard, 454 B.R. 444 (Bankr. E.D. Mich. 2011) (same); In re Lindsay, 2010 WL 1780065 (Bankr. S.D.N.Y. May 4, 2010) (same). CompareIn re Adamo, 582 B.R. 267 (Bankr. E.D.N.Y. 2018) (subsequent history omitted); In re Palladino, 556 B.R. 10 (Bankr. D. Mass. 2016); Shearer v. Oberdick (In re Oberdick), 490 B.R. 687 (Bankr. W.D. Pa. 2013); In re Cohen, 2012 WL 5360956 (Bankr. W.D. Pa. Oct. 31, 2012), rev’d in part on other grounds, 487 B.R. 615 (W.D. Pa. 2013); In re Lewis, 2017 WL 1344622 (Bankr. E.D. Pa. Apr. 7, 2017) (declining to allow avoidance and recovery of tuition payments).
[4] A key concept to grasp is the meaning of the term “avoid” as used in the bankruptcy context. It describes the ability of a trustee to set aside, invalidate, nullify, disregard, or unravel a transfer, transaction, or obligation of a debtor in bankruptcy. As detailed herein, the powers afforded under chapter 5 of the Bankruptcy Code allow the trustee to avoid certain liens, set-aside fraudulent transfers (whether granted through actual or constructive fraud), and claw back.
[5] Most states have enacted a version of the Uniform Voidable Transactions Act (formerly the Uniform Fraudulent Transfers Act) approved by the National Conference of Commissioners on Uniform State Laws. To clarify, most states enacted the predecessor statute, the Uniform Fraudulent Transfers Act. The revised and renamed version has been enacted by some, but not a majority of, states.
[6] Consider, by way of example, the Florida Uniform Fraudulent Transfer Act. See Fla. Stat. 726.101 et seq. Specifically, section 726.105 of the Florida statutes provides, in pertinent part, as follows:
(1) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:
With actual intent to hinder, delay, or defraud any creditor of the debtor; or
Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:
1. Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
2. Intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.
[7] In the case of Mukamal v. Citibank (In re Kipnis), 555 B.R. 877 (Bankr. S.D. Fla. 2016), the bankruptcy court permitted a trustee to reach back 10 years to unwind a fraudulent transfer by grafting the IRS 10-year statute of limitations.
[8]See Jacobs v. Jacobowitz (In re Jacobs), 394 B.R. 646, 661 (Bankr. E.D.N.Y. 2008); MFS/Sun Lift TrustHigh Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 934 (S.D.N.Y. 1995); Glinka v. Bank of Vt. (In re Kelton Motors, Inc.), 130 B.R. 170, 179 (Bankr. D. Vt. 1991).
[9] The decisional split on the standard of proof is beyond the scope of this article but should be noted in examining actual fraud-based avoidance actions. For more on the issue, see Baldi v. Lynch (In re McCook Metals, L.L.C), 319 B.R. 570 (Bankr. N.D. Ill. 2005). Practitioners and thought leaders have tried to reconcile the issue by establishing pleading standards, revising state statutes and commentary, and limiting to use of the term “fraud” as it relates to avoidance actions. See Uniform Voidable Transfers Act, § 4(a), off. cmt. 10.
[10] In cases where the debtor operated a Ponzi scheme, as did the Palladinos, courts have found actual intent to defraud is presumed to the extent the transfers at issue furthered the Ponzi scheme. See, e.g., Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund, Ltd.), 359 B.R. 510, 517–18 (Bankr. S.D.N.Y. 2007), aff’d in part, rev’d in part, 397 B.R. 1, 22–26 (S.D.N.Y. 2007).
[11] DeGiacomo v. Sacred Heart Univ., Inc. (In re Palladino), 556 B.R. 10, 16 (Bankr. D. Mass. 2016).
[12] Although this article focuses primarily on cash tuition payments as potential fraudulent transfer targets, it is important to note that the applicable statutes allow challenges to debt obligations (i.e., loans, guarantees, etc.) as well. To the extent colleges and universities accept such obligations from parents, they should be prepared to defend the propriety of the transaction in the event of the parents’ insolvency.
[13]See 11 U.S.C. § 548(a)(1)(B); see also UVTA § 4(1)(b).
[14] Pergament v. Hofstra Univ. (In re Adamo), 582 B.R. 267 (Bankr. E.D.N.Y. 2018), vacated and rem’d on other grounds sub nom., Pergament v. Brooklyn Law Sch., 595 B.R. 6 (E.D.N.Y. 2019); see also Mangan v. University of Conn. (In re Hamadi), 597 B.R. 67 (Bankr. D. Conn. Jan. 31, 2019).
[18] Jenna C. MacDonald, Out of Reach: Protecting Parental Contributions to Higher Education from Clawback in Bankruptcy, 34-1 Emory Bankr. Dev. J. 264 (2017).
[19] Protecting All College Tuition Act of 2015, H.R. 2267.
If data is the new gold, every company should be setup like Fort Knox, keeping its customer records locked away from malicious actors. As anyone who has been the victim of identity theft will confirm, however, data protection is nowhere near as watertight as it should be.
According to recent research, the cost of cyber attacks will top $2 trillion in 2019, and around 4 million customer records were stolen every single day in 2018. The effects can be devastating for companies hit by attacks. American Medical Collection Agency is just one example of many, with the medical company filing for bankruptcy within a year after thieves targeted its client records.
Against that backdrop, what is in store for 2020 with respect to data breaches, and how can companies and individuals prepare?
Expect Another Record Year for Data Breaches Worldwide
Companies must be aware that we are passing through a historic peak in the number of attacks and successful data extractions by cyber criminals. The year 2019 looks set to break records for the number of data breaches. As Risk Based Security reports, as of September, the total number of attacks increased by 54 percent over 2018’s total, with some 44.1 billion records exposed. That is a significant rise in assaults on databases and a sign that defenses are struggling to cope.
Will 2020 be any quieter? On the one hand, there are signs that companies are recognizing the scale of the problem. In late 2018, 84 percent of C-level security officers surveyed by Thales eSecurity reported that cybersecurity budgets would rise. In addition, capital has been pouring into cybersecurity startups, prompted by concerns from Amazon and Facebook. However, at least 33 percent of small businesses in the UK reportedly have no cybersecurity strategy, and more than 50 percent have no systems in place to understand whether their security measures actually work. Thus, there is a cultural issue that will make life much easier for data thieves.
E-mail Addresses Will Likely Continue to Be Prime Targets
Assuming data breaches continue to increase, what are thieves likely to target the most? In 2019, the major target was personal e-mails, which accounted for around 70 percent of the data extracted. That is no surprise; e-mail addresses are gold dust for phishers and fraudsters, who can use them as leverage to take out credit cards and carry out elaborate identity thefts. They are also handy for phishers who seek to take over contact lists to spam their messages or even to gain access to online banking and social media platforms.
No Sector Will Be Safe From Data Breaches
If 2019’s shocking history of data breaches proved anything, it is that no company is secure from data theft. The news may have been dominated by massive data losses from financial giants like First American Financial (885 million records), or Facebook leaking hundreds of millions of records in two separate incidents, but plenty of less prominent companies have fallen victim.
The year began with a vast Fortnite data breach, when 200 million gamers were affected. After that, all kinds of companies were afflicted. From photo-sharing site 500px and the Family Locator app, to Bodybuilding.com and Canva’s online design tools, thieves are happy to pick a diverse range of targets.
In 2020, any app or small company could become a victim, making it imperative for smaller businesses to take action. Even simple controls like a VPN shield could be the difference between leaking vital customer records and serene, hassle-free operations. Whatever they do, companies cannot fall into complacency. Data leaks are not just about the big boys; they are something about which every business must worry.
Anticipate More Inventive Attacks as 2020 Unfolds
Another key takeaway to prepare for 2020 is that the diversity of data breaches is increasing as hackers find older techniques less effective and resort to more innovative methods. For example, 2019 saw an uptick in Magecart-style attacks, which uses JavaScript injection to hijack online payment portals, extracting credit-card and identity details via a keylogger. In one episode, a group of attackers used Magecart to target 962 online stores in just 24 hours.
Magecart is not alone. Expect credential stuffing attacks to rise in 2020, as attackers use the credentials stolen in previous thefts to brute force other, more lucrative databases. In addition, be alert for new ways of weaponizing .pdf attachments or infecting browser extensions with malware.
Expect Successful Companies to Proactively Tackle Data Breaches
Finally, 2020 will see companies thrive if they take data loss seriously. No company can be totally immune from data thefts, but those that create a culture of security and train staff to avoid human error will have a significant advantage. The same applies for companies that enforce VPN usage for remote workers and use encryption and authentication across the board.
Look out for new analytical tools in 2020, with suppliers offering real-time data theft protection, and pay attention to data-flow mapping tools, which can use AI to map potential vulnerabilities. Both products offer extra reassurance in an increasingly hostile environment.
Act Now to Protect Against 2020’s Worst Data Breaches
Preparation for data breaches is non-negotiable. Companies that fail to prepare can expect significant financial costs, lost customers, legal nightmares, and in many cases, complete failure.
Fortunately, there are a few good ways to minimize the risks of data breaches. First, investing in password security via training and routine use of encrypted password managers is a good idea. Making multifactor authentication mandatory for access to key databases is also advisable, and auditing all hardware for potential vulnerabilities should be carried out on a regular basis.
Additionally, it makes a lot of sense to make VPN usage part of corporate culture. VPNs secure remote devices, which are becoming more and more common in modern companies, and encrypt data passing into and out of servers, making databases harder to access.
Choosing a solid VPN is vital, so take time to assess the pros and cons of leading players like ExpressVPN or NordVPN.
The year 2020 looks set to be another banner year for data breaches, so buckle up, take what precautions you can, and stay tuned for more spectacular attacks as the new year begins.
The Securities and Exchange Commission recently proposed to simplify crucial corporate disclosures regarding legal proceedings and risk factors by moving toward a more principles-based approach; yet, the SEC continues to pursue big-dollar enforcement actions that offer filers little clarity about what precisely constitutes accurate disclosure of their risk factors.
Weighing materiality and the potential for liability are traditionally hazy areas that have tripped up a number of companies, including most recently:
Mylan NV, which agreed to pay $30 million because it calculated as “remote” rather than “reasonably possible” the likelihood that a government investigation would impose a substantial liability on the company
Facebook, which in using of the word “may” rather than “have” in its risk-factor disclosures about customer data likely cost the company $100 million
Altaba Inc. (formerly known as Yahoo!), which reached a $35 million settlement last year with the SEC for its tardy disclosure of a data breach
These settlements all point to a heightened focused on analyses of materiality and probability in SEC risk-factor disclosures, which often hinge on standards that are subject to wide variances of interpretation: Is the risk material? Is the liability probable? Is the fact significant? How is a company supposed to communicate to shareholders about the likelihood of adverse consequences?
Slippery Standards
The SEC offers guidance on disclosure descriptions and best practices in performing analysis, but the way in which courts and the SEC have applied the standards has often confounded filers. It may seem black or white to a class-action plaintiff or the SEC looking in hindsight to determine whether a data breach occurred or whether litigation risk should have been more definitive. However, companies answering these questions in real time must pick through numerous cyber incidents and litigation filings to decide which demand disclosure.
In August, the SEC proposed modernizing risk-factor disclosures with the stated intention of improving information available to investors and simplifying compliance for registrants. If finalized as proposed, the disclosure threshold would change from “most significant” to “material” factors. It is far from certain, though, that the new standard would offer brighter lines to filers assessing whether and how to describe unclear scenarios.
Murky Materiality
The Facebook case is an example of how a materiality analysis can be viewed in one way by the company in real time and another way by a regulator in hindsight. For example, the SEC took issue with a disclosure that read, “our users’ data may be improperly accessed, used or disclosed” (emphasis added). The disclosure continued in the same form even after the company became aware that such a breach had in fact occurred. According to the co-director of the SEC’s enforcement division, that meant the company had “presented the risk of misuse of user data as hypothetical when they knew user data had in fact been misused.” Although the SEC repeatedly emphasized materiality in its announcement of the settlement, the staff did not address the specific data breach considerations that should have resulted in a different materiality call. We also do not know the exact materiality considerations that Facebook went through in determining its disclosures.
Determining whether an “event” is material—and required to be disclosed—typically involves undertaking an analysis under SEC Staff Accounting Bulletin No. 99. This 20-year-old standard requires both quantitative and qualitative considerations. Auditors often use five to ten percent of net income as a rule-of-thumb cutoff for a quantitative materiality threshold. However, even that seemingly straightforward accounting practice is packed with many caveats requiring the consideration of numerous inputs that could potentially nullify the initial conclusion. For example, an initially immaterial netted result could become material when reviewed in isolation, whereas similar reliance on a commonplace accounting precedence or on industry practices could inappropriately mask an otherwise material event.
Qualitative analysis is even more complex. To develop risk factors, public companies must assess a list of considerations that is so extensive that it requires its own chapter in the applicable concept note issued by the Financial Accounting Standards Board. Considerations include a mishmash of terminology: estimate imprecisions, masked trends, analyst expectations, misleading impressions, significant segments, contractual requirements, executive compensation, and lawfulness. Even highly experienced accountants, disclosure counsel, and subject-matter experts struggle to apply theoretical generally accepted accounting principles to practical real-world events.
Despite the imprecision in materiality analysis, companies can put themselves in as defensible a position as possible by ensuring the inclusion of subject-matter experts in drafting and reviewing relevant disclosures. Board members, in-house and outside counsel, and consultants well versed in weighing the appropriate considerations must collaborate with subject matter experts as well, and all participants should be empowered to apply those assessments in an impartial manner.
Probable Probability
The Mylan case is a warning to companies that rely on the uncertainties of litigation and investigation to omit loss disclosures and accruals. In its complaint, the SEC mentioned tolling agreements four times, signaling that in the SEC’s view, entering into a tolling agreement means the company has determined an adverse outcome is no longer just “remote,” but now “reasonably possible and probable.” The SEC’s enforcement division emphasized that it is “critical that public companies accurately disclose material business risks and timely disclose and account for loss contingencies that can materially affect their bottom line.”
Evaluating a loss contingency typically falls under SEC Regulation S-K and its FASB counterpart, Accounting Standards Codification 450 (with roots in FAS 5). This guidance requires that an estimated loss from a contingency be recognized if a liability has been incurred as of the date of the financial statements and the amount can be reasonably estimated. Further complicating matters, companies may still need to disclose loss contingencies that do not meet the recognition criteria.
Public companies often associate this standard with “significant litigation” disclosure obligations. In reality, though, the standard applies more broadly to any loss contingency, including asset impairment, product injury, property damage, asset expropriation, and assessments. A separate test under the same standard applies to less common gain contingencies as well.
Companies then face the daunting task of categorizing pending legal matters, whether litigation or investigations, as remote, reasonably possible, or probable. The harsh reality is that depending on the stage of litigation, none of the descriptions may be completely appropriate. Even during negotiations, the initial gap between settlement offers can range in the tens of millions of dollars, leaving a significant possibility that the matter continues to trial without settling at all. Forcing a disclosure that puts a dollar figure on a specific matter in advance of a settlement also puts the company in a weak negotiating position. In addition, during a government investigation, a company often has an extremely limited view of the outcome the enforcement attorney is seeking, whether it be a settlement, a penalty, or a fine.
To Be Continued . . .
A further word of caution: Disclosure analyses do not end upon arriving at a final materiality or liability disclosure determination. If such evaluations affirm a material risk or reasonably probable liability, simply disclosing it is not always sufficient—the risk must be remediated. In October 2019, the SEC held an administrative proceeding against Northwestern Biotherapeutics for “internal control weaknesses” related to the supervision of accounting operations. The company had concluded that the weaknesses were material and publicly disclosed them in its risk factors, but the SEC found that the company failed to remediate in a timely manner the weaknesses it repeatedly identified in its risk factors.
The SEC’s latest move toward principles-based disclosure notwithstanding, the actual enforcement message to SEC filers on materiality, liability disclosures, and accruals is a fairly ominous one.
As chairs of the ABA’s Private Target Mergers & Acquisitions Deal Points Study (the Private Target Deal Points Study), we are pleased to announce that we published the latest iteration of the study to the ABA’s website in early December 2019.
Congratulations! But Wait. What Exactly Is This Private Target Deal Points Study, Anyway?
The Private Target Deal Points Study is a publication of the Market Trends Subcommittee of the Business Law Section’s M&A Committee. It examines the prevalence of certain provisions in publicly available, private target M&A transactions during a specified time period. The Private Target Deal Points Study is the preeminent study of M&A transactions, widely utilized by practitioners, investment bankers, corporate development teams, and other advisors.
The 2019 iteration of the Private Target Deal Points Study analyzes publicly available definitive acquisition agreements for transactions executed and/or completed either during calendar year 2018 or during the first quarter of calendar year 2019. In each case, the transaction involved a private target acquired by a public buyer, with the acquisition material enough to that public buyer for the Securities and Exchange Commission to require public disclosure of the applicable definitive acquisition agreement.
The final sample examined by the Private Target Deal Points Study is made up of 151 definitive acquisition agreements and excludes agreements for transactions in which the target was in bankruptcy, reverse mergers, divisional sales, and transactions otherwise deemed inappropriate for inclusion.
Although the deals in the Private Target Deal Points Study reflect a broad array of industries, the technology and healthcare sectors together made up approximately 40 percent of the deals. Asset deals comprised 5.3 percent of the study sample, with the remainder either equity purchases or mergers.
Of the Private Target Deal Points Study sample, 34 deals signed and closed simultaneously, whereas the remaining 117 deals had a deferred closing some time after execution of the definitive purchase agreement.
The transactions analyzed in the Private Target Deal Points Study were in the “middle market,” with purchase prices ranging between $30 million and $750 million; purchase prices for most deals in the data pool were below $200 million.
The Private Target Deal Points Study Sounds Great! How Can I Get a Copy?
All members of the M&A Committee of the Business Law Section received an e-mail alert from Jessica Pearlman with a link when the study was published. If you are not currently a member of the M&A Committee but do not want to miss future e-mail alerts, committee membership is free to Business Law Section members, and you can sign up on the M&A Committee’s homepage.
The published 2019 Private Target Deal Points Study is available for download by M&A Committee members from the Market Trends Subcommittee. Also available are the most recently published versions of the other studies published by the Market Trends Subcommittee, including the Canadian Public Target M&A Deal Points Study, Carveout Transactions M&A Deal Points Study, and Strategic Buyer/Public Target M&A Deal Points Study.
How Does the 2019 Private Target Deal Points Study Differ from the Prior Version?
The 2019 version of the Private Target Deal Points Study has a number of features that differentiate it from prior iterations.
Data in the 2019 version of the Private Target Deal Points Study is more current. The 2019 version of the Private Target Deal Points Study includes not only 2018 transactions, but also transactions from the first quarter of 2019.
The 2019 version of the Private Target Deal Points Study contains new data points. The 2019 version of the Private Target Deal Points Study includes new data points throughout, including three new representations on #MeToo, data privacy, and cybersecurity. There are other new data points scattered throughout the study with “new data” flags (like the sample shown below) to make them easy to spot:
The 2019 version of the Private Target Deal Points Study includes more correlations. Representations and warranties insurance (RWI) is changing the M&A game, and we are keeping score. We have added a number of data points to our correlations with deals that reference RWI and deals that do not.
Please join us in extending a hearty thank you to everyone who worked so hard on this study, from leadership to advisors to issue group leaders to the working groups, all of whom are listed in the credits pages.
For more information, register for the In the Know webinar, during which the chairs and issue group leaders will provide analysis and key takeaways from the results of the Private Target M&A Deal Points Study, on April 16, 2020, from 1:00 p.m. to 2:30 p.m. (ET).
The U.S. Supreme Court recently narrowed the circumstances under which a court will defer to an agency’s interpretation of its own regulation. In Kisor v. Wilkie, the Court considered whether to overturn a line of precedent that requires courts to defer to the agency’s interpretation unless it is “plainly erroneous or inconsistent with the regulation.”[1] Although all of the justices agreed to uphold this so-called Auer deference, Kisor may render agencies’ deference “maimed and enfeebled,” at least according to one justice’s concurring opinion. It may also provide banking organizations with new methods to encourage agencies to engage in more open, transparent, and careful decision making.
The Lead-Up to Kisor
History of the Auer Deference
In 1945, the Supreme Court established a fundamental principle of administrative law that, where “the meaning of the words [of an agency’s regulation] is in doubt,” the agency’s interpretation of the regulation “becomes controlling weight unless it is plainly erroneous or inconsistent with the regulation.”[2] The principle came to be applied in a mechanical and highly deferential manner beginning in the 1960s and 1970s with the rise of the administrative state.[3] Although certain Supreme Court justices cast some doubt on its continuing viability in the early 1990s,[4] the Court’s 1997 Auer v. Robbins opinion has generally been seen as reaffirming that an agency’s interpretation should be controlling “unless plainly erroneous or inconsistent with the regulation.”[5]
Significance of Auer Deference through the Years
Auer deference appears to make a difference in outcome. An empirical study of over 1,000 Supreme Court cases found that the Court upheld an agency’s interpretation of its own regulations 91 percent of the time.[6] A similar review of district court and circuit court cases found that the lower courts upheld agency interpretations of agency rules 76 percent of the time.[7] However, the Court in recent years has discussed limits to Auer deference,[8] and more recent empirical analysis has demonstrated a decline in deference to agency interpretations of regulations.[9]
Relevance to Chevron Deference
Auer deference is different and less well-known than “Chevron deference.” In short, application of the doctrines depends on whether the agency interpretation is of a regulation or a statute. Whereas Auer deference may apply to an agency’s interpretation of its own regulations,[10]Chevron deference may apply to an agency’s interpretation of statutes for which it has authority to make rules.[11] Under Chevron, courts will adopt an agency’s interpretation if the statute is ambiguous and the agency’s interpretation is reasonable.[12]Auer and Chevron deference share many similarities; therefore, Kisor could provide insight into the future of Chevron deference. However, Kisor does not purport to directly affect Chevron deference, with two of its concurring opinions explicitly noting that Kisor does not “touch upon” Chevron.[13]
Kisor’s Test
Drawing from the Court’s earlier discussions of the limitations of Auer deference, Kisor sets forth a multifactor test that an agency’s interpretation must pass in order to receive such deference.
Is the regulation “genuinely ambiguous”? Under Kisor, a court should not apply Auer deference unless a regulation is “genuinely ambiguous.”[14] Although ambiguity has always been a requirement for deference, Kisor provides that a court may make this determination only after exhausting “all the traditional tools of construction,” including the “text, structure, history and purpose of the regulation.”[15] The Court noted that “hard interpretive conundrums, even those related to complex rules, can often be solved” and that a court’s independent, careful consideration of the issue will make Auer deference inappropriate for “many seeming ambiguities.”[16]
Is the agency’s interpretation reasonable? The interpretation offered by the agency also must fall within the “zone of ambiguity” the court has identified in considering whether the regulation was genuinely ambiguous. In other words, the court’s analysis in the step above not only determines whether a regulation is ambiguous, but also determines the range of reasonable interpretations. Kisor adjures that there should “be no mistake: That is a requirement an agency can fail.”[17]
Does the “character and context” of the interpretation entitle it to deference? In order to grant Auer deference, the court must also determine that the “character and context” of the interpretation warrants deference. In other words, the court must decide whether is it appropriate to presume that Congress would have wanted the agency to resolve the particular interpretive issue presented.[18] The Court gave “some especially important markers” under this inquiry and noted other considerations could be relevant.[19]
Was the interpretation actually made by the agency?Kisor explains that the interpretation must be the agency’s “authoritative or official position” in order to receive deference.[20] Although this standard encompasses more than just interpretations directly approved by the head of the agency (g., official staff memoranda published in the Federal Register), it does not include every memorandum, speech, or other pronouncement from agency staff.[21] The interpretation “must at the least emanate from those actors, using those vehicles, understood to make authoritative policy.”[22]
Does the interpretation implicate the agency’s substantive expertise? The Court explained that, generally, agencies have a nuanced understanding of the regulations they administer, such as when a regulation is technical or implicates policy expertise.[23] However, deference may not be warranted where an interpretive issue “falls more naturally into the judge’s bailiwick,” such as a common law property term or the award of attorney’s fees.[24]
Does the interpretation reflect the “fair and considered judgment” of the agency? Deference also may not be warranted where the agency interpretation creates “unfair surprise,” such as when the interpretation conflicts with its prior interpretation or imposes retroactive liability for long-standing conduct that the agency had never before addressed.[25] Similarly, agency interpretations that are “post hoc rationalizatio[ns] advanced to defend past agency action” should not be afforded deference.[26]
Kisor’s Potential Implications
Kisor’s effect on banking agencies and banking organizations remains to be seen as few cases have yet applied Kisor’s test to an agency interpretation.[27] It is also unclear whether and to what extent Kisor will affect how agencies interpret their own regulations. On the one hand, the potential additional scrutiny of a court may not deter an agency (or its staff) from making questionable interpretations of regulations simply because of the historically low likelihood of banking organizations challenging these agencies in court.[28] On the other hand, Kisor has the potential to affect the agencies and their interactions with banking organizations in a number of significant ways.
Improve Quality of Agency Interpretations and Regulations
Kisor could improve the quality of agency interpretations of regulations (as well as the regulations themselves) for a number of reasons. First, agencies may be more likely to issue interpretations through the head(s) of the agency or other authoritative or official processes, thereby subjecting them to additional review, so that the interpretation can clearly meet the “authoritative or official position” aspect of the Kisor test. Second, the additional rigor of other aspects of the Kisor test may encourage agencies to more carefully consider their interpretations of regulations. Third, agencies may be more willing to consider banking organizations’ views of the meaning of regulations and their underlying rationale prior to issuing official interpretations (through requests for interpretations or otherwise). Kisor should be seen as giving those outside the agencies a greater role in analyzing interpretive questions; the opinion makes clear that an agency’s views regarding the text, structure, history, and policy of the regulation are not the only ones that matter. Rather, these issues are considered independently—as if there were “no agency to fall back on.”[29] Fourth, an agency may be more reluctant to offer interpretations that are likely to fail the Kisor test, such as those that would “unfair[ly] surprise” banking organizations or for which the agency has no particular expertise. Finally, Kisor also appears to decrease any agency’s incentive to issue open-ended or otherwise ambiguous regulations, as it now should be less likely that the agency would receive Auer deference for its interpretation of such a regulation.[30]
Encouraging Notice and Comment Rulemakings
Kisor also could be seen as further cabining an agency’s ability to create binding requirements outside of the Administrative Procedure Act’s rulemaking process.[31] The banking agencies recently have acknowledged that, although law and regulations have the force and effect of law, “supervisory guidance” does not.[32] In other words, supervisory guidance may not be phrased in terms of binding requirements, and an agency may not treat the guidance as if it were binding.[33] However, agency interpretations, like the regulations they interpret, may be phrased as binding requirements and treated as binding.[34]
Of course, agencies are aware of this distinction and may use it to impose binding requirements on banking organizations, sometimes by characterizing statements that appear to be supervisory guidance as interpretations. For example, in a bank’s appeal of a cease-and-desist order issued by the FDIC, the 9th Circuit disagreed with the bank’s argument that the FFIEC’s BSA/AML Examination Manual[35] could not impose legal obligations on the bank, and found that the manual was an interpretation of the FDIC’s regulations entitled to Auer deference.[36] The Kisor test may have led the 9th Circuit to reach a different outcome because the test would have required the court to engage in a much more careful analysis of this question than the two paragraphs the 9th Circuit afforded it.[37] In other words, Kisor’s additional constraints on deference should make it more difficult for agencies to successfully impose binding requirements by issuing interpretations of regulations or characterizing supervisory guidance as an interpretation of a regulation.
The impact of a new Supreme Court case can be easy to overstate, and Kisor may be no exception to this general rule. However, the Kisor test and the Court’s underlying rationale do at least appear to provide new methods to encourage the banking agencies to engage in more open, transparent, and rigorous consideration of interpretive questions.
[1] Kisor v. Wilkie, 588 U.S. __ (2019); see also Bowles v. Seminole Rock & Sand Co., 325 U.S. 410, 414 (1945).
[2]Seminole Rock, 325 U.S. at 414. Even if the court finds that an agency’s interpretation should not be given controlling weight under Auer (or Chevron, discussed below), a court may nonetheless uphold the agency’s interpretation if it finds the interpretation persuasive. This “power to persuade,” generally referred to as “Skidmore deference,” considers factors such as a thoroughness of the agency’s consideration, the validity of its reasoning, and its consistency with earlier and later pronouncements. See, e.g., Skidmore v. Swift & Co., 323 U.S. 134, 141–42 (1944). Some have argued that this weaker form of deference represents no deference at all. Colin S. Diver, Statutory Interpretation in the Administrative State, 133 U. Pa. L. Rev. 549, 565 (Mar. 1985) (“Of course, the ‘weight’ assigned to any advocate’s position is presumably dependent upon the ‘thoroughness evident in its consideration’ and the ‘validity of its reasoning.’ . . . The argument’s pedigree adds nothing to the persuasive force inherent in its reasoning.”).
[3]See Sanne H. Knudsen & Amy J. Wildermuth, Unearthing the Lost History of Seminole Rock, 65 Emory L.J. 47 (2015).
[4] Thomas Jefferson University v. Shalala, 512 U.S. 504, 525 (Thomas, J., dissenting); Shalala v. Guernsey Memorial Hosp., 514 U.S. 87, 108–09 (1995) (O’Connor, J. dissenting).
[5]See, e.g., Kristen E. Hickman & Richard J. Peirce, Jr., Admin. L. Treatise 353 (6th ed. 2019).
[6] William N. Eskridge, Jr. & Lauren E. Baer, The Continuum of Supreme Court Treatment of Agency Statutory Interpretations from Chevron to Hamdan, 96 Geo. L.J. 1083 (2008).
[7] Richard J. Pierce, Jr. & Joshua Weiss, An Empirical Study of Judicial Review of Agency Interpretations of Agency Rules, 63 Admin. L. Rev. 515 (2011).
[8]See Christopher v. Smithkline Beecham Corp., 567 U.S. 142 (2012); Talk America, Inc. v. Michigan Bell Tel. Co., 564 U.S. 50 (2011).
[9] Cynthia Barmore, Auer in Action: Deference After Talk America, 76 Ohio State L.J. 813 (2015).
[10] Although Auer deference generally does not apply to an agency’s interpretation of another agency’s regulations, the D.C. Circuit has held that Auer deference may apply to one agency’s interpretation of another’s rules if Congress had reassigned responsibility for implementing the statute on which the rule was based from the other agency to the first agency. Amerada Hess Pipeline Corp. v. Fed. Energy Regulatory Comm’n, 117 F.3d 596 (D.C. Cir. 1997).
[11]See, e.g., United States v. Mead Corp., 533 U.S. 218, 231–34 (2001).
[12] Chevron U.S.A. v. Nat. Res. Def. Council, Inc., 468 U.S. 837, 842–43 (1984).
[13]Kisor, slip op. at 2 (Roberts, C.J., concurring in part); id., slip op. at 2 (Kavanaugh. J., concurring in judgment).
[27] At least three lower court cases applying the Kisor test do not defer to the agency interpretation in question whereas at least another two cases do. Wolfington v. Reconstructive Orthopaedic Assocs. II PC, 935 F.3d 187 (3d Cir. 2019); Romero v. Barr, 937 F.3d 282 (4th Cir. 2019), reh’g denied (Oct. 29, 2019); Am. Tunaboat Ass’n v. Ross, 391 F. Supp. 3d 98 (D.D.C. 2019);N. Carolina Div. of Servs. for Blind v. United States Dep’t of Educ., No. 1:17CV1058, 2019 WL 3997009 (M.D.N.C. Aug. 23, 2019), report and recommendation adopted sub nom. State of N. Carolina v. United States Dep’t of Educ., Rehab. Servs. Admin., No. 1:17CV1058, 2019 WL 4773496 (M.D.N.C. Sept. 30, 2019); Belt v. P.F. Chang’s China Bistro, Inc., 401 F. Supp. 3d 512 (E.D. Pa. 2019).Of the three cases that do not defer, the agency interpretations most commonly failed the “genuinely ambiguous” and “unfair surprise” inquiries. Courts’ characterizations of the impact of the Kisor test have also been mixed. See, e.g., Spears v. Liberty Life Assurance Co. of Bos., No. 3:11-CV-1807 (VLB), 2019 WL 4766253 (D. Conn. Sept. 30, 2019) (“Kisor did not change anything about Auer, but merely explained its application”); Devon Energy Prod. Co., L.P. v. Gould, No. 16-CV-00161-ABJ, 2019 WL 6257793 (D. Wyo. Sept. 11, 2019) (“The Court [in Kisor] chose to restrict the Auer doctrine rather than abolish it.”).
[28] Similarly, agencies may choose to cast their interpretations of regulations as interpretations of the underlying statute, which would subject the interpretation to the test for Chevron deference rather than the Kisor test. As one state supreme court justice recently noted, “Not long ago, the distinction [between Chevron deference and Auer deference] might not matter in a case like this one, because Auer was generally understood to give even more deference to agency interpretations of rules than is accorded to agency interpretations of statutes under Chevron. … The upshot of that shift [due to Kisor] is that while courts previously could have been insensitive to whether the implicit agency interpretation of a statute that they were deferring to under Chevron was actually an implicit interpretation of a rule—because even if it were, deference would be required anyway—accepting that uncertainty is no longer an option. Given that Auer and Chevron have different, non-coextensive limits, it cannot be appropriate to defer to an agency’s implicit interpretation under Chevron unless it is either clear that the agency really is interpreting a statute, or, at a minimum, that the agency’s interpretation would be owed deference under Auer and Kisor even if the agency were interpreting a rule.” E. Or. Mining Ass’n v. Dep’t of Envtl. Quality, 445 P.3d 251, 278 (Or. 2019) (Balmer, J. dissenting). The justice clarified that “[n]ow, Auer’s own application having been restricted, we should not use Chevron to avoid Kisor’s limitations.” Id. at 278 fn. 4.
[30] As the Court noted earlier, Auer deference “creates a risk that agencies will promulgate vague and open-ended regulations that they can later interpret as they see fit, thereby frustrat[ing] the notice and predictability purposes of rulemaking.” Christopher, 564 U.S. at 158. In Kisor, Justice Kagan, joined by Justices Ginsburg, Breyer, and Sotomayor, argues that this criticism of Auer has notable empirical and theoretical weaknesses. Kisor, slip op. at 24–25.
[33]See, e.g., U.S. Telephone Ass’n v. Fed. Commc’n Comm’n, 28 F.3d 1232 (D.C. Cir. 1994); Community Nutrition Institute v. Young, 818 F.2d 943 (D.C. Cir. 1987); Pac. Gas & Electric Co. v. Federal Power Commission, 506 F.2d 33 (D.C. Cir. 1974).
[34] The ability to bind courts under Auer deference without notice and comment, Justice Gorsuch argues, “subverts the [Administrative Procedure Act]’s design.” Kisor, slip op. at 18 (Gorsuch, J., concurring in judgment).
[35] As noted by the 9th Circuit, the FDIC itself had characterized the manual as containing the agency’s “supervisory expectations.” FDIC, Financial Institution Letter 17-2010 (Apr. 29, 2010); compareGuidance on Guidance, at 1 (“Unlike a law or regulation, supervisory guidance does not have the force and effect of law, and the agencies do not take enforcement actions based on supervisory guidance. Rather, supervisory guidance outlines the agencies’ supervisory expectations or priorities and articulates the agencies’ general views regarding appropriate practices for a given subject area.”) (emphasis added).
[36] Cal. Pac. Bank v. Fed. Deposit Ins. Co., 885 F.3d 560, 573–75 (9th Cir. 2018).
[37] For example, it is not clear that the 9th Circuit would have concluded, based on its independent analysis of the text, structure, history, and purpose of the FDIC’s regulation, that the FFIEC BSA/AML Examination Manual is within the range of reasonable interpretations that the court identified in its analysis, or that the “character and context” of the Manual warranted deference. See, e.g., Kisor, slip op. at 16 (“So the basis for deference ebbs when the subject matter . . . falls within the scope of another agency’s authority.”) (internal quotations omitted).
In a recent decision, In Re Clovis Oncology, Inc. Derivative Litigation,[1] the Delaware Court of Chancery held that stockholders of Clovis Oncology, Inc. (Clovis), a developmental biopharmaceutical company, adequately pled facts that supported a pleading stage inference that the Clovis board of directors breached its fiduciary duties by failing to oversee the clinical trial of the company’s most promising drug, and then allowing the company to mislead the market regarding the drug’s efficacy. This decision follows the Delaware Supreme Court’s recent reversal in Marchand v. Barnhill,[2] which involved the dismissal of Caremark claims arising from a listeria outbreak at Blue Bell Creameries USA, Inc., resulting in a number of deaths.
Background
Clovis is a biopharmaceutical company that has no products on the market and generates no sales or revenue. In early 2014, the Clovis board was determined to get U.S. Food and Drug Administration (FDA) approval for the company’s then-most promising, cancer-fighting drug, Roci, before AstraZeneca’s competing drug for lung cancer received FDA approval. After clinical trials began in 2014, the Clovis board received data suggesting that management was inaccurately reporting Roci’s efficacy by including unconfirmed responses to corroborate Roci’s cancer-fighting potency. Although the Clovis board allegedly knew that under the protocols for its clinical trial the FDA could base approval of Roci’s new drug application only on confirmed responses, the Clovis board did nothing to address the fundamental departure from protocol. Clovis continued to publicly report inflated numbers in 2014 and early 2015, and used the inflated numbers to obtain additional funding from investors during that timeframe. By November 2015, the FDA informed Clovis that it could report only confirmed responses, and Clovis issued a press release informing the public of Roci’s actual efficacy, which led to a 70-percent drop in the company’s stock price. In April 2016, the FDA voted to delay action on Roci until Clovis could provide concrete evidence that Roci produced meaningful tumor shrinkage in patients treated with the drug, which led to another 17-percent drop in the company’s stock price, and Clovis withdrew its new drug application for Roci.
Analysis
In this action, plaintiffs alleged that the Clovis directors breached their fiduciary duties under Caremark by either failing to institute an oversight system for the Roci clinical trial, or consciously disregarding a series of red flags that the clinical trial was failing. The defendant directors moved to dismiss plaintiffs’ claims for failure to (1) make a pre-suit demand under Court of Chancery Rule 23.1, and (2) state a claim upon which relief could be granted. The court disagreed and found that: (1) pre-suit demand was excused because plaintiffs pled particularized facts to support a reasonable inference that the Clovis directors faced a substantial likelihood of liability under a Caremark theory of liability that excused plaintiffs’ failure to make a pre-suit demand, and (2) plaintiffs stated a Caremark claim by making well-pled allegations that the Clovis board acted in bad faith by consciously disregarding red flags that arose during the course of Roci’s clinical trial that placed FDA approval of the drug in jeopardy. According to plaintiffs, the Clovis board then allowed the company to deceive regulators and the market regarding the drug’s efficacy.
As the court noted, successful Caremark claims require well-pled allegations of bad faith to survive dismissal, i.e., allegations that the directors knew that they were not discharging their fiduciary obligations. Plaintiffs may meet that burden by showing either that the board completely failed to implement any reporting or information system or controls, or that the company implemented an oversight system but the board failed to monitor it as evidenced by red flags which were known, but ignored, by the board. Here, the court found that plaintiffs successfully pled that the Clovis board ignored red flags that revealed a mission-critical failure to comply with drug protocols and associated FDA regulations. The court noted that a board’s oversight obligations are enhanced with respect to mission-critical products while operating in a heavily regulated industry.
Takeaways
As then-Chancellor Allen stated of a Caremark theory of liability: “The theory here advanced is possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment”.[3] In order to meet this enhanced pleading burden, the plaintiffs in Clovis and Marchand brought books and records actions under section 220 of the General Corporation Law of the State of Delaware prior to bringing their Caremark complaints. The books and records actions enabled the plaintiffs to gather crucial facts that highlighted potential gaps in compliance systems and board-level ignorance of red flags. Some practical lessons can be drawn from both cases.
In Clovis, the Court of Chancery emphasized the importance of a board’s oversight function when a company is operating in the midst of a mission-critical regulatory compliance risk, suggesting that a board’s oversight of such impactful business risks may be subject to greater scrutiny than the same board’s oversight of less-critical business risks. In Marchand, the Delaware Supreme Court’s decision emphasized the importance for corporations operating in heavily regulated industries to implement a system that ensures that mission-critical risks and compliance issues are brought to the attention of the board whether through a board-level compliance committee or a direct reporting line between the corporation’s top compliance officer and the board. Both cases underscore the importance of board engagement in regular discussion of critical business risks and compliance issues and the evaluation of the effectiveness of existing monitoring and compliance systems.
Prior decisions of the Delaware courts relating to Delaware corporations with vast global operations have emphasized the importance for such an enterprise to: (1) establish compliance standards and procedures that are designed to prevent violations of the law at all levels of the organization, (2) require participation in training programs, and (3) establish whistleblower systems that enable employees to report potential wrongdoing anonymously and without fear of retaliation.
Acme’s cloud storage provider just got hacked. Private information was exposed. Acme’s customers who lost information in the hack are angry and don’t care that it was a third party that failed to secure the information or that some maleficent hacker from across the globe got into their system. Likewise, their customers don’t care how difficult it is for Acme to migrate data, or how they retain and store their records, or what regulations govern each part of Acme’s business. Acme’s customers care only about their information, their data, and whether Acme performs for them.
This story could be any company’s story. The problems afflicting Acme could be one of a number of information-management issues that confound most businesses. In 2020, you should expect that bad actors will seek to break into your information trove and find and exploit any weakness in your information culture. Expect they will try regularly—they are trying right now, in fact. Expect that customers will become ever more aware of “their” private information, and when (not if) that information is exposed, it may impact your relationship with your customers, vendors, and the public. Expect that confidential information may fly across the ether unprotected, and that sensitive information may fall into the wrong hands. Expect that records may be kept for too long or not long enough, and that discovery for a lawsuit may be inexplicably gone, precipitating a claim for spoliation.
If every worst-case scenario is not only possible, but likely at some point, then now what? Take a deep breath and read on because there is a path forward. As you reflect on how to change the course of, or mitigate the fallout from, some future event, you could find help in building a mindful information culture at your company. Building a more mindful information culture has several distinct and critical elements:
Who Is the Organization’s “Champion”? Every major project or initiative requires a champion possessing a combination of institutional knowledge and political savvy to help make the journey more productive and less painful. It is critical that the face of the journey to build a mindful information culture has the right temperament and skill set. In order to establish and properly incubate this shift, your champion must demonstrate three essential qualities: the ability to clearly communicate, a balance of business and technology acumen, and knowledge of the organization. Properly selecting the right champion will enable the new culture to grow and flourish, whereas failing to select the right champion will likely doom it to failure.
Relying on the Right Support to Do the Heavy Hauling and Deliver Guidance. Every programmatic trek also needs the right supporting cast that represents the essential parts of your organization. Without the right supporting team members to haul each segment of the organization forward, the initiative will likely experience headwinds and hurdles (which might happen anyway). For every information project, there must at a minimum be business, IT, and legal executive involvement, and do not minimize the need for excellent project-management skills, too. Getting the right executive’s imprimaturs will be essential in getting the employees’ behind the initiative.
Assessing Where You Are in the Fog. The only way you know where you are is by looking. The only way you know what needs fixing is by assessing “the good, the bad, and the ugly.” Knowing what is “good enough” and what needs fixing is an essential part of the project, and it should happen early in the process. Additionally, when you have several issues that must be addressed, each issue must be evaluated based on risk to the organization. In other words, the issues that create the greatest risk, and the issues that can be addressed fairly easily, should be tackled first. Until you assess, you cannot address, but only after identifying your organization’s problems can you begin to change your information culture.
Building a Plan to Get to Information Nirvana. Having the right remediation path and taking the right action steps to triage and fix any information problem requires a plan. Ensuring your organization provides long-term solutions to address company and employee needs for information similarly requires a plan, and likely new technology to ensure information accessibility.
So, what should your organization’s plan look like? You have done your triage and know that immediate litigation response requirements likely take precedence over longer-term records retention fixes. Likewise, managing private information that is sitting unprotected on a server likely takes precedence over training on information classification. However, the plan must be more than just triaging emergencies. The tyranny of the immediate cannot derail you from your long-term goals. Your organization can implement tactical fixes at the same time that it fleshes out the strategic initiatives. You simply must manage resources to maximize effectiveness and not overwhelm a particular business unit or individual.
Part of the path forward also requires that your plan consider your organization’s existing information culture. What is your work force’s openness to change? Are they technologically sophisticated? Centralized? Are business units autonomous? Does your company vet and buy applications for the entire company? How big is the problem? Who is required to fund and fix it? Are employees going to balk if you change e-mail retention, for example? The bottom line is to be ambitious but take the time to build a plan that includes the needed expertise from across the organization, and be realistic about what can get done given the company information culture, resource constraints, and other projects impacting employee availability.
Messaging as the Information Mantra. Moving your team, department, or organization to change is not easy. It will be effective only if the key leaders properly message the change. Mid-level management typically does not steer the ship; redirection is done by the people at the top.
For example, when moving to a new collaboration environment or migrating to O365, your workforce’s needs and concerns should be anticipated and managed, otherwise the project will likely get derailed. Providing the necessary information to the proper people and giving them the opportunity to ease into change and readjust their way of operating will be necessary for your plan to succeed.
People default to what is simple and what they know. Therefore, the messaging surrounding building an information culture is critical. It must be clear, consistent, and anchored to a “why” that resonates with your employees and makes their life better (not just simpler, but better). This will allow them to move past the “but this is how we have always done it” response toward becoming mindful stewards of your organization’s information. Mindful employees are essential to building a great information culture.
Achieving a Mindful Information Culture Requires Processes and Repetition. Achieving any organizational goal, let alone building a mindful information culture, requires the right processes and directives that can become muscle memory—implementable, repeatable, and followed over time. Diligence must become your organization’s state of being. Persistence must be how the champion and executive team manages any information-related initiative and program. A mature information culture is a state of being, like a never-ending marathon. Culture is not a “sometimes thing,” it is an “all the time thing.” If your company is able to wrangle its information security risks, it is because information security mindfulness was made part of the fabric of your organization. If your organization right-sizes its information footprint annually, it is because minimizing cost and mitigating the risk of keeping unneeded data has also been woven into the fabric of your company. It takes a person doing something correctly 14 times in a row to make it a habit, and achieving information nirvana is no different. Building a mindful information culture can be achieved only by implementing a consistent, persistent, evolving cycle to assess, plan, implement, communicate, monitor, resolve, and repeat. This is the way to truly effectuate cultural change.
Information Mindfulness. All organizations care about profits and costs, yours included. Harvesting and harnessing information can promote both. To be a truly information-mindful organization, your company must use information as a differentiator. Information can promote employee satisfaction and provide a more valuable workplace. Information can advance your customers’ needs and create a deeper customer experience, which translates into a deeper customer connection, which translates into greater sales. Information mindfulness is about using information as the currency that makes business better and the glue that connects people in various ways with your company.
Finding Easy Places to Focus. Your organization should focus its efforts on the most critical gaps first while finding some low-hanging fruit to bolster the credibility of project champion. Once you solve a few of the less complex issues impeding your organization, you can move on to the tougher issues, having acquired wins under your belt and hopefully having banked goodwill and support from management. When employees see the changes to your information culture helping their work day, they will almost certainly climb aboard.
Conclusion
A leader’s obligation is to be constant in principle but flexible in approach—to change just before change is necessary. Specifically, once the pillars are poured, you and your champions must find a new way to look at and think about the enterprise’s information culture, whether a new angle or new focus, a new way forward, or simply to decide to do what you are already doing, just more efficiently. The bad actors never rest and are always reinventing themselves. Without that same dedication to diligence as a way of corporate life, your information culture will stagnate, issues will appear, and you will likely feel the pain that is exacted on the nonvigilant.
In the July issue of BLT I described briefly the consequences of the application of RULLCA’s default rule to members of a limited liability company (LLC) who fail to provide for member death. Readers suggested a follow-up piece that would provide suggestions to avoid those consequences.
The issue arises because, unlike the shares of a corporate shareholder all of whose rights, unless otherwise provided in a shareholders agreement, pass to his or her estate, when an LLC member dies, unless something is provided to the contrary, his or her interest divides, with only economic rights passing to the estate.[1] The management rights devolve upon the remaining members. In a multi-member LLC (MMLLC), where the pick-your-partner principle of partnership law applies, this result is clearly appropriate. In a single member LLC (SMLLC) pick-your-partner protection is oxymoronic.
The consequences for the decedent’s heirs are different in the MMLLC from those in the SMLLC. In the former, the estate is treated as an assignee or transferee of the economic rights.[2] The now former member, dissociated at death, has provided his or her heirs with little or no authority to enforce their inherited economic rights. They are at the mercy of the remaining LLC members who may choose not to make distributions. They have no right to participate in the direction, whether wise or foolhardy, in which the surviving members may take the LLC. [3] Recovery of the decedent’s capital account will not be realized until the LLC dissolves if that event should ever occur. The estate has no right to compel the LLC’s dissolution[4] or even, perhaps, to acquire information as to the LLC’s ability to make distributions.[5]
In the SMLLC, where the economic rights also pass to the estate, the problem is that if the estate does not act within a short statutory period to name a successor member who accepts the role, the memberless LLC dissolves with whatever unintended consequences flow from that event.[6]
Knowledgeable business lawyers will protect against these consequences. When a multi-member LLC is formed, and all the members are on the same side of the table and don’t know who will be the first to die, the lawyers will offer suggestions as to how the members may wish to provide for death in their operating agreement. If admission to membership of one or more successors to a deceased member is not desired, perhaps a buy-out on death can be negotiated, or provision made for the heirs to have certain rights short of participation in management.
In the SMLLC provision should also be made in the operating agreement for the one future event that is certain to occur. Here are a few suggestions.
1. Treat the member’s interest similar to that of a sole shareholder in a corporation. The operating agreement might provide that:
Upon the death of the member (or last surviving member in a multi-member LLC), the member’s estate is admitted to membership in the LLC on the member’s date of death with both economic rights and full management authority.
The time gap between the date of death and the appointment of an executor or administrator for the estate, during which business operations may not be able to be directed, might be addressed by naming an interim manager.
2. The operating agreement might name a successor member admitted to membership immediately upon the death of the member.[7]
3. If the governing statute permits, name a special member who has no capital account or percentage interest in the LLC and thus should not impair its disregarded status for income tax purposes.[8]
4. If the governing statute permits, the concept of a springing member might be utilized.
5. Instead of placing the membership interest in the individual, it may be placed in a revocable trust for the client (a) if a trust may be an LLC member and (b) if the client is willing to incur the complexity and cost of a trust agreement in addition to an operating agreement.
My attention has been called to The Uniform TOD Securities Registration Act, part of the Uniform Non-Probate Transfers on Death Act, promulgated in 1989 when LLCs were in their infancy. Its design is to provide the owner of securities an alternative to the process of probate. Although the statute’s definition of security is broad enough to encompass an interest in an LLC, the statute does not address the dichotomy between economic and management rights. It is doubtful that, in a multi-member LLC, authorization for non-probate transfer overrides the pick-your-partner principle. The statute’s usefulness to a SMLLC, limited by the definition of Registering Entity, may present practical difficulties.
[1]Ott v. Monroe, 2011 WL 5325470 (Va. 2011): An LLC interest, like a partnership interest, is comprised of two separate components. The first is the management right to control or participate in administration. The second is the economic or financial right to participate in the sharing of profits and losses and receipt of distributions. The only interest alienable is the economic interest
[2]Faienza v. T-N-B Marble-N-Granite, LLC, 2018 WL 1882586 (Conn. Sup. Ct. 2018): The deceased member’s estate has only the rights of a transferee, not a member, and cannot sue for dissolution. To the same effect: Estate of Calderwood v. ACE Grp., Int’l, LLC, 61 N.Y.S. 3d 589 (App. Div. 2017); SDC University Circle Developer, L.L.C. v. Estate of Patrick Whitlow, M.D., 2019 WL 92791 (Ct. App. Ohio 2019).
[3] See, Gebroe-Hammer v. West Green Gables, LLC, 2019 WL 3428499 (App. Div. N.J. 2019). Act of sole surviving member bound, LLC.
[5]Succession of McCalmont, 261 So.3d 903 (La. App. 2018): As a mere assignee the deceased member’s estate as could not access the LLC’s books and records to determine if it was getting its fair share of distributions.
[7]Blechman v. Estate of Blechman, 160 So. 3d 152 (Fla. App. 2015): Where supported by adequate consideration, contracts transferring a property interest upon death are neither testamentary nor subject to the Statute of Wills, but are instead evaluated under contract law. See also, in the corporate context, Jimenez v. Carr, 764 S.E.2d 115 (Va. 2014)
[8] Support for this proposition is Historic Boardwalk Hall, LLC v. C.I.R., 694 F.3d 425 (3rd Cir. 2012), where the entity involved was not recognized as a partnership for tax purposes because the purported partner had no meaningful stake in its success or failure.
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