Potential Auditor Liability in the Wake of Colonial Bancgroup

Posted on March 13, 2018 by - Uncategorized

In a rare loss by an audit firm in a case involving financial-crisis-era fraud, an Alabama federal court recently held accounting giant PricewaterhouseCoopers (PWC) liable to the Federal Deposit Insurance Corporation (FDIC) for its failure to detect a $2 billion fraud. Judge Barbara Jacobs Rothstein’s December 28, 2017 liability opinion in The Colonial Bancgroup, Inc., et al. v. PricewaterhouseCoopers LLP, et al. departed from the typical rule that because receivers like the FDIC stand in the shoes of their debtors, they can only recover where the debtor itself could recover—which excludes cases where the debtor has “unclean hands.” Instead, and despite undisputed evidence of Colonial Bancgroup’s fraud, the court applied Alabama state law to view the FDIC, a government entity, as different from a normal successor-in-interest, and granted the receiver’s claim.

Since the U.S. Supreme Court’s decision in O’Melveny & Myers v. FDIC, 512 U.S. 79, 114 S. Ct. 2048 (1994), there has been no question that state law governs claims brought by the FDIC as a receiver. In light of this fact, the decision in Colonial Bancgroup is instructive. It shows that this area of law is unsettled, and that auditors may face greater potential liability in states like Alabama, where friendly state laws could allow courts to permit the FDIC (and its sister entity, the National Credit Union Administration) to pursue lawsuits against them related to failed banks and credit unions.

Suing Auditors Is Often a Losing Proposition

The law generally insulates auditors from civil liability for losses stemming from their alleged failure to detect frauds committed by their clients, including financial institutions.

First, under the law of many states, privity requires that a third-party plaintiff have more than de minimis direct contact with the auditor as a precondition to recovery.[1] Given that this rarely occurs, the doctrine of privity generally functions as a bar to suits by third parties against auditors for professional negligence before even reaching the question of whether the auditor’s failure to exercise due care caused significant injury to the putative plaintiffs.[2] Whether the third-party plaintiff is a shareholder in a bankrupt company, an investor who entrusted that company with his or her funds, or an unrelated victim of the underlying fraud, those parties rarely will be permitted to pursue the auditor for its negligence.

Second, even when a company itself is badly damaged (or even bankrupted) by a fraud, courts will bar a suit by the company itself against the auditors under the doctrine of in pari delicto (literally, “in equal fault,” such that the position of the defending party is the stronger one)[3] because a fraud committed by the company’s own management or employees is imputed to the company. The theory, to put it simply, is that a company that destroys itself through fraud should not be permitted to lay the burden of that misconduct on a third party.[4]

These rules form a formidable pair of obstacles that seemingly foreclose any such claims against an auditor whose negligence fails to discover devastating fraud. Third parties without a direct relationship with the auditor (and whose reliance is not foreseeable by the auditor) may not assert such a claim due to lack of privity, but the auditor’s client—the company—is barred from the claim because of its own imputed participation in the fraud.

The Colonial Bancgroup Litigation

Notwithstanding this legal backdrop, the Colonial Bancgroup litigation demonstrates that auditors are not entirely immune from civil liability, particularly in situations where there have been substantial losses to the public at large.

The Colonial Bancgroup litigation arose from a massive fraud that led to the failing of Colonial, a national bank that was a fully owned subsidiary of the Colonial Bancgroup (CBG).[5] When the FBI raided Colonial in August 2009, it was one of the 25 largest banks in the United States. Ten days later, Alabama banking regulatory authorities closed Colonial and appointed the FDIC as its receiver. CBG filed for Chapter 11 bankruptcy protection 11 days later.

Colonial’s failure was the result of a fraud perpetrated by Taylor, Bean & Whitaker Mortgage Corporation (TBW), the largest customer of Colonial’s Mortgage Warehouse Lending Division (MWLD), and several of Colonial’s employees. Colonial’s MWLD provided short-term funding to mortgage originators like TBW to enable such companies to originate and fund mortgage loans until those loans could be sold to third-party investors such as Freddie Mac and Ginnie Mae. Between 2002 and 2009, TBW and some of Colonial’s employees engaged in a multifaceted fraud that disguised TBW’s failure to repay Colonial’s short-term funding. By the time the fraud was discovered in 2009, it had grown to $2.3 billion.

During this period, PWC acted as outside auditor for CBG and because it performed the audit on a consolidated basis, that audit included Colonial.

The Colonial failure cost the FDIC’s deposit insurance fund $2.3 billion, and the FDIC was appointed receiver for the bank.[6] CBG and the FDIC each sued PWC, alleging that PWC breached the professional and contractual duties it owed CBG and Colonial, thereby allowing the fraud to go undetected. Both lawsuits also state claims against Crowe Horwath LLP, who acted as CBG’s internal auditor during the years that Colonial was victimized by the fraud and who also failed to detect the fraud. CBG’s and the FDIC’s claims against PWC and Crowe were consolidated, and the parties proceeded through discovery and pretrial motions. Ultimately, the claims against PWC and against Crowe were bifurcated, and the case was also bifurcated with respect to liability and damages.

Following the liability portion of the PWC bench trial,[7] the district court issued its findings and rulings on December 28, 2017. In a lengthy written decision, the court found that CBG could not hold PWC liable because the wrongful conduct of Colonial’s employees was imputed to Colonial and then to CBG based on its control over Colonial. On the other hand, the court found that PWC was liable to the FDIC for its negligence in failing to detect the massive, long-running fraud. In other words, the FDIC was treated differently than Colonial (and CBG), even though the FDIC (as a receiver) was stepping into the shoes of Colonial.

The court found that under Alabama law, PWC owed a duty to both CBG and Colonial to exercise reasonable care in performing its audits of CBG—a proposition that PWC did not dispute. The court then found that PWC breached those professional obligations by failing to plan and perform its audit to detect fraud, and by failing to obtain sufficient audit evidence regarding the particular types of transactions through which the fraud was executed.

In the bench trial, PWC witnesses acknowledged that PWC had an obligation to design its audits to detect fraud, and the court noted that in deposition testimony in the case brought by TBW’s trustee, PWC engagement partners, audit managers, and audit staff repeatedly admitted that PWC did not design its audit procedures to do so. Based on that testimony, the court concluded that PWC had failed to design its audits to detect fraud, and that PWC thereby violated applicable auditing standards.

The court also credited the plaintiffs’ assertion that PWC should have—but failed to—physically inspect the mortgage loan documents that were associated with the bank’s transactions with TBW, and which were supposed to be held by Colonial until it was paid its interest in the transaction. In doing so, it rejected PWC’s argument that even if it had attempted to inspect the underlying loan documents, it would not have uncovered the fraud because the fraudsters would have created fake documents. “This, of course, is something that we will never know,” the court observed. “However, what we do know is that . . . one of the key fraudsters . . . testified that if PWC had asked to see even just ten loan files, ‘[t]he jig would be up.’” In addition, PWC’s comparison of different management reports—to make sure the numbers matched—reflected insufficient “professional skepticism,” and PWC had missed certain red flags (like transaction dates that were illogical) that should have alerted it to the need to physically inspect the underlying documents. To the court, PWC’s decision to base its conclusions on TBW’s representations about the underlying assets instead of conducting its own investigation was “quintessentially the same as asking the fox to report on the condition of the hen house.”[8]

Why the FDIC Could Assert Colonial’s Claim

The FDIC faced legal hurdles in attempting to assert claims against PWC because it was stepping into the shoes of parties that would presumably be barred from asserting such claims. If the FDIC were viewed as asserting Colonial’s claims against its auditor, the doctrine of in pari delicto would presumably bar the claims because Colonial’s management and employees were complicit with (or even responsible for) the fraud. In addition, if the FDIC were viewed as asserting claims on behalf of the bank’s depositors (whom it has made whole through its insurance function), the depositors’ lack of privity with PWC would operate as a bar to the claims.

Nevertheless, the district court reached a different conclusion.[9] The starting point for the court’s analysis was that receiverships are governed by state law, and that Alabama law generally does not permit receivers to stand in a better position than the failed institutions they represent. In finding that the FDIC should not be so limited, the court relied in part on a 1991 Alabama Supreme Court case holding that the Resolution Trust Corporation—a federal receiver with substantive duties that mirror those of the FDIC—was not subject to punitive damages based on the misdeeds of the failed institution it inherited. There, the state high court reasoned that the imputation of wrongdoing to receivers is tempered by equitable principles:

A receiver operates for the benefit of creditors, unsecured depositors and the federal tax payer. However, punitive damages are imposed to punish the wrongdoer and to deter others. Where the wrongful party is in receivership and the damages are to be paid by innocent creditors, punitive damages create an inequitable result and are therefore improper. [The bank] no longer exists and cannot be punished. . . . Imposing punitive damages against RTC would not accomplish the purposes which punitive damages are meant to serve.[10]

According to Judge Rothstein, the same logic compelled a liability finding in Colonial Bancgroup. The court found that the purpose of in pari delicto would not be served by using it to bar claims by the FDIC. To further buttress this conclusion, the court relied on a Ninth Circuit decision involving the FDIC that helps to differentiate the FDIC from Colonial itself:

A receiver . . . does not voluntarily step into the shoes of the bank; it is thrust into those shoes. It was neither a party to the original inequitable conduct nor is it in a position to take action prior to assuming the bank’s assets to cure any associated defects or force the bank to pay for incurable defects. This places the receiver in stark contrast to the normal successor in interest who voluntarily purchases a bank or its assets and can adjust the purchase price for the diminished value of the bank’s assets due to their associated equitable defenses. In such cases, the bank receives less consideration for its assets because of its inequitable conduct, thus bearing the cost of its own wrong.[11]

What Comes Next?

Although Judge Rothstein’s opinion was limited to Alabama law and her prediction of how the state’s supreme court would view cases brought by the FDIC, it was also motivated by public-policy concerns that could have broader application. It is difficult to predict whether the decision and those public-policy issues will encourage other courts to permit the FDIC to assert claims against auditors.

One reason for this is that there are significant differences among how states treat receivers.[12] Consider as an example how Colonial Bancgroup might have been decided if the audit had taken place in New York. As in Alabama, the general rule under New York law is that the “liquidator . . . ‘stands in the shoes’ of the insolvent, gaining no greater rights than the insolvent had.”[13] For this reason, under New York law, the receiver of a bankrupt corporation can be barred by the in pari delicto doctrine from bringing claims against service providers to the corporation.[14]

In the past, some New York trial courts refused to impute knowledge of corporate wrongdoing to court-appointed receivers who are “innocent successors” to the corporation. These decisions draw upon federal cases, and the same public policy rationales that motivated the decision in Colonial Bancgroup.[15] Consistent with this line of cases, in a 1996 decision, a federal district court interpreting New York law found that the FDIC was not subject to an in pari delicto defense that could have been raised against the failed bank.[16]

However, those decisions pre-date the most recent New York Court of Appeals decision on imputation and in pari delecto: Kirschner v. KPMG LLP, 15 N.Y.3d 446, 938 N.E.2d 941 (2010). In that case, the court found that the primary, and arguably lone, exception to the general rule imputing an agent’s knowledge to his principal is the “adverse interest” exception, which applies only when the agent has “totally abandoned his principal’s interests” and is “acting entirely for his own or another’s purposes.” Where both the agent/employee and the corporation benefit, the exception does not apply.[17] In reaching this decision, the court reasoned that public-policy goals would not be served by exposing corporate auditors to additional liability:

The derivative plaintiffs caution against dealing accounting firms a “get-out-of-jail-free” card. But as any former partner at Arthur Andersen LLP—once one of the “Big Five” accounting firms—could attest, an outside professional (and especially an auditor) whose corporate client experiences a rapid or disastrous decline in fortune precipitated by insider fraud does not skate away unscathed. In short, outside professionals—underwriters, law firms and especially accounting firms—already are at risk for large settlements and judgments in the litigation that inevitably follows the collapse of an Enron, or a Worldcom or a Refco or an AIG-type scandal. . . . It is not evident that expanding the adverse interest exception or loosening imputation principles under New York law would result in any greater disincentive for professional malfeasance or negligence than already exists. Yet the approach advocated by the Litigation Trustee and the derivative plaintiffs would allow the creditors and shareholders of the company that employs miscreant agents to enjoy the benefit of their misconduct without suffering the harm.[18]

Although the decision does not directly apply to the FDIC, the court’s public-policy analysis differs significantly from that of Judge Rothstein. The Kirschner court’s skepticism that frauds can be deterred by expanding civil liability for auditors suggests that Colonial Bancgroup may have been decided differently if New York law had governed the FDIC’s claims against PWC.

Conclusion

The decision in Colonial Bancgroup demonstrates that auditors face difficulties in evaluating their potential liability for audits of banks and credit unions. In the event that a bank or credit union fails, and the auditor was unable to detect the underlying fraud for some period of time, that auditor may be held responsible for a massive amount of losses. Ultimately, the auditor’s liability in such a situation may turn on the vagaries of state laws governing receivership and how courts view the costs and benefits of holding auditors accountable for frauds perpetrated by others.

[1]              There are circumstances in which an auditor may be liable to a third party when it has conducted work specifically for the benefit of that third party, but there are few cases finding a factual basis for such liability. Instead, the requirement of privity otherwise generally bars such claims. See, e.g. CRT Inves., Ltd. v. BDO Seidman, LLP, 85 A.D.3d 470, 472, 925 N.Y.S.2d 439 (1st Dep’t 2011) (finding complaint failed to plead claim for negligence) (citing Sec. Pac. Bus. Credit v. Peat Marwick Main & Co., 79 N.Y.2d 695, 706, 586 N.Y.S.2d 87 (1992)).

[2]              See, e.g., In re Adelphia Commc’ns Corp. Secs. & Derivative Litig., slip op., 2014 WL 6982140, at *9 (S.D.N.Y. Dec. 10, 2014) (barring claim for negligence against auditor in absence of privity) (citing Guy v. Liederbach, 501 Pa. 47, 459 A.2d 744, 750 (Pa. 1983)); In re MF Global Holdings Ltd. Inv. Litig., 998 F. Supp. 2d 157, 187–88 (S.D.N.Y. 2014) (holding negligence claim requires under New York law showing of “near privity”) (citing Credit Alliance Corp. v. Arthur Andersen Co., 65 N.Y.2d 536, 493 N.Y.S.2d 435 (1985)); Bily v. Arthur Young & Co., 3 Cal. 4th 370, 406, 834 P.2d 745, 767 (1992) (barring investors claims for negligence against auditor of bankrupted company).

[3]              The leading case on the doctrine is Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449 (7th Cir.), cert. denied, 459 U.S. 880 (1982).

[4]              For example, in Colonial Bancgroup, the bankruptcy trustee for the failed bank’s parent company sought to recover damages from PricewaterhouseCoopers for its negligence but was barred from doing so under the in pari delicto doctrine. See Colonial Bancgroup, Case No. 2:11-cv-00746-BJR-TFM, Order on the Liability Phase of the PWC Bench Trial, Doc. 798 (M.D. Ala. Dec. 28, 2017).

[5]              This description of the facts is taken from the court’s findings issued following the liability phase of the bench trial in that case. See id.

[6]              The court’s ultimate decision reduced the potential damages to an estimated $1.4 billion after determining that a related breach by Bank of America of its custodial obligations to Colonial Bank was not foreseeable by the auditor.

[7]              Certain of the claims for which the plaintiffs had the right to a jury trial are to be tried separately to a jury. The Crowe bench trial was scheduled to commence after the conclusion of the PWC bench trial, although it was subsequently rescheduled for later in the proceedings.

[8]              The court was also critical of PWC for failing to understand how certain of the transactions were supposed to work. One PWC auditor admitted that understanding these transactions was “above his paygrade,” and PWC ultimately assigned the evaluation of these transactions (a $589 million asset) to a college intern. PWC’s failure to understand this class of transactions was compounded by its failure to examine physically the actual documentation that underlay each transaction and constituted the collateral at issue. “Instead,” the court noted, “PWC chose to rely on . . . the college intern[‘s] assessment that it was not necessary to inspect the . . . collateral because ‘PWC feels that the collateral for these [transactions] is adequate.’”

[9]              This issue was addressed in the context of the FDIC’s motion for partial summary judgment on the defendants’ affirmative defenses. See generally Colonial Bancgroup, Case No. 2:11-cv-00746-BJR-TFM, Order Granting in Part and Denying in Part FDIC’s Motion for Partial Summary Judgment on Defendants’ Affirmative Defenses, Doc. 720 (M.D. Ala. Aug. 18, 2017).

[10]             Id. at 7–8 (quoting Resolution Tr. Corp. v. Mooney, 592 So. 2d 186, 190 (Ala. 1991)).

[11]             Id. at 10–11 (quoting FDIC v. O’Melveny & Myers, 969 F.2d 744, 751–52 (9th Cir. 1995)).

[12]             Judge Rothstein recognized as much in her opinion, in which she stated that there are countervailing opinions from other jurisdictions, but she was not persuaded by the reasoning of these courts. Id. at 11, n.2.

[13]             In the Matter of Liquidation of Union Indem. Ins. Co. of N.Y., 89 N.Y.2d 94, 109, 651 N.Y.S.2d 383, 674 N.E.2d 313 (1996) (quoting Stephens v. Am. Home Assurance Co., 811 F. Supp. 937, 947 (S.D.N.Y.1993), vacated & rem’d on other grounds, 70 F. 3d 10 (2d Cir.1995).

[14]             See, e.g., Cobalt Multifamily Inv’rs I, LLC v. Shapiro, 857 F. Supp. 2d 419, 431 (S.D.N.Y. 2012).

[15]             See, e.g., Williamson v. Stallone, 28 Misc. 3d 738, 905 N.Y.S.2d 740, 752–53 (N.Y. Sup. Ct. 2010) (citing FDIC v. O’Melveny & Myers, 61 F.3d 17 (9th Cir. 1995)); Williamson v. PricewaterhouseCoopers, LLP, 2007 WL 5527944 (N.Y. Sup. Ct. Nov. 7, 2007) (same).

[16]             FDIC v. Abel, 1996 WL 520906, at *1 (S.D.N.Y. Sept. 12, 1996) (“Because the FDIC is acting on behalf of the depositors and creditors . . . that defense cannot succeed.”).

[17]             Kirschner v. KPMG LLP, 15 N.Y.3d 446, 466, 938 N.E.2d 941, 954 (2010).

[18]             Id. at 476–77.

New Fintech Legislation: The Madden and True Lender Bills

Posted on February 15, 2018 by - Uncategorized

Partnerships between banks and fintech companies are a staple of the modern credit industry and have fueled significant growth in the online lending space. A lack of regulatory consistency and predictability, however, arguably hinders growth and innovation in such partnerships. Congress is now poised to lend stability to this market segment with two bills currently pending before it.

Applying varying standards, several courts have concluded that the nonbank partner is the true lender in a bank partnership, and that the nonbank partner must comply with state lender licensing requirements and rate limitations. Likewise, the Second Circuit decision in Madden v. Midland created uncertainty as to whether a nonbank assignee of a loan is permitted to enforce rates contracted for by the originating bank. Two bills currently progressing through Congress address these issues.

The Modernizing Credit Opportunities Act of 2017 (H.R. 4439) (True Lender Bill), introduced to the House of Representatives and referred to the House Financial Services Committee (HFSC) on November 16, 2017, creates statutory guidelines for when a financial institution may be considered the “true lender” to a transaction. No vote has yet been scheduled, but the bill was discussed during a HFSC subcommittee hearing entitled “Examining Opportunities and Challenges in the Financial Technology (Fintech) Marketplace” on January 30, 2018.

The Protecting Consumers’ Access to Credit Act of 2017 (H.R. 3299) (Madden Bill) would overrule the controversial Second Circuit decision in Madden v. Midland and codify the valid-when-made doctrine. The HFSC approved the bill, sending it to the floor of the House on January 30, 2018, and the House voted favorably on the bill on February 14, 2018.

The True Lender Bill’s stated intention is to “clarify that the role of the insured depository institution as lender and the location of an insured depository institution under applicable law are not affected by any contract between the institution and a third-party service provider.” The True Lender Bill adds provisions to the Bank Service Company Act and the Home Owners’ Loan Act that expressly provide that the determination of the location of an insured depository institution or savings association will not be affected by the geographic location of a service provider or the existence of an economic relationship with another person.

The True Lender Bill also states the intention to “clarify that Federal preemption of State usury laws applies to any loan to which an insured depository institution is the party to which the debt is initially owed according to its terms, and for other purposes.” To that effect, the True Lender Bill adds the following statement to section 85 of the National Bank Act, and analogous statements to the rate exportation provisions of the Home Owners’ Loan Act and the Federal Deposit Insurance Act:

A loan, discount, note, bill of exchange, or other debt is made by an association, and subject to [rate exportation] where the association is the party to which the debt is owed according to the terms of the loan, discount, note, bill of exchange, or other debt, regardless of any later assignment. The existence of a service or economic relationship between an association and another person shall not affect the application of this section to the rate of interest upon the loan or discount made, or the note, bill, or other evidence of debt or the identity of the association as the lender under the agreement.

The Madden Bill would amend section 85 of the National Bank Act as well as the Home Owners’ Loan Act, the Federal Credit Union Act, and the Federal Deposit Insurance Act to provide that a loan that is valid when made as to its maximum rate of interest in accordance with this section shall remain valid with respect to such rate regardless of whether the loan is subsequently sold, assigned, or otherwise transferred to a third party, and may be enforced by such third party notwithstanding any state law to the contrary.

The Madden Bill seeks to contextualize Madden as anomalous and justify the valid-when-made doctrine on public policy grounds. The Congressional Findings section of the bill notes the long history of the valid-when-made doctrine. The section also highlights that the doctrine “bring(s) certainty to the legal treatment of all valid loans that are transferred, greatly enhances liquidity in the credit markets by widening the potential pool of loan buyers and reduc(es) the cost of credit to borrowers at the time of origination . . .” The section also cites studies that claim that Madden v. Midland “has already disproportionately affected low- and moderate-income individuals in the United States with lower FICO scores.”

Passage of these bills would lend regulatory stability to an area of the law plagued recently with uncertainty. With certainty, we would expect to see activity in this space to increase, resulting in competition and, most likely, lower-cost loans to consumers.

 

The Rise and Danger of Virtual Assistants in the Workplace

Posted on February 15, 2018 by - Uncategorized

“Don’t ever say anything you don’t want played back to you someday.” This famous quote from Mafioso John Gotti is not the most likely advice that we would think to give to our clients. After all, law school and years of practice have taught us to counsel them on the need for good record-keeping practices to aid in prosecuting a lawsuit or ensuring a meaningful defense. We, especially those who are in-house counsel, are also likely to dispense advice regarding how to avoid litigation altogether by creating processes and providing training to ensure that clients and their employees are aware of their contractual obligations and comply with them. Although these tasks are still the linchpin of sound lawyering, a new area of concern has emerged.

We would be remiss if we did not counsel our clients on the impact of virtual assistants like Amazon’s Alexa, Apple’s Siri, Google’s Assistant or Microsoft’s Cortana, who rely on speech-recognition technology to listen and record our every word. When it comes to the impact of recorded statements, Gotti may be an expert, and his advice is perhaps some of the best that we can give to our clients. In some respects, these devices closely mimic wiretapping and may be used both intentionally and unintentionally to this end.

Although the term “speech recognition” sounds complex, it refers simply to what these virtual assistants do to understand our commands to call our friends, play music, or add events to our calendars. Those in the technology sector define it as “the ability to speak naturally and contextually with a computer system in order to execute commands or dictate language.” At this point, most of this technology has become so precise that a simple command, or “wake word” (i.e., “Alexa?!”), allows us to ask our virtual assistants a myriad of questions from “how long is my commute to the office?” to “when is President’s day this year?” In fact, reviewers of Alexa and her technological siblings (Siri and Cortana) distinguish them from first-generation voice assistants because of this “responsiveness.” They praise the technology for doing away with an “activation button,” which, as a result, allows users to “simply say the trigger word (either “Alexa,” “Echo,” “Amazon,” or “Computer”) followed by what you want to happen.” Our ability to speak to Alexa, which is essentially a hands-free speaker you control with your voice, is what we as users find both novel and convenient. It is what allows us to play music while typing an e-mail, or add an appointment to our calendars without opening Outlook.

Amazon.com, Alexa’s creator, boasts that the Alexa Voice Service, which is integrated into the Echo (the “smart speaker” that allows users to connect to Alexa) is “always getting smarter.” When you interact with Alexa, the Echo streams audio to the Cloud. Amazon’s Terms of Use for the Echo duly notifies users that “Alexa processes and retains your Alexa Interactions, such as your voice inputs, music playlists, and your Alexa to-do and shopping lists, and in the cloud to provide and improve our services.” Cloud storage of Alexa’s audio raises a host of privacy concerns that have been best highlighted by the recent Arkansas trial of James Bates for the murder of his friend, Victor Collins, who was found dead, floating face-up in Mr. Bates’ bathtub. Specifically, in the Bates case, the prosecution asked Amazon to disclose recordings from Mr. Bates’ Amazon Echo. Amazon refused, citing privacy concerns. Ultimately, the constitutional issue of whether Amazon may use the First Amendment’s protection of free speech to refuse to disclose the recordings gathered by our Amazon Echoes went unresolved, without addressing Amazon’s position regarding privacy concerns, because Mr. Bates voluntarily turned over the recordings. The case remains important, however, because it makes clear that users have access to their recordings and can therefore willingly disclose them. Amazon confirms such access, stating on its website that Amazon’s Alexa app keeps a history of the voice commands that follow the wake word (“Alexa!”). Specifically, Amazon’s response to whether users can review what they have asked Alexa is, “Yes, you can review voice interactions with Alexa by visiting History in Settings in the Alexa App. Your interactions are grouped by question or request. Tap an entry to see more detail, provide feedback, or listen to audio sent to the Cloud for that entry by tapping the play icon.” Accordingly, it is clear that data stored to the Cloud may allow Alexa to function more seamlessly and “get smarter,” but it does so at the cost of storing information that many users may have considered unattainable and private.

Not surprisingly, as Alexa and other virtual assistants continue to increase in popularity, we are beginning to see them in both homes and businesses. If a virtual assistant is a luxury at home, then certainly it is a necessity at work. In fact, on November 30, 2017, Amazon introduced “Alexa for Business,” which is a set of tools specifically designed to

give [business customers] the tools [they] need to manage Alexa-enabled devices, enroll [their] users, and assign skills at scale. [They] can build your own custom voice skills using the Alexa Skills Kit and the Alexa for Business APIs, and [they] can make these available as private skills for [their] organization[s].

In rolling out this new platform for Alexa, Amazon.com advertises that “Alexa helps you at your desk,” “Alexa simplifies your conference rooms,” and “Alexa helps you around the workplace.” So, if we use Alexa the way that Amazon.com hopes, Alexa will be in every office, conference room, and even the hallway of our workplaces. We won’t have to undergo the mundane task of dialing into a conference call. Instead, we can just use our voice to allow it to commence. According to Amazon.com, Alexa can also “find an open meeting room, order new supplies, report building problems, or notify IT of an equipment issue.” Gone are the days when you have to walk around the office in search of an empty conference room, but also gone are the days when you have any privacy in a closed office or conference room.

In most offices, it is common to hear a topic raised in the hallway, only to be abruptly halted by one party asking for the conversation to continue in his or her office. Other times, a conversation that began in e-mail will be postponed until the parties have the ability to talk in person. The obvious reason for these conversations to take place in person, behind closed doors, is to avoid creating a record or to avoid being overheard. With the advent of virtual assistants in the workplace, however, closing the door to talk privately may actually ensure that you are allowing your virtual assistant the ability to listen to your conversation with unfiltered access, and thus creating a potentially discoverable and admissible record. In this environment, Gotti’s advice, “Don’t ever say anything you don’t want played back to you someday,” is perhaps the best that we can offer our clients. At a minimum, they should be aware that a “closed-door conversation” is more a term of art than a certainty and definitely not a given simply because the door is in fact closed. Instead, if the room contains Alexa or another type of device, one’s conversation can be recorded, especially if the parties are using the assistant to obtain answers to search inquires or to complete tasks.

With respect to the admissibility of the recordings of virtual assistants like Alexa, we must question whether they can actually be used during litigation. The simple answer is that it depends, and there currently are no laws on the books that specifically address how courts will treat statements recorded by virtual assistants. If they are treated like other recorded statements, including those obtained during wiretapping, then the jurisdiction where the communication took place will dictate whether they can be introduced into evidence.

States typically fall into one of two categories: those that require “one-party consent” or those states that require “two-party consent.” Federal law follows the one-party consent doctrine, which allows the recording of telephone calls and in-person conversations with the consent of at least one of the parties. Under one-party consent law, you can record a phone call or conversation so long as you are a party to the conversation. New York, New Jersey, and Indiana have adopted the one-party consent doctrine. New York, which follows this law, makes it a crime to record or eavesdrop on an in-person or telephone conversation unless one party to the conversation consents. Other states, like Massachusetts and California, require two-party consent. This means that it is a crime to secretly record a conversation, whether the conversation is in-person or taking place by telephone or another medium, like Alexa. However, the information recorded from Alexa and other virtual assistants, including transcribed search terms, may be treated differently because they are more akin to data from a computer, not wiretapping. Given that this is a new area of law, attorneys will play a critical role in helping to put these issues before the courts, which may create an entirely new body of law.

*The authors would like to thank paralegal Megan Kessig as well as Alexa, Bixby, Siri, Google’s Assistant, and Cortana for their assistance. For further reference, see Robert D. Lang & Lenore E. Benessere, Alex, Siri, Bixby, Google’s Assistant and Cortana Testifying in Court, 99 N.Y. State Bar J. 9 (Nov./Dec. 2017).

Protecting the Sacred Writing: The Operating Agreement

Posted on February 14, 2018 by - Uncategorized

My previous column in Business Law Today explained how, “Like Great Britain, a Limited Liability Company May Have an Oral Constitution” and noted some of the resulting dangers. This column shifts focus and provides practical steps toward protecting a written operating agreement from claims of oral or implied-in-fact modification. Such claims undercut the purpose of “reducing the agreement to writing,” replacing definiteness with uncertainty and substituting swearing matches for the written word. See, e.g., Laurel Hill Advisory Grp., LLC v. Am. Stock Transfer & Tr. Co., LLC, 112 A.D.3d 486, 486, 977 N.Y.S.2d 213, 214–15 (2013) (“The dispute over the validity of the written agreement and the inconsistent terms between that agreement and the alleged oral agreement raise factual issues that cannot be resolved at this juncture [on a motion to dismiss]”).

Understanding the Context—Governing Law and Contract Law

The Three Bulwarks from Contract Law: SOF, PER, NOM

Contract law provides three principal bulwarks to protect written agreements: statutes of frauds, “no oral modification” provisions, and the parol evidence rule. As you will recall, a statute of frauds specifies a type of contract (e.g., “a contract for the sale of goods for the price of $500 or more,” U.C.C. § 2-201) and makes unenforceable an oral agreement of the specified type. For example, Filippi v. Filippi, 818 A.2d 608, 618 (R.I. 2003), applied the statute of frauds to an alleged oral agreement to transfer land owned by a limited partnership to one of its partners. Equally important, in most instances and jurisdictions, if a contract is subject to a statute of frauds, the statute will preclude an oral modification unless the modification takes the contract out of statute. Restatement (Second) of Contracts § 149. But see Grp. Hosp. Servs., Inc. v. One & Two Brookriver Ctr., 704 S.W.2d 886, 890 (Tex. App. 1986) (“Not every oral modification to a contract within the Statute of Frauds is barred. The critical determination is whether the modification materially effects [sic] the obligations in the underlying agreements.”) (Emphasis in the original). Judge-made law and some statutes provide exceptions to some statutes of frauds; in most instances reliance is a necessary (though not sufficient) element.

A “no oral modification” (NOM) provision amounts to a statute of frauds adopted by private agreement. Both the phrase and its acronym are misnomers; if the provision is properly drafted, it precludes implied-in-fact modification as well. A better acronym would be WMO—written modifications only.

In any event, “as a general rule, no-oral-modification clauses are disfavored in the law.” Bank of Am., N.A. v. Corporex Realty & Inv., LLC, 875 F. Supp. 2d 689, 701 (E.D. Ky. 2012). In the words of Justice Cardozo, “Those who make a contract may unmake it. The clause which forbids a change may be changed like any other. The prohibition of oral waiver may itself be waived.” Beatty v. Guggenheim Expl. Co., 225 N.Y. 380, 387, 122 N.E. 378, 381 (1919) (superseded by statute). We will revisit this disfavor below.

Although the statute of frauds (when applied to modifications) and NOM/WMO provisions both aim at post-formation claims, the parol evidence rule addresses the contract formation process. If a written agreement fully integrates the parties’ deal, the rule bars evidence of prior agreements, statements, understandings, etc. if the evidence is offered to vary or contradict the writing.

Choosing the Governing Law

Choosing the jurisdiction of formation for a limited liability company chooses the governing law for the internal affairs of the company, and that law includes not only the jurisdiction’s LLC statute, but also the jurisdiction’s law of contracts. Some LLC statutes are better than others with regard to protecting written operating agreements. The same is true with regard to the common law of contracts. Thus, protecting the operating agreement begins with choosing the jurisdiction of formation.

The most important criterion is the LLC statute’s approach to NOM/WMO provisions. Some statutes seek to supersede the judicial disfavor. For example, the Uniform Limited Liability Company Act (2006) (Last Amended 2013) supports NOM/WMO provisions in two separate sections. Section 105(a)(4) states that “the operating agreement governs . . . the means and conditions for amending the operating agreement.” Section 107(a) states in relevant part: “An operating agreement may specify that its amendment requires . . . the satisfaction of a condition. An amendment is ineffective if its adoption does not . . . satisfy the specified condition.” An official comment notes, “Because ‘[a]n operating agreement may specify that its amendment requires . . . the satisfaction of a condition,’ an operating agreement can require that any amendment be made through a writing or a record signed by each member.” The Delaware LLC statute has a similar provision. Del. Code Ann. tit. 6, § 18-302(c).

A related criterion is whether the LLC statute ousts the statute of frauds. To the surprise of many practitioners (especially those who “dabble in Delaware”), the Delaware statute does exactly that: “A limited liability company agreement is not subject to any statute of frauds . . . .” Del. Code Ann. tit. 6, § 18-101(7). It is thus theoretically possible for a Delaware limited liability company to assert that under an oral term of the company’s operating agreement, a member has transferred to the company title to land, or vice versa. (Delaware enacted this statute to negate a decision of the Delaware Supreme Court applying the one-year provision of the statute of frauds to operating agreements. Olson v. Halvorsen, 986 A.2d 1150, 1161 (Del. 2009). However, a good NOM/WMO provision should cover this problem.)

 As to the law of contracts, the most important criterion is whether the jurisdiction follows Williston or Corbin on the parol evidence rule:

Under the restrictive ‘plain meaning’ view [advanced by Williston] of the parol evidence rule, evidence of prior negotiations may be used for interpretation only upon a finding that some language in the contract is unclear, ambiguous, or vague. . . . . Under the view embraced by Professor Corbin and the Second Restatement [of Contracts], there is no need to make a preliminary finding of ambiguity before the judge considers extrinsic evidence.

Taylor v. State Farm Mut. Auto. Ins. Co., 175 Ariz. 148, 152, 854 P.2d 1134, 1138 (1993). Clearly, transactional lawyers wish to party down with Williston, not Corbin.

Secondary criteria include:

  • the strength of the judicial antipathy to NOM/OWM provisions and what the law requires to establish waiver in the face of a no-waiver provision. See EWB-I, LLC v. PlazAmericas Mall Texas, LLC, 527 S.W.3d 447, 468 (Tex. App. 2017) (noting the “general view . . . that [a] party to written contract can waive [a] contract provision by conduct despite existence of antiwaiver or failure-to-enforce clause in [the] contract”); and
  • whether the jurisdiction treats merger clauses as dispositive.

Drafting Techniques

The Duty to Scriven with Precision

Clear, comprehensive drafting is important in every term of a written contract, and “the [lawyer’s] duty to scriven with precision,” is enhanced when he or she drafts provisions disfavored by the courts. Willie Gary LLC v. James & Jackson LLC, No. CIV.A. 1781, 2006 WL 75309, at *2 (Del. Ch. Jan. 10, 2006), aff’d, 906 A.2d 76 (Del. 2006). For example, in EWB-I, LLC v. PlazAmericas Mall Texas, LLC, 527 S.W.3d 447, 468 (Tex. App. 2017), the court considered the following nonwaiver provision:

No delay or omission by any Party hereto in exercising any right or power accruing upon the non-compliance or failure of performance by any other Party under the provisions of this Agreement shall impair any such right or power or be construed to be a waiver thereof. A waiver by any Party of any of the covenants, conditions or agreements herein to be performed by any other Party shall not be construed to be a waiver of any subsequent breach or of any other covenant, condition or agreement herein contained.

(Emphasis added by the court.) Noting that “[t]his nonwaiver clause addresses waiver premised on inaction—the failure to demand that another party comply with contractual requirements”—and that the claim of waiver rested in part on action taken by the other party, the court reversed a summary judgment based on the nonwaiver clause. Id.

In contrast, the Maine Supreme Court approved the following language as sufficient to protect a written lease from parol evidence:

[S]ection 17.06 of the lease addresses integration, providing that “[n]o oral statement or prior written matter shall have any force or effect. [Tenant] agrees that it is not relying on any representations or agreements other than those contained in this Lease. This Lease shall not be modified or cancelled except by writing subscribed by all parties.” Through this unambiguous integration clause, the parties clearly expressed their intention to treat the lease as the complete integration of their agreement. The court therefore correctly concluded that it could not consider evidence extrinsic to that clause in deciding whether the contract was integrated.

Handy Boat Serv., Inc. v. Prof’l Servs., Inc., 1998 ME 134, ¶ 12, 711 A.2d 1306, 1309.

Do We Really Want to Exclude Evidence of Course of Dealing/Performance and Usage of Trade?

When writing a NOM/WMO provision, it is worthwhile to consider what to say about course of performance, course of dealing, and usage of trade. A comment to U.C.C. Section 1-303 provides the best explanation for allowing these constructs to affect the words of a contract, no matter how carefully scrivened:

The Uniform Commercial Code rejects both the “lay-dictionary” and the “conveyancer’s” reading of a commercial agreement. Instead the meaning of the agreement of the parties is to be determined by the language used by them and by their action, read and interpreted in the light of commercial practices and other surrounding circumstances. The measure and background for interpretation are set by the commercial context, which may explain and supplement even the language of a formal or final writing.

U.C.C. § 1-303. Course of Performance, Course of Dealing, and Usage of Trade., cmt. 1.

However, in the context of an operating agreement, course of dealing and performance are prime targets for a well-drafted NOM/WMO provision. As for usage of trade, the concept is a nonsequitur in a business organization. In a commercial transaction, it makes sense to look at any “practice or method of dealing having such regularity of observance in a place, vocation, or trade as to justify an expectation that it will be observed with respect to the transaction in question,” U.C.C. § 1-303(c). But relations among members of a limited liability company are sui generis—whatever vocation or trade the company pursues.

Think of the Operating Agreement as the Owners’ Manual and Draft Accordingly—in Plain English

Oliver Wendell Holmes taught us that “The life of the law has not been logic; it has been experience.” Oliver Wendell Holmes, Jr., The Common Law (Boston, 1881). Similarly, if experience (conduct) suggests one rule and a writing states another, the deviation threatens the writing. But how often do clients think of an operating agreement (or any other contract) as the relevant rules of the game?

In my experience, seldom. The problem comes from lawyer’s language (and byzantine formulations) that are incomprehensible and therefore alienating to business people. How can a lawyer expect such language to be the ready reference for LLC managers and members?

The solution is to draft operating agreements in language the members can understand and live by. Granted, if the deal is complex, its expression will probably be complex, but  business people can understand complex concepts. For example, the business analysis of whether and how to terminate a manufacturing company’s highest volume dealer is as complex as any legal rule (except perhaps for the rule against perpetuities, the rule of 78s, and the Treasury Regulations sections on “substantial economic effect”). In addition, keep in mind the background and training of those who will be reading the language if the operating agreement later becomes an issue in litigation.

Assuming the language of the operating agreement is accessible to the members whose deal it expresses and governs, it is important to teach the client(s) the importance of conforming conduct to language or vice versa. A longstanding deviation evidences a modification implied in fact or a waiver. A good NOM/WMO provision will refer to and reject claims of “agreements implied in fact, whether labeled course of performance, course of dealing, usage of trade, or otherwise, or not labeled at all.” (drafted by the author)

Nonetheless, a sustained, substantial deviation between word and deed invites a court to reject even a well-written NOM/WMO provision. Moreover, the deviation raises the specter of waiver, which is perhaps the most difficult assertion to negate early on in litigation.

Shift the Burden

Finally, in addition to a merger provision (parol evidence rule) and a NOM/WMO provision, consider obliging members to speak up before relying on either alleged conversations or patterns of conduct. I offer the following suggestion, based on a model operating agreement drafted some 20+ years ago for the first edition of Bishop & Kleinberger, Limited Liability Companies: Tax and Business Law. The language presupposes a well-written merger provision (i.e., “entire agreement” for PER purposes) and an equally well written NOM/WMO provision.

SECTION 3.03. Invalidity and Unreasonableness of Expectations Not Included in This Agreement

(A) The Members fear the uncertainty and the potential for discord that would exist if:

(1) the unstated expectation, expectancy, understanding, or other belief (“expectation of belief”) of one or more Members can be used to gain advantage through litigation; or

(2) an expectation or belief stated or expressed outside the confines of this Agreement can become actionable even though not all Members agree with the expectation or belief or have assented to them and even though some Members have expressed or may harbor conflicting expectations or beliefs.

 (B) The Members therefore agree that:

(1) it is unreasonable for any Member to have or rely on an expectation or belief that is not reflected in this Agreement;

(2) any Member who has or develops an expectation or belief contrary to or in addition to the contents of this Agreement has a duty to:

(a) immediately inform [the Managers and] all other Members; and

(b) promptly seek to have this Agreement amended to reflect the expectation or belief;

(3) if a Member who has or develops an expectation or belief contrary to or in addition to the contents of this Agreement neglects or fails to obtain an amendment of this Agreement as provided in Section 3.03(B)(2)(b):

(a) is evidence that the expectation or belief was not reasonable; and

(b) bars the Member from asserting that expectation or belief as a basis for any claim against the Company or any other Member;

(4) no Member has a duty to agree to an amendment proposed under Section 3.03(B)(2)(b) if the Member:

(a) holds an inconsistent expectation or belief, regardless of whether the expectation or belief:

(i) is reasonable; or

(ii) has been previously expressed to the Company or any other member of the Company; or

(b) believes that the amendment is not in the best interests of the Company or is contrary to the legitimate self-interests of the Member, regardless of whether the belief is reasonable.

In the next column, we change gears and consider Remedies – Beginning with the Distinction between Direct and  Derivative Claims.

In Memoriam: Geoffrey C. Hazard, Jr.

Posted on February 14, 2018 by - Uncategorized

How does one commemorate a career full of content and commitment?

On January 11, 2018, the Professional Responsibility Committee, the Business Law Section as a whole, and indeed the entire American legal community lost a good friend. Geoffrey C. Hazard, Jr., Professor Emeritus, prolific author, distinguished scholar, former executive director of the American Law Institute, and former Business Law Advisor, passed away at the age of 88.

Geoff’s was a storied teaching career, spanning over 50 years. He grew up in Kirkwood, Missouri and graduated from Swarthmore College and Columbia Law School. He taught law at Yale, the University of Chicago, the University of California at Berkeley, the University of Pennsylvania, and the University of California, Hastings, from which he retired in 2013. Though his interests in the law were wide-ranging (he once taught at course entitled “Western Moral Concepts”), his principal areas of academic interest were civil procedure and legal ethics.

His choice of these areas of concentration, as he recounted in a 2014 interview with Business Law Today, was not deliberate but purely adventitious. Originally slated to teach torts at Boalt Hall in the 1950s, he switched to civil procedure when a staffing problem created a need in that discipline. “It was a lucky break for me,” he said. He never looked back.

Similarly, an accident of fate led him to the field of legal ethics. Concurrently with a move in 1964 to teach at the University of Chicago, Geoff became executive director of the American Bar Foundation, which led to involvement in the drafting of the Model Code of Professional Responsibility. He went on to be the principal draftsman of the Model Code of Judicial Conduct in 1972 and the reporter for the Model Rules of Professional Conduct in 1983.

It is well known that all of us take a professional responsibility course in law school as a mandatory prerequisite to the awarding of a law degree. Ethics credit is also a mainstay of many states’ mandatory continuing legal education (CLE) requirements. What is less well known is that inclusion of ethics in the core curriculum and in CLE is due to Geoff’s efforts to gain widespread recognition of the central importance of this subject.

The list of influential treatises and casebooks co-authored by Professor Hazard is impressive. Prominent among them are The Law of Lawyering (4th ed. 2015) with W. William Hodes and Peter R. Jarvis; The Law of Ethics of Lawyering (6th ed. 2017) with Susan P. Koniak, Roger C. Cramton, George M. Cohen, and W. Bradley Wendel; and Legal Ethics: A Comparative Study (2004) with Angelo Dondi. Also of particular interest to our Section’s readership, and exemplary of the breadth of Geoff’s interests, is Board Games: The Changing Shape of Corporate Power (1988) with Arthur Fleisher, Jr. and Miriam Z. Klipper, a book that examined the transformation of industry, finance, and corporate governance by the M&A wave of the 1980s.

Characteristic of Geoff’s collaborative nature was this marked preference for co-authorship. As he explained in his 2014 Business Law Today interview, “[Y]ou have to talk about your ideas with your colleague. Typically, that results in seeing things that you wouldn’t have seen if you didn’t have the conversation.”

Collaborative efforts were also, of course, at the heart of his work when he succeeded Herbert Wechsler as the fourth executive director of ALI. Serving for 15 years in that capacity, Geoff’s stewardship saw the completion of many important projects, including the Principles of Corporate Governance and the Restatement (Third) of Foreign Relations Law, and the initiation of new or updated Restatement projects in a host of areas, including Agency, The Law Governing Lawyers, Property, Restitution, Suretyship, Torts, Trusts, and Unfair Competition. He was also involved in the parturition (and increasing globalization) of several Principles of the Law projects, including Family Dissolution, Transnational Civil Procedure, and Transnational Insolvency.

For all his immense learning, Geoff was a quiet and reserved member of the Professional Responsibility Committee, but he was a reliable participant. Even when age, infirmity, or the press of other commitments prevented him from attending meetings in person, he regularly communicated his thoughts and was tremendously helpful to me during my tenure as chair of that committee. He was invariably supportive of our efforts and complimentary of the work we did when advising the Section on resolutions proposed for consideration by the House of Delegates.

Geoff Hazard’s imprint on legal ethics, and on the American legal system in general, is immanent. He was a gentleman, a scholar, a mentor, a counselor, and a friend. He will be sorely missed.

The Accord and Guidelines and the Formation of the Section’s Legal Opinions Committee

Posted on February 14, 2018 by - Uncategorized

The Business Law Section’s Legal Opinions Committee was not formed until 1989. By then the TriBar Opinion Committee (TriBar, formed in 1974 and originally comprised of members of the County, City and State Bars of New York) and the California Bar Business Law Section Corporations Committee (CalBar) were six years into a dispute about the proper approach to the remedies opinion.

TriBar’s 1979 report stated that the remedies opinion covered “each and every” undertaking of the Company in the agreement that was the subject of the opinion. CalBar’s approach was that only “essential” undertakings in the agreement were covered by the remedies opinion. As a result of the dispute, the recipient of a remedies opinion could not be certain which meaning the opinion giver intended.

Early in 1988, the section’s leadership was enlisted to try to resolve this unhappy situation by James Fuld, a New York lawyer who had been instrumental in the formation of TriBar. He had authored what continues to be regarded as the seminal article on legal opinion practice (Legal Opinions in Business Transactions, 28 Bus. Law. 915 (1973)).

A number of those in section leadership positions had extensive experience with third-party legal opinion practice (opinion practice). A planning committee with geographically dispersed membership was appointed, consisting of Brad Clark (Calif.), Dick Deer (Ind.), Pat Garrett (Tex.), Joe Hinsey (Mass.), Herb Wander (Ill.), and Arthur Field (N.Y.) with Henry Wheeler (Mass.) as chair. Rather than merely seeking to resolve the NY-California dispute over the remedies opinion, the planning committee decided to call a national conference on opinion practice as the first step in an effort to move toward a national consensus. More than a year went into the planning of what has come to be referred to as the Silverado Conference. Articles on a variety of opinion subjects were prepared to guide the discussion at the conference.

The conference was held in 1989 in California. Those interested in opinion practice from across the country met and worked together, often for the first time. Attendee discussions established that there was a national consensus on most opinion practice issues. The idea of a section-sponsored comprehensive opinion practice statement gained broad support, but the attendees made no progress in resolving the NY-California remedies opinion dispute (which was not resolved until a 2004 CalBar Report which stated that the diligence involved in the two approaches did not vary significantly. See 60 Bus. Law. 907).

At the end of the conference, all attendees were invited to join a new Section Legal Opinions Committee (chaired by Henry Wheeler). Most of the 72 attendees did so. Fuld did not participate in Silverado or the work of the committee directly, but his influence was nonetheless significant in these efforts.

In order to educate the bar on legal opinion practice, a National Institute on Third-Party Legal Opinions was organized under the chairmanship of (now Judge) Tom Ambro and Truman Bidwell. The Institute was held in Chicago, New York, and San Francisco in 1990. Materials prepared for the Silverado Conference were used for the National Institute. Interest in what had been discussed at the Silverado Conference was high across the country.

Joe Hinsey, who had practiced law in New York but by then was teaching at the Harvard Business School, took the leadership role in the proposed report. After considering a number of possible formats, the committee adopted a novel approach. The report was not to be a statement of customary opinion practice. Instead, it was to present an alternative to customary opinion practice. The alternative was a contract-based approach that came to be called the Legal Opinion Accord (the Accord). In arguing for the Accord approach, Hinsey maintained that customary opinion practice was a “slippery slope” that would defeat all efforts to achieve the precision required for an effective opinion practice.

The drafting effort for the Accord was intensive. A drafting committee of 18, functioning under the direction of Hinsey, prepared materials for committee review. Work on the Accord was completed in just two years. The strength of the Accord was that it provided a common starting point for opinions. It did so by incorporating the Accord document by reference in opinion letters. That was intended to allow the opinion giver and recipient’s attorney to limit their opinion negotiations to divergences from the Accord document. Material divergences were to be specified in the opinion letter.

The text of the Accord was circulated as an “exposure draft” in The Business Lawyer in February 1991. Many comments were received. The final version of the Accord was published as part of a report of the committee in the November 1991 issue of The Business Lawyer. The Accord was 47 pages long. Mastery of the Accord document by both opinion giver and recipient’s attorney was required to use it effectively. The Accord did not purport to be a statement of customary practice. It resolved uncertainty on a variety of legal opinion questions and followed established custom when that was clear.

Quite a number of attorneys began to use the Accord and expressed satisfaction with its approach, but there was also sustained and significant criticism of the Accord approach. Some attorneys regarded the Accord document as unfairly favoring the opinion giver. Others were not interested in “fixing” what they saw as a well-functioning system. Many opinion preparers and recipient’s attorneys declined to master the Accord document for a variety of reasons. Accord opinions were not accepted by many institutional lenders. In the end, Accord usage was diminished, and the Accord was not utilized to any significant extent in major transactions.

We think of the Accord as one of those remarkably intelligent efforts we see from time to time that are influential because of their ideas, but are not widely used for their intended purpose. The Accord helped to advance a national consensus on opinion practice, although it provided an alternative to customary opinion practice. Many attorneys concerned with opinion practice keep a copy of the Accord on their bookshelf for reference.

As part of the 1991 Legal Opinions Committee report that included the Accord, the Guidelines (fully titled Certain Guidelines for the Negotiation and Preparation of Third-Party Legal Opinions) were also issued. The Guidelines dealt with topics that did not seem to the drafting committee to “fit” into the Accord. They were less than 10 pages long and were stated to be applicable whether an Accord or customary practice opinion was given. This project of the committee proceeded at the same time the Accord was prepared by the committee. (The Guidelines were updated in 2002 by Guidelines II, with Steve Weise as the reporter. See 57 Bus. Law. 875.) The Guidelines and Guidelines II have achieved broad acceptance.

In a remarkable burst of energy, in the four years 1988–1991, the committee was formed and made a lasting contribution to opinion practice. It held the only national conference ever on opinion practice. It followed up with a National Institute on Third Party Legal Opinions in three cities across the country, and it issued both the Accord and Guidelines. After more than 25 years, both of them still have significance in opinion practice.

The year 2018 marks the 30th anniversary of the first efforts of the Business Law Section regarding opinion practice. These early efforts have been continued and expanded under the leadership of the committee chairs. Steve Weise succeeded Henry Wheeler as chair; thereafter the following served as chair: (now Judge) Tom Ambro; Don Glazer; Arthur Field; Carolan Berkley; John Power; Stan Keller; Tim Hoxie; and the current chair, Ettore Santucci.

Harvey Weinstein Tax May Hit Both Plaintiffs and Defendants

Posted on February 14, 2018 by - Uncategorized

Harvey Weinstein, Kevin Spacey, Bill O’Reilly, and many other figures in the business and entertainment world have been accused of serious acts of sexual harassment. The torrent that was unleashed came to be known on social media as the #MeToo movement. As 2017 drew to a close, Time Magazine selected the “Silence Breakers” as its person of the year. See Edward Felsenthal, The Choice, Time (Dec. 6, 2017).

With tax reform under discussion, many people seem shocked that for businesses, legal settlements and legal fees are nearly always tax deductible. Even legal fees related to clearly nondeductible conduct (such as a company negotiating with the SEC to pay a criminal fine) can still be deducted. In general, only fines and penalties paid to the government are not deductible.

The recently passed tax bill includes what some have labeled a Harvey Weinstein tax. The idea of the new provision is to deny tax deductions for settlement payments in sexual harassment or abuse cases if there is a nondisclosure agreement. Notably, this “no deduction” rule applies to attorney’s fees as well as settlement payments. The language is simple. See Tax Cuts and Jobs Act, Pub. L. 115-97, § 13307.

Section 162 of the tax code generally lists business expenses that are tax deductible; however, new section 162(q) provides:

(q) PAYMENTS RELATED TO SEXUAL HARASSMENT AND SEXUAL ABUSE. —No deduction shall be allowed under this chapter for—

(1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or

(2) attorney’s fees related to such a settlement or payment.

Most legal settlement agreements have some type of confidentiality or nondisclosure provision. There has been recent speculation that sexual harassment settlements may now start breaking this normal confidentiality mold.

Some observers have pointed out that it is not crystal clear that the denial of legal fees is only in cases where a nondisclosure agreement is included. The nondisclosure is clearly the trigger for the denial of the deductibility of the settlement monies, but the legal fees are not so clear. It is possible (although I would hope unlikely) that the IRS might read the law as a denial of a tax deduction for legal fees related to sexual harassment or abuse, even without a nondisclosure agreement.

Moreover, what about legal fees paid by the plaintiff in a sexual harassment case in which a confidential settlement is reached? It is shocking to think that they might not be deductible. The tax treatment of legal fees a plaintiff pays to reach a recovery, often on a contingent-fee basis, has been troubled for decades.

In 2005, the U.S. Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005), held that plaintiffs in contingent-fee cases must generally recognize gross income equal to 100 percent of their recoveries. This means that the plaintiff must figure a way to deduct the 40-percent fee. Plaintiffs were relieved when a few months before the Banks decision, Congress provided an above-the-line deduction for legal fees in employment cases.

Since that 2004 statutory change, plaintiffs in employment cases have been taxed on their net recoveries, not their gross. Now, though, there is real concern that the legal-fee deduction rules are going backwards. It may be fine to deny Harvey Weinstein and Miramax any tax deduction for settlements and legal fees, but how about the plaintiffs?

On its face, the new law would seem to prevent any deduction for legal fees in this context. One answer to this surely unintended result might be to revisit the 2004 change that ushered in the above-the-line deduction for employment cases. That language is still in the tax code, promising an above-the-line deduction for legal fees in any employment-related claim, yet the new Weinstein provision says that it trumps all others, including the above-the-line deduction. One would hope that the IRS would view the plaintiff’s legal fees as materially different from those of the defendant in this context, but we do not yet know. Despite the somewhat worrisome wording of the new statute, plaintiffs and their tax preparers might well assume that this nondeduction provision can surely not have been intended to apply to plaintiffs. Surely Congress would not want a sexual harassment victim to pay tax on 100 percent of his or her recovery when 40 percent goes to the lawyer!

Below the Line?

One might think that even if the IRS were to read the Weinstein provision as applying to defendants and to plaintiffs, there might be a fallback position. Before the 2004 change, many employment-claim plaintiffs had to be content with a below-the-line deduction. In such a case, some of the fees were nondeductible on account of the two percent of gross income threshold.  Miscellaneous itemized deductions were not deductible except to the extent they exceeded two percent of adjusted gross income.

There were also phase outs of deductions, depending on the size of the plaintiff’s income. Worse still, there could be alternative minimum tax (AMT) repercussions. However, now the below-the-line deduction seems to be gone, too, at least until 2026. Tax Cuts and Jobs Act, Pub. L. 115-97, § 11045.

This is not a feature of the Weinstein tax, but of the other significant changes in the new tax law. With higher standard deductions, the law now eliminates miscellaneous itemized deductions. Thus, for the sexual harassment plaintiff, the choice would appear to be either an above-the-line deduction or nothing. This suggests a broader tax problem. Outside of the employment context, there is a large problem for legal fees. Plaintiffs who do not qualify for an above-the-line deduction for legal fees evidently now must pay tax on 100 percent of their recoveries, not merely on their post-legal fee net. Only employment and certain whistleblower claims are covered by the above-the-line deduction.

Sexual Harassment Allocations

Will any mention of sexual harassment claims trigger the Weinstein provision? If it does, will it bar any tax deduction, even if the sexual harassment part of the case is minor? Plaintiff and defendant may want to expressly agree on a particular tax allocation of the settlement in an attempt to head off the application of the Weinstein tax.

In a $1M settlement over numerous claims, could one allocate $50,000 to sexual harassment? This figure may or may not be appropriate on the facts; however, legal settlements are routinely divvied up between claims. There could be good reasons for the parties to address such allocations now. The IRS is never bound by an allocation in a settlement agreement, but the IRS often pays attention to allocations and respects them. I expect that we will start seeing such explicit sexual harassment allocations. We may see them where the sexual harassment was the primary impetus of the case, and where the claims are primarily about something else. Suppose that the parties allocate $50,000 of a $1M settlement to sexual harassment. That amounts to five percent of the gross settlement. If $400,000 is for legal fees, five percent of those fees ($20,000) should presumably be allocated to sexual harassment, too.

One other possible answer might be for the parties to expressly state that there was no sexual harassment, and that the parties are not releasing any such claims, but defendants typically want complete releases. Thus, what about including the complete release, but stating that the parties agree that no portion of the settlement amount is allocable to sexual harassment? This may make sense in some cases.

These are big and worrisome tax changes, and they may complicate already difficult settlement discussions. Whoever you represent, get some tax advice and try to be prepared for the new dynamics that these issues may raise. Finally, when it comes to attorney’s fees for plaintiffs, this may be a sea change.

For many types of cases involving significant recoveries and significant attorney’s fees, the lack of a miscellaneous itemized deduction could be catastrophic. There may be new efforts, therefore, to explore the exceptions to the Supreme Court’s 2005 holding in Banks, which laid down the general rule that plaintiffs have gross income on contingent legal fees. The court alluded to various contexts in which this general 100-percent gross income rule might not apply. We should expect taxpayers to more aggressively try to avoid being tagged with gross income on their legal fees.

Preparing In-House Counsel and External Lawyer Advocates for Effective, Good-Faith Mediation of Mergers & Acquisitions

Posted on February 14, 2018 by - Uncategorized

When deciding whether to mediate a mergers and acquisitions (M&A) dispute, and then preparing for the mediation, there are a variety of factors that both in-house counsel and external counsel should jointly evaluate. We recently consulted with a panel of experienced business mediation and litigation attorneys, an experienced professional business dispute mediator, and experienced in-house counsels of public companies who considered these topics. Here are some of their key thoughts.[1]

Is the Dispute Right for Mediation?

The initial question that should be addressed by all parties is: why mediate the dispute? The parties should first consider the cost of having to mediate an M&A dispute. This evaluation should include not only the economic loss, but also the business implications (and political implications) in proceeding to court to obtain a determination versus mediation. Of course, the parties should also consider the reality of the legal document they are working with, i.e., what it says and what their rights are under the document. Rick Duda, in-house counsel with Ingredion Incorporated, noted that counsel must ensure that there is a mediation clause in the agreement. Obviously, there are other facts to consider; for example, not obtaining a court decision may be against an entity’s business interest so that it may not be the right thing to do strategically. In-house counsel must consider all these factors alongside the external legal team to ascertain the pros and cons of mediation.

Business litigation attorney Matthew Allison of Baker McKenzie noted that sometimes it is a question of timing. If both sides are willing to mediate the dispute, this is an affirmative statement that the parties are willing to resolve the claim. Also, this is a good time to walk through the process. In addition, counsel should consider that there is flexibility in terms of scope of what can be mediated as well as cost—when is the right time? In mediation, the only thing limiting the parties is their own creativity and willingness to resolve their dispute as opposed to obtaining a ruling.

Mediation can also be a good tool to bring business partners to the table to talk things out. Ideally, this allows each party to calmly evaluate and assess its case. Time and neutral evaluation may allow tempers to cool down and avoid suit. There is a countervailing concern, which Matthew Allison identified, that one does not want to be forced into a corner to resolve an issue or prevented from pursuing their claims. The panel also referred to a famous quote by Sandra Day O’Connor: “[T]he courts of this country should not be the places where resolution of disputes begins. They should be the places where the disputes end after alternative methods of resolving disputes have been considered and tried.”

Preparing for the Mediation

Mediator Stuart Widman of Wildman Law Offices often sends a template to the parties to be used when preparing their mediation statements. Included in this template is a request to identify the preferred type of mediation (facilitative, evaluative, or a blend). Mediation statements should include enough information to mediate, but not so much that extensive discovery results. Consider early on the key information you may want to share with the other side to the negotiations about your case. Rick Duda noted that key information will make a difference if there is going to be anything accomplished in the mediation—so why not give to the other side? Matthew Allison stated that counsel and clients must keep in mind that they are presenting their case to the other side. Therefore, having sufficient information to outline or support points and arguments may be necessary.

However, even if the information exchange is protected by privilege, counsel must consider whether full discovery still works for the company overall. Counsel and their clients may not want information in the other side’s mind if at the end of the day the mediation is not successful. Counsel may want a clean slate if it falls apart, so even limited discovery could be instructive for future discovery requests if litigation goes forward.

Also consider that sometimes a reporting deadline for one side can impact negotiation and warrant holding off on resolving matters, or push matters into litigation. For example, maybe it is more up front to recognize this if no one is doing anything now to advance this process. Therefore, it may make sense to do something to move the timeline. Business litigation attorney Brian Laliberte of Tucker Ellis noted that most seasoned lawyers on both sides of a case recognize this and tend to find ways to eliminate public company reporting deadlines as an impediment to a deal, especially if the potential wait time is relatively short and the economic incentives are large enough.

Know Your Client

Both in-house and external counsel must be sure to understand the client’s business and its position in the marketplace. Brian Laliberte emphasized that defining the client’s objectives early at the outset of a case is critical. This exercise allows for a better client relationship and more effective advocacy, especially during mediation when difficult decisions must be made. Outside counsel must therefore communicate early and often with their client as to how things are going. Risk tolerances change as cases progress, and outside counsel must stay dialed-in to their client’s internal and external settlement pressures or lack thereof. Critical questions typically include:

  • Is the company willing to take a case to trial?
  • What is their trial experience?
  • What are the internal implications for in-house counsel?
  • What are the economic and noneconomic costs of a settlement?

Heather Clefisch, in-house counsel with Spectrum Brands, believes that clients should spend a lot of money on prep time, and then counsel should remind the client to compare the cost to the total cost to mediate the case versus take it to trial.

It is important early on and throughout the process to assess and critically evaluate all aspects of the dispute/case. Understand the matter and the governing/applicable law. Also, consider the client’s potential risk exposure. Brian Laliberte typically uses the following guidelines to ascertain his client’s position regarding mediation and settlement early on:

  • Internal—How will senior management, the board, etc. react?
  • Financial—How will a settlement or adverse verdict affect the client’s financial health, stock price, etc.?
  • Investors—Will investors pursue claims if stock value declines?
  • Public Relations—How will the public and/or customers perceive claims, settlement, or an adverse verdict?
  • Regulatory—Is the client in a regulated industry? Will regulators take notice of a private civil suit? A settlement? A verdict?
  • Investigate the court’s track record in similar cases, e.g., scope of discovery allowed, published dispositive motion decisions, affirmances and reversals on appeal, etc.
  • Determine whether jury verdicts have been reported in similar cases and the outcomes in the same or similar jurisdictions, i.e., plaintiff/defense verdicts, compensatory damages, punitive damages, etc.
  • Assess the likelihood of success on the merits.

Set the Stage for Mediation

The lawyer should communicate regularly with both the company and with opposing counsel, avoid becoming a polarizing figure in the dispute/case, and maintain his or her integrity and credibility. Brian Laliberte and Matthew Allison agree that having integrity and credibility in the mediator’s eyes also is critical. Both try to be as cooperative and accommodating as possible without compromising their respective clients’ positions.

It is difficult at times for litigators to mediate effectively when there is an information deficit. Litigators must ensure that they have as much information as the discovery process can yield prior to mediation, and that they have accounted for critical facts in their settlement analysis. Mediators and litigators alike should do their best to determine whether one side or the other is blocking or filtering important information before recommending or making a bad deal during negotiations.

Counsel should be transparent when possible during negotiations to obtain clear authority to negotiate and use specific settlement terms. Counsel should be sure to keep his or her word. This goes to build rapport and to be perceived as acting in good faith. Do not take an extreme position if it will not go anywhere. Time the mediation to maximize potential outcomes. Brian Laliberte believes that litigators, especially those with considerable trial experience, should show the other side their best case early and often. This includes “bad facts.” Such facts should be acknowledged, and the reasons they do not affect the case should be explained proactively. In complex cases, demonstrative exhibits may assist counsel in demonstrating the strength of the client’s claims or defenses such that a settlement looks more appealing during mediation than a jury trial.

Preparing for mediation, and setting the stage with the parties and the mediator, will facilitate a better mediation process. Remember that a mediator will measure the credibility of genuineness and good faith of parties, and it matters as to how the mediator works with them and proceeds. Matthew Allison prepares his client for the concept of a separate caucus because it is important they understand that the purpose is to allow the mediator to use all the tools in their toolkit to get a deal done. Brian Laliberte typically tries to select a solid client representative who, if necessary, can have an effective and direct conversation with the mediator about settlement considerations, monetary parameters, and broader issues that may affect whether a deal can be achieved.

What Is Success in a Mediation?

If counsel has prepared for the mediation and done risk analysis, then both counsel and the client can evaluate whether the result makes sense. Success is not always winning, but rather getting what the company needs as opposed what the company wants. Success could cost a lot of money and getting things resolved sooner may have more value.

In Summary

A few final takeaways from the panel’s experienced business disputes mediator Stuart Widman include:

  • M&A has a high potential for disputes after closing, so parties should consider putting a dispute resolution clause (including mediation) in the deal documents.
  • Mediation entails lots of “Ps”: preparation, persistence, patience, and possibility.
  • The right mediator may reality test the parties’ expectations.
  • “Success” in mediation can mean many things: partial settlement, full settlement, avoiding bad precedent, saving resources, etc.
  • One of The Rolling Stones’ song lyrics captures an important strategic mediation concept: “[Y]ou can’t always get what you want, but if you try some time, you just might find, you get what you need.”

[1]  This article summarizes comments from the speakers at a program from the ABA Business Law Section Annual Meeting in Chicago on September 13, 2017, in which the Dispute Resolution Committee’s panel included: Matthew Allison, Esq., Partner, Baker McKenzie LLP, Chicago; Heather Clefisch, Vice President & Division General Counsel, Spectrum Brands Inc., Madison, Wisconsin; Rick Duda, Associate General Counsel, Ingredion Incorporated, Chicago; Brian Laliberte, Esq., Counsel, Tucker Ellis LLP, Columbus, Ohio; and Stuart Widman, Esq., Principal, Widman Law Offices, Chicago. Leslie Berkoff, Esq., Partner, Moritt Hock & Hamroff LLP, New York City, and John Levitske, Senior Managing Director, Ankura, Business Valuation Dispute Analysis practice, Chicago, co-chaired this program.

Conflict Issues in the Sale of Closely Held Businesses—Tensions Among Family Members

Posted on February 13, 2018 by - Uncategorized

The sale of a business is often the largest and most important business decision an individual will encounter during the ownership of the enterprise. If the business has multiple owners, particularly family members, the process can become more stressful due to the various interests and conflicting positions that may arise.

Consulting/Employment Agreements

In most sale transactions, the active managers receive consulting or employment contracts from the buyer for service post-closing. To ease the transition period, often the buyer will want the former managers to stay with the business for several months or a year or two. In other instances, long-term management retention is a critical component of the sale. The amount of the compensation paid could be perceived as part of the purchase price if the amount is in excess of what would typically be paid to a third-party manager. In addition, the length of any consulting or employment agreement, as well as the benefits demanded by an active manager, may put such individual at odds with the other owners. Such manager may be prepared to stop the sale because his or her demands will not be met. This creates an irreconcilable conflict for the attorney handling the sale. Often this potential conflict is known at the beginning of the sale process, and the sale attorney should advise the manager to engage separate counsel. At times, the conflict does not arise until midway through the process. At that point, the sale attorney must recommend the manager retain separate counsel so that the attorney can fulfill his or her duties to the other owners.

Noncompete Agreement

On a related issue, often there is only one owner involved in the business while the other owners remain in the wings or uninvolved. In connection with the purchase of the business, the buyer will expect the owners to provide noncompetition covenants that preclude the owners from entering another business that competes with the sold business. The nonactive owners will generally have no problem providing a noncompetition agreement, whereas the active owner may have an issue agreeing to anything that deprives him or her from engaging in activities that have been his or her livelihood for years. The active owner may insist on compensation for this prohibition. From the buyer’s perspective, the noncompete is part of the purchase price. To the buyer, how the purchase price is allocated and paid among the owners is generally not a critical issue.

If the active owner has at least a majority of the business, there is generally not a separate payment to him or her in consideration of the noncompete. Where the manager has a minority ownership interest, however, it is not unusual for the individual to insist upon and to receive separate compensation for such a covenant. The size of such payment could put the owners in a conflict situation, and the attorney who is handling the sale of the business must be cognizant of the conflict that has arisen among these clients. Obviously, any payment made entirely to the active owner reduces the size of the payments made to the nonactive owners. If the active manager receives an employment or consulting agreement, a noncompete provision may be contained in this agreement abating, to a degree, the need for a separate payment.

One caveat is that several states, including California and Oklahoma, do not recognize noncompete provisions in an employment setting as a matter of public policy; however, even these states will enforce noncompete provisions from owners selling their business. Consequently, even if noncompetes are contained in employment or consulting agreements, buyers will also insist such provisions be included in the sale agreement or an ancillary agreement.

Indemnification Clauses

A third area of potential conflicts arises in the provision of indemnification. In the sale agreement, the sellers will generally provide the buyer representations, including, among other items, ownership of the assets, the lack of environmental or tax issues, the collectability of receivables, or the condition of the building or equipment used in the operations of the business. Buyers will look to all of the owners of the business to give these representations. The nonactive owners are reluctant to provide indemnification with respect to facts relating to a business of which they have little knowledge. The active manager may be willing to provide such representations, but will be reluctant to be responsible for more than his or her pro-rata share, particularly if his or her ownership percentage is substantially less than 100 percent. From the perspective of the active manager, all owners have participated for years in the profits of the business and should then also participate in the provision of standard representations.

This area of conflict is often resolved by placing a portion of the purchase price in escrow for a certain period, generally 12 to 24 months. The escrowed monies provide the sole source of funds available to the buyer for breaches of representations or warranties. Funds that remain available for distribution to the sellers after the end of the escrow period are then distributed pro-rata among the owners. In lieu of an escrow, often a portion of the purchase price is evidenced by a promissory note. The buyer can utilize offset rights under the note to satisfy the indemnification obligations.

From a seller’s perspective, obviously an escrow is preferable because it eliminates the risk that the buyer will financially be unable to make note payments or allege false or weak claims for indemnification. So long as the buyer has the funds due to the seller, the buyer remains in a stronger position. If neither buyer nor seller has control of the funds, there is an incentive for both sides to reach agreement on the disputed claims. However, ensuring all buyers have the funds available at closing to pay the full purchase price is not always possible, and taking a note may be the only avenue available to effect the transaction.

Buyers will generally want the sellers’ indemnities to be joint and several. A buyer will not want to chase multiple sellers for their pro rata shares. Minority owners generally refuse to give indemnities for the full indemnifiable amount. A majority owner often will be prepared to provide the full indemnification, provided all owners execute a contribution agreement. The contribution agreement requires all owners to reimburse, pro rata, any owner that is obligated to pay more than its proportionate share.

Dispute Resolutions

Finally, multiple owners will have multiple views on the resolution of disputes that may arise post-closing. Although the agreement of all or the majority of the owners may be necessary to sell the business, if an issue arises over an indemnification claim or interpretation of a contract provision, the buyer will want to deal with only one representative of the sellers. Accordingly, the definitive agreement should specifically appoint a single representative or small committee with authority to negotiate on behalf of all sellers disputes that might arise with the buyer. This representative should not be the active manager if such individual is, post-closing, an employee or consultant to the buyer. This creates potential conflict by placing the individual between the current employer and his or her former partners.

The sale of a family business or any business with multiple owners creates potential conflicts among the owners as well as potential issues for the attorney representing the sellers. If these issues are identified early and are properly addressed, however, the sale process can go smoothly.

Sitting at the Front of the Class: The Importance of Timely Opt Outs

Posted on February 12, 2018 by - Uncategorized

Should a plaintiff opt out of a class action and, if so, when? A recent U.S. Supreme Court decision has forced businesses and individuals to make that determination sooner than they would like. The rules governing class actions are complicated, but are something that every business owner and investor must understand. For many individuals with small potential lawsuits, a class action permits them to aggregate their claims with other entities and individuals with similar claims, and to bring a lawsuit against a business that has harmed them. It’s a win-win all around in that the individual plaintiffs get a recovery they wouldn’t otherwise receive, the defendant resolves a single lawsuit rather than multiple piecemeal claims, and the plaintiffs’ attorneys (sometimes referred to as class counsel) get a piece of the ultimate recovery, often as much as one-third.

For some businesses (and high-net-worth individuals), however, a class action is not a silver bullet. Being part of a class means giving up one’s right to bring suit in one’s own name. If a business or person doesn’t want to be part of a class, it must opt out before a court-set deadline. Once that deadline passes, the potential opt-out plaintiff is stuck being part of the class. The deadline to opt out of a class typically is announced after a settlement has been reached, which may take years to achieve. The problem is that, by that time, it may be too late to opt-out.

First a little history. The modern version of class actions was created by Congress in 1966. Prior to that point, there was no mechanism for a large group of individuals to bring civil claims for monetary damages arising from a common set of facts. With the passage of the class-action rules (which are now codified at Rule 23 of the Federal Rules of Civil Procedure), a class can be formed for several reasons, including most commonly by a group of persons or entities who have been similarly harmed by an investment or product, provided that the common questions of law and fact for the class “predominate” over other questions, and that a class action is “superior” to other lawsuit types for the case.

But a person or entity doesn’t have to be part of a class; they can instead opt out and choose to file their own lawsuit. As an initial matter, this choice doesn’t make sense for small claims. For such plaintiffs, class actions are likely the only available vehicle for recovery. But for those who hold significant claims (generally at least several hundred thousand dollars), an opt-out lawsuit may result in a far larger settlement than the plaintiff would receive as part of a class action.

In fact, a recent study indicates that in the average case with an opt-out, an additional amount of almost 13 percent is paid to plaintiffs who opt out, and in a number of cases, more than 20 percent was paid to opt-out plaintiffs. Recent settlements support the economic case for opting out of certain class actions. For example, our experience has shown that in securities cases, class-action settlements of under 10 percent of losses are typical, whereas opt-out plaintiffs typically recover multiples of this amount.

Recently, however, it has become more difficult for plaintiffs to take a “wait and see” attitude toward class actions. Many class actions are filed under securities laws that contain so-called statutes of repose, which act as a legal bar to how long someone can wait to sue. In many cases, these limits are three or five years from the date of the securities offering in question. Although that may sound like a lot of time, it’s really not when one considers that the average length of a case that goes to trial in federal court is over two years, and that some cases take far longer to try.

What this means is that it may take five or more years before a court rules on the merits of a class-action complaint, or even decides if the case should have been filed as a class action. What if the court rules that the case should never have been a class action after the statute of repose has been filed? Then the individual plaintiff—who could have opted out years before if they had acted quickly—is out of luck. That’s right, the person or business that has been patiently waiting for six years to see how the class action would turn out will be completely out of luck if the court tosses the suit for any reason because the claim will no longer be timely.

This unforgiving outcome is the result of a recently decided U.S. Supreme Court case, California Public Employees’ Retirement System v. ANZ Securities, Inc., 137 S. Ct. 2042 (2017) (CalPERS). In that case, the court held that statutes of repose are not subject to the doctrine of equitable tolling, which means that even if the class action is timely filed, that filing pauses only the statute of limitations, not the statute of repose, as to any class members who choose to opt out and bring their own action.

Because the CalPERS court recognized the need for “certainty and reliability” as a “necessity in the marketplace,” it ruled that statutes of repose are designed to protect defendants against future liability and provide certainty that no further suits will be filed after a set period. With that logic in mind, the court held that the three-year statute of repose in the Securities Act of 1933 does apply to opt-out plaintiffs, and thus limited Securities Act suits to those filed within three years of the date of the last culpable act, even if the plaintiff has spent some part of that three-year period in a class action timely filed against defendants. Thus, under CalPERS, the only way for a plaintiff to preserve its opt-out rights in light of statutes of repose is to opt out before the statute of repose passes (and often before the court rules on the merits of the class action suit). It is no longer possible for a plaintiff to wait and see what a proposed class action settlement looks like before determining whether to opt out.

Opting out, as noted above, may have significant benefits. The opt-out plaintiff can drive case strategy independently without relying on the strategic decisions of class counsel; the opt-out plaintiff can choose to settle only when it most benefits him or her; the opt-out plaintiff can even pursue legal theories that might benefit just the opt-out plaintiff, but not necessarily all the other class members; and finally the opt-out plaintiff can sometimes extract a greater settlement by being the “squeaky wheel” that the defendants want to pay off to make go away. All these argue for opting out of class actions where the claims have merit and are sufficiently large.

Another reason to opt-out, which often isn’t reported, is that an opt-out plaintiff can bring suit in state court, often relying on state securities claims that would not be available in a federal class-action suit. These state claims often are superior vehicles for recovery than federal claims and permit few defenses, but they are underutilized because Congress—at the behest of supportive defendants—passed the Securities Litigation Uniform Standards Act of 1998 (SLUSA) and barred state securities claims from being part of class actions. The ability to assert state securities claims is another tremendous benefit of opting out of federal class actions.

Finally, opting out of lawsuits offers the possibility of a customized solution for a plaintiff—something not available to the general class of plaintiffs. For example, an opt-out plaintiff could agree to settle its claims sooner than the class does and therefore receive a settlement payment years before any class-action plaintiff sees a penny. All these factors may support the decision to opt out of a class action.

What this means for persons and companies receiving notice of a class action is that they must consult with an attorney promptly to identify whether the claim could support an opt-out lawsuit and the deadline for making that decision. Prior to CalPERS, class members could wait to opt out of a class action until a final settlement was proposed, but class members no longer have that luxury. Now, if they don’t act quickly enough, they can find themselves limited to the general class outcome, having squandered the possibility of a much greater recovery from a separate litigation controlled by the opt-out plaintiff.

In light of CalPERS, class action plaintiffs—including pension funds and other large investors—are well advised to keep careful track of timing throughout the life of a litigation and to be mindful of time elapsed not only from the date an injury is discovered, but also of how much time  has passed since the defendant’s actual misconduct. Keeping an eye on this clock will permit potential opt-out plaintiffs to preserve strong claims that may have substantially greater payouts than those available to the rest of the class.