On May 15, 2023, the New York Times reported that “The Greatest Wealth Transfer in History Is Here, with Familiar (Rich) Winners.”^[1] This transfer of wealth includes giving to tax-exempt organizations, as highlighted by a recent Forbes article on how the late Subway cofounders gave away billions in order to minimize tax liability for themselves and their foundations.^[2] But this unprecedented transfer of wealth occurs at a time when many predict an imminent economic slowdown or worse. The convergence of a massive transfer of wealth and an economic downturn might create a perfect storm, imposing the remedy of centuries-old fraudulent transfer law against charities that receive gifts that are later shown to constitute fraudulent transfers by the donors. The result may be money judgments against the charities.

This article examines what a charity should know about its exposure to liability as the transferee of a donation that turns out to be a fraudulent transfer by the donor. A charity can perform due diligence to manage most kinds of risk resulting from its receipt of a donated asset (e.g., hard-to-manage/risky assets, the risk of inadvertently participating in a tax shelter,^[3] etc.), but a charity—even a large charity with sophisticated general counsel—faces a much more difficult challenge in attempting to mitigate the risk potentially posed by fraudulent transfer law. This article will also address how the law surrounding this intersection has evolved and how the courts have approached the issue of charity liability under fraudulent transfer law.

Fraudulent Transfer Law in a Nutshell

The core of the ancient doctrine of fraudulent transfer permits a creditor to set aside a transfer made by its debtor when the debtor intended to “hinder, delay, or defraud” any of its present or future creditors. A fraudulent transfer of this primordial type has come to be referred to as involving “fraud in fact” or “actual fraud.” Fraudulent transfer law also permits a creditor to set aside a transfer made by its debtor when, regardless of the debtor’s intent, the debtor does not receive “reasonably equivalent value” in return and the debtor is in a sufficiently bad financial condition, such as by being insolvent at the time of, or as a result of, the transfer. A fraudulent transfer of this type has come to be referred to as involving “fraud in law” or “constructive fraud.” A gift will almost certainly satisfy the first requirement of constructive fraud because gifts are typically made without the donor receiving, or even expecting to receive, any asset in exchange. Not surprisingly, constructively fraudulent transfers are quite often made by a debtor to the debtor’s friends and family.

Fraudulent transfer law is addressed by state statutes as well as the Bankruptcy Code. The vast majority of states have adopted the Uniform Fraudulent Transfer Act (“UFTA”), promulgated in 1984.^[4] The UFTA was amended in 2014, and those amendments included changes in terminology as well as a name change to the Uniform Voidable Transactions Act (“UVTA”).^[5]

The terms actual fraud and constructive fraud, although consistent with the UFTA terminology, are misleading because no fraud is required under either theory of recovery. Consequently, under the UVTA, the term fraudulent transfer was replaced with voidable transaction.^[6] More than half of the states that have adopted the UFTA have adopted the UVTA amendments to the UFTA. However, because the decisions discussed below involved application of the UFTA and its terminology (as well as the Bankruptcy Code) references will be made to the traditional UFTA terminology.

It is important to understand that both present and future creditors may seek relief under fraudulent transfer law.^[7] Additionally, the actual fraud theory requires the plaintiff creditor only to prove that the debtor made the transfer with intent to hinder, delay, or defraud creditors. Because direct evidence of intent is often difficult to obtain, a creditor may rely on circumstantial evidence of intent such that intent may be presumed or inferred (e.g., the “badges of fraud”). A claim under the actual fraud theory does not disappear because the debtor received value in exchange for what the debtor transferred. If the debtor received sufficient value in exchange, it may be that the debtor’s creditor need not seek fraudulent transfer relief against the debtor’s transferee because the creditor can satisfy its claim against the debtor by simply pursuing the debtor. But receipt of value by the debtor from the transferee does not mean that a creditor is prohibited from seeking recovery against the transferee. As the attractiveness of the exchanged asset diminishes, the prospects of an actual fraud claim against the transferee increase.

Merely avoiding a fraudulent transfer is not the only remedy available to creditors. As many courts have noted, rewarding a debtor and transferee with a mere reversal of the transfer simply encourages debtors to transfer “low-hanging fruit” because the worst that can happen is a creditor will reverse the transfer. Instead, a creditor may seek a monetary judgment against the transferee of the transfer. In addition, as discussed later, the creditor might also seek additional relief, such as punitive damages.

Why would someone in financial distress donate to charity? As one court noted, “[p]rominent displays of charity attract public attention generally. They can attract new investor-victims through the general semblance of success and a charity-specific ‘affinity factor.’ And, they put up a broad cover of good will that can mask the perpetrator’s underlying dishonesty.”^[8]

Charity Exposure to Fraudulent Transfer Liability

In a common fraudulent transfer scenario involving a donor’s transfer of wealth to a noncharity, a debtor may transfer assets to a friend or a trust created for family members. These individuals might be aware of the debtor’s plan to thwart creditors and can make a well-informed judgment as to whether it is worth participating and assuming the risk of a monetary judgment. The debtor may even conspire with individuals to assure them that if anything goes wrong, the debtor will make the transferee whole. Not surprisingly, courts have awarded compensatory and punitive damages to a creditor who expends resources unwinding transactions, including by imposing liability on transferees and others who assist the transactions. Courts commonly appeal to utilitarian and retributivist principles in fashioning fraudulent transfer relief. This is reflective of a cause of action that has its roots in a penal statute, the ancient Statute of 13 Elizabeth.^[9]

Charities, as transferees, may assert various defenses against creditors. In an action under the so-called actual fraud theory, the charity may assert an absolute defense under UFTA section 8(a). Specifically, the charity will escape exposure if it can show that it acted in good faith and gave reasonably equivalent value. If attacked under the so-called constructive fraud theory, the charity can defend itself by showing that it provided reasonably equivalent value, because failure of the transferee to give reasonably equivalent value in return for the asset it received from the debtor is a prerequisite for any constructive fraud claim. The analysis can differ if the debtor is bankrupt because, for example, a good-faith defense would not exist for a charity that is considered to be the debtor’s “initial” transferee but would exist for a charity that is considered to be the debtor’s “subsequent” transferee that provides value and does not know about the voidability of the transfer.^[10]

A donor to a charity might intend to thwart creditors, but the charity most likely has no idea of a donor’s circumstances or intent. In contrast to a charity, a friend or family member of the debtor who receives a fraudulent transfer is bound to have information about the debtor and the transfer that will enable the individual to make a decision—and to seek legal advice—about the individual’s fraudulent transfer exposure. Importantly, the remedies for a fraudulent transfer include not only avoidance of the transfer but also a possible money judgment against the transferee. This is more likely to occur where the transferee transfers the transferred asset or dissipates the asset before a creditor can reach it (though the UVTA and UFTA literally give the creditor a free choice between avoidance and a money judgment).

Given the range of remedies and potential impact on charities, it is worth reviewing relevant case law.

Cases Involving Charities as Transferees

Cases about fraudulent donations to charity often feature large gifts made by principals of Ponzi schemes, funds received through auctions and pledges, and situations in which the charity may attempt to escape liability in bankruptcy by claiming that it is a “mere conduit.” Timing may also play an important role. Such fact patterns appear in the following cases.

Scholes v. Lehmann. Perhaps the best-known case involving a charity’s exposure to fraudulent transfer liability is Scholes v. Lehmann.^[11] In Scholes, the receiver for corporations owned by a Ponzi scheme principal brought fraudulent transfer actions (under Illinois law) to recover investor funds from the former principal’s spouse, one of the Ponzi scheme investors, and several charities that received funds from the corporations. The charities argued that the donations they received from the principal should not be subject to attack under fraudulent transfer law, which would provide the receiver with money judgments against the charities in the amount of the donations. A money judgment against a charity can be problematic because charities may not hold onto donated funds but instead apply the funds for immediate charitable purposes.^[12] At the oral argument on appeal from money judgments rendered against the charities, counsel for the charities argued that if charities are liable for fraudulent donations, charities will have to host “annual ‘fraud balls’ at which they try to raise money to pay judgments in suits brought by persons who claim that some of the money donated to the charity had been obtained from these persons by a fraud or theft by the donor.”^[13]

In upholding the district court’s judgment that the charities were liable, Judge Posner gave thought to ways in which charities might limit their exposure. Instead of annual “fraud balls,” charities could screen donors (which he acknowledged “hardly seems feasible”) and hold cash reserves for fraudulent transfer exposure.^[14] Judge Posner also considered whether a charity could obtain insurance to cover its fraudulent transfer exposure. Judge Posner found the charities’ arguments “appealing” but commented that charities should seek relief through the legislative process.^[15] Scholes highlights the danger a charity faces of being held responsible for paying a creditor for the amount of a donation received.

In re Rothstein Rosenfeldt Adler, P.A. The case In re Rothstein Rosenfeldt Adler, P.A.^[16] involved the bankruptcy of a law firm accused of orchestrating a $1.2 billion Ponzi scheme that resulted in a named partner’s fifty-year sentence. The issue arose as to whether the law firm payments to a charity for auction items via a competitive auction, as well as payments pursuant to a pledge, would be recoverable by the bankruptcy. Alternatively, if section 548(c) of the Bankruptcy Code applied, it would permit the charity to retain the funds and enforce its obligation to the extent that it gave value to the debtor and acted in good faith. The court determined that the charity acted in good faith and received value in exchange for auction items^[17] as well as pursuant to a preexisting pledge agreement.^[18]

In re Engler. The case In re Engler^[19] involved a Ponzi scheme that bilked investors out of approximately $170 to $350 million; in the process, the debtors running the Ponzi scheme donated to a church project. The donations were the subject of a recovery action by a Chapter 7 bankruptcy trustee, which ultimately proved unsuccessful for the trustee, the details of which follow.

A group of parishioners of St. John the Evangelist Catholic Church in Naples, Florida, sought to raise money for Food for the Poor, an international faith-based organization. Specifically, Food for the Poor was raising money for its Jamaica Housing Project (“Project”). Some of the church parishioners created the Jamaica Outreach Program (“JOP”), a nonprofit organization, to raise money for the Project, where funds would be used to help build homes for poor Jamaican residents. Because the JOP had not obtained its 501(c)(3) tax-exempt status at the time it began soliciting donations for the Project, the JOP asked the church to receive donations on its behalf, to which the church agreed. Because the church believed it could not set up a separate project account under Diocesan accounting rules, it accepted donations—including funds from the debtors—into its general operating account, which was commingled with church revenue. However, the church did create a subaccount and separately accounted for the donations.

Because the fraudulently transferred funds were separately accounted for and were not for the church’s use, the court held that the church was a “mere conduit” and thus escaped liability for receiving this fraudulent transfer under section 550 of the Bankruptcy Code:

All of the donors, including the Debtors, specifically earmarked their donations for the Project. And that is where the money ultimately went. This is not a case where the Debtors simply donated money to the Church to build a parish center or fund its general operations. The Church’s use of the Debtors’ donation was circumscribed by its legal obligations to the Debtors and the JOP.^[20]

Pergament v. Brooklyn Law School. The timing of a fraudulent transfer to a charity may play a role in determining whether the charity can escape liability on the ground that it is a conduit or is entitled to assert a good-faith defense. Such was the case in Pergament v. Brooklyn Law School,^[21] in which a debtor was sued for allegedly bilking someone out of millions of dollars. During the course of the litigation, the debtor paid tuition for his children (including to Brooklyn Law School) before ultimately having a judgment entered against him. After the judgment of approximately $11 million was entered against him, he filed bankruptcy. Pergament demonstrates how timing matters. If the tuition payments were refundable, the student for whose benefit the transfers were made—not the school—could be viewed as the initial transferee. But once the tuition payment obligation matured (i.e., after the refund period expired), then, as to the amount considered nonrefundable, the tuition became the school’s (viewed as a creditor), and the school could do whatever it wanted with the funds. At this point, the school would become the “initial transferee” and not a mere conduit.

State Laws That Provide Limited Protection to Charities

Some states have special statutes that provide some protection for charities that receive fraudulently transferred assets. These states include Florida, Georgia, and Minnesota. The key issues with these statutes is to determine whether protection exists based on the type of person making the donation (e.g., individual or business entity), the type of asset donated, the type of charity entitled to protection, the period for which protection may exist, potential caps on annual amounts donated, and the nature of the fraudulent transfer theory being asserted (constructive versus actual) that is required to trigger protection under the statute. The nature of the fraudulent transfer theory is particularly important because if the debtor-donor is running a Ponzi scheme, courts will presume that the debtor’s charitable donations are subject to recovery under the actual fraud theory. Where more than one state’s fraudulent transfer law may apply, complex choice of law issues emerge. While the UVTA amendments provide certainty for a charity performing due diligence on large donations due to an easy-to-apply choice of law pointer, no such provision exists in the UFTA, leading to expensive litigation to determine applicable fraudulent transfer law.^[22]

Florida. In Florida, section 726.109 of the Florida UFTA (relating to defenses, liability, and protection of a transferee) provides that a charitable contribution to a “qualified religious or charitable entity or organization” is not a constructive fraud transfer under section 726.105(1)(b) as long as the contribution was received in good faith. This protection does not extend to an actual fraud claim available to all creditors or the type of constructive fraud claim available to present creditors when the debtor is left insolvent after the transfer. Put differently, a contribution to a charity where the donor makes the donation with actual intent to hinder, delay, or defraud, or does not receive reasonably equivalent value in exchange for the contribution and is rendered insolvent, is fair game for certain creditors to pursue a charity as a transferee.

Further, a contribution from a “natural person” is a fraudulent transfer if the transfer was received on, or within two years before, the earlier of the date a cause of action is brought for a fraudulent transfer, the filing of a bankruptcy petition, or commencement of insolvency proceedings under any state or federal law, including an assignment for the benefit of creditors or the appointment of a receiver. The statute goes on to provide that the transfer will not be fraudulent for the natural person if the transfer was made consistent with the person’s practices of making charitable contributions or the transfer was received in good faith and the amount of the contribution did not exceed 15 percent of the person’s gross annual income for the year in which the contribution was made. The charitable contribution protected by the Florida UFTA is one that is defined in Internal Revenue Code (“I.R.C.”) section 170(c), as long as the contribution is a financial instrument as defined in I.R.C. section 731(c)(2)(C) or cash.

The effect of these statutory protections is to protect charities from certain forms of constructive fraud claims, as well as protect charities for receiving relatively small and routine donations made by individuals. This means that donations made by the debtor-donor with actual intent to hinder, delay, or defraud creditors (e.g., donations from Ponzi schemes) are prone to recovery, whereas tithing transfers by individuals are less likely to be recovered.

Georgia. Georgia’s UVTA has a special section dedicated to transfers to charities. Section 18-2-85 provides that a transfer made to a “charitable organization” will be considered voidable only if it is established that (1) a voidable transaction has occurred as described in section 18-2-74 (actual and constructive fraud as to all creditors) or 18-2-75 (constructive fraud as to present creditors), and (2) the charitable organization had actual or constructive knowledge of the voidable nature of the transfer.

Minnesota. Minnesota’s protection for charitable organizations is housed in the definitional section of Minnesota’s UVTA. Here, the term transfer does not include a transfer of a charitable contribution to a “qualified charitable or religious organization or entity,” with some exceptions. If the transfer was made within two years of a claim brought under the Minnesota UVTA, the charitable contribution is considered a voidable transfer.

However, a contribution within two years that was not made with actual intent to hinder, delay, or defraud the debtor-donor’s creditors is not a voidable transfer as long as the amount involved did not exceed 15 percent of the gross annual income of the debtor for the year in which the transfer of the contribution was made, or the contribution exceeded that amount but was consistent with practices of the debtor in making charitable contributions. Investment returns on the amounts contributed are excepted from the term transfer. Only charities described in I.R.C. section 170(c)(1), (2), or (3) may use this protection.

Federal Bankruptcy Law Protection for Charities

Section 548 of the Bankruptcy Code was amended by the Religious Liberty and Charitable Donation Act of 1998 to provide charities with some protection from a fraudulent transfer attack brought in the debtor-donor’s bankruptcy case. Section 548(a)(2) provides that a charitable contribution to a “qualified religious or charitable entity or organization” will not be considered a constructively fraudulent transfer if (i) the amount of the contribution did not exceed 15 percent of the gross annual income of the debtor in the year the contribution was made, or (ii) the contribution exceeded the 15 percent amount but was consistent with the debtor’s practices in making charitable contributions. The protection does not extend to a transfer that is attacked under the actual fraud theory. Furthermore, it has been held that a contribution that exceeds the 15 percent ceiling and is not “consistent with the debtor’s practices in making charitable contributions” is voidable in its entirety, not merely the portion above 15 percent.^[23] As Professor Jeffrey Davis noted, even though this protection extends to charities defined in I.R.C. section 170(c)(1) and (2), “it is clear that congress’ motive was to protect tithes received by churches.”^[24]

Insurance Coverage for Fraudulent Transfers

In Scholes v. Lehmann, Judge Posner suggested that a charity might obtain insurance coverage to limit its fraudulent transfer exposure. Unfortunately for charities, many policies exclude an insured-transferee’s monetary obligation from the definition of loss. Payment of such amounts has been compared to disgorgement or restitution for which coverage should not exist on public policy grounds. Such transactions are generally viewed as uninsurable either under the definition of loss and/or via endorsement.^[25]

It may be that a charity and/or individual directors could seek defense coverage under a directors and officers (“D&O”) policy for engaging in a “wrongful act,” but as to a monetary judgment, a fraud exclusion could apply. Ultimately, the terms of the policy, including governing law, are vital to determining the extent to which coverage exists. Consequently, charities should consult with their insurance adviser regarding the extent of coverage provided (if any) in the event that the charity is sued as the transferee of a donation. A few cases discussed below highlight some of the issues involved in coverage disputes involving fraudulent transfer liability.

Case Law Regarding Fraudulent Transfer Coverage

In Huntington National Bank v. AIG Specialty Insurance Co.,^[26] a lender accepted loan payments from a borrower who allegedly ran a Ponzi scheme and later filed for bankruptcy. Some of the loan payments were received by the lender in good faith, but some payments made after a certain date, according to the court, were not received in good faith. Recall that section 548(c) of the Bankruptcy Code provides a good-faith defense. These subsequent payments, if not received in good faith, would be subject to recovery by the bankruptcy trustee. The lender eventually agreed to return $32 million via settlement with the bankruptcy trustee.

One of the key issues in the case was whether the lender was entitled to recover under its insurance policy that covered professional services, which policy had been issued by two different insurers (primary and excess coverages). Coverage potentially existed under the policy because the alleged wrongful acts of the lender arose from the lender’s performance of banking services to the bankrupt borrower. The primary policy covered losses arising from a claim first made against the insured during the policy period and reported to the insurer for any wrongful acts of the insured in rendering or failing to render professional services. A “loss” was defined to include damages, judgments, settlements, and defense costs. Importantly, the definition of loss was modified by an endorsement to exclude “matters that may be deemed uninsurable under the law pursuant to which this policy shall be construed.”^[27] The policy also had several potentially applicable exclusions.

Ultimately, the primary insurer concluded that the policy terms precluded coverage. This prompted the lender to sue the insurer, alleging breach of contract and bad-faith denial of coverage. The insurer argued that no “loss” had occurred, and even if a loss had occurred, coverage was precluded by the endorsement. The court considered the governing law, Ohio, in its coverage analysis. The court noted that in other cases a distinction was made between the wrongful “retention” of money, which might be insurable, versus the wrongful “acquisition” of money, which is not. In the case before it, the court focused on whether the lender’s receipt of payments accepted without good faith constituted unlawful taking of money or unlawful holding of money. The lender argued that the fact that the loan payments by the borrower were found to be fraudulent transfers by the borrower meant only that the money was wrongfully held by the lender. The court held that while the lender had a right to be repaid, it did not have a right to accept payments from the debtor in the absence of good faith and to the detriment of the borrower’s fraud victims. Because acceptance of the funds by the lender was “wrongful,” the receipt of the payments was the wrongful taking of money and was uninsurable.^[28]

Huntington National Bank thus illustrates how a court will focus on the type of fraudulent transfer along with the facts and circumstances when evaluating insurance coverage. It also illustrates how courts generally avoid finding coverage for monetary judgments due to public policy against insurability for what the courts might view as disgorgement or restitution.^[29] However, each case must be examined on its merits, considering not only the terms of the insurance contract but also governing law, as highlighted in Sycamore Partners Management, P.P. v. Endurane American Insurance Co.^[30]

In Sycamore Partners, Delaware law applied to a coverage dispute involving a fraudulent transfer. Notably, in Delaware, losses are uninsurable as against public policy only if the legislature so provides. In that case, investment funds (Sycamore) purchased all of the stock of a target company (Jones Group) in a leveraged buyout where Jones Group was renamed Nine West. Nine West sold various high-performing assets to Sycamore, which then sold those assets for a net profit of $336 million.^[31] Nine West ultimately filed for bankruptcy, from which a variety of lawsuits, including a fraudulent transfer action, were brought against Sycamore and its management. Sycamore ultimately settled by paying $120 million to Nine West’s estate in exchange for dismissal of the claims.

Sycamore made a claim against its insurers to recover a portion of the settlement and the expenses it had incurred to defend Nine West’s claim. The insurers denied coverage, prompting Sycamore to sue them for breach of contract. The insurers raised several defenses, including the argument that the settlement was not insurable as a matter of public policy because it constituted disgorgement by Sycamore of ill-gotten gains that Sycamore had procured from the Nine West transactions.

The insurance policy contained a “law most favorable to insurability” clause, which the court viewed as a choice of law clause. Because Sycamore was seeking coverage, the provision allowed Sycamore discretion to choose any reasonable forum that it believed would maximize its chances of defeating the insurability defense. Sycamore chose Delaware law, which the court would utilize unless the insurers could demonstrate clearly that the “law most favorable” provision was unenforceable because of a public policy in a state with an interest materially greater than Delaware’s. Because the insurers could not do that, the court had to decide whether the settlement was insurable under Delaware law. Recall that in Delaware, losses are uninsurable as against public policy only if the legislature so provides. On this point, the court looked to Delaware law: while Delaware has a fraudulent transfer statute, it does not have a statute that renders insuring against disgorgement or restitution contrary to Delaware public policy. While the court ruled in Sycamore’s favor (on Sycamore’s motion for partial summary judgment as it pertained to the insurers’ uninsurability defense based on public policy grounds), the court also noted that it was not suggesting that insurance companies are required to cover restitution or disgorgement. It just so happened that, based on the terms of the particular insurance policy, the insurers were faced with their own contractual limitations that resulted in coverage.

Important Considerations for Charities Receiving Large Gifts

Many issues that are ancillary to transferee liability under fraudulent transfer law can be addressed in advance by a well-drafted gift agreement.^[32] However, given its potential exposure to transferee liability, a charity should consider additional steps to minimize its risk when it accepts a donation or donations that bring an increased probability of liability. Given their susceptibility to receiving donations tied to Ponzi schemes, charities should also consider the use of a morals clause to address ancillary issues arising out of particularly egregious donor fact patterns.^[33]

Searching public records for pending lawsuits is an easy way to discover whether a donor’s circumstances suggest an unusual likelihood of a fraudulent transfer action. A sound understanding of the nuances of fraudulent transfer law would also be helpful. For example, knowledge of applicable fraudulent transfer law would help to decide the period for which the charity retains funds—and how it retains them—before using them. A charity would benefit if it were able to identify factors that might give rise to its actual or constructive knowledge of the nature of the donation as a fraudulent transfer, which may later affect its entitlement to a defense.

Some protection might already exist in case law that may deter fraudulent transfers to charities in the first place. Many courts have awarded damages (including punitive damages) to creditors in fraudulent transfer cases, thereby providing a potential deterrent effect from those wishing to hinder their creditors. “Without punitive damages, nothing other than costs would deter a debtor from attempting to fraudulently transfer his assets. If he gets caught, so be it: The cost would simply be what was owed in the first place.”^[34] In certain circumstances, courts have also been willing to find those who conspire or aid and abet fraudulent transfers to be liable for damages. Some state fraudulent transfer statutes provide a creditor with attorney fees, which may also act as a deterrent to the fraudulent transfer of assets.

A charity that finds itself the target of a recovery action will reach out to legal counsel to review the viability of the claim and potential defenses, and analyze the costs and benefits involved in defending the action. Charities and their executives should consult with their insurance advisers—before litigation is filed or threatened—as to whether coverage for fraudulent transfer–related litigation exists under their policies. That inquiry may involve determining whether certain policies could provide coverage (e.g., errors and omissions (“E&O”) or D&O), whether any difference in coverage exists based on the nature of the fraudulent transfer (e.g., actual versus constructive fraud), and what types of losses are potentially covered. If coverage is not available, charities should consider negotiating with carriers for the coverage sought. If coverage is not available or feasible on the commercial market and a risk-scoring analysis supports pursuing such coverage, a charity should consider the use of alternative risk solutions (e.g., a risk retention group, a captive insurance company,^[35] etc.).

In closing, where a charity finds itself exposed for receipt of a fraudulent transfer, the courts have ruled in favor of creditors. These decisions pit the public policy of fraudulent transfer law protecting creditors against the public policy supporting charitable giving. While the decisions might seem harsh to charities, there are general defenses along with limited statutory protections, and charities can—and should—take the steps described above to protect against a court order requiring the return of funds.

1. Talmon Joseph Smith & Karl Russell, The Greatest Wealth Transfer in History Is Here, with Familiar (Rich) Winners, N.Y. Times (May 14, 2023). ↑

2. Jemima McEvoy, Subway’s Hidden Billions Revealed: How Its Founders Sliced Up a Fortune, Forbes (Apr. 17, 2023). ↑

3. See Letter from Kevin M. Brown, Acting Comm’r, Internal Revenue Serv., to Charles E. Grassley, U.S. Senator (June 28, 2007) (“In the tax shelter area, abusive programs often require a ‘tax-indifferent party’ to make the scheme work. Some tax-exempt customers continue to allow themselves to be used, often in new ways, as accommodation parties to enable abusive tax shelters.”). ↑

4. The first uniform act was the Uniform Fraudulent Conveyance Act (“UFCA”), promulgated in 1914. Because the UFCA is in force in only two states, it will not be addressed. ↑

5. In 2014, the Uniform Law Commission changed the term fraudulent transfer to voidable transaction via amendments to the Uniform Fraudulent Transfer Act (with such act being renamed the “Uniform Voidable Transactions Act”). Notwithstanding the change in terminology, the modern term voidable transaction will be referred to as fraudulent transfer unless context requires otherwise. ↑

6. Given the modernization of terminology under the UVTA amendments, the term actual fraud should be replaced with primordial rule, and constructive fraud should be replaced with undercompensated transaction. ↑

7. See generally David J. Slenn, The Fraudulent Transfer of Wealth: Unwound and Explained (Am. Bar Ass’n Publ’g 2022). ↑

8. In re Petters Co., Inc., 532 B.R. 100, 104–05 (Bankr. D. Minn. 2015). ↑

9. South Carolina’s fraudulent conveyance statute still calls for a penalty and incarceration. A number of states have a criminal statute that addresses “defrauding creditors,” which may mean secured or unsecured creditors. These range from misdemeanors to felonies, based on certain factors. ↑

10. See In re JVJ Pharmacy Inc., 630 B.R. 388, 400 (S.D.N.Y. 2021) (explaining the difference between an initial and subsequent transferee):

    The difference between the first two categories [initial transferee and entity for whose benefit the transfer was made] and an “immediate or mediate transferee of such initial transferee,” i.e., a subsequent transferee, has legal significance. A subsequent transferee can raise an affirmative defense to liability by demonstrating that it took the transfer “for value . . . in good faith, and without knowledge of the voidability of the transfer avoided.” Id. § 550(b)(1). Meanwhile, the initial transferee or the entity for whose benefit the transfer was made is limited to the defense contained in section 548(c), which is similar to the defense available to a subsequent transferee in section 550(b)(1), but for one important difference. Under section 548(c), an initial transferee or entity for whose benefit the transfer was made may retain the transfer if it took the transfer “for value and in good faith” and “gave value to the debtor in exchange for such transfer or obligation.” Id. § 548(c) (emphasis added). Thus, while a subsequent transferee may invoke a defense to recovery by proving that it took the transfer “for value” from the previous transferor, in addition to acting in good faith and without knowledge of the transfer’s avoidability, the initial transferee or the entity for whose benefit the transfer was made must further show that it “gave value” to the debtor.

    See also In re Teleservices Grp., Inc., 444 B.R. 767, 793 (Bankr. W.D. Mich. 2011), objections overruled sub nom. Meoli v. Huntington Nat’l Bank, No. 1:12-CV-1113, 2015 WL 5690953 (W.D. Mich. Sept. 28, 2015), rev’d in part sub nom. Meoli v. Huntington Nat’l Bank, 848 F.3d 716 (6th Cir. 2017). (“Of course, treating Huntington as the initial transferee would have eliminated its eligibility for the Section 550(b)(1) defense and would have brought Section 548(c) into play instead.”). ↑

11. Scholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995). ↑

12. Id. at 760 (“In this case, the charities used donations for “missionary endeavors here and abroad, but included as well are earthquake relief in San Francisco and the construction of a chicken hatchery and a children’s dormitory in Africa.”); see also Petters, 532 B.R. at 105 (“By the time they are called to account, charity-recipients have usually expended the donated funds on their mission—many times without capital enhancement from the expenditure.”). ↑

13. Id. at 761. ↑

14. Id. ↑

15. The nature of the conflict pits important public policy that one must be honest to his creditors before anyone else, against public policy supporting charitable organizations. See Petters, 532 B.R. at 105 (“[T]his invocation of fraudulent transfer remedies presents a snarl of conflicting public policy considerations. It is a troubling conundrum for any court that presides over such litigation.”). ↑

16. In re Rothstein Rosenfeldt Adler, P.A., 483 B.R. 15, 17 (Bankr. S.D. Fla. 2012). ↑

17. Id. at 21 (“The auction and attendance was an arm’s length transaction and the funds were received by the Foundation from RRA in good faith.”). ↑

18. Id. (“The pledge agreement entered into by RRA was entered into in good faith by the Foundation, was a customary and routine arm’s length transaction, and was a typical arrangement that the Foundation participated with many other donors. The payments were received in the same manner. These contributions raised RRA’s profile in the community, which provided it with additional intangible value.”). ↑

19. In re Engler, 497 B.R. 125 (Bankr. M.D. Fla. 2013). ↑

20. Id. at 130. ↑

21. Pergament v. Brooklyn L. Sch., 595 B.R. 6 (E.D.N.Y. 2019). ↑

22. The differences among potentially applicable fraudulent transfer statutes governing a fraudulent donation might determine a charity’s liability. See In re Palm Beach Fin. Partners, L.P., No. 09-36379-BKC-PGH, 2014 WL 12498025, at *10 (Bankr. S.D. Fla. Dec. 10, 2014). The bankruptcy court, sitting in Florida, applied Florida’s choice of law rules. In doing so, the court applied the Second Restatement’s “significant relationships” test for actions sounding in tort and concluded that Georgia law applied to the trustee’s fraudulent transfer claims. The National Christian Foundation, Inc., as transferee-defendant, argued for application of Minnesota law, which potentially barred the trustee’s claims. Id. at *3 (“Minnesota’s Charitable Contribution Exception applies retroactively. Although Florida and Georgia both passed amendments enacting similar charitable contribution exceptions in 2013, neither Florida’s amendment nor Georgia’s amendment applies retroactively.”). ↑

23. See In re McGough, 737 F.3d 1268, 1275–76 (10th Cir. 2013) (transferee charity, Word of Life Christian Center, unsuccessfully argued for a return of only the amount that exceeds 15 percent):

    Despite the statute’s plain meaning, the Center argues we should nevertheless adopt its interpretation of the statute because to do otherwise would reach an absurd result—it would protect a debtor’s right to donate 15% of his GAI to a charitable organization but allow a trustee to avoid the entire amount of the donations if they are one cent over the 15% threshold. Such a result, according to the Center, would place an undue burden on churches and other charitable organizations which would have to investigate a donor’s financial background in order to use funds within two years of their receipt (the reach-back period). Moreover, according to the Center, to allow a trustee to avoid the entire transfer if it exceeds 15% of GAI would undercut the purposes of RLCDPA—to protect religious and charitable organizations from having to turn over donations they receive from individuals who subsequently file for bankruptcy and to protect the rights of debtors to make religious and charitable donations up to 15% of their GAI.

    See also Jay D. Adkisson, McGough: Debtors’ Charitable Giving Limited to 15% of Gross Income in Bankruptcy, Forbes (Mar. 16, 2012). ↑

24. Jeffrey Davis, Protecting Charities from State Fraudulent Transfer Law 2 (Fla. Bar Bus. L. Section, 2012). ↑

25. See generally Kyle D. Black, Looking Past the Labels: How to Determine Whether Disgorgement or Restitution Payments Are Insured, Brief, Summer 2022, at 34, 35 (“Insurers do not want to insure a thief. And courts have generally recognized that using insurance proceeds to restore ill-gotten gains is against public policy. That is why directors and officers (D&O), errors and omissions (E&O), and professional liability policies often exclude ‘fines and penalties’ or other ‘matters which may be deemed uninsurable under applicable law’ from their definition of ‘loss.’” (internal citations omitted)). ↑

26. Huntington Nat’l Bank v. AIG Specialty Ins. Co., No. 2:20-CV-256, 2022 WL 17741060 (S.D. Ohio Dec. 16, 2022). ↑

27. Id. at *955. ↑

28. The lender filed an appeal to the Sixth Circuit on January 17, 2023. ↑

29. The insurance company noted such decisions in its response in opposition to the lender’s motion for partial summary judgment. Defendants’ Response in Opposition to the Huntington National Bank’s Motion for Partial Summary Judgment at 12–13, Huntington Nat’l Bank v. AIG Specialty Ins. Co., 2021 WL 6552130 (S.D. Ohio Dec. 17, 2021) (“Chubb Custom Ins. Co., 2011 WL 4543896, at *11; William Beaumont Hosp., 552 F. App’x at 498; see also In re TransTexas Gas Corp., 597 F.3d 298, 309 (5th Cir. 2010) (holding that the insured’s claim for fraudulent transfers was uninsurable under the law); Level 3 Commc ‘ns, Inc. v. Fed. Ins. Co., 272 F.3d 908, 910 (7th Cir. 2001) (‘a “loss” within the meaning of an insurance contract does not include the restoration of an ill-gotten gain’); Millennium Partners, L.P. v. Select Ins. Co., 24 Misc. 3d 212, at *216 (NY Sup. Ct. Mar. 9, 2009), aff’d, appeal dismissed, 68 A.D.3d 420, 889 N.Y.S.2d 575 (2009) (‘disgorgement of “ill-gotten funds is not insurable under the law” because such disgorgement “does not constitute ‘damages’ or a ‘loss’ as those terms are used in insurance policies”’).”) ↑

30. Sycamore Partners Mgmt., L.P. v. Endurance Am. Ins. Co., No. CVN18C09211AMLCCLD, 2021 WL 761639 (Del. Super. Ct. Feb. 26, 2021). ↑

31. Id. at *2. ↑

32. See generally Reynolds T. Cafferata, Anatomy of a Charitable Gift Agreement—with Useful Drafting Tips, 46 Est. Plan. 19, 2019 WL 4254678 (2019). The agreement may not only include terms of payment and enforcement but also identify the proper parties to the gift agreement to minimize a challenge to the gift by a third party whose consent was required. ↑

33. For an overview of how such a clause would help, including a sample morals clause, see Adam Scott Goldberg, When Charitable Gift Agreements Go Bad: Why a Morals Clause Should Be Contained in Every Charitable Gift Agreement, Fla. B.J., Dec. 2015, at 48, 50 (“A good agreement includes a process for amendment, an effective date, a reporting and stewardship clause, a governing law clause, and a clause stating the agreement represents the entire agreement between the parties. A very good agreement should also include a morals clause (commonly referred to as a bad boys or misconduct clause). The charity’s failure to place a morals clause in an agreement can lead to bad publicity, awkward situations, and future litigation.”). ↑

34. Alliant Tax Credit 31, Inc. v. Murphy, 924 F.3d 1134, 1150 (11th Cir. 2019). ↑

35. For an overview of captive insurance and associated tax and regulatory issues, see The Captive Insurance Deskbook for the Business Lawyer (David J. Slenn ed., Am. Bar Ass’n Publ’g 2018). ↑

So many capable law firms spend countless hours strategizing how to attract more business and cultivate clients. But while most firms recognize that law is a business, they focus mainly on the proficiency of their work product and sometimes fail to appreciate the finer business relationship nuances that help to attract and retain business.

There may have been a day when client relationships were so tight that law firms had a lock on virtually all of a client’s flow and needed to do little to nurture the relationship. To be sure, there are still some high-stakes matters that inevitably are entrusted to only a small cadre of lawyers with proven track records and institutional connections to avoid second-guessing on why someone new was tried out if the result is suboptimal. And perhaps a client’s close personal relationship with a law firm friend or colleague influences some flow.

Otherwise, however, it is relatively open season. Clients use many law firms and are often open to expanding their roster, particularly for specialized or boutique-ish needs. They also tend to select individual lawyers, rather than law firms that then internally designate a partner to head the assignment. And they typically assign work based on practical factors that blend past experiences with the overall relationship dynamic—including steering away from irritants, unpleasant experiences, and noncompetitive fees. More and more, clients are considering diversity factors as well.

Among the most important decisions for an in-house lawyer is which outside counsel to hire and when to change horses. A client’s baseline expectation for all outside counsel is certainly quality work, so if the product falls short, whether due to sloppiness or worse, the relationship is obviously in peril. And, unsurprisingly, the internet and legal marketplace abound with advice about strengthening relationships by understanding the client and its needs, improving communications, and enhancing efficiency.^[1]

But what about the smaller things? Does it also matter if a client’s emails or calls are not returned for hours or days? Should the client’s dissatisfaction with a product or service invite argument, rebuke, and a complaint to a more senior in-house representative? Are there typos in the client’s own name in drafts? Has the firm served up an engagement letter loaded with one-sided terms and conflict waivers? Is the bill twice what was expected?

Think of all the other commercial relationships in life where the enterprise offers quality goods, but the shopping experience is exasperating. The more critical the deliverable—whether for household use, for medical diagnosis and treatment, or for a technological innovation—the more a customer will tolerate the dissatisfaction. Conversely, for the mundane items or services that are in abundant supply, the exasperation can quickly alienate the customer.

The legal industry does not operate in a special bubble immune from commercial reality. Law firms should focus beyond their work product on the nuances, hiccups, and irritants that can likely be managed and mitigated but have the potential to snowball if left festering. This article accordingly drills down, based on the author’s decades managing a global in-house litigation and regulatory proceedings group and previous practice as a law firm litigator, on some of these finer points that can make a difference in attracting new business, reinforcing relationships, and avoiding needless disruption:

• Embracing the Fundamentals. Fundamentals are the substantive aspects of work product that every law firm should get right and that clients expect, and that may truncate the relationship if a contrary pattern emerges.
• Exhibiting Proper Etiquette. While a superstar lawyer hired for a critical assignment may be afforded more latitude, most clients will not tolerate flippancy, abusiveness, and arrogance.
• Handling “Difficult” Clients. Client representatives are human, bringing their stress and eccentricities to the relationship.
• Soliciting Business. Websites and blast client memos are far less likely to attract business than proper introductions, networking, and successes.
• Learning from Failures. Rather than burying a relationship failure by failing to deal with a fracture or blaming the client, what can be done to salvage and repair?
• Getting Noticed. Whether new to the legal practice or a veteran, there are ways to make a mark with a potential client.

Embracing the Fundamentals

Law firms universally claim to provide top-notch work product and to represent clients zealously. Some market themselves as smarter or nimbler than the competition. Others point to their deep experience handling certain legal topics. Many have slogans or taglines that purport to capture their special distinction and talents.

Fundamentally, however, while law firms themselves may recognize particularly impressive work product of peers—denoting a “lawyer’s lawyer”—many clients do not have the capacity or sensitivity to scrutinize those avowed credentials on that level. They instead measure success or failure largely by the result. At the same time, they do notice smaller nuances that tend to undermine credibility and that are easily avoided with care and diligence.

Some precepts are so basic that they require little discussion here. Obviously, a law firm should never lie to or mislead a client, eviscerating the entire relationship of trust and possibly implicating ethical issues.^[2] Clients also expect and deserve respect and responsiveness, which may come at different levels but must always meet a threshold standard. And law firms should not overstate their expertise, as it is better to candidly pass on an assignment than risk the relationship when they prove to be outmatched.

Other fundamentals, however, impact the quality of work product and avoid the embarrassing hiccups.

Master the Facts and Law. First and foremost, a failure to master the facts and law will invite an awkward client discussion as to how something was missed. Bevies of postmotion submissions addressing matters that should have been detailed in the motion itself beg the question of whether balls were dropped even if the client ultimately prevails. Winning a clawback of discovery materials that never should have been produced is not a “victory” from a client’s perspective. More likely, these lapses will invite a discussion of whether the law firm should bear the cost of the needless sideshows, and raise concerns as to the firm’s quality controls.

Research should be thorough and updated. Factual investigations should leave open no loose ends and include a comprehensive review of documents, emails, and witnesses. In a world of electronic communication, it is no longer feasible or cost-effective for law firms to manually review every email and text, but the process must be robust and avoid surprises. And even then, law firms should never assume or represent that every fact has been definitively pinned down because something is often lurking around the corner.

Don’t Overpromise, Overpredict, or Guess. Clients understand uncertainty and risk, but they want their expectations to be managed realistically. Law firms can get overly enamored with their positions and make bold predictions that prove unsustainable. Even worse, preferring not to seem unprepared, they may shoot from the hip or make an educated guess that proves unfounded.

For better or worse, outcomes tend to be scrutinized with hindsight. If success depends on prevailing on a series of uncertain factors or arguments, they should be spelled out and realistically assessed individually and holistically. If adverse legal authority exists, it should be flagged. And above all, little in the legal world is a sure thing, meaning that even the most optimistic assessments should recognize and factor in potential adverse results. Law firm predictions often influence internal reserves, and overoptimism can translate into awkwardness when the ultimate price tag and reserves deviate.

The same is true with respect to scheduling. An aggressive prediction on when drafts will be ready does not help a client manage the workload. Whatever the prediction, if there are delays, the worst thing is for a law firm to grant itself an unannounced extension rather than engaging with the client and discussing the delay and a more realistic schedule.

Be Precise and Don’t Overrely on Technology. No law firm would knowingly file with the court a brief full of typos, skewed margins, and erroneous citations. Yet, strikingly, drafts go to clients even misspelling their names. Any client will resent being made a proofreader, but the sloppiness also may raise concerns about the substance of the entire work product.

Spell check and auto-citation are simply not replacements for good, old-fashioned proofreading and cite checking. The system may miss misspelled words that, in fact, spell other words. Autocomplete may select the wrong filling. Voice dictation often detects a close but unintended word or phrase. And the advent of artificial intelligence brings its own perils, including citation of fictitious authorities and outright plagiarizing of material that reads well but is entirely inapposite.

Exhibiting Proper Etiquette

If a restaurant keeps a customer waiting despite a reservation, ignores the customer once finally seated, and then responds indignantly to complaints about the slow service and quality of the food, would the customer ever return? So, too, law firms can lose sight of the old adage that “the customer is always right” and common rules of etiquette, damaging the relationship regardless of their substantive work product.

As a threshold matter, clients come in different shapes and sizes, so etiquette must be tailored to each client’s preferences and idiosyncrasies. Some are demanding micromanagers, and others delegate and defer to outside counsel. Some are supersmart, and others slower to grasp analysis. Some are inherently nice, and others always on edge with stress. The same is likely true among the law firm lawyers themselves, but potential business is not on the line when internal irritation occurs.

Despite these tailoring needs, several overarching principles always apply.

Understand the Organization-Versus-Representative Dynamic. The “client” in a corporate setting is typically the organization and not the individual liaison. Yet, the reality is that the day-to-day representative holds the reins and probably will be instrumental in securing additional assignments. Going over that individual’s head to register a complaint or question instructions will inevitably cause friction and should accordingly be done sparingly—and even then with extreme finesse that includes, if possible, the individual’s participation.

While the organization must be respected as the “client,” it acts only through its employees, who should be treated as part of the organization and not the arm’s-length adversary. If “Miranda” warnings must be given to protect the organizational privilege—which should be thoughtfully considered in context and not administered automatically—they can at least be expressed gently without making employee witnesses feel like they are under personal scrutiny and perhaps even need their own counsel.

Exploit Communication. Perhaps most important, communication is the key to sustaining any relationship, yet law firms seem to resort almost exclusively to emails these days for most purposes: to gather information, to provide drafts, and even to report developments. Sometimes, virtual meetings occur using online platforms, particularly in the new era when law firms allow lawyers more freedom to work remotely. But seldom does anyone seem to pick up the phone or arrange in-person meetings.

Whether the loss of physical and voice contact is the result of generational culture shifts or the pandemic, the diminishing occurrence of such contact is profound. Think about how close friendships inevitably erode when sustained only by long-distance, occasional texts. Communicating with a client is not a burden to be satisfied through the expedient of email, but an opportunity to reinforce the relationship and demonstrate proficiency. And when better to call live than to report a positive development?

How often to communicate again depends on the client’s appetite. But communications should be aimed at managing the client’s expectations and avoiding surprises:

• Developments should be reported promptly, and if a law firm needs to prepare a lengthy summary that gets reviewed up the chain, at least the headline should be reported immediately, with more to follow.
• Saving up several rounds of drafts or briefs to send along as a bundle does not help a client representative, who may prefer to review things piecemeal and stay ahead of the curve rather than receiving an overwhelming tome in bulk.
• Fire drills occur but should be flagged for the client immediately rather than by delivering an unexpected draft the night before it is due without warning.
• Drafting schedules should be discussed at the outset, in all events avoiding the Friday afternoon unadvertised draft that feels like a weekend homework assignment to a client. Law firms undoubtedly manage projects internally to accommodate levels of review, so why not factor in the client’s required lead time at the start?
• Law firm team members typically focus on a handful of matters at any time, although each may include dozens of workstreams. Those lawyers live and breathe the matters and so are intimately familiar with deadlines and scheduled calls. By contrast, in-house lawyers and business personnel may manage many dozens of matters and rely heavily on outside counsel for the granular aspects of each one. As a result, law firm emails months before laying out schedules and calls easily get lost in that overwhelming flow or overtaken by the crisis of the moment. Law firms should accordingly update and remind clients regularly about upcoming events and drafts. Even an email flagging that a call is about to begin with the dial-in number or video platform link can be a huge help to a client who has lost track of time or is absorbed in another situation.

Obviously, cost considerations may factor into the method and frequency of communication, but the client should be asked for any preferences.

If electronic communication is used, law firms should at least avoid needless debates and inordinate length and strings that are too unwieldy to read, much less synthesize. And emails and texts should avoid insensitive language or attempted humor that disrupts too many relationships when emerging in the wrong context. Similarly, if a law firm leaves voicemail in an age where few calls are answered by recipients or bygone assistants, the message should be short and succinct (or if the message is lengthy, leave an executive summary at the start).

Offer Reasonable Fees. Finally, fees should be reasonable, competitive, in proportion to expectations, and billed in accordance with the client’s preferred time schedule. They should be discussed up front and along the way, particularly if they start deviating from budgets or forecasts. While a bill in a “bet-the-company” or large transactional matter may be hard to scrutinize against a benchmark, commodity-type assignments in particular tend to have a standard range that will be the baseline for considering the law firm’s cost reasonableness and effectiveness. The best work and result will not likely invite a return engagement if the fees were disproportionate.

Handling “Difficult” Clients

Curmudgeons seem to be everywhere within the legal industry, and clients are no exception.^[3] But it is important to distinguish a client who is ornery or having a bad day from one who is involved and demanding. While law firms may be used to total delegation by some clients, others will choose to participate actively and even debate issues with outside counsel. Although such clients are certainly more challenging, they nonetheless are just doing their jobs and can add value.

The Upside of Active Clients. An active client is arguably a benefit for law firms, not a burden. A client who closely manages a matter and has the intellectual skills to discern quality can be impressed and a source for future business recommendations. Client engagement and buy-in takes more effort but also avoids later misunderstandings about potential outcomes and cost. A client’s delivery may be inartful or miss the point at times, but it is worth the time to get on the same wavelength because clients can offer practical business observations and factual precision that outside counsel might otherwise fail to appreciate.

The Downside of Active Clients. On the other hand, some clients can indeed make the adventure more difficult without adding much value. There are the clients who fail to respond to requests for factual information or comments on drafts, or else provide comments at the last possible moment (which may be off target). There are the windbags who never stop talking and the insecure clients who seek to dominate any meeting or call. Others spin the story, forum shop for the advice they want to hear, and interpose outside counsel amid their internal politics and quest for credit. It is even possible that a client is simply petulant, offensive, or demeaning.

There is little to be gained from pushing back where a client’s behavior falls into one of these benignly unhelpful categories. It is better to maintain poise; express empathy and patience; and, if extreme, discreetly escalate the situation within the client organization. Escalation obviously may end up burning bridges so should be a last recourse.

But whatever the circumstances, there is no place for abusive or offensive conduct, and a law firm owes it to the client organization to flag the issue diplomatically at a higher level if it occurs.^[4]

Soliciting Business

Law firm memos to clients on legal developments are certainly appreciated, but do they stand a better chance of landing business than the incessant stream of marketing pitches and spam arriving in personal inboxes every day? And perhaps presenting at symposiums and conferences or displaying flashy websites (featuring those catchy slogans and taglines) might raise a law firm’s profile. But those devices are expedients more to maintain a market presence than to secure specific assignments. Does any client really get sold by a catchphrase like (to pluck a few from the internet) “A Small Firm That Acts Big” or “Committed to Helping Our Clients Succeed,” or even “Lawyers You’ll Swear By. Not At.”?

Sometimes a new client may approach a law firm to take advantage of a specific lawyer’s expertise or reputation. Other times, a client may follow a lawyer who moves to a new firm. But otherwise, securing new relationships depends heavily on a firm’s networking and proper introductions.

Garner Introductions. The best channel for an introduction to a client’s legal function is its business team. The legal function, while typically independent, nonetheless is commercial and should respond favorably to a recommendation that comes from the revenue side of the company. If a law firm has steered business opportunities to the client, business personnel in particular should be open to reciprocating by means of such an introduction.

Alternatively, any relationship with the client’s business or legal personnel is an opportunity for an introduction. Perhaps a law firm lawyer and client businessperson are social acquaintances or their children attend the same school. Or perhaps the law firm represents another client in the same industry who can make the introduction.

Exploit Success. If a foot is already in the door, the best time to seek more assignments is in the wake of a victory or good work. If the success story benefited that client, it should be exploited promptly within the organization. But even if the impressive event was for another client, there is every reason to reach out more broadly to the firm’s existing and prospective client base to report the news and discuss how the firm can similarly help.

Don’t Be Picky. As a corollary, law firms should not be picky when trying to establish or expand a relationship. They may prefer assignments that are lucrative or high-profile, but client inventory is uncontrollable, and every firm needs to start someplace. Quality and efficient work will likely be recognized and rewarded with more.

Prepare Retention Letters Carefully. Finally, law firms that are lucky enough to establish or perpetuate client relationships should think hard before serving up one-sided retention letters that dictate a flurry of terms while essentially waiving all past, present, and future actual or potential conflicts. Bar association rules often require some sort of written engagement confirmation, but the versions that seem to proliferate both burden a client with the need to review the tome and elicit the wrong tone for a relationship that should feel close and trusted.

Learning from Failures

Balls get dropped and things go wrong in any relationship. Too often, a small problem gets magnified due to nondetection, avoidance, or mismanagement. And bigger issues are deemed futile or blamed on the client. How hiccups or worse get identified and dealt with can deeply impact the future client relationship.

Detection. Law firms are no different fundamentally than any other supervisory organization that monitors activity and seeks to detect issues. Individuals have a responsibility to self-report when something goes wrong, and more senior lawyers should be on the lookout for problems. Indeed, clients, particularly regulated ones, use surveillance tools as part of their compliance regime, begging the question of whether law firms should do the same to identify circumstances or language that deviates from the norm. If law firms are practiced at spotting problematic client communications, they should be able to apply the same skills to their own.

Obviously, if a client reaches out to complain about something, there is reason for concern even if the complaint is deemed misplaced. Red flags may signify client strain or discontent. Certainly, if business levels drop, that is an occasion to figure out why and explore how to repair the relationships. If lawyers internally refer to a client disparagingly, they are probably not treating the client with respect. And if a relationship lawyer is in regular touch with the client, even just to check in, the substance or tone may suggest that something is amiss.

Engagement and Repair. Even before determining what happened, engagement with the client is critical. The client is not only a source of information but the ultimate arbiter on whether the issue has been adequately addressed. The client should know that someone cares, will investigate, and will report back. By contrast, an ignored client will be left to stew and fester.

Central to dealing with any mishap is a heartfelt apology. If there are corrective measures to be taken, they should be discussed with the client to secure buy-in. Perhaps more frequent communication is needed, or better scheduling efforts. And perhaps the law firm’s fees should be reduced. In an extreme instance, staffing might be adjusted. Finally, whatever the issue, a solution should be considered more broadly to obviate similar problems with other clients.

Getting Noticed

Lots of lawyers are hardworking and smart, so standing out takes something special. Sometimes, getting noticed (whether within the law firm or beyond) is a matter of luck—getting assigned to the right client and matter at the right time. But whether junior or senior, lawyers do have significant control over their fate.

Track Record. Establishing a track record and subject matter expertise is key to attracting career attention. A dramatic success in a high-profile matter will result in instant fame. Otherwise, it takes sustained effort, but virtually anyone can become proficient in a legal area by working on a number of matters, continuously following developments, networking at relevant bar or industry conferences, and publishing insightful pieces. As reputations expand, word gets around, and clients follow.

Observers. You never know who is watching your performance beyond your own client. It may be a codefendant’s client. It may be a lawyer from another firm. It may even be a judge or regulator. The point is that lawyers should always do their best not only to serve their current client, but also because there is a larger audience that may notice. There have been plenty of occasions when this author noticed an adept lawyer representing another party and made it a point to hire that lawyer in the future.

Special Qualities. Above all, lawyers stand out when they exhibit special qualities. They may have a passion to win, fortitude and conviction, eloquence in delivery and advocacy, a flair for written work, a mastery of facts, a recognition of nuances others don’t pick up, a high degree of preparation and organization, and/or precision. This list is not exhaustive, and not every lawyer possesses every quality, but having some of them may help a lawyer rise above the crowd, particularly if a self-critical analysis identifies strengths and weaknesses so that the former can be exploited and the latter minimized. And, needless to say, it helps to be likable and have decent social skills.

Exploiting Opportunity and Taking Chances. Sometimes a lawyer is not looking for a change, but a unique opportunity arises. Perhaps the firm needs more resources in an area outside a lawyer’s comfort zone, representing an opportunity to expand horizons. Clients may need interim help, and there is no better way to get close to a client and learn its business than through a secondment. Pursuing something new and different does not sidetrack the career path; to the contrary, it demonstrates adaptability and utility.

Commerciality and Practicality. The old saying goes “millions for defense, not one cent for tribute.” The problem is that clients pay the bills. Law firms need to think commercially and practically to serve a client’s best interests by balancing results and cost. A quick and practical solution that obviates an expensive and lengthy slog may truncate an otherwise lucrative assignment but will likely earn the eternal gratitude of a client—and repeat business.

Conclusion

Law schools teach concepts and theory to get students intellectually ready to practice law, and law firms focus on producing outstanding legal work product to serve clients and gain reputational glory. These facets are the core of legal practice—but when viewed as a business, the legal profession could afford to pay more attention to the smaller nuances that matter in any commercial relationship.

* * * *

The author wishes to express his gratitude to James Beha, Jonathan Clarke, and Carrie Cohen for sharing their insights on this topic.

1. For a discussion of the evolution of the in-house counsel role and its relationship to outside counsel, see Eli Wald, Getting In and Out of the House: The Worlds of In-House Counsel, Big Law, and the Emerging Career Trajectories of In-House Lawyers, 88 Fordham L. Rev. 5 (2020). ↑

2. Interestingly, ethical rules typically proscribe only lies that are “material.” See Leonard M. Niehoff, How Not to Lie: A Don’t-Do-It-Yourself Guide for Litigators, 49 A.B.A. Litig. J. (Summer 2023). There is no room in a client relationship for lying, whether material or not. ↑

3. Mark Edward Hermann, The Curmudgeon’s Guide to Practicing Law (2d ed. 2020). ↑

4. For a discussion concerning clients to avoid altogether and setting ground rules with particularly insistent clients, see Lynda C. Shely, Armchair Quarterbacks, 50 A.B.A. Litig. J. (Fall 2023) at 23. ↑

When the New Jersey Revised Uniform Limited Liability Company Act (“NJ-RULLCA” or the “Act”)^[1] was adopted on March 18, 2012, it included provisions allowing a New Jersey (“NJ”) corporation to convert to a NJ limited liability company (“LLC”), and vice versa. However, the legislation did not include amendments to the New Jersey Business Corporation Act (“NJBCA”)^[2] authorizing such conversions. As a result, the provisions of NJ-RULLCA addressing a NJ corporation’s conversion to a NJ LLC, and vice versa, were dormant for over a decade.

On May 8, 2023, Governor Phil Murphy signed into law Senate Bill 142 (P.L. 2023, Chapter 38), which amended and supplemented the NJBCA to allow a NJ corporation to convert to a NJ LLC, and vice versa. As of the effective date of the law, November 4, 2023 (180 days after enactment), a NJ corporation may finally convert to a NJ LLC (or a foreign LLC), and vice versa. Further, a NJ corporation may redomesticate to another state, and vice versa.

The types of conversions and domestications involving corporations and LLCs in New Jersey may be summarized by the following table:

1. Conversion of NJ Corporation

a. Conversion of NJ Corporation to NJ LLC

NJ-RULLCA provides that a NJ entity^[3] (other than a foreign LLC) may convert to a NJ LLC, and a NJ LLC may convert to any other form of entity (other than a foreign LLC).^[4] Focusing on corporations, NJ-RULLCA provides that a NJ corporation may convert to a NJ LLC if:

• the governing statute of the corporation authorizes conversion;^[5]
• the conversion is not prohibited by the law of the jurisdiction of the corporation; and^[6]
• the corporation complies with its governing statute in effecting the conversion.^[7]i.

i. Directors’ and Shareholders’ Approval

As a result of the amendments to the NJBCA, the foregoing requisites are satisfied, and a NJ corporation may now convert to a NJ LLC.^[8] To convert:

• The corporation’s board of directors must adopt a resolution approving a plan of conversion, which plan must state that the corporation will be converting to a NJ LLC and direct that the plan be submitted to a vote at a meeting of the shareholders.^[9]
• All shareholders, whether or not they are entitled to vote, must be given written notice of the shareholders meeting, with such notice being given not less than twenty nor more than sixty days prior to the meeting.^[10]
• All shareholders, whether or not they are entitled to vote, must approve the plan of conversion.^[11] To repeat, even shareholders holding non-voting shares of stock must vote in favor of the plan of conversion.^[12]

The amendments to the NJBCA also provide that the plan of conversion must be approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.^[13] This is curious language because the LLC is formed upon conversion and, therefore, is not yet in existence in New Jersey and may not have an operating agreement until conversion. How would the LLC approve the conversion? Nonetheless, because the shareholders of the NJ corporation will likely be the members of the LLC and will want to know the terms of the operating agreement prior to the conversion, this hurdle may be satisfied by the members executing the operating agreement immediately prior to the conversion.

ii. Plan of Conversion

The amendments to the NJBCA do not specify what information should be included in a plan of conversion.^[14] By contrast, NJ-RULLCA provides that the plan of conversion must include the following information:

• name of the entity before conversion;^[15]
• form of the entity before conversion (i.e., a NJ corporation);^[16]
• name of the entity after conversion;^[17]
• form of the entity after conversion (i.e., a NJ LLC);^[18]
• the terms and conditions of conversion, including the manner and basis for converting interests of the converting entity (e.g., shares of stock of a NJ corporation) into any combination of cash, interests in the converted entity (e.g., membership interests in a NJ LLC), and other consideration.^[19] (For example, the plan may state that a shareholder with 25 of 100 issued and outstanding shares of the NJ corporation will receive a 25 percent membership interest in the LLC.); and
• the organizational documents of the converted entity that are, or are proposed to be, in writing (e.g., the certificate of formation and the operating agreement of a NJ LLC).^[20]

Therefore, when converting from a NJ corporation to a NJ LLC, the foregoing items must be included in the plan of conversion.

iii. Certificate of Conversion

Once the board of directors and the shareholders approve the plan of conversion, the NJ corporation would file a certificate of conversion with the New Jersey Division of Revenue and Enterprise Services (“NJDORES”).^[21] The certificate of conversion must include the following information:

• The name of the corporation.^[22]
• If the corporation wants to change its name, the proposed new name of the LLC.^[23] (If the corporate name includes “Inc.,” “Corp.,” etc., it must be changed to “LLC,” “L.L.C.,” etc.; therefore, the proposed new name of the LLC would be included in the certificate.)
• The future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing.^[24]
• A statement that that the plan of conversion was adopted by the board of directors and the shareholders as required by N.J.S.A. 14A:11A-2(3).^[25]

NJ-RULLCA does not address the contents of articles of conversion for an entity, such as a NJ corporation, converting to a NJ LLC. It simply requires that the certificate of formation include additional information relating to the conversion.^[26]

iv. Certificate of Formation

A NJ corporation converting to a NJ LLC must file a certificate of formation with the NJDORES.^[27] In addition to the information required by N.J.S.A. 42:2C-18(b) (which is the name, the registered agent, and the registered office of the NJ LLC), the certificate of formation must include the following information (when a corporation is converting to a NJ LLC):

• a statement that the NJ LLC has been converted from a corporation;^[28]
• the name of the corporation;^[29]
• the form of the converting entity (e.g., a NJ corporation);^[30]
• the jurisdiction of the converting entity (e.g., New Jersey); and^[31]
• a statement that the conversion was approved in a manner that complied with the converting entity’s governing statute (e.g., the NJBCA).^[32]

b. Conversion of NJ Corporation to Foreign LLC

A NJ corporation may convert to a foreign LLC.^[33]

i. Approval by Directors and Shareholders

See previous discussion at Section 1(a)(i).

ii. Plan of Conversion

See discussion at Section 1(a)(ii). (With any conversion from a NJ entity to a foreign entity, the statute of the foreign entity must be reviewed for any requirements that must be stated in the plan of conversion and the certificate of conversion.)

iii. Certificate of Conversion

Once the directors and shareholders approve the plan of conversion, the NJ corporation would file a certificate of conversion with the NJDORES, which must include the following information:

• The name of the corporation, and, if the name has been changed, the name under which it was originally incorporated.^[34]
• The date of filing of its original certificate of incorporation.^[35]
• The name of the foreign LLC after conversion.^[36]
• The jurisdiction where the conversion will occur.^[37]
• A statement that the conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.^[38] (As noted, the LLC is formed upon conversion and, therefore, is not yet in existence and may not have an operating agreement at that time. Nonetheless, the statement will be included in the certificate of conversion since the conversion would need to be approved in accordance with applicable law and, if in existence, the operating agreement.)
• The future date or time when the conversion will be effective, if not effective upon filing, which cannot be more than ninety days after filing.^[39]
• If, after conversion, the foreign LLC will be conducting business in New Jersey, a statement that “it shall comply with the provisions of this act [i.e., the NJBCA] with respect to foreign entities, . . .”^[40]
• A statement that the foreign LLC may be served with process in New Jersey in any proceeding to enforce any obligation of the converting NJ corporation.^[41]
• The foreign LLC’s irrevocable appointment of the NJDORES as its agent to accept service of process in any proceeding to enforce any obligation of the converting corporation.^[42]
• The address of the foreign LLC—within or outside New Jersey—where the NJDORES will mail process of service to the foreign LLC.^[43]

c. Conversion / Domestication of NJ Corporation to Foreign Corporation

A NJ corporation may convert to a foreign corporation.^[44] This type of conversion is commonly known in NJ as a domestication, although such a term is not used in the amendments to the NJBCA.^[45]

i. Approval by Directors and Shareholders

See previous discussion at Section 1(a)(i).

ii. Plan of Conversion

See discussion at Section 1(a)(ii).

iii. Certificate of Conversion

See discussion at Section 1(b)(iii).

d. Effect of Conversion / Domestication of NJ Corporation

The conversion (or domestication) of a NJ corporation to (a) a NJ LLC, (b) a foreign LLC, (c) a foreign corporation, or (d) another form of NJ or foreign entity does not affect any of the NJ corporation’s obligations or liabilities, or the personal liability of any person, incurred prior to the conversion.^[46] Upon conversion, the new NJ LLC (or foreign LLC, foreign corporation, or other form of NJ or foreign entity) is, for all purposes, deemed to be the same entity as the NJ corporation.^[47]

The amendments to the NJBCA provide that, upon conversion (using a conversion from a NJ corporation to an LLC for this discussion):

• all of the corporation’s rights, privileges and powers belong to the LLC;
• all of the corporation’s real, personal, and mixed property belong to the LLC and, with respect to real property, it will not revert or be in any way impaired as a result of the conversion;
• all debts owed to the corporation will be owed to the LLC;
• all rights of creditors and all liens on any property of the corporation are preserved unimpaired, meaning that the LLC’s property is subject to any liens filed against the corporation’s property;^[48]
• all of the corporation’s debts, liabilities and duties belong to the LLC and may be enforced against the LLC as if it incurred or contracted them; and
• all of the foregoing items are not deemed transferred from the corporation to the LLC.^[49]

NJ-RULLCA likewise provides:

• all of the corporation’s property remains vested in the NJ LLC;^[50]
• all of the corporation’s debts, obligations and other liabilities continue as the debt, obligations and liabilities of the NJ LLC;^[51]
• any action or proceeding by or against the corporation is continued as if the conversion had not occurred (in other words, the action or proceeding of or against the corporation continues as the action or proceeding of or against the NJ LLC); ^[52]
• all of the rights, privileges, immunities, powers, and purposes of the NJ corporation remain vested in the NJ LLC, except as prohibited by law (other than NJ-RULLCA);^[53] and
• upon conversion, the terms and conditions of the plan of conversion take effect, except as otherwise provided in the plan of conversion.^[54]

The conversion is not deemed a dissolution (unless otherwise agreed in the plan), and the NJ corporation is not required to wind up its business, pay its liabilities, and distribute its assets.^[55] The NJ corporation continues in the form of the NJ LLC (or foreign LLC, foreign corporation, or other form of NJ or foreign entity).^[56]

For a conversion of a NJ corporation to a foreign LLC, corporation, or other form of entity, the conversion is not deemed to affect the choice of law applicable to the NJ corporation with respect to matters arising prior to conversion.^[57]

2. Conversion of NJ LLC

a. Conversion of NJ LLC to NJ Corporation

As a result of the amendments to the NJBCA, a NJ LLC may now convert to a NJ corporation.^[58]

i. Approval by Members

To convert, the NJ LLC must approve a plan of conversion and a certificate of incorporation, which must be approved in accordance with the LLC’s operating agreement and applicable law, as appropriate (which for a NJ LLC means NJ-RULLCA).^[59]

NJ-RULLCA provides that all members of a NJ LLC converting to a NJ corporation (or any other form of entity) must consent to the plan of conversion,^[60] unless the operating agreement authorizes conversion with the consent of less than all members.^[61] Even in a manager-managed LLC (as opposed to a member-managed LLC), the members (not the managers) approve the plan of conversion, unless the operating agreement provides otherwise.^[62]

ii. Plan of Conversion

NJ-RULLCA provides that the plan of conversion must include the:

• name of the entity before conversion;^[63]
• form of the entity before conversion (i.e., a NJ LLC);^[64]
• name of the entity after conversion;^[65]
• form of the entity after conversion (i.e., a NJ corporation);^[66]
• terms and conditions of conversion, including the manner and basis for converting interests of the converting entity (e.g., membership interests of the NJ LLC) into any combination of cash, interests in the converted entity (e.g., shares of stock of a NJ corporation), and other consideration;^[67] and
• organizational documents of the converted entity that are, or are proposed to be, in writing (e.g., the certificate of incorporation, the bylaws and the organizational resolutions appointing directors and officers, and, if applicable, the shareholders agreement).^[68]

iii. Certificate / Articles of Conversion

Once the members approve the plan of conversion and the certificate of incorporation, the NJ LLC would file articles/certificate of conversion and a certificate of incorporation with the NJDORES.^[69] The articles/certificate of conversion must be signed by an authorized person.^[70]

NJ-RULLCA provides that the articles of conversion must include the following information:

• a statement that the NJ LLC has been converted to a corporation;^[71]
• the name of the NJ LLC;^[72]
• the form of entity and such other information as may be required by the NJDORES to correctly identify the company and the jurisdiction of its governing statute;^[73]
• the date the conversion is effective under the governing statute of the converted entity;^[74]
• a statement that the conversion was approved as required by NJ-RULLCA;^[75] and
• a statement that the conversion was approved as required by the governing statute of the converted entity (e.g., the NJBCA).^[76]

By comparison, the amendments to the NJBCA provide that the certificate of conversion must include the following information:

• the date when the LLC was formed;^[77]
• the jurisdiction where the LLC was formed, and, if it has changed, the jurisdiction immediately prior to the conversion to a NJ corporation;^[78]
• the name of the LLC prior to filing the certificate of conversion;^[79]
• the name of the NJ corporation as set forth in the certificate of incorporation to be filed with the certificate of conversion;^[80]
• the future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing;^[81] and
• a statement that the plan of conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.^[82] (Although the entire statement would be included in the certificate, if there is no operating agreement, then for a NJ LLC the plan of conversion would be in accordance with NJ-RULLCA, which serves as the LLC’s default operating agreement).

Although there is no indication in either the NJ-RULLCA or the NJBCA of how to reconcile the requirements of each statute, a NJ LLC converting to a NJ corporation would likely file one certificate / one set of articles of conversion combining all information required in N.J.S.A. 14A:11A-1(5) and N.J.S.A. 42:2C-80(a)(1) to comply with each statute. In fact, the NJDORES has published two forms of certificate of conversion—one form (CD100) to be used when the resulting entity will be a NJ entity and the other (CD101) when the resulting entity will be a foreign entity. The forms are intended to be used in all types of entity conversions. The NJDORES has done an admirable job of distilling the statutory requirements in NJ-RULLCA and the NJBCA into one-page certificates. The forms are available on the NJDORES website.^[83]

iv. Certificate of Incorporation

A NJ LLC converting to a NJ corporation must file a certificate of incorporation with the NJDORES, which must be signed in accordance with the NJBCA.^[84] This provision states that a document may be signed by the chairman, president, or vice president of the corporation;^[85] however, the corporation would not have any directors until the certificate of incorporation is filed and would not have any officers until the organizational meeting of the directors is held. Therefore, the certification of incorporation will likely be signed by an incorporator.^[86]

b. Conversion of NJ LLC to Foreign Corporation

A NJ LLC may convert to a foreign corporation.^[87]

i. Approval by Members

See previous discussion at Section 2(a)(i).

ii. Plan of Conversion

See discussion at Section 2(a)(ii).

iii. Articles of Conversion

A NJ LLC converting to a foreign corporation would file articles of conversion under NJ-RULLCA. Because the conversion is to a foreign corporation, it would not need to comply with the requirements under the amendments to the NJBCA. See previous discussion at Section 2(a)(iii) on the contents of the articles of conversion under NJ-RULLCA.

Further, if a NJ LLC converts to a foreign corporation, and the foreign corporation will not be authorized to transact business in New Jersey, the articles of conversion must also include the street and mailing addresses of an office which the NJDORES may use for the purposes of N.J.S.A. 42:2C-81(c), which purposes are discussed in the next two sentences.^[88] By doing so, the foreign corporation consents to the jurisdiction of the courts in New Jersey to enforce any debt, obligation, or other liability for which the NJ LLC is liable if the NJ LLC was subject to suit on such debt, obligation, or other liability prior to the conversion.^[89] The foreign corporation also appoints the NJDORES as its agent for service of process of any suit relating to such debt, obligation, or other liability.^[90]

c. Domestication of NJ LLC to Foreign LLC

A NJ LLC may become a foreign LLC by domestication if:

• the foreign LLC’s governing statute authorizes domestication;^[91]
• domestication is not prohibited by the law governing the foreign LLC;^[92] and
• the NJ LLC complies with the foreign LLC’s statute in effecting the domestication.^[93]

i. Member Approval

All members must consent to the plan of domestication,^[94] unless the operating agreement authorizes conversion with the consent of less than all members.^[95] Even in a manager-managed LLC (as opposed to a member-managed LLC), the members (not the managers) approve the plan of domestication, unless the operating agreement provides otherwise.^[96]

ii. Plan of Domestication

The plan of domestication must include the:

• name of the NJ LLC before domestication and other such information the NJDORES requires to correctly identify the LLC (e.g., the business identification number);^[97]
• name of the foreign LLC after domestication;^[98]
• jurisdiction of the foreign LLC after domestication;^[99]
• terms and conditions of the domestication;^[100] and
• organizational documents of the foreign LLC (e.g., the certificate of formation and the operating agreement or an amendment to the existing operating agreement).^[101]

iii. Articles of Domestication

After the plan of domestication has been approved, the NJ LLC would file articles of domestication with the NJDORES, which articles must include:

• a statement that the NJ LLC has domesticated to a foreign LLC;^[102]
• the name of the NJ LLC and any other information required by the NJDORES to identify the NJ LLC (e.g., its business identification number);^[103]
• the name of the foreign LLC after domestication;^[104]
• the jurisdiction of the foreign LLC after domestication;^[105]
• the date the domestication is effective under the foreign LLC’s governing statute;^[106] and
• a statement that the domestication was approved as required by NJ-RULLCA.^[107]

If a NJ LLC converts to a foreign LLC, and the foreign LLC will not be authorized to transact business in New Jersey, the articles of domestication also must include the street and mailing addresses of an office which the NJDORES may use for the purposes of N.J.S.A. 42:2C-85(b), which purposes are discussed in the next two sentences.^[108] By doing so, the foreign LLC consents to the jurisdiction of the courts in New Jersey to enforce any debt, obligation, or other liability for which the NJ LLC is liable if the NJ LLC was subject to suit on such debt, obligation, or other liability prior to the domestication.^[109] The foreign LLC must also appoint the NJDORES as its agent for service of process of any suit relating to such debt, obligation, or other liability.^[110]

iv. Statement of Surrender

When a NJ LLC domesticates to a foreign LLC, the NJ LLC must file a statement with the NJDORES surrendering its certificate of formation. The statement must include:

• the name of the NJ LLC and any other information required by the NJDORES to identify the NJ LLC (e.g., its business identification number);^[111]
• a statement that the certificate of formation is being surrendered in connection with the domestication of the NJ LLC to a foreign jurisdiction;^[112]
• a statement that the domestication was approved as required by NJ-RULLCA;^[113] and
• the jurisdiction of the foreign LLC.^[114]

d. Effect of Conversion / Domestication of a NJ LLC

Upon conversion, the NJ LLC will be a NJ corporation governed by the NJBCA.^[115] The NJ corporation will be deemed to have been commenced on the date that the LLC was first formed.^[116] For example, if a NJ LLC was formed on March 19, 2013, and converted to a NJ corporation on November 5, 2023, the NJ corporation will be deemed to have been in existence since March 19, 2013.

The conversion of a NJ LLC to a NJ or foreign entity does not affect any of the NJ LLC’s obligations or liabilities, or the personal liability of any person, incurred prior to the conversion.^[117] Upon conversion, the corporation is deemed to be the same entity as the LLC, which means:

• all of the LLC’s rights, privileges, and powers belong to the corporation;
• all of the LLC’s real, personal, and mixed property belong to the corporation and, with respect to real property, it will not revert or be in any way impaired as a result of the conversion;
• all debts owed to the LLC will be owed to the corporation;
• all rights of creditors and all liens on any property of the LLC are preserved unimpaired, meaning that the corporation’s property is subject to any liens filed against the LLC’s property;^[118]
• all of the LLC’s debts, liabilities, and duties belong to the corporation and may be enforced against the corporation as if it incurred or contracted them; and
• all of the foregoing items are not deemed transferred from the LLC to the corporation.^[119]

The effect of a NJ LLC domesticating to a foreign LLC is the same as a NJ LLC converting to a NJ or foreign corporation, discussed previously.^[120]

NJ-RULLCA contains comparable provisions on the effect of a NJ LLC converting to a corporation, which were discussed in this article earlier at Section 1(d).

The conversion is not deemed a dissolution, and the LLC is not required to wind up its business, pay its liabilities, and distribute its assets.^[121] The LLC continues in the form of a NJ corporation.^[122]

3. Conversion of Foreign Corporation to NJ Entity

a. Conversion of Foreign Corporation to NJ LLC

A foreign corporation may convert to a NJ LLC if:

• the foreign corporation’s governing statute authorizes conversion;^[123]
• the conversion is not prohibited by the law of the foreign corporation^[124] and
• the foreign corporation complied with its governing statute in effectuating the conversion.^[125]

i. Approval of Directors and Shareholders

The directors and shareholders of a foreign corporation would approve the conversion to a NJ LLC in accordance with the statutory law governing the foreign corporation.

ii. Plan of Conversion

The plan of conversion is summarized at Section 1(a)(ii).

iii. Certificate of Conversion

The certificate of conversion and the certificate of formation to be filed with the NJDORES are summarized at Sections 1(a)(iii) and (iv).

iv. Effect of Conversion

The effect of the conversion is summarized at Section 1(d) in the NJ-RULLCA discussion.

b. Conversion of Foreign Corporation to NJ Corporation

A foreign corporation may convert (that is, domesticate) to a NJ corporation.^[126]

i. Approval of Directors and Shareholders

The directors and shareholders of a foreign corporation would approve the conversion to a NJ corporation in accordance with the statutory law governing the foreign corporation.

ii. Plan of Conversion

The plan of conversion is summarized at Section 2(a)(ii) above in the NJBCA discussion.

iii. Certificate of Conversion

The certificate of conversion is summarized at Section 2(a)(iii) above in the NJBCA discussion.

iv. Effect of Conversion

The effect of the conversion is summarized at Section 2(d) in the NJBCA discussion.

c. Conversion of Foreign Corporation Authorized to Do Business in NJ to a Foreign LLC Authorized to Do Business in NJ

The scenario of a foreign corporation authorized to do business in New Jersey converting to a foreign LLC is not addressed in the amendments to NJBCA. Nor is it addressed in NJ-RULLCA. Nonetheless, the NJDORES would likely require the new foreign LLC to file a new application for authority to do business in NJ.^[127] This would be comparable to a foreign LLC authorized to do business in New Jersey converting to a foreign corporation. If the foreign corporation seeks to continue doing business in New Jersey, the amendments to the NJBCA require it to file a new application to do so.^[128]

4. Conversion of Foreign LLC to NJ Entity

a. Domestication of Foreign LLC to NJ LLC

A foreign LLC may become a NJ LLC by domestication^[129] if:

• the foreign LLC’s governing statute authorizes domestication;^[130]
• domestication is not prohibited by the laws of the jurisdiction of the foreign LLC;^[131] and
• the foreign LLC complied with its governing statute in effecting the domestication.^[132]

i. Approval of Members

The members of a foreign LLC would approve domestication to a NJ LLC in accordance with the statutory law governing the foreign LLC.

ii. Plan of Domestication

The plan of domestication is summarized at Section 2(c)(ii).

iii. Articles of Domestication

The articles of domestication to be filed with the NJDORES are summarized at Section 2(c)(iii). The articles must also include a statement that the domestication was approved as required by the statute governing the foreign LLC.^[133]

iv. Effect of Domestication

The effect of a foreign LLC domesticating to a NJ LLC is the same as a foreign corporation converting to a NJ LLC, which is summarized at Section 1(d) in the NJ-RULLCA discussion.^[134]

b. Conversion of Foreign LLC into NJ Corporation

A foreign LLC may convert to a NJ corporation.^[135]

i. Approval by Members

To convert, the foreign LLC must approve a plan of conversion and a certificate of incorporation, which must be approved in accordance with the foreign LLC’s operating agreement and applicable law, as appropriate.^[136]

ii. Plan of Conversion

The plan of conversion should address the terms and conditions of the conversion, including the manner and basis for converting the membership interests of the foreign LLC into cash, property, shares of stock, or other rights or securities of the NJ corporation (or of another NJ entity), or whether they will be cancelled.^[137] As noted, in addition to the certificate of incorporation, the plan of conversion should include the proposed bylaws of the NJ corporation and proposed organizational resolutions appointing directors and officers, and, if applicable, the proposed shareholders agreement.

iii. Certificate of Conversion

Once the members of the foreign LLC approve the plan of conversion, it would file a certificate of conversion and a certificate of incorporation with the NJDORES.^[138] The certificate of conversion must be signed by an authorized person.^[139]

The certificate of conversion must include the following information:

• the date when the LLC was formed;^[140]
• the jurisdiction where the LLC was formed, and, if it has changed, the jurisdiction immediately prior to the conversion to a NJ corporation;^[141]
• the name of the LLC prior to filing the certificate of conversion;^[142]
• the name of the NJ corporation as set forth in the certificate of incorporation to be filed with the certificate of conversion;^[143]
• the future date or time when the conversion will be effective, if not effective upon filing, which future date cannot be more than ninety days after filing;^[144]
• a statement that the plan of conversion was approved in the manner provided in the LLC’s operating agreement and in accordance with applicable law, as appropriate.^[145] (Although the entire statement would be included in the certificate, if there is no operating agreement, then for a NJ LLC the plan of conversion would be in accordance with NJ-RULLCA, which serves as the LLC’s default operating agreement).

c. Conversion of Foreign LLC Authorized to Do Business in NJ to a Foreign Corporation Authorized to Do Business in NJ

If a foreign LLC is authorized to do business in New Jersey and converts to a foreign corporation, the foreign corporation must file with NJDORES a new application for authority to do business in New Jersey.^[146] The application must include:

• the name of the foreign corporation;^[147]
• the jurisdiction where it is incorporated;^[148]
• the name of the foreign LLC that was authorized to do business in New Jersey;^[149]
• the ten-digit business identification number of such foreign LLC;^[150]
• the date of conversion of the foreign LLC to a foreign corporation;^[151]
• the date the foreign LLC was authorized to do business in New Jersey;^[152]
• the address of the principal place of business of the foreign corporation (which the law describes as the main office or headquarters office);^[153]
• the foreign corporation’s registered agent and registered office in New Jersey, and that the registered agent may be served with process against the corporation;^[154]
• the character of the business to be conducted in New Jersey;^[155] and
• a statement that the foreign corporation is authorized to conduct business in its state of incorporation.^[156]

The application must be accompanied by a certificate of good standing (or comparable equivalent) from the jurisdiction of the foreign corporation, which certificate must be issued after the date of conversion and within thirty days of the filing of the application.^[157] Upon filing the application, the NJDORES will issue a new certificate of authority to the new foreign corporation.^[158]

5. Tax Considerations

There are several tax considerations when converting a corporation to an LLC, and vice versa. The following discussion is a mere general summary, and any conversion should be done in consultation with a knowledgeable tax accountant or tax attorney because the tax laws are complex and contain many nuances.

a. Income Tax Consequences^[159]

i. Conversion of LLC to Corporation

An LLC taxed as a partnership (i.e., an LLC with two or more members) or as a disregarded entity (i.e., an LLC with one member) may usually convert to a C corporation on a tax-free basis, assuming compliance with certain requirements in the U.S. Tax Code.^[160]

ii. Conversion of Corporation to LLC

Generally, a corporation converting to an LLC taxed as a partnership (i.e., an LLC with two or more members) or to a disregarded entity (i.e., an LLC with one member) is treated as a taxable liquidation of the corporation. This means that the corporation is treated as having sold its assets to its shareholders for fair market value (“FMV”), followed by the shareholders’ contribution of the assets to the LLC.

1. C Corporations

The liquidation of a C corporation can result in double taxation—a tax paid by the C corporation and a tax paid by its shareholders.

• A C corporation must recognize gain on the liquidating distribution of assets to its shareholders, which is the difference between the FMV of the assets and their adjusted tax basis.^[161]
• Each shareholder recognizes gain equal to the difference between the FMV of the assets deemed to have been received by the shareholder on liquidation on a pro rata basis with the other shareholders and the adjusted tax basis of the shareholder’s shares of stock surrendered to the corporation in exchange for the assets. If the shares of stock have been held for more than one year, the shareholder would recognize a long-term capital gain. If not, the shareholder would have a short-term capital gain (which would effectively be treated as ordinary income).

2. S Corporations

The liquidation of an S corporation does not result in double taxation; instead, the S corporation’s gain passes through to the shareholders.

• An S corporation must recognize gain on the liquidating distribution of assets to its shareholders, which is the difference between the FMV of the assets and their adjusted tax basis.
• However, the S corporation’s gain passes through to the corporation’s shareholders on a pro rata basis and is included on their personal income tax returns. If the assets have been held for more than one year, they would generally recognize a long-term capital gain. If not, they would have a short-term capital gain (which would effectively be treated as ordinary income). However, the gain on certain assets, such as accounts receivable and inventory (as well as depreciation recapture), would be ordinary income regardless of how long they have been held.
• Each shareholder would also recognize gain equal to the difference between the FMV of the assets deemed to have been received on liquidation and the adjusted tax basis of their shares of stock surrendered to the corporation in exchange for the assets, with the shareholder’s tax basis adjusted to reflect the gain between the FMV of the assets and their adjusted tax basis. If the shares of stock have been held for more than one year, the shareholder would recognize a long-term capital gain. If not, the shareholder would have a short-term capital gain (which would effectively be treated as ordinary income).

Further, an S corporation may be required to pay corporate income taxes if it has built-in gains (“BIG”) in its assets. The BIG tax applies to a C corporation that made an S corporation election and liquidates within five years of the election. The rule is intended to discourage a C corporation from electing to be taxed as an S corporation immediately prior to a liquidation to avoid double taxation. The BIG tax is imposed at the highest corporate tax rate (currently a federal tax rate of 21 percent, plus any applicable state and local income taxes) and is triggered by the disposition of any asset the C corporation held at the time it elected to be taxed as an S corporation. Therefore, it does not apply to any assets acquired after the S corporation election.

b. Tax Clearance Certificates

If a NJ corporation merges into a foreign corporation or LLC, which foreign entity will be the surviving entity, the NJ corporation is required to obtain a tax clearance certificate to complete the merger (that is, in order for the NJDORES to file the certificate of merger), unless the foreign entity is authorized to transact business in New Jersey (or will become authorized to transact business by simultaneously filing an application to transact business in New Jersey).^[162]

There is no legal authority on the issue at this time, but it would be logical that a tax clearance certificate would be required when a NJ corporation is converting to a foreign corporation or LLC when the foreign entity will be the surviving entity. In other words, the NJ corporation would need to obtain a tax clearance certificate to complete the conversion (that is, in order for the NJDORES to file the certificate of conversion), unless the foreign entity is authorized to transact business in New Jersey (or will become authorized to transact business by simultaneously filing an application to transact business in New Jersey).^[163]

c. EIN^[164]

For many entities, the entity’s retaining its employer identification number (“EIN”) is critical to the continued success of its business because of the historical data associated with the EIN—for example, an entity’s credit history with customers or vendors. If an entity is required to obtain a new EIN upon conversion, it could lose all of its credit history and goodwill with a customer or vendor and would need to start from scratch.

Therefore, an important issue when considering conversion is determining whether a corporation converting to an LLC, or vice versa, can retain its EIN or if it is required to obtain a new EIN. The starting point for this analysis is IRS Publication 1635 (Rev. 2-2014).^[165] It states that a new EIN is needed if:

• a sole proprietor incorporates, which would be an LLC taxed as a disregarded entity converting to a corporation;
• a partnership incorporates, which would be an LLC taxed as a partnership converting to a corporation; or
• a corporation becomes a partnership or a sole proprietorship, which would be a corporation converting to an LLC taxed as a partnership or an LLC taxed as a disregarded entity. However, a corporation is not required to obtain a new EIN in connection with a corporate reorganization involving only a change of identity, form, or place of organization.^[166]

However, the Treasury regulations have exceptions to these general rules, which can be found in the “check-the-box” regulations. Specifically, Treasury Regulation §301.6109-1(h)(1) provides that any entity that has an EIN will retain that EIN if its federal tax classification changes under Treas. Reg. §301.7701-3.

Another source of authority to support an entity retaining its EIN after a conversion or domestication is the Internal Revenue Manual dated April 14, 2022 (“IRM”). Although it is not legally binding on the IRS, its staff relies on the IRM in handling many procedural issues, including an entity’s retention of its EIN.

As noted, IRS guidance (i.e., Publication 1635) states that a new EIN is required upon conversion, but the IRM provides otherwise. The IRM is not binding on the IRS, so there is some risk in relying on it, but it should be viewed as a calculated risk. The balance of this article’s discussion of the EIN issue should be considered proposed best practices to retain an EIN upon conversion.

i. Corporation Conversion to LLC

If a C corporation converts to an LLC through a state’s conversion statute, the new LLC should be able to retain the corporation’s EIN regardless of whether the LLC will be taxed as a partnership, a C corporation, an S corporation, or a disregarded entity.^[167] The new LLC should submit a letter to the IRS requesting to retain the corporation’s EIN and provide proof of the conversion (e.g., a copy of the filed certificate or articles of conversion).^[168]

When the corporation files its final corporate tax return (Form 1120) and its first partnership tax return (Form 1065), it should attach a copy of the filed certificate or articles of conversion and an explanation that it has converted from a corporation to an LLC and retained the corporation’s EIN.^[169]

ii. LLC Conversion to Corporation

If an LLC converts to a corporation through a state’s conversion statute, the new corporation should be able to retain the LLC’s EIN.^[170] The new corporation should submit a letter to the IRS requesting to retain the LLC’s EIN and provide proof of the conversion.

When the partnership files its final partnership tax return (Form 1065) and its first corporate tax return (Form 1120), it should attach a copy of the filed certificate or articles of conversion and an explanation that it has converted from an LLC to a corporation and retained the LLC’s EIN.

6. Conclusion

As a result of the amendments to the NJBCA, NJ corporations may now convert to NJ LLCs, foreign LLCs, and foreign corporations, and vice versa. As noted, there are some procedural questions, but they should be answered when the NJDORES disseminates official forms and guidance on conversions and domestications and the New Jersey Division of Taxation provides guidance on the tax clearance issue. In the meantime, New Jersey has finally taken a small step in modernizing its statutes.^[171]

1. N.J.S.A. 42:2C-1, et seq. ↑

2. N.J.S.A. 14A:1-1, et seq. ↑

3. NJ-RULLCA uses the term “organization,” but to be consistent with the new amendments to the NJBCA, this article uses the term “entity.” ↑

4. N.J.S.A. 42:2C-78(a). The exclusion of foreign LLCs is because a change from a NJ LLC to a foreign LLC, and vice versa, is a domestication under N.J.S.A. 42:2C-82, and not a conversion under N.J.S.A. 42:2C-78. ↑

5. N.J.S.A. 42:2C-78(a)(1). ↑

6. N.J.S.A. 42:2C-78(a)(2). ↑

7. N.J.S.A. 42:2C-78(a)(3). ↑

8. N.J.S.A. 14A:11A-2(2). The new law also allows a NJ corporation to convert to other forms of entity, such as general partnerships and limited partnerships. N.J.S.A. 14A:11A-2(2) & (1) (definition of “other entity”). However, a corporation will not be able to convert to a NJ general partnership or NJ limited partnership until the New Jersey Uniform Partnership Act, N.J.S.A. 42:1A-1, et seq., and the New Jersey Uniform Limited Partnership Law, N.J.S.A. 42:2A-1, et seq., are amended to authorize such conversions. Such legislation has been pending in the New Jersey Legislature for a decade. The current bills, S134 and A3831, have not yet worked their way through the legislative process. ↑

9. N.J.S.A. 14A:11A-2(3). ↑

10. N.J.S.A. 14A:11A-2(3). ↑

11. N.J.S.A. 14A:11A-2(3). ↑

12. By comparison, a merger of a NJ corporation into an LLC requires only the affirmative approval of a majority of the votes cast by shareholders holding the shares entitled to vote. N.J.S.A. 14A:10-3(1)(b)(2). For NJ corporations organized prior to January 1, 1969, two-thirds approval is required. Id. Therefore, there may be situations where it will be easier to merge a NJ corporation into an LLC than to convert it to an LLC. Where unanimous approval of all voting and non-voting shareholders is questionable, practitioners may continue to use the alternative of merging a NJ corporation into an LLC. ↑

13. N.J.S.A. 14A:11A-2(3), last sentence. ↑

14. See N.J.S.A. 14A:11A-1 & -2. ↑

15. N.J.S.A. 42:2C-78(b)(1). ↑

16. N.J.S.A. 42:2C-78(b)(1). ↑

17. N.J.S.A. 42:2C-78(b)(2). ↑

18. N.J.S.A. 42:2C-78(b)(2). ↑

19. N.J.S.A. 42:2C-78(b)(3). See also N.J.S.A. 14A:11A-2(9). ↑

20. N.J.S.A. 42:2C-78(b)(4). A NJ corporation converting to a NJ LLC may decide not to have a written operating agreement and instead rely on the default provisions in NJ-RULLCA. See N.J.S.A. 42:2C-11(2). This would be a poor decision, especially for a NJ LLC that will have two or more members, because the default provisions include surprises for the unwary (e.g., members having equal distribution and voting rights regardless of their capital contributions and ownership percentages). See N.J.S.A. 42:2C-34(a) & -37(b)(2). See also Gianfranco A. Pietrafesa, “An Operating Agreement is Essential under RULLCA,” 210 N.J.L.J. 664 (November 19, 2012). ↑

21. N.J.S.A. 14A:11A-2(4). ↑

22. N.J.S.A. 14A:11A-2(4)(a). ↑

23. N.J.S.A. 14A:11A-2(4)(a). ↑

24. N.J.S.A. 14A:11A-2(4)(b). ↑

25. N.J.S.A. 14A:11A-2(4)(c). ↑

26. See N.J.S.A. 42:2C-80 (specifically N.J.S.A. 42:2C-80(a)(2), discussed infra). ↑

27. N.J.S.A. 42:2C-80(a)(2). ↑

28. N.J.S.A. 42:2C-80(a)(2)(a). ↑

29. N.J.S.A. 42:2C-80(a)(2)(b). ↑

30. N.J.S.A. 42:2C-80(a)(2)(b). ↑

31. N.J.S.A. 42:2C-80(a)(2)(b). ↑

32. N.J.S.A. 42:2C-80(a)(2)(c). ↑

33. A NJ corporation seeking to convert or domesticate to a foreign entity will also need to comply with the specific requirements in the statute governing the foreign entity, which requirements are beyond the scope of this article. ↑

34. N.J.S.A. 14A:11A-2(5)(a). ↑

35. N.J.S.A. 14A:11A-2(5)(b). ↑

36. N.J.S.A. 14A:11A-2(5)(c). ↑

37. N.J.S.A. 14A:11A-2(5)(c). ↑

38. N.J.S.A. 14A:11A-2(5)(d). ↑

39. N.J.S.A. 14A:11A-2(5)(e). ↑

40. N.J.S.A. 14A:11A-2(5)(f). This statement is fine for a foreign corporation, but how and why would a foreign LLC comply with the NJBCA? The term “applicable law of this State” should have been used instead of “this act.” For foreign LLCs, this applicable law would be NJ-RULLCA, and a foreign LLC that intends to transact business in New Jersey must apply to do business in New Jersey. See N.J.S.A. 42:2C-58 (application of authority to do business in NJ). By analogy, see the discussion in this article at Section 4(c) concerning a foreign LLC (which is authorized to do business in New Jersey) converting to a foreign corporation, which would be required to file a new application for authority to do business in New Jersey. ↑

41. N.J.S.A. 14A:11A-2(5)(f)(i). ↑

42. N.J.S.A. 14A:11A-2(5)(f)(ii). ↑

43. N.J.S.A. 14A:11A-2(5)(f)(ii). ↑

44. N.J.S.A. 14A:11A-2(2) & (1) (definition of “other entity” includes foreign corporations). ↑

45. Apparently, the amendments to the NJBCA are based on Delaware law and, therefore, like Delaware law, do not use the term “domestication.” See note 91, infra, for a discussion of nomenclature. ↑

46. N.J.S.A. 14A:11A-2(10) & 14A:11A-2(7). ↑

47. N.J.S.A. 14A:11A-2(10); N.J.S.A. 42:2C-81(a). ↑

48. A secured party should file an amendment to a financing statement to reflect the change of name of the debtor and/or the change of its state of organization after a redomestication to another state. ↑

49. N.J.S.A. 14A:11A-2(10). ↑

50. N.J.S.A. 42:2C-81(b)(1). ↑

51. N.J.S.A. 42:2C-81(b)(2). ↑

52. N.J.S.A. 42:2C-81(b)(3). ↑

53. N.J.S.A. 42:2C-81(b)(4). ↑

54. N.J.S.A. 42:2C-81(b)(5). ↑

55. N.J.S.A. 14A:11A-2(8); N.J.S.A. 42:2C-81(b)(6). ↑

56. N.J.S.A. 14A:11A-2(8). ↑

57. N.J.S.A. 14A:11A-2(7). ↑

58. N.J.S.A. 14A:11A-1(2) & (1) (definition of “other entity” includes a NJ LLC); N.J.S.A. 42:2C-78(a). NJ-RULLCA and the amendments to the NJBCA also allow other entities, such as general partnerships and limited partnerships, to convert to a NJ LLC or a NJ corporation, or vice versa. However, as noted in note 8, supra, a NJ general partnership or a NJ limited partnership will not be able to convert to a NJ LLC or a NJ corporation, or vice versa, until the New Jersey Uniform Partnership Act and the New Jersey Uniform Limited Partnership Law are amended to authorize conversions. ↑

59. N.J.S.A. 42:2C-78(b); N.J.S.A. 14A:11A-1(3). ↑

60. N.J.S.A. 42:2C-79(a). ↑

61. N.J.S.A. 42:2C-86(a). See also N.J.S.A. 42:2C-11(c)(10) & -86(b). ↑

62. N.J.S.A. 42:2C-37(c)(4)(b). ↑

63. N.J.S.A. 42:2C-78(b)(1). ↑

64. N.J.S.A. 42:2C-78(b)(1). ↑

65. N.J.S.A. 42:2C-78(b)(2). ↑

66. N.J.S.A. 42:2C-78(b)(2). ↑

67. N.J.S.A. 42:2C-78(b)(3). See also N.J.S.A. 14A:11A-1(11). Other than stating that a plan of conversion must be approved by the entity being converted (e.g., the NJ LLC), the amendments to the NJBCA do not specify the contents of the plan. See N.J.S.A. 14A:11A-1. ↑

68. N.J.S.A. 42:2C-78(b)(4). ↑

69. N.J.S.A. 42:2C-80(a)(1); N.J.S.A. 14A:11A-1(4)(a). ↑

70. N.J.S.A. 14A:11A-1(10); N.J.S.A. 42:2C-80(a)(1) & 42:2C-20(a)(1). It is unknown why the committee that reviewed, drafted, and advocated for the adoption of NJ-RULLCA did not change the word “articles” to “certificate” to conform to the nomenclature typically used in New Jersey. ↑

71. N.J.S.A. 42:2C-80(a)(1)(a). ↑

72. N.J.S.A. 42:2C-80(a)(1)(b). ↑

73. N.J.S.A. 42:2C-80(a)(1)(b). ↑

74. N.J.S.A. 42:2C-80(a)(1)(c). ↑

75. N.J.S.A. 42:2C-80(a)(1)(d). ↑

76. N.J.S.A. 42:2C-80(a)(1)(e). ↑

77. N.J.S.A. 14A:11A-1(5)(a). ↑

78. N.J.S.A. 14A:11A-1(5)(a). ↑

79. N.J.S.A. 14A:11A-1(5)(b). ↑

80. N.J.S.A. 14A:11A-1(5)(c). ↑

81. N.J.S.A. 14A:11A-1(5)(d). ↑

82. N.J.S.A. 14A:11A-1(5)(e). ↑

83. See https://www.nj.gov/treasury/revenue. ↑

84. N.J.S.A. 14A:11A-1(4)(b). See N.J.S.A. 14A:1-6. ↑

85. N.J.S.A. 14A:1-6(2). ↑

86. See N.J.S.A. 14A:2-6(1). ↑

87. N.J.S.A. 42:2C-78(a). ↑

88. N.J.S.A. 42:2C-80(a)(1)(f). ↑

89. N.J.S.A. 42:2C-81(c). ↑

90. N.J.S.A. 42:2C-81(c). ↑

91. N.J.S.A. 42:2C-82(b)(1). Note that some jurisdictions do not use the term “domestication”; instead, they use the term “conversion.” For example, Delaware allows the conversion of a foreign LLC to a DE LLC, and vice versa. DE Title 6, §18-214(a) & §18-216(a). Likewise, it allows the conversion of a foreign corporation to a DE corporation, and vice versa. DE Title 8, §265(a) & §266(a). Therefore, going from a NJ LLC to a DE LLC, or vice versa, would be a “domestication” in NJ and a “conversion” in DE. Notwithstanding the different nomenclature in the statutes, the legal effect is the same. ↑

92. N.J.S.A. 42:2C-82(b)(2). ↑

93. N.J.S.A. 42:2C-82(b)(3). ↑

94. N.J.S.A. 42:2C-83(a)(1) ↑

95. N.J.S.A. 42:2C-86(a). See also N.J.S.A. 42:2C-11(c)(10) & -86(b). ↑

96. N.J.S.A. 42:2C-37(c)(4)(b). ↑

97. N.J.S.A. 42:2C-82(c)(1). ↑

98. N.J.S.A. 42:2C-82(c)(2). ↑

99. N.J.S.A. 42:2C-82(c)(3). ↑

100. See N.J.S.A. 42:2C-82(c)(3). ↑

101. N.J.S.A. 42:2C-82(c)(4). ↑

102. N.J.S.A. 42:2C-84(a)(1). ↑

103. N.J.S.A. 42:2C-84(a)(2). ↑

104. N.J.S.A. 42:2C-84(a)(3). ↑

105. N.J.S.A. 42:2C-84(a)(3). ↑

106. N.J.S.A. 42:2C-84(a)(4). ↑

107. N.J.S.A. 42:2C-84(a)(5). ↑

108. N.J.S.A. 42:2C-84(a)(7). ↑

109. N.J.S.A. 42:2C-85(b). ↑

110. N.J.S.A. 42:2C-85(b). ↑

111. N.J.S.A. 42:2C-85(c)(1). ↑

112. N.J.S.A. 42:2C-85(c)(2). ↑

113. N.J.S.A. 42:2C-85(c)(3). ↑

114. N.J.S.A. 42:2C-85(c)(4). ↑

115. N.J.S.A. 14A:11A-1(6). ↑

116. N.J.S.A. 14A:11A-1(6). ↑

117. N.J.S.A. 14A:11A-1(7). ↑

118. As noted, a secured party should file an amendment to a financing statement to reflect the change of name of the debtor and/or the change of its state of organization after a redomestication to another state. ↑

119. N.J.S.A. 14A:11A-1(8). ↑

120. Compare N.J.S.A. 42:2C-85(a) with N.J.S.A. 42:2C-81(a) & (b). ↑

121. N.J.S.A. 14A:11A-1(7). ↑

122. N.J.S.A. 14A:11A-1(9). ↑

123. N.J.S.A. 42:2C-78(a)(1). ↑

124. N.J.S.A. 42:2C-78(a)(2). ↑

125. N.J.S.A. 42:2C-78(a)(3). ↑

126. N.J.S.A. 14A:11A-1(2) & (1) (definition of “other entity” includes foreign corporations). ↑

127. See N.J.S.A. 42:2C-58 & -60. ↑

128. See N.J.S.A. 14A:13.6-1 (discussed at Section 4(c) infra). ↑

129. As noted, the governing statute of a foreign LLC may use a different nomenclature (e.g., Delaware uses the term “conversion” for domestications), but it still authorizes a change of an LLC from one state to another (e.g., a DE LLC to a NJ LLC, or vice versa). ↑

130. N.J.S.A. 42:2C-82(a)(1). ↑

131. N.J.S.A. 42:2C-82(a)(2). ↑

132. N.J.S.A. 42:2C-82(a)(3). ↑

133. N.J.S.A. 42:2C-84(a)(6). ↑

134. Compare N.J.S.A. 42:2C-85(a) with N.J.S.A. 42:2C-81(a) & (b). ↑

135. N.J.S.A. 14A:11A-1(2) & (1) (definition of “other entity” includes a foreign LLC). ↑

136. N.J.S.A. 14A:11A-1(3). ↑

137. N.J.S.A. 14A:11A-1(11). ↑

138. N.J.S.A. 14A:11A-1(4)(a). ↑

139. N.J.S.A. 14A:11A-1(10). ↑

140. N.J.S.A. 14A:11A-1(5)(a). ↑

141. N.J.S.A. 14A:11A-1(5)(a). ↑

142. N.J.S.A. 14A:11A-1(5)(b). ↑

143. N.J.S.A. 14A:11A-1(5)(c). ↑

144. N.J.S.A. 14A:11A-1(5)(d). ↑

145. N.J.S.A. 14A:11A-1(5)(e). ↑

146. N.J.S.A. 14A:13-6.1(1). ↑

147. N.J.S.A. 14A:13-6.1(1)(a). ↑

148. N.J.S.A. 14A:13-6.1(1)(a). ↑

149. N.J.S.A. 14A:13-6.1(1)(b). ↑

150. N.J.S.A. 14A:13-6.1(1)(c). ↑

151. N.J.S.A. 14A:13-6.1(1)(d). ↑

152. N.J.S.A. 14A:13-6.1(1)(e). ↑

153. N.J.S.A. 14A:13-6.1(1)(f). ↑

154. N.J.S.A. 14A:13-6.1(1)(g). ↑

155. N.J.S.A. 14A:13-6.1(1)(h). ↑

156. N.J.S.A. 14A:13-6.1(1)(h). ↑

157. N.J.S.A. 14A:13-6.1(2). ↑

158. N.J.S.A. 14A:13-6.1(3). ↑

159. The author would like to thank Gordon F. Moore, Esq. of Archer & Greiner, P.C. for his comments to this Section 5(a) of the article. Any errors are the author’s sole responsibility. ↑

160. Such requirements are beyond the scope of this article. ↑

161. This article ignores the possibility of a loss on a conversion. ↑

162. See N.J.S.A. 54:50-13. See also NJDORES FAQ at https://www.njportal.com/DOR/BusinessAmendments/Home/FAQ#umc80. ↑

163. See, e.g., N.J.S.A. 54:50-13. ↑

164. The author would like to thank Jason Zoranski, Esq. of Archer & Greiner, P.C. for his research on the EIN issue and his comments to this Section 5(c) of the article. Any errors are the author’s sole responsibility. ↑

165. IRS Publication 1635 can be found online at https://www.irs.gov/pub/irs-pdf/p1635.pdf. ↑

166. A conversion of a corporation to an LLC, which elects to be taxed as a C corporation (i.e., an F Reorganization), or a domestication of a corporation from one state to another, could be a corporate reorganization, but the language is not clear. ↑

167. See IRM 3.13.2.26. ↑

168. If the new LLC wants to make a “check-the-box” election to be taxed as a C corporation instead of being taxed under the default classification (e.g., as a partnership for an LLC with two or more members), then it would file Form 8832 (Entity Classification Election) with proof of the conversion. ↑

169. The conversion of a corporation to an LLC should qualify as an F reorganization pursuant to Internal Revenue Code Section 368(a)(1)(F). Under this alternative, the LLC would file Form 1120 (U.S. Corporation Income Tax Return) for the year of conversion and attach an F reorganization statement pursuant to Treasury Regulation Section 1.368-3 with the tax return. ↑

170. See IRM 3.13.2.26. ↑

171. The author would like to thank Gordon F. Moore, Esq. and Shamila R. Ahmed, Esq., both of Archer & Greiner, P.C., for their comments to this article. Any errors are the author’s sole responsibility. ↑

Federal regulators have signaled that they will be scrutinizing companies that rely on artificial intelligence (“AI”), including in consumer financial services,^[1] to ensure their compliance with existing laws.^[2] Last year, the Consumer Financial Protection Bureau (“CFPB”) issued interpretive guidance stating that companies that rely on “complex algorithms” to make lending decisions must nonetheless adhere to the requirement of the Equal Credit Opportunity Act (“ECOA”) to provide notice to credit applicants of the specific reasons they were declined credit.^[3] That advisory opinion was in turn followed by a September 2023 circular instructing that creditors that use AI in their underwriting models may not rely on the CFPB’s model adverse action notice forms if the specific and accurate principal reasons for the action are not captured by those forms.^[4] The ECOA, as implemented by Regulation B,^[5] is not the only federal consumer finance law requiring a creditor to notify consumers in certain circumstances when it takes adverse action against them. The Fair Credit Reporting Act (“FCRA”), as implemented by Regulation V,^[6] likewise contains an adverse action notice requirement.

The adverse action notice requirements under each statute apply in different contexts: the ECOA applies to creditors, and notice must be provided to applicants for extensions of credit where a creditor takes action that negatively impacts the applicant; the FCRA’s requirement extends more broadly to anyone who takes an adverse action against a consumer on the basis of information pertaining to that consumer’s creditworthiness in contexts ranging from transactions for insurance to applications for employment or housing. The adverse action notice requirements of both statutes dovetail, however, when a creditor denies a consumer an application for credit.

To comply with both statutes’ notice requirements, a creditor must understand both the sources of information upon which the credit decision relies and the manner in which those sources and any other factors are assessed to justify the adverse action. Where that decision is made by AI, a lack of clarity about the model’s design and functions may heighten regulatory concerns about a creditor’s ability to provide compliant adverse action notices and could expose a creditor to litigation and enforcement risk. Creditors should therefore design and employ AI models that are explainable in a manner that is sufficient to satisfy their adverse action notice obligations under both the ECOA and the FCRA.

Adverse Action Defined

The ECOA

makes it unlawful for any creditor to discriminate against any applicant . . . on the basis of race, color, religion, national origin, sex or marital status, age (provided the applicant has capacity to contract), [use of public assistance programs], or because the applicant has [exercised rights] under the Consumer Credit Protection Act.^[7]

The ECOA defines adverse action as a denial of credit in the amount or terms requested by an applicant, absent a counteroffer, or an account termination or unfavorable alteration to account terms.^[8]

The FCRA governs consumer credit report records access and is intended to encourage accuracy, fairness, and the protection of personal information assembled by credit reporting agencies (“CRAs”).^[9] As it applies to creditors, the FCRA defines adverse action as coextensive with the ECOA’s definition under section 701(d)(6)^[10] of that statute. It also includes an action that is taken on an application or transaction initiated by a consumer or affiliated with an account review and that is adverse to the interests of the consumer.^[11] A creditor must provide an FCRA adverse action notice when it takes an adverse action based on information that was (1) in a consumer report;^[12] (2) obtained from non-consumer-reporting-agency third parties addressing the creditworthiness, character, personal characteristics, or other similar traits of an applicant;^[13] or (3) provided by a corporate affiliate of the creditor.^[14]

Since these rules differ, an adverse notice may be necessary under one or both statutes, depending upon the circumstances. Financial institutions can include the disclosures required under both the ECOA and the FCRA in one adverse action notice if both notices are required. For example, both statutes may require a financial institution to provide an adverse action notice when an adverse credit decision is based on either a consumer credit report or information obtained through a non-CRA third party. The FCRA does not impose deadlines to provide adverse action notices, but Regulation B of the ECOA requires notice to be provided within thirty to ninety days, depending on the nature of the adverse action. Thus, combined notices usually adhere to the timing requirements in the ECOA.^[15]

Adverse Action Notice Requirements

ECOA

ECOA adverse action notices must be in writing and contain (1) a statement of the action taken; (2) the name and address of the creditor; (3) a statement of the relevant provisions of section 701(a) of the act; and (4) the name and address of the federal agency that oversees the creditor’s compliance.^[16]

The written notification must also include either the reasons for action taken (i.e., “a statement of reasons”) or disclosure of the applicant’s right to a statement of reasons and instructions for obtaining one. Statements of reasons must be specific and articulate the principal reasons behind any adverse action,^[17] although the relationship between those reasons and the credit denial does not necessarily need to be clear to the applicant.^[18] According to 12 C.F.R. part 1002.9(b)(2), statements that the adverse action occurred due to the internal standards of the creditor or that the applicant failed to achieve a qualifying score pursuant to the credit scoring system of the creditor are insufficient.^[19] Courts have held that statements of reasons must be detailed enough to be informative.^[20]

FCRA

The contents of an adverse action notice under the FCRA vary depending on the sources of information used to make a decision adverse to a consumer’s interests:

• A creditor that takes adverse action based on information in a consumer report is required to, among other things, provide the consumer with oral, written, or electronic notice of the action.^[21] If a credit score factored into the adverse decision, the creditor is required to provide written or electronic notice of the credit score and also provide other information about the credit score, including the range of possible credit scores, factors that adversely affected the consumer’s credit score, the date on which the score was created, and the name of the person or entity that provided the credit score or file upon which it was created.^[22]
• A creditor that takes adverse action based on information from third parties other than CRAs regarding such factors as creditworthiness, credit standing, credit capacity, character, or other factors must disclose upon request the nature of the information used to reach the adverse action.^[23] The “nature of the information” refers to the type of information but not necessarily the source on which the creditor relied.^[24]
• A creditor that takes adverse action based upon information provided by one of its corporate affiliates must disclose upon request the nature of the information, except for any information solely related to experiences between the consumer and the affiliate that furnished the information.^[25] The standard appears to be less specific and prescriptive than that of the ECOA.

Implications of AI Decision-Making for Adverse Action Notifications

There are clear benefits to using complex algorithms, including AI or machine learning, in consumer credit decisions. AI has the potential to grow access to credit by enabling financial institutions to evaluate the creditworthiness of applicants who might otherwise be impossible to assess using traditional methods because AI can allow creditors to consider more information about credit applicants than is otherwise possible. Such technology could also lead to more efficient, informed, equitable decisions and even lower the cost of credit.^[26]

Notwithstanding those potential benefits, AI models in which inputs or outputs lack transparency or are not explainable may pose regulatory risks to creditors. The CFPB has, for example, signaled that a “creditor cannot justify noncompliance with the ECOA and Regulation B’s [adverse action] requirements based on the mere fact that the technology it employs is too complicated or opaque to understand.”^[27] Use of an AI model likely poses similar risks to a creditor’s compliance with the FCRA’s adverse action requirements, which require the creditor to be able to identify the nature of the information used (outside of a consumer report) to assess an applicant’s creditworthiness.

As the Official Interpretations to Regulation B make clear, however, disclosure of information sufficient to satisfy one statute’s adverse action notice requirements does not necessarily establish compliance with the other’s.^[28] As previously noted, courts in particular appear to scrutinize the quality and content of the statement of reasons for adverse action under the ECOA much more carefully than they do the sources of information required to be disclosed in an adverse action notice under the FCRA.

To comply with both statutes, therefore, a creditor must be able to identify inputs to an AI and understand how those inputs were used to arrive at the model’s result. Implementing appropriate governance around the use of these models, including documentation of design choices and updates, testing to improve transparency and explainability, and legal and/or compliance oversight of the adverse action notices, will help reduce regulatory risks.^[29]

In addition, where such models are built by third-party vendors, creditors should consider revising their contracts to allow for a creditor’s precontractual diligence and vetting of those models^[30] to ensure that the creditor is able to comply with these regulatory obligations. Moreover, for those creditors subject to the authority of the Federal Deposit Insurance Corporation (“FDIC”), Board of Governors of the Federal Reserve (“FRB”), or the Office of the Comptroller of the Currency (“OCC”), care should be taken to ensure that any third-party relationships adhere to the recent Interagency Guidance on Third-Party Relationships: Risk Management.

The authors wish to thank summer associate Lauren Burns for her assistance.

1. Chatbots in Consumer Finance, Consumer Fin. Prot. Bureau (June 6, 2023). ↑

2. Rohit Chopra, Dir., Consumer Fin. Prot. Bureau, et al., Joint Statement on Enforcement Efforts Against Discrimination and Bias in Automated Systems (2023). ↑

3. Consumer Financial Protection Circular 2022-03, Consumer Fin. Prot. Bureau (2022). ↑

4. Consumer Financial Protection Circular 2023-03, Consumer Fin. Prot. Bureau (2023). ↑

5. 15 U.S.C. § 1691 et seq.; 12 C.F.R. pt. 1002. ↑

6. 15 U.S.C. § 1681 et seq.; 12 C.F.R. pt. 1022. ↑

7. 15 U.S.C. § 1961(a). ↑

8. 12 C.F.R. § 1002.2(c)(1). ↑

9. U.S. Dep’t of Just., Fair Credit Reporting Act (last visited Sept. 22, 2023). ↑

10. 15 U.S.C. § 1691(d)(6). ↑

11. Id. § 1681a(k)(1). ↑

12. Id. § 1681m(a). ↑

13. Id. § 1681m(b)(1). ↑

14. Id. § 1681m(b)(2). ↑

15. See Sarah Ammermann, Adverse Action Notice Requirements Under the ECOA and the FCRA, Consumer Compliance Outlook (2013). ↑

16. 12 C.F.R. pt. 1002.9(a)(2). ↑

17. 15 U.S.C. § 1691(d)(3); 12 C.F.R. pt. 1002.9(b)(2). ↑

18. 12 C.F.R. pt. 1002 (Supp. I), sec. 1002.9, para. 9(b)(2)-4 (providing, as an example, that the “age of automobile” must be disclosed if it was an actual reason for the denial, even if it is not apparent to an applicant why the vehicle’s age matters). ↑

19. For a sample list of specific reasons for credit denial, see Federal Banking Law Reporter ¶ 64-519 (Adverse Action and Other Notices) (2019). ↑

20. Compare Fischl v. Gen. Motors Acceptance Corp., 708 F.2d 143, 146–48 (5th Cir. 1983) (finding that “credit references are insufficient” was not an adequate statement of reasons because it did not “signal the nature of the deficiency”), with Carr v. Cap. One Bank (USA) N.A., No. 1:21-CV-2300-AT-JKL, 2021 WL 8998918, at *7–8 (N.D. Ga. Dec. 8, 2021) (upholding “adverse past or present legal action” as a sufficient statement of reasons and rejecting plaintiff’s request for more detail on the legal action). ↑

21. 15 U.S.C. § 1681m(a)(1). ↑

22. Id. §§ 1681m(a)(2), 1681g(f)(1). ↑

23. Id. § 1681m(b)(1). ↑

24. See Barnes v. DiTech.com, No. 03-CV-6471, 2005 WL 913090, at *5 (E.D. Pa. Apr. 19, 2005) (holding that disclosure of inadequate cash reserves as the reason for an adverse action was sufficient and finding that defendant was not required to identify the source of this information). ↑

25. 15 U.S.C. §§ 1681m(b)(2)(A)(ii), 1681m(b)(2)(C)(ii). ↑

26. See, e.g., Patrice Alexander Ficklin, Tom Pahl & Paul Watkins, Innovation Spotlight: Providing Adverse Action Notices When Using AI/ML Models, Consumer Fin. Prot. Bureau (July 7, 2020); Andrew Johnson, Revolutionizing Credit Assessment: The Power of Artificial Intelligence, Medium (May 22, 2023); Deepak H. Saluja, Artificial Intelligence: Why AI Has the Power to Revolutionize the Digital Lending Industry, Medium (Apr. 3, 2023); Dominique Williams, Problem Solved?: Is the Fintech Era Uprooting Decades Long Discriminatory Lending Practices?, 23 Tul. J. Tech. & Intell. Prop. 159 (2021) (notifying consumers of adverse credit decisions involving AI). ↑

27. See Consumer Fin. Prot. Circular 2022-03, supra note 3 (adverse action notification requirements in connection with credit decisions based on complex algorithms). ↑

28. See Official Interpretations, 12 C.F.R. 1002.9(b)(2)-9 (“Disclosing that a credit report was obtained and used, as the FCRA requires, does not satisfy the ECOA requirement to disclose specific reasons.”). ↑

29. See Avi Gesser et al., The Value of Having AI Governance—Lessons from ChatGPT, Debevoise & Plimpton (Apr. 5, 2023). ↑

30. See Avi Gesser et al., The Top Eight AI Adoption Failures and How to Avoid Them, Debevoise & Plimpton (June 14, 2023). ↑

The Complications Involved with Cross-Border Restructuring

Cross-border restructurings often present a variety of challenging issues, not only for the entity involved, but also for the practitioners engaged to steer the process. This is often due to circumstances where the jurisdiction of incorporation of the company in financial difficulty does not have an efficient or sophisticated restructuring regime in place. It is standard practice for these companies to look to other jurisdictions for a clearer path forward or to seek to utilize parallel processes, such as (i) commencing Chapter 11 or Chapter 15 proceedings in the US bankruptcy courts or (ii) using one of many restructuring tools available in England—provided the company can demonstrate it has a sufficient connection to England. However, it is clear that utilizing these US- or UK-based restructuring alternatives is not always appropriate. For example, it may be difficult to establish the nexus to the relevant jurisdiction, or there may be adverse tax consequences associated with the proposal.

Cayman Schemes of Arrangement

A Cayman Islands scheme of arrangement is a court-supervised process that allows for the rights of creditors or members to be varied by forcing the relevant non-consenting creditors and/or members into the compromise or arrangement. Although often used for financial restructuring involving external debt, a Cayman Islands scheme of arrangement is a flexible tool and can also be utilized to facilitate (i) intra-group restructurings and reorganizations, (ii) mergers, or (iii) take-private transactions. Helpfully, a scheme can also be used to implement a “pre-pack,” where all the stakeholders involved in the process agree on the key terms of the restructuring proposal.

That said, a scheme is not a formal insolvency process, and, in the absence of liquidation proceedings, the directors remain in control of the company while negotiating the terms of and promoting a scheme to stakeholders. Importantly, with respect to the Cayman Islands, a scheme of arrangement utilized outside of a formal insolvency process would not be able to benefit from the automatic stay from unsecured creditor claims that a liquidation or restructuring officer procedure offers. However, it can be utilized either with or without a court-imposed moratorium.

Recent amendments to the Cayman Islands Companies Act (As Revised) abolished the “headcount test” for member’s schemes so that approval only requires an affirmative vote of 75 percent in value. The “headcount test” still applies to creditor schemes of arrangement, meaning that the approval threshold is a majority in number representing 75 percent in value of the creditors or class of creditors (as the case may be) who are present and voting either in person or by proxy at the relevant creditors’ meeting.

The Scheme Objective

The relevant Cayman Islands statutory framework broadly reflects the regime in England (and in other Commonwealth jurisdictions such as Canada and Australia). The Cayman court’s jurisdiction is broad, and in addition to effecting a scheme in relation to any company that is liable to be wound up in the Cayman Islands, it is possible to shift a company’s center of main interests to the Cayman Islands in order to ground that jurisdiction in appropriate circumstances.

The objective of a scheme of arrangement Is to allow the company to enter into an agreement with its members and/or creditors (or any class of them) to either:

1. restructure its affairs so that it can continue to trade and avoid a liquidation process; and/or
2. reach a compromise or arrangement with creditors or members (or any class of them).

In assessing a scheme, the Cayman court will consider the interests of the relevant class of creditor or member and seek to ascertain whether the class as a whole will benefit from the proposal. Whether such benefit is sufficient is a commercial matter for the creditors or members to approve, and the Cayman court will not generally seek to interfere with that part of the process. Accordingly, so long as the requisite statutory majority (discussed below) of each class of creditors or members (as appropriate) supports the scheme, all creditors or members will be bound by it and forced to accept its terms irrespective of whether they voted in favor of the proposal or not.

Dissenting Stakeholders

A Cayman Islands scheme requires the approval of each class of affected stakeholder in order for the scheme to ultimately be sanctioned by the Cayman court. The threshold approval requirement is prescribed by statute, which provides that at least 75 percent in value of those voting, in person or by proxy, need to vote in favor of and approve the terms of the proposed scheme. So, while the level of consent for a Cayman Islands scheme is higher than that required to approve a plan of reorganization in Chapter 11 proceedings, the scheme remains an effective company restructuring and rescue tool, especially when used in conjunction with parallel US proceedings.

Adding to the above, unlike in Chapter 11 proceedings, where a plan can sometimes be confirmed in circumstances where there is a non-accepting class of stakeholder (subject to certain controls, such as the “absolute priority rule”), if any class of stakeholder that would be affected by a proposed Cayman Islands scheme does not approve the terms under which the scheme proposes the restructure, then the scheme as a whole will not be able to be sanctioned by the Cayman court and will fail. That said, subject to the circumstances of the restructure, it may be that the scheme class composition can be structured to avoid this situation derailing the proposal.

All stakeholders affected by a scheme, including those who oppose the proposal, have the right to attend the sanction hearing and have their objections to the scheme heard by the Cayman court. As noted above, the Cayman court will be reluctant to tamper with or take a view on the commercial aspects of a proposal. Therefore, although the sanction hearing provides a forum for open opposition to a proposed scheme, provided the scheme procedures have been followed and the requisite statutory majorities have been achieved at the scheme meeting, the Cayman court is likely to consider that the affected stakeholders are the best judges of their own commercial interests and will, except in very specific circumstances, ordinarily approve the scheme.

Restructuring Officer

Recent amendments to Part V of the Cayman Islands Companies Act (As Revised) have been introduced to implement a new restructuring officer regime available to companies in financial difficulty. Under the new regime, it is now possible to petition the Cayman court to appoint “restructuring officers” and, from the time of filing, for the company to take the benefit of an automatic moratorium (akin to a US Chapter 11 stay or English administration moratorium). Once initiated, with the benefit of breathing space and expert guidance, the relevant company may endeavor to promote and implement a restructuring (e.g., via a scheme of arrangement, a parallel process in a foreign jurisdiction, or a consensual compromise).

Some key features of the new regime follow.

1. The petition seeking the appointment of a restructuring officer may be presented by the directors of a company: (i) without a shareholder resolution and/or an express power to present a petition in its articles of association; and (ii) without the need to present a winding up petition.
2. The moratorium will arise on presenting the petition seeking the appointment of restructuring officers, rather than from the date of the appointment of officeholders.
3. The powers of restructuring officers will be flexible and will be defined by the terms of the appointment order made by the Cayman court.
4. Secured creditors with security over the whole or part of the assets of the company will still be entitled to enforce their security without the leave of the cayman Court and without reference to the restructuring officers.

Parallel Proceedings

The Cayman Islands restructuring regime, including the use of a Cayman scheme of arrangement, is routinely used to support Chapter 11 proceedings.

This involves a petition to the Cayman court seeking to appoint provisional liquidators or restructuring officers, who are qualified insolvency practitioners. If required, a foreign qualified practitioner can also be appointed jointly with the Cayman Islands provisional liquidators or restructuring officers. As mentioned above, appointing officeholders results in a stay on proceedings brought by unsecured creditors in the Cayman Islands, and this limits the risk of dissenting creditors derailing the main Chapter 11 proceedings.

Where necessary (such as where there is debt not governed by US law), a Cayman Islands scheme of arrangement might be used to compromise the debt of the Cayman Islands debtor to mirror the terms of the Chapter 11 plan. The Cayman court, Cayman insolvency practitioners, and Cayman attorneys are well-versed in dealing with parallel proceedings, which may give rise to issues of comity, conflict of laws, and cooperation.

Utilizing a Cayman Scheme

A restructuring of US law–governed debt ordinarily requires recognition pursuant to US law. Helpfully, a Cayman Islands scheme of arrangement is able to be recognized under Chapter 15 procedures and is likely to be significantly cheaper to implement than the US alternatives. There are now many examples of US bankruptcy courts giving full force and effect to the terms of a Cayman Islands scheme. As noted above, this ultimately prevents dissenting creditors from taking action, seizing US property of the debtor, and attempting to derail liquidation proceedings.

This article is not intended to be a substitute for legal advice or a legal opinion. It deals in broad terms only and is intended to merely provide a brief overview and give general information.

The general rule that lawyers may not accept engagements on behalf of clients that involve conflicts of interest is widely settled. The rule is designed to “assure clients that [a] lawyer’s work will be characterized by loyalty, vigor and confidentiality.”^[1] Although clients affected by a conflict of interest can, under certain circumstances, consent to representation where a conflict is present, some conflicts of interest are deemed “nonconsentable.”^[2] For example, when clients are aligned directly against each other in the same litigation, the institutional interest in the vigorous development of each client’s position renders the conflict nonconsentable.^[3]

American Bar Association (“ABA”) Model Rule of Professional Conduct (“MRPC”) 1.7 provides that a lawyer cannot represent one client in a matter adverse to another unless the lawyer believes that the representation would not adversely affect the relationship with the other client and with both clients in the individual engagements.

Can that standard be met when the underlying cause of action being asserted against the other client is fraud?

A Brief History: Pre-2002 MRPC 1.7, Comment [8]

Before 2002, comment [8] to MRPC 1.7 provided some specificity about the circumstances under which lawyers may—or may not—accept an engagement in which they would advocate in favor of one client against another current client. It stated:

Ordinarily, a lawyer may not act as advocate against a client the lawyer represents in some other matter, even if the other matter is wholly unrelated. However, there are circumstances in which a lawyer may act as advocate against a client. . . . The propriety of concurrent representation can depend on the nature of the litigation. For example, a suit charging fraud entails conflict to a degree not involved in a suit for declaratory judgment concerning statutory interpretation.^[4]

Thus, prior to 2002, under the Model Rules and in those states that had adopted the Model Rules, it generally was considered a disqualifying—or nonwaivable—conflict for an attorney to represent a client in litigation that involved claims of fraud against another current client, even if the two engagements were wholly unrelated to each other.

Accordingly, at that time, courts faced with disqualification motions sometimes considered the nature of the action in determining whether a conflict was “waivable.” Those courts reasoned that the nature of certain types of claims, like fraud claims, necessarily attacked the character of the individual or company and, therefore, made it nearly impossible for an attorney to maintain his or her duty of loyalty to his/her client while asserting such a claim against that client. How, those courts questioned, could an attorney adequately represent the interests of the client in one action while attacking that client’s character on behalf of another client in a separate action?

As one example, in Fisons Corp. v. Atochem North America, Inc., Dechert Price & Rhoads (“Dechert”) served as counsel to Pennwalt Corporation (“Pennwalt”) in connection with trademark disputes and, particularly, the sale of its pharmaceutical group to Fisons Corporation (“Transaction”).^[5] With Pennwalt’s consent, Fisons retained Dechert at the same time to serve as Fisons’s counsel in connection with a trademark dispute concerning two products, Allerest and Alleract. Pennwalt’s consent allowing Dechert to handle the trademark dispute was conditioned on Fisons’s agreement that Dechert could represent Pennwalt in any subsequent litigation between Pennwalt and Fisons relating to the Transaction. A dispute relating to the Transaction arose in which Fisons claimed that Pennwalt/Atochem made fraudulent representations. Dechert entered its appearance for Pennwalt’s successor, Atochem North America, Inc., in the ensuing litigation. Notwithstanding the prior consent, Fisons moved to disqualify Dechert, arguing, in part, that the nature of the litigation precluded consent to the conflict of interest.

The court analyzed the matter utilizing the applicable provisions of the governing New York Code of Professional Responsibility. The relevant provision was Disciplinary Rule (“DR”) 5-105, which stated in pertinent part that “a lawyer may represent multiple clients if it is obvious that he can adequately represent the interest of each and if each consents to the representation after full disclosure of the possible effect of such representation on the exercise of his independent professional judgment on behalf of each.”^[6]

Although the wording of MRPC 1.7 was different, the court looked to it for guidance and found comment [8] of MRPC 1.7 particularly instructive.^[7] The court noted its agreement with the proposition that waivers cannot be secured as to certain causes of action, particularly a fraud claim:

[A] fraud cause of action generally implicates the defendant’s character. . . . [W]hen an attorney asserts charges against his client that attack his client’s character, the attorney’s ability to adequately represent his client in the unrelated action is severely hindered. . . . [I]n this situation, the conflict of interest is heightened to such a degree that disqualification may be mandatory.^[8]

However, the court refined its analysis by stating that this rule is designed to govern situations where the lawyer charges his/her own client with fraud. The court distinguished the case before it from the general rule because Dechert was not charging its own client, Fisons, with fraud. Rather, Dechert was defending a fraud claim—on behalf of one client, brought by another current client represented by other counsel.

Changes in 2002

In 2002, MRPC 1.7 was amended, along with its accompanying commentary, leaving open for debate the issue of whether a conflict triggered by a cause of action for fraud should be subject to consent. Based on recommendations by the American Bar Association Ethics 2000 Commission (“Commission”), the Model Rules were revised to set forth a clear standard for consentability of certain conflicts while specifically providing that some conflicts are not waivable, such as those “prohibited by law.” Comment [8], specifically the sentence about the effect of fraud claims on current client conflicts, was deleted. Although the reporter for the Commission published an Explanation of Changes, the only explanation offered for the changes was that the material is now addressed in comment [6].^[9]

While it is true that the general principles embodied in former comment [8] are captured in comment [6], the suggestion that the specific nature of the claims should be considered when determining whether a particular conflict is waivable is notably absent. While making some minor wording changes, comment [6] added the following pertinent provisions to the prior commentary:

Loyalty to a current client prohibits undertaking representation directly adverse to that client without that client’s informed consent. Thus, absent consent, a lawyer may not act as an advocate in one matter against a person the lawyer represents in some other matter, even when the matters are wholly unrelated. The client as to whom the representation is directly adverse is likely to feel betrayed, and the resulting damage to the client-lawyer relationship is likely to impair the lawyer’s ability to represent the client effectively. In addition, the client on whose behalf the adverse representation is undertaken reasonably may fear that the lawyer will pursue that client’s case less effectively out of deference to the other client. . . . Similarly, a directly adverse conflict may arise when a lawyer is required to cross-examine a client who appears as a witness in a lawsuit involving another client, as when the testimony will be damaging to the client who is represented in the lawsuit. . . .^[10]

The Commission did not reveal any substantive explanation for the decision to remove the specific sentence relating to fraud claims. And, notably, when the Commission wanted to prohibit representation where the conflict was too great—such as representing multiple defendants in a criminal matter—the commentary so states.^[11]

This largely unexplained change in the commentary, coupled with the fact that few courts had expressly addressed this issue, resulted in a profound lack of clarity in this area of conflicts analysis. Notwithstanding the deliberate deletion of the reference to actions involving fraud claims, many professional responsibility counsel continued to advise their firms that current-client conflicts that require a law firm to assert a fraud-based claim on behalf of one client against another client are not waivable.

A recent case, SuperCooler Technologies, Inc. v. Coca-Cola Co., establishes that such advice is outdated. In the author’s view, this court got it right.

Fraud Claim Conflicts Waivable in SuperCooler Technologies, Inc. v. Coca-Cola Co.

In SuperCooler Technologies, the court denied a motion to disqualify the Paul Hastings law firm in a case where a claim of fraud in the inducement was being asserted by Paul Hastings’s lawyers against its client Coca-Cola.^[12]

In 2021, Coca-Cola engaged Paul Hastings in connection with international human rights work. The engagement letter contained a broad advance waiver. Paul Hastings undertook additional work for Coca-Cola that was unrelated to the instant litigation. No new engagement letter was signed.

In March and early April 2023, the lawyers representing SuperCooler in the litigation between SuperCooler and Coca-Cola joined Paul Hastings. They notified Coca-Cola’s counsel of this change in law firm affiliations. Just a few days later, counsel for Coca-Cola notified Paul Hastings that it was not consenting to the law firm’s representation of SuperCooler against it in this matter and filed a motion on April 12, 2023, to disqualify the firm. 

Applying the applicable Florida Rules of Professional Conduct, which are analogous to the ABA Model Rules, the court had no problem concluding that Paul Hastings’s representation of SuperCooler was a conflict of interest under Florida Rule 4-1.7(a)—the interests of Coca-Cola were directly adverse to the interests of SuperCooler in this litigation. Although Coca-Cola argued that the rule violation was the end of the matter, the court continued its analysis under Florida Rule 4-1.7(b), which allows client consent to a representation involving a conflict of interest if the four-part test set forth there is met: the representation is not prohibited by law, the lawyer reasonably believes that the attorney can provide competent and diligent advice to both clients, the representation will not involve the lawyer asserting a position adverse to the other client, and both clients waive the conflict with informed consent. ^[13] (The ABA Model Rule is the same.)^[14]

The court quoted at length from comment [22] to Rule 1.7 of the ABA Model Rules, which addresses the effectiveness of future waivers.^[15] It also relied heavily on comment [6] to Model Rule 1.0, which explains and provides guidance for the term informed consent.^[16] In concluding that Coca-Cola provided informed consent, the court engaged in a fact-sensitive analysis of Paul Hastings’s disclosure.

The engagement letter, the court noted, made clear that Paul Hastings was a large firm, which represented many other clients, including those in the same industry or a related industry, some of whom may have interests that are actually or potentially adverse to Coca-Cola in a wide variety of matters including, specifically, litigation.^[17] The letter also stated that Paul Hastings could represent those clients in matters directly adverse to Coca-Cola.^[18] The waiver did have a limitations clause. First, it stated that Paul Hastings would not represent another client in a matter adverse to Coca-Cola that was substantially related to the work Paul Hastings was doing for Coca-Cola.^[19] Second, the new matter would not prejudice the firm’s effective representation of, and its discharge of its professional responsibilities to, Coca-Cola.^[20] Third, the firm agreed to protect all confidential information and implement ethical walls as necessary.^[21] Fourth, the law firm would obtain informed consent from the other client to waive potential and actual conflicts with respect to the firm’s work for Coca-Cola.^[22] The letter also contained disclosures relating to potential risks, including that the firm could “be less zealous“ in representing Coca-Cola and could use confidential information of Coca-Cola in a manner adverse to its interests.^[23] Finally, the letter suggested that Coca-Cola should seek the advice of independent counsel before agreeing to the waiver.^[24]

The court specifically addressed the argument by Coca-Cola that the disclosure was inadequate because it did not explain that one of Paul Hastings’s other clients might sue Coca-Cola for fraud. The court agreed that allegations of fraud “lobbed by one client against another can influence whether an advanced waiver is effective informed consent.”^[25] Yet, the court found that such allegations constituted just one factor to consider “in the overall informed consent analysis, not a per se prohibition by itself.”^[26]

The court completed its analysis by analyzing whether the disclosure was reasonably adequate. The court noted that Coca-Cola was a sophisticated consumer of legal services.^[27] Indeed, the evidence showed that in the last five years, it had retained more than fifty outside law firms, spending tens of millions of dollars.^[28] Coca-Cola also was represented by independent counsel when it gave its consent to the conflict waiver in the engagement letter.^[29] Given the circumstances, the court held that it was reasonably foreseeable for Coca-Cola to understand that Paul Hastings might appear as counsel against it in litigation and therefore waived the specific conflict in this case.^[30]

Conclusion

The argument that fraud claims cannot be waived is principally supported by the personal nature of such matters. Yet, what could be more “personal” than family law proceedings where, in certain circumstances, one lawyer can represent both the husband and wife with informed consent?^[31] Why should fraud claims be subject to a higher standard? Where there is no prohibition by applicable law, conflicts involving fraud claims should be subject to waiver.

The court evaluated all of the critical factors in reaching its conclusion that the advanced waiver was enforceable:

• the sophistication of the client
• the type of client (a large corporation)
• the quality of the conflicts disclosure and its specificity
• the nature of the claims giving rise to the conflict
• the opportunity to secure independent counsel

These factors offer a well-tested set of criteria that can be used to structure a valid conflict waiver, supported by informed consent, where fraud claims against a current client are involved in a new engagement.

1. Restatement (Third) of the Law Governing Lawyers § 122 cmt. (b) (Am. L. Inst. 2000). ↑

2. Model Rules of Pro. Conduct r. 1.7(b) (Am. Bar Ass’n 2020). ↑

3. Id. r. 1.7(b)(3), cmt. 28; Restatement (Third) of the Law Governing Lawyers § 122, cmt. (g)(i). ↑

4. Model Rules of Pro. Conduct r. 1.7 cmt. 8 (emphasis added). ↑

5. No. 90 Civ. 1080 (JMC), 1990 U.S. Dist. LEXIS 15284 (S.D.N.Y. Nov. 14, 1990). ↑

6. N.Y. Code of Pro. Resp. DR 5-105(C) (2007). ↑

7. Fisons, 1990 U.S. Dist. LEXIS 15284, at *22. ↑

8. Id. at *21–22. ↑

9. Ethics 2000 Comm’n, Model Rule 1.7: Reporter’s Explanation of Changes. ↑

10. Model Rules of Pro. Conduct r. 1.7 cmt. 6 (Am. Bar Ass’n 2002) (emphasis added). ↑

11. Id. r. 1.7 cmt. 23 (“The potential for conflict of interest in representing multiple defendants in a criminal case is so grave that ordinarily a lawyer should decline to represent more than one co-defendant.”). ↑

12. SuperCooler Techs., Inc. v. Coca-Cola Co., No. 6:23-cv-187- CEM-RMN, 2023 U.S. Dist. LEXIS 145316 (M.D. Fla. July 17, 2023). ↑

13. The commentary refers to several examples: representing more than one defendant in a capital case, certain representations by former government lawyers, and conflicts relating to certain municipalities that are precluded from granting conflict waivers. Model Rules of Pro. Conduct r. 1.7 cmt. 16. Notably absent from this prohibition is any reference to fraud claims. ↑

14. ABA Model Rule 1.7(b) provides as follows:

    Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if: (1) the lawyer reasonably believes that the lawyer will be able to provide confident and diligent representation to each affected client; (2) the representation is not prohibited by law; (3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and (4) each affected client gives informed consent, confirmed in writing. ↑

15. SuperCooler Techs., 2023 U.S. Dist. LEXIS 145316, at *19. ↑

16. Id. at *20. ↑

17. Id. at *21–22. ↑

18. Id. at *22. ↑

19. Id. ↑

20. Id. ↑

21. Id. ↑

22. Id. ↑

23. Id. ↑

24. Id. ↑

25. Id. at *25. ↑

26. Id. at *26. ↑

27. Id. ↑

28. Id. at *27. ↑

29. Id. ↑

30. Id. at *28. ↑

31. Am. Coll. of Tr. & Est. Couns., The ACTEC Commentaries on the Model Rules of Professional Conduct 92 (4th ed. 2006) (commentary on Model Rule 1.7). ↑

Those who practice in or are familiar with the Delaware Court of Chancery are likely aware that it is a court of limited jurisdiction. Unlike most jurisdictions, Delaware never merged its courts of law and equity. “As Delaware’s Constitutional court of equity, the Court of Chancery can acquire subject matter jurisdiction over a cause in only three ways, namely, if: (1) one or more of the plaintiff’s claims for relief is equitable in character, (2) the plaintiff requests relief that is equitable in nature, or (3) subject matter jurisdiction is conferred by statute.” Candlewood Timber Grp., LLC v. Pan Am. Energy, LLC, 859 A.2d 989, 997 (Del. 2004). If the Court of Chancery lacks jurisdiction by statute, it “has only that limited jurisdiction that the Court of Chancery in England possessed at the time of the American Revolution.” El Paso Nat. Gas Co. v. TransAmerican Nat. Gas Corp., 669 A.2d 36, 39 (Del. 1995). Accordingly, parties seeking to take advantage of the Court of Chancery’s expertise in business disputes frequently endeavor to style their claims brought or the relief sought as equitable in nature.

In the past, the Court of Chancery has recognized equitable jurisdiction over claims for the release of money held in escrow. Beginning in Xlete, Inc. v. Willey, 1977 WL 5188 (Del. Ch. June 6, 1977), the Court held that such claims were sufficient to invoke equitable jurisdiction because, even if a party successfully won a judgment in the Delaware Superior Court for the sum held in escrow, the Superior Court (Delaware’s law court) would not have legal authority to actually compel delivery of the money to that party. This holding remained undisturbed for nearly fifty years, and indeed has been relied upon in decisions within the past decade. See, e.g., United BioSource LLC v. Bracket Holding Corp., 2017 WL 2256618, at *4 (Del. Ch. May 23, 2017); East Balt LLC v. East Balt US, LLC, 2015 WL 3473384 (Del. Ch. May 28, 2015); see also Haney v. Blackhawk Network Holdings, Inc., 2017 WL 543347 (Del. Super. Ct. Feb. 8, 2017) (transferring case to Court of Chancery to hear all claims, including claim for the disbursement of disputed funds in escrow).

However, recent decisions from the Court of Chancery have called into question the continued application of Xlete and the equitable jurisdiction over claims for the release of escrowed funds. Cases involving a request for release of escrowed funds create a tension between two different concepts raised in determining equity jurisdiction. On the one hand, equity jurisdiction only exists where there is no adequate remedy at law, and a dispute over the release of escrowed funds is fundamentally a fight over money the plaintiff contends it is owed, usually pursuant to a contract. On the other hand, while the underlying dispute may be one sounding in contract over money owed, the Superior Court lacks the authority to order a party holding particular funds in escrow to actually release them, raising the question of whether equitable relief is necessary. As discussed below, the ruling in Xlete has been construed narrowly in recent months, with the Court of Chancery resolving the tension by finding the cases are really ones for money damages. Consequently, parties and their counsel should be wary of continued reliance on Xlete in cases seeking the release of escrowed funds.

Elavon v. Electronic Transaction Systems Corp.

In Elavon v. Electronic Transaction Systems Corp., 2022 WL 667075 (Del. Ch. Mar. 7, 2022), plaintiff Elavon brought several claims against Electronic Transaction Systems and its former owners, including for release of funds that had been placed in escrow to satisfy potential indemnification claims. After one of the individual defendants moved to dismiss the action, Vice Chancellor Sam Glasscock III raised, sua sponte, the issue of whether the Court had subject matter jurisdiction over Elavon’s claims for release of escrowed funds. Elavon, 2022 WL 667075, at *1.

In arguing in favor of equitable subject matter jurisdiction, Elavon relied upon Xlete, East Balt, and Haney, pointing out that “only the Court of Chancery can issue an [injunction] directing the Escrow Agent to release the funds if it fails to do so.” Id. at *2 (internal quotation marks omitted) (emphasis in original). In response, Vice Chancellor Glasscock distinguished the cases cited by Elavon on their facts and stated that, to the extent Xlete and East Balt indicate that equitable jurisdiction should be had under the circumstances, the Court declined to follow their rationale. Id. at *3.

In particular, the Elavon Court took issue with what it described as the “speculative” nature of the argument in favor of equitable jurisdiction, explaining:

There is nothing in the pleadings that makes it likely that the escrow agent, post-decision in the Superior Court, would defy that Court’s determination of contract rights and breach its duties to the parties by refusing a consistent directive by the parties to release the funds. In other words, a complete and efficient remedy is available at law. The fact that an unexpected subsequent breach by the escrow agent might give rise to a need for equity to act does not make this matter one that requires Chancery jurisdiction. This would not be the tail wagging the dog; it would be an unanticipated second dog biting that tail—the possibility of such a speculative cause of action does not, to my mind, open the kennel of equity.

Id. at *2.

The Court also distinguished Xlete and East Balt because the plaintiffs there sought only the funds in escrow. In Elavon, the Court noted that “the damages sought exceed the value of the Escrow Fund.” Id. at *3.

The Court then dismissed the action for lack of subject matter jurisdiction, subject to transfer to Superior Court pursuant to 10 Del. C. § 1902, concluding that “[a] legal action cannot be transformed into an equitable one merely by suggesting that contingent relief, such as an escrow agent gone rogue, may necessitate an injunction.” Id. at *4.

ISS Facility Services, Inc. v. JanCo FS 2, LLC

For nearly a year, it appeared that Elavon might be an outlier from Xlete and its progeny, distinguishable on its facts. However, on June 20, 2023, Vice Chancellor Glasscock once again declined to find equitable jurisdiction over claims for the release of escrowed funds.

In ISS Facility Services, Inc. v. JanCo FS 2, LLC, 2023 WL 4096014 (Del. Ch. June 20, 2023), plaintiff ISS Facility Services brought three causes of action, including for declaratory judgment and specific performance of the contracts at issue. In arguing in favor of equitable subject matter jurisdiction, ISS Facility Services argued that “injunctive relief via specific performance is necessary to compel Defendants to issue instructions to an escrow agent to disburse those contested funds.” JanCo, 2023 WL 4096014, at *1. The Court disagreed.

In its analysis, the Court looked to the escrow agreement at issue, which provided that “disbursements can occur ‘only pursuant to (i) [Defendants’] written direction, (ii) a Joint Written Direction or (iii) a Final Order.’” Id. (alteration in original). The Court determined that a declaratory judgment issuing from the Superior Court would satisfy (iii) of the escrow agreement, making equitable relief compelling Defendants to comply with (i) unnecessary. Id. at *2. In addition, the computation of the amount owed under the contracts was a matter of contractual interpretation, a “quintessential exercise of law.” Id. As a result, plaintiffs had an adequate remedy at law, and the Court found a lack of equitable jurisdiction.

In contrast to Elavon, the facts in JanCo did not raise any additional issues or damages beyond the release of the funds held in escrow. Thus, JanCo seemingly expanded the reasoning detailed in Evalon to all actions for the release of escrowed funds without narrow factual limitations.

Buescher v. Landsea Homes Corp.

In September of this year, the Court again determined that it lacked subject matter jurisdiction to hear a claim involving the release of funds from escrow. In Buescher v. Landsea Homes Corp., 2023 WL 5994144 (Del. Ch. Sept. 15, 2023), the plaintiff sought an order of specific performance requiring defendant to direct an escrow agent to release $5 million held by the parties arising out of plaintiff’s purchase of defendant’s interest in a Florida LLC. Citing to JanCo, Vice Chancellor Glasscock stated: “Our recent case law has suggested that jurisdiction based solely on a request for the aid of equity to recover funds in escrow is inadequate to invoke subject matter jurisdiction, where the availability of a declaratory judgment at law makes the need for injunctive relief unlikely.” Id. at *1. Accordingly, the Court ordered the parties to brief whether the Court had subject matter jurisdiction. Interestingly, both plaintiff and defendant sought to keep the case in the Court of Chancery and even filed a joint brief. Given the recent case law finding the Court lacked jurisdiction over claims to release escrowed funds, the parties attempted to obtain jurisdiction based on the defendant’s equitable fraud counterclaim. The Court rejected this argument, finding that the parties failed to allege a special relationship between the commercial counterparties to the contract, which is a requirement for equitable fraud. Therefore, the Court dismissed the case, subject to the parties applying for a transfer to Superior Court.

Conclusions

Multiple conclusions can be drawn from the decisions in Elavon, JanCo, and Buescher. First, these cases serve as a reminder that, like the majority of trial courts in the United States, in the Court of Chancery, horizontal stare decisis does not operate as an absolute bar against decisions departing from relevant precedent. However, this should not be viewed, at least without future evidence, as a disagreement among the current members of the Court over whether it has jurisdiction over post-closing escrow release cases. To the contrary, as regular Chancery practitioners know, the decisions of the Court rarely significantly diverge, and it would be unsurprising if other members of the Court continued the trend of Vice Chancellor Glasscock’s recent decisions rejecting escrow release as a basis for equitable jurisdiction.

Second, parties and their counsel should carefully consider the appropriate Delaware court for claims relating to the release of escrow funds, including what potential grounds exist to seek equitable jurisdiction. The Court of Chancery will not hesitate to raise subject matter jurisdiction sua sponte, which could lead to added costs and delays that should be considered when determining choice of venue. Indeed, this occurred shortly after Vice Chancellor Glasscock issued his ruling in JanCo. The day after that decision was issued, Vice Chancellor Paul A. Fioravanti Jr. directed the parties to a pending action for the release of escrowed funds to provide the parties’ positions as to the application of JanCo to that action. See Four Cents Holdings, LLC v. M&E Printing, Inc., 2023 WL 4561491 (Del. Ch. July 14, 2023) (ORDER). The parties in Four Cents Holdings conferred and dismissed the action for lack of subject matter jurisdiction, electing to transfer it to Superior Court pursuant to 10 Del. C. § 1902.

Finally, practitioners have no reason to despair if Chancery jurisdiction over post-closing escrow disputes has become a thing of the past. While the Court of Chancery has well-earned its reputation as the preeminent business court in the country, the Complex Commercial Litigation Division of the Delaware Superior Court (“CCLD”), though much younger in existence having been founded in 2010, has proven to be another excellent venue for the resolution of complex business disputes, such as the ones arising from post-closing litigation and involving escrowed funds. Indeed, the Delaware Supreme Court recently recognized the CCLD’s expertise in complex business disputes by issuing an order, at the request of the Chancellor and President Judge of the Superior Court, allowing for a one-year trial period for the CCLD judges to be “designated with the consent of the Chancellor to sit as a Vice Chancellor on the Court of Chancery for the purpose of hearing and deciding cases filed under Section 111 [of the Delaware General Corporation Law] as selected by the Chancellor and the President Judge.” Accordingly, regardless of whether post-closing disputes over escrowed funds are heard in the Court of Chancery or CCLD, practitioners and their clients can expect timely and skillful resolution of their cases.

Jason C. Jowers is a director and Justin C. Barrett is an associate at Bayard, P.A. in Wilmington, Delaware, where they practice in the areas of corporate, alternative entity, and complex commercial litigation.

Generative AI (artificial intelligence) is going to upend the labor market. This is old news. Every week we see a new analyst publication giving us their numbers.^[1] Lawyers comfort themselves with the view that “a machine will never be able to replace us” in the exercise of professional judgment and interpersonal engagement. But even for those sacred duties, change is coming.

The four professional competencies

For lawyers—and indeed professionals generally—functional competency can be whittled down to the following:

At the core is Knowledge:

• applicable laws and regulations;
• the client’s business: operational features, commercial approach, and priorities; and
• market/industry practice and content standards.

Surrounding this core is what you might call the ring of power—Judgment. The ability to make the right decisions around things such as:

• risk parameters
• content look and feel
• narratives
• interpersonal and organizational dynamics
• how to balance commercial and operational drivers

The next functional competency is Content Creation. Historically, content creation was all about written communications, but these days you can include numerical (e.g., Excel) and graphic (e.g., PowerPoint^[2]) forms as well. And let’s not forget those most fashionable outputs in the legal ops world: workflows and process designs.

Finally, we have Persuasion, which has always been the lawyer’s superpower. Persuasion is the competency that executes with maximum effectiveness the delivery of all that knowledge, judgment, and content and is a more pervasive activity than you might think. Examples of persuasion are:

• counterparties (negotiations);
• clients (pitches, advice);
• colleagues (training, coaching, leadership); and
• market (thought leadership, events, and presentations).

Bringing these competencies together is Experience, which we define as the effective use of judgment based on knowledge acquired through sufficient practice. That’s a functional definition, as distinct from simply having “twenty-five years of experience in reviewing NDAs in the noodle packaging sector.”

Here comes the machine

AI will play an increasingly central role in the performance of all of these competencies, and not just knowledge and content creation, which are the industry’s current focus. As the available datasets grow, and as practitioners and service providers invest in the design and build of new use cases, the ability of AI systems to accumulate, organize, summarize, extract, and pattern-sift information will augment how lawyers come to form their judgments and the tools available for persuasion. For example:

What next?

What does all this mean for junior lawyers looking at the road ahead? In a word: opportunity. AI is going to open up access to new realms of data and new methods of exploiting that information. Exercising legal judgment will be increasingly based on real data rather than precedent, anecdote, or simply years in the field. The skill of persuasion may become ever more artful in the use of infographics, and in tracking what works and what does not. So here are three things the new generation of lawyers should be thinking about as they consider the brave new world of AI-enabled lawyering:

1. If your job is all about risk assessment, ask yourself how much of that risk assessment is currently based on hard data.
2. Can AI increase the amount of hard data that you are using in your risk assessments?
3. Can AI improve the ways you can present your analysis, so that you can be more persuasive?

Understanding the limits of current generative AI tools—and especially the limitations of the data pools which have trained those tools—will be a key skill for the new generation of legal professionals. The AI is not self-aware and is not exercising its own judgment. It has no idea what you intend to do with its output, but its ability to inform your judgment and enhance your persuasiveness will be transformative.

1. Check out, for example, McKinsey Global Institute’s July 2023 report Generative AI and the Future of Work in America. ↑

2. Other office productivity brands are available. ↑

3. See, e.g., World Commerce & Contracting Most Negotiated Terms report, 2022. ↑

What Exactly Is This Private Target Deal Points Study, Anyway?

The Private Target Deal Points Study is a publication of the Market Trends Subcommittee of the Business Law Section’s M&A Committee. It examines the prevalence of certain contract provisions in publicly available, private target M&A transactions during a specified time period. The Private Target Deal Points Study is the preeminent study of M&A transactions and is widely utilized by practitioners, investment bankers, corporate development teams, and other advisors.

What Time Period Will Be Covered by the Study?

The 2023 iteration of the Private Target Deal Points Study will analyze publicly available definitive acquisition agreements for transactions executed and/or completed either during calendar year 2022 or during the first quarter of calendar year 2023.

What Industries Will Be Covered by the Study?

The deals in the Private Target Deal Points Study reflect the broad array of industries of the deals that were conducted in our time period. In this year’s study, the technology, healthcare, and financial services sectors together make up approximately 45 percent of the deals.

What Is the Size of the Transactions in the Study?

The transactions analyzed in the Private Target Deal Points Study were in the “middle market,” with purchase prices ranging between $30 million and $750 million; purchase prices for most deals in the data pool were below $200 million.

Where Are You in the Process of Releasing the Study?

Almost all of our ten issue groups have turned in their data, and we are processing and analyzing it, running quality control checks, and finalizing the slides.

Can You Share Any Sneak Preview Data?

We shared a couple of sneak preview data points with attendees at the meeting of the Market Trends Subcommittee at the ABA Business Law Section’s M&A Committee meeting in September and encourage you to sign up for the M&A Committee and its various subcommittees if you haven’t already—at the following link: Join the BLS M&A Committee.

We can give you a peek ahead (understand, however, that our process is still ongoing, and thus these data points may not be final):

Number of deals referencing RWI has decreased for the first time

• The sneak peek: Representations and warranties insurance (RWI) has been a huge game changer in M&A deals. We measure whether a deal in our study pool utilized RWI by the closest proxy we can access: whether the purchase agreement references RWI. (Of course, RWI may have been obtained without such a reference in the purchase agreement.) The 2021 version of the Private Target Deal Points Study showed RWI references in nearly two-thirds of the deals referencing RWI. The 2023 version of the study will show a drop in RWI references, to 55%.
• What to watch for: Use of RWI in a deal impacts a variety of the negotiated provisions, as evidenced by our prior study data correlations. We are correlating even more data points with RWI references in the 2023 version of the Private Target Deal Points Study, so watch for those.

Please keep an eye out for our study and for an In the Know webinar to be scheduled, during which the chairs and issue group leaders will provide analysis and key takeaways from the results of the 2023 Private Target M&A Deal Points Study.

The legal obligations of an insurer and the insured are governed by the contract between them, which is the insurance policy, and certain state laws. An important aspect of the insurance relationship arising under a liability insurance policy is the insurer’s duty to defend the insured, or to reimburse the insured for defense costs, where the insured timely notifies the insurer of a potentially covered claim. Among other things, where a liability policy includes a right and duty to defend, the insurer must hire and pay for legal counsel to defend an insured in the underlying lawsuit.

Recoupment of Defense Costs

When an insurer provides a defense but it is later determined that there was no duty to defend, the insurer may attempt to recoup defense costs from the insured. Some insurance policies expressly require the insured to reimburse the insurer; most do not. Even where the insurance policy does not include an express provision requiring the insured to reimburse defense costs, an insurer may pursue recoupment. Jurisdictions differ on whether an insurer can recoup defense costs in that situation.

If an insurer has defended the insured under a reservation of rights, courts in some states allow the insurer to recover the costs of defense based on equitable remedies such as implied contract or unjust enrichment. These courts reason that the insured was never entitled to payments for defense costs under the insurance policy if there was no duty to defend from the outset, and the insured must reimburse an insurer for those payments.^[1] Other courts have applied a restitution theory to find that reimbursement is necessary to ensure adherence to the terms of the insurance policy, again reasoning that the policyholder “was never entitled” to a defense under the contract terms.^[2]

Courts in other states, however, restrict an insurer’s right to recoupment only to situations in which the insurance policy expressly provides for such reimbursement. These courts generally hold that a court would be amending or altering the insurance policy if it were to grant the insurer a right that does not exist under the terms of the insurance contract. The decisions frequently rely on state law that imposes a broad duty to defend on liability insurers, one that is broader than the duty to indemnify.

Eleventh Circuit: No Recoupment Absent an Express Policy Provision

In a recent decision applying Georgia law, the U.S. Court of Appeals for the Eleventh Circuit held that insurers should be limited to contractual rights under the language of the insurance policies, not under a new contract supposedly created in the insurers’ reservation of rights letters. The court in Continental Casualty Co. v. Winder Laboratories, LLC (“Winder Labs”) predicted how the Georgia courts would rule on reimbursement of defense costs absent an express reimbursement provision in the policy.^[3] Persuaded by the logic of other jurisdictions that “wide-ranging reimbursement is necessarily inappropriate in a system—like Georgia’s—that is predicated on a broad duty to defend and a more limited duty to indemnify,” the Eleventh Circuit predicted that “the Supreme Court of Georgia would follow that logic to adopt a ‘no recoupment’ rule to protect its insurance system.”^[4]

In so deciding, the court affirmed a Georgia federal district court decision holding that the insurers did not have a duty to defend Winder Laboratories or its manager in an underlying lawsuit alleging that Winder Laboratories falsely or misleadingly advertised a generic pharmaceutical. The operative claim fell within a “failure to conform” exclusion within the policies, so neither insurer had an ongoing duty to defend as a result of the district court’s ruling.^[5]

More significantly, the Eleventh Circuit decided, as a matter of first impression under Georgia law, whether a reservation of rights letter that asserts a right to reimbursement entitles an insurer to recoup defense costs even though the policy does not contain such a condition. The court held that it does not.^[6]

The insurance policies at issue in Winder Labs had no language conferring a right to reimbursement of defense costs and did not specify who would choose defense counsel. After the insurers received notice of the underlying lawsuit, they sent a series of reservation of rights letters that purported to reserve the right to seek reimbursement of defense costs for all claims that were not covered under the policies. The letters also gave the insureds a choice to retain their own defense counsel or to have the insurers choose defense counsel. The insureds responded that they would retain their own defense counsel. After the district court found that the insurers had no duty to defend, the insurers stopped paying defense costs and sought to recoup costs that they had previously paid.

The Eleventh Circuit affirmed the district court’s ruling that the insurers did not have a right to reimbursement of defense costs incurred before the district court’s duty-to-defend ruling, where the purported reimbursement right was asserted in the reservation of rights letters but was not a contractual requirement of the insurance contract. As an initial matter, because insurers have an “extremely” broad duty to defend under Georgia law, based on the allegations in the complaint, the insurers had a defense obligation until the district court ruled otherwise.^[7] The court then rejected two arguments advanced by the insurers in support of their phantom right to reimbursement: (1) the reservation of rights letters created a new contract because the insureds were provided a defense and were allowed to choose their defense counsel, and (2) the insureds were unjustly enriched because they received a defense through the insurers despite the district court ultimately finding no duty to defend.^[8]

The Eleventh Circuit held that the insurers’ new contract argument failed for lack of consideration.^[9] The insurance policies already required the insurers to defend the insureds in the underlying lawsuit (at least at first).^[10] Thus, there was no new consideration received for the agreement to pay for the defense stated in the reservation of rights letters.^[11] The reservation of rights letters merely reiterated a promise to perform a preexisting contractual obligation under the policies.^[12] Similarly, because the insurance policies did not specify who would choose defense counsel, the insurers did not give up any explicit right by allowing the insureds to choose their defense counsel.^[13] The key takeaway is that reservation of rights letters do not create new rights or duties or alter the insurance policy—their purpose is to inform the policyholder about the insurer’s coverage position and issues that may exist based on the policy. The policy itself dictates the rights and duties under the policy.

As for the insurers’ unjust enrichment argument, the Eleventh Circuit questioned whether it failed at the outset because under Georgia law unjust enrichment is an equitable claim precluded by the existence of a written contract.^[14] Even on the merits, though, the Eleventh Circuit concluded that there was nothing unjust about requiring the insurers to fulfill their contractual obligation to provide a defense until the district court ruled that there was no duty to defend.^[15]

Ultimately, on this matter of first impression, the Eleventh Circuit predicted that “the Supreme Court of Georgia would not allow an insurer to recoup its expenses based on a reservation of rights without any contractual provision allowing for reimbursement.”^[16] The Eleventh Circuit also noted its belief that “this position comports with the national trend that disfavors recoupment in similar circumstances,” citing the following language from the Restatement of the Law of Liability Insurance:

Over the past few decades, the pro-recoupment cases have been viewed as stating the majority position, while anti-recoupment cases have been labeled the minority. But in recent years, several state courts, including several state high courts, have faced recoupment of defense costs as an issue of first impression and have rejected a right of recoupment for the insurer, unless that right is established expressly by contract.^[17]

Key Takeaways from Winder Labs

The recent Eleventh Circuit decision in Winder Labs held that, to be actionable, a right to reimbursement must be set forth in the insurance policy or otherwise expressly agreed to by the insurer and the insured. Insurers, however, likely will continue their push to have courts recognize an equitable right to reimbursement, whether or not that right is in the insurance policy. Policyholders therefore should determine—at the time of placing the policy as well as after a liability claim arises—whether their policy expressly provides for reimbursement of defense costs in the event it is later decided that the claim is not covered. After notifying the insurer of a claim, the insured should carefully review all correspondence from the insurer—especially reservation of rights letters—because through the correspondence the insurer may attempt to establish an ancillary agreement to reimburse the insurer for defense costs. The insured also should analyze the applicable jurisdiction’s law to evaluate whether the insurer has an extracontractual basis to argue that defense costs may be reimbursable.

1. See, e.g., Nautilus Ins. Co. v. Access Med., LLC, 137 Nev. 96, 102, 482 P.3d 683, 689 (2021) (concluding “that when a court determines that the insurer never had a duty to defend, and the insurer clearly and expressly reserved its right to seek reimbursement, it is equitable to require the policyholder to pay”). ↑

2. Chiquita Brands Int’l, Inc. v. Nat’l Union Fire Ins. Co., 57 N.E.3d 97, 101 (Ohio Ct. App. Dec. 30, 2015). ↑

3. 73 F.4th 934 (11th Cir. 2023). ↑

4. Id. at 950. ↑

5. Id. at 942. ↑

6. Id. at 945–47. ↑

7. Id. at 944, 948. ↑

8. Id. at 945–47. ↑

9. Id. ↑

10. Id. at 947. ↑

11. Id. ↑

12. Id. at 946. ↑

13. Id. at 947. ↑

14. Id. ↑

15. Id. ↑

16. Id. at 950–51. ↑

17. Id. at 948–49 (citing Restatement of the L. of Liab. Ins. § 21, cmt. a (Am. L. Inst. 2019)). ↑