This is a summary of the Hotshot course “Materiality Scrapes: Buyer and Seller Perspectives,” a discussion of the perspectives and negotiating positions of buyers and sellers regarding materiality scrapes in acquisition agreements. View the course here.
Buyer and Seller Perspectives
Buyers and sellers have different perspectives on materiality scrapes.
Buyers like them because they reduce the buyer’s financial risk for smaller, or immaterial, matters.
Sellers typically dislike them (especially breach scrapes) because they:
Create potential liability for immaterial matters; and
Increase the amount of information sellers need to include in the disclosure schedules.
When the buyer gets a rep & warranty insurance policy, the debate over materiality scrapes becomes much less important.
The parties often agree to include scrapes with little or no negotiation.
Damages Scrapes
Damages scrapes usually aren’t heavily negotiated.
Buyers often want to include them and sellers are usually comfortable with that.
Most sellers don’t think the provision increases their liability since a damages scrape doesn’t affect what constitutes a breach.
There’s also the issue of “double materiality”, which in this context means the buyer:
First must prove that the damages are material to show a breach of the rep.
Then must prove that damages caused by the breach exceed the basket or deductible. The basket or deductible acts as a second materiality standard on the size of damages that applies to the seller’s reps.
Sellers often choose not to fight to retain the double materiality protection provided by a damages scrape.
Breach Scrapes
Breach scrapes are usually heavily negotiated and much more consequential than a damages scrape.
They’re what buyers and sellers care most about in the context of materiality scrape negotiations.
Sellers’ perspective:
The concern for the seller with a breach scrape provision is that even though the reps in an acquisition agreement were negotiated to include materiality qualifiers or similar concepts, these materiality qualifiers are essentially removed from the reps in the acquisition agreement as a whole for indemnification purposes.
This means that the seller can be responsible for indemnifying the buyer for a greater amount of losses with a breach scrape than without one.
In addition, when an agreement has a breach scrape, the seller’s lawyers tell the seller to include all exceptions to the reps in the disclosure schedules (however immaterial) to avoid indemnification claims.
Buyers’ perspective:
Buyers like breach scrapes for the reasons sellers oppose them.
Buyers want to be able to be made whole as a result of any breach of a rep without having to worry if the breach is material.
They’d also like to receive disclosure schedules that are as complete as possible.
In other words, they like the liability and disclosure implications of breach scrapes.
Rep and Warranty Insurance
When the buyer purchases rep & warranty insurance, the debate over materiality scrapes is much less important.
This is because a rep and warranty insurance policy will generally include a scrape for both breaches and damages as long as the purchase agreement also contains a double materiality scrape.
The insurance would then typically cover the liability for breach claims.
The seller therefore generally has very little at stake and will usually agree to a double materiality scrape.
However, the parties don’t always know from the start if the deal will have rep and warranty insurance.
Therefore, they often have to negotiate on the assumption that there won’t be.
Also, for very large deals, insurance may not be cost effective because:
The retention amount could be too high; and
The cost of purchasing insurance could be very expensive.
The rest of the video includes interviews with ABA M&A Committee members Rita-Anne O’Neill from Sullivan & Cromwell LLP and Craig Menden from Willkie Farr & Gallagher LLP.
This is a summary of the Hotshot course “Materiality Scrapes,” an introduction to damages scrapes, breach scrapes, and double materiality scrapes. View the course here.
What Are Materiality Scrapes?
When parties draft and negotiate reps and warranties in acquisition agreements, an important area of focus is the concept of materiality.
Sellers try to qualify many of their reps and warranties with materiality to:
Avoid being liable for immaterial claims or damages; and
Reduce their disclosure burden.
Buyers accept many of these materiality qualifiers, but often want them to be disregarded when it comes to indemnification.
The way buyers try to do this is by using materiality scrapes.
A materiality scrape is a provision in the indemnification section of an acquisition agreement that removes qualifiers like “material” or “material adverse effect” from the reps and warranties for purposes of indemnification.
There are two concepts that can be included in a materiality scrape provision:
A “breach scrape,” which removes materiality when determining if a rep has been breached; and
A “damages scrape,” which removes materiality when calculating damages.
A materiality scrape provision that includes both a breach scrape and a damages scrape is often referred to as a “double materiality scrape.”
It’s common for a materiality scrape provision to cover damages only (and not breaches), but you typically won’t see it the other way around (a breach scrape on its own).
This is because buyers generally ask for both in first drafts of acquisition agreements and the sellers usually push back the strongest on the breach scrape.
So when the parties agree on a compromise position that results in only one of the two types of scrapes being removed, it’s almost always the breach scrape that’s removed.
Relation to Other Provisions and Impact on a Deal
Materiality scrape provisions effect several areas of an acquisition. These include:
The seller’s reps and warranties and the indemnification provisions.
In addition to removing materiality qualifiers from the reps, scrape provisions also relate to the baskets in the indemnification section.
This is because sellers will often agree to materiality scrapes in exchange for increasing the size of the indemnification basket.
The disclosure schedules.
If an agreement has a breach scrape, the seller’s disclosure burden is greater because they will have to list out every exception to the reps and warranties, without regard to materiality.
In other words, they’ll need to include disclosures that would have otherwise been immaterial because in the aggregate those issues may exceed the basket and result in indemnification liability.
Rep and warranty insurance.
Rep and Warranty insurance is an alternative to indemnification.
It protects buyers against breaches of reps and warranties by the seller.
When a deal has this insurance policy in place, the debate over scrapes is essentially moot.
This is because the seller has no liability for breaches of most reps.
There can also be scrapes of knowledge qualifiers as well as scrapes of materiality qualifiers in covenants.
These are less common though.
Example
Here’s an example of how the different types of scrape provisions can impact a deal and the financial risk for the parties.
Say the seller’s litigation rep in an acquisition agreement for a $500 million company says that there’s “no material litigation outstanding”.
When the agreement is signed, the seller has a pending $20,000 claim from an employee to collect a bonus the employee claims was promised.
The seller disputes that the bonus was promised, and considers this an immaterial claim, so it’s not included in the disclosure schedule.
After the deal, the claim is resolved for $10,000 and the buyer incurs $15,000 in legal fees, for total damages of $25,000.
Assume that there’s no rep and warranty insurance in the deal.
If the acquisition agreement does not contain any materiality scrape language:
Then the seller’s litigation rep would be accurate – $20,000 isn’t material for a company worth half a billion dollars.
The buyer wouldn’t be able to make an indemnity claim for any of its damages.
If the acquisition agreement contains both a damages scrape and a breach scrape:
Then the materiality qualifier doesn’t apply and the rep would be interpreted to say there is no litigation outstanding at all.
The rep therefore is not correct because the seller has this small employee litigation outstanding and didn’t disclose it.
If the deductible is otherwise satisfied, the buyer would be entitled to recover for its $25,000 in damages.
If the acquisition agreement includes a damages scrape only:
Then the materiality qualifier applies when determining if there has been a breach.
The rep would still be true.
The buyer would not be able to make an indemnity claim for any of its damages.
The rest of the video includes interviews with ABA M&A Committee members Rita-Anne O’Neill from Sullivan & Cromwell LLP and Craig Menden from Willkie Farr & Gallagher LLP.
As artificial intelligence (AI), such as ChatGPT, continues to evolve and become more commonplace, many trade and professional associations are turning to AI technology to enhance their operations and decision-making processes and benefit their members. However, as with any emerging technology, the use of AI by associations raises a number of important legal issues that must be carefully considered and worked through.
Data Privacy
One of the primary legal issues associated with the use of AI by associations is data privacy. AI systems rely on vast amounts of data to train and improve their algorithms, and associations must ensure that the data they collect is used in accordance with applicable federal, state, and international privacy laws and regulations. Associations must be transparent with their members about how their data will be collected, used, and protected, and they must obtain the necessary member consents to use and share sensitive data. Remember that data (such as confidential membership information) that is inputted into an AI system such as ChatGPT will no longer remain confidential and protected and will be subject to the AI system’s most-current terms of use/service. As such, associations should not allow their staff, volunteer leaders, or other agents to input into an AI system any personal data, data constituting a trade secret, data that is confidential or privileged, or data that may not otherwise be disclosed to third parties.
Intellectual Property
Intellectual property is a key legal issue that associations must consider when using AI. AI systems can generate new works of authorship, such as software programs, artistic works, and articles and white papers; associations must ensure that they have the necessary rights and licenses to use and distribute these works, and that they are transparent about who/what created such works. Take steps to ensure that AI-generated content is not, for instance, registered with the Copyright Office as the association’s own unless it has been sufficiently modified to become a product of human creation and an original work of authorship of the association. Associations also must be mindful of any third-party intellectual property rights that may be implicated by their use of AI, such as copyrights or patents owned by AI vendors, developers, or others, and ensure that they do not infringe any third-party copyright, patent, or trademark rights. Finally, as stated above, be mindful not to permit the inputting into an AI system of any confidential or otherwise-protected content (such as trade secrets or information subject to a nondisclosure obligation or the attorney-client privilege), as such content will no longer be protected and confidential.
Discrimination
Another legal issue to consider is discrimination. AI systems can inadvertently perpetuate bias and discrimination, particularly if they are trained on data that reflects historic biases or inequalities. Associations must ensure that their AI systems do not discriminate on the basis of race, ethnicity, national origin, gender, age, disability, or other legally protected characteristics, and must take steps to identify and address any biases that may be present in their algorithms. For instance, the use by large employers of AI systems to help screen applicant résumés and even analyze recorded job interviews is rapidly growing. If AI penalizes candidates because it cannot understand a person’s accent or speech impediment, for instance, that could potentially lead to illegal employment discrimination. While this will only become a legal issue in certain contexts (such as the workplace), the use of AI has the potential to create discriminatory effects in other association settings (such as membership and volunteer leadership) and needs to be carefully addressed.
Tort Liability
Associations must consider the potential tort liability issues that may arise from their use of AI. If an AI system produces inaccurate, negligent, or biased results that harm members or other end users, the association could potentially be held liable for any resulting damages. Associations must therefore ensure that their AI systems are reliable and accurate, and that all resulting work product (such as industry or professional standards set by an association) is carefully vetted for accuracy, veracity, completeness, and efficacy.
Insurance
Associations need to ensure that they have appropriate insurance coverage in place to protect against potential liability claims in all of these areas of legal risk. Note that traditional nonprofit directors and officers (D&O) liability and commercial general liability insurance policies may be—and likely are—insufficient to fully protect associations in all of these areas. Associations also should explore acquiring an errors and omissions liability/media liability insurance policy to fill those coverage gaps.
* * * * *
In conclusion, while the use of AI by associations presents numerous opportunities and benefits, there are a number of legal issues that need to be carefully considered before going too far down the AI path. Among other things, associations must ensure that they are transparent with their members about the use of their data, obtain necessary intellectual property rights and licenses and avoid infringing others’ rights, address any potential biases in their algorithms, protect themselves against potential tort liability claims, and secure appropriate insurance coverage to protect against these risks.
As the work of associations involves both staff and member leaders, adopting and distributing appropriate policies governing AI usage by staff, officers, directors, and committee members is critical, as is policing compliance with such policies. Similar clauses should be built into employee handbooks and contracts with staff, contractors, and members (including agreements with volunteer speakers, authors, and board and committee members).
With careful planning and attention to these issues, associations can use ever-developing AI technology to enhance their operations, programs, and activities, better serve their members, and further advance their missions.
On March 17, 2023, in honor of Fair Housing Month, the U.S. Department of Housing and Urban Development (“HUD”) announced it would reinstate the 2013 discriminatory effects rule (the “2013 Rule”) (see 24 C.F.R. § 100.500 (2014)) under the Fair Housing Act. In doing so, HUD will also officially rescind its 2020 rule governing Fair Housing Act disparate impact claims (the “2020 Rule”) (see 24 C.F.R. § 100.500 (2020)). While HUD believes the 2013 Rule is more consistent with how the Fair Housing Act has been applied in the courts, in its announcement, HUD failed to reference the U.S. Supreme Court’s 2015 ruling in Tex. Dep’t of Hous. & Cmty. Affairs v. Inclusive Communities Project, Inc., 576 U.S. 519 (2015), which was one of the primary motivators behind the 2020 Rule.
The final rule re-adopting the 2013 Rule was published March 31, 2023, in the Federal Register. The effective date is May 1, 2023.
The Fair Housing Act (42 U.S.C. § 3601 et seq.) prohibits discrimination in housing and housing-related services because of race, color, religion, national origin, sex (including sexual orientation and gender identity), familial status, and disability. This includes a general prohibition against discrimination in the sale or rental of housing, in “residential real estate-related transactions,” and the provision of brokerage services. Further, the discriminatory effects doctrine, which includes disparate impact, can extend Fair Housing Act protections to policies that result in discrimination—even if such policies were not adopted with discriminatory intent. For example, 42 U.S.C. § 3605(a) provides: “It shall be unlawful for any person or other entity whose business includes engaging in residential real estate-related transactions to discriminate against any person in making available such a transaction, or in the terms or conditions of such a transaction, because of race, color, religion, sex, handicap, familial status, or national origin” (emphasis added).
As background, the 2013 Rule was an attempt to, at that time, codify then-relevant case law under the Fair Housing Act’s discriminatory effects test. Under the 2013 Rule, the discriminatory effects framework focused on whether a policy had a discriminatory effect on a protected class, and if so, assessed whether such a policy was necessary to achieve a substantial, legitimate, non-discriminatory interest, or if a less discriminatory alternative could serve that same interest. For the Rule 2013 analysis, a practice has a discriminatory effect where it actually or predictably results in a disparate impact on a group of persons or creates, increases, reinforces, or perpetuates segregated housing patterns because of race, color, religion, sex, handicap, familial status, or national origin. 24 C.F.R. § 100.500(a) (2014). Naturally, if a less-intrusive option is available, such an option would prevail over a more intrusive one.
The 2020 Rule changed this analysis by adding new pleading and proof requirements, as well as new defenses, all fashioned upon the U.S. Supreme Court’s ruling in Inclusive Communities. However, in Mass. Fair Housing Ctr. v. HUD, 496 F. Supp. 3d 600 (D. Mass. 2020), the court stayed the 2020 Rule prior to implementation on the basis that development of the rule did not meet the requirements of the Administrative Procedure Act. As such, the 2013 Rule remained in effect, and following the 2020 election (which ushered in a new presidential administration), the 2020 Rule was never implemented.
Regarding the discriminatory effects doctrine and disparate impact, under the 2013 Rule, a legally sufficient justification:
[E]xists where the challenged practice: (i) Is necessary to achieve one or more substantial, legitimate, nondiscriminatory interests of the respondent, with respect to claims brought under 42 U.S.C. § 3612, or defendant, with respect to claims brought under 42 U.S.C. §§ 3613 or 3614; and (ii) Those interests could not be served by another practice that has a less discriminatory effect.
(24 C.F.R. § 100.500(b)(1) (2014))
Moreover,
[a] legally sufficient justification must be supported by evidence and may not be hypothetical or speculative. The burdens of proof for establishing each of the two elements of a legally sufficient justification are set forth in paragraphs (c)(2) and (c)(3) of this section.
(24 C.F.R. § 100.500(b)(2) (2014))
As for which party shoulders the burden of proof in discriminatory effects cases, the 2013 Rule provides:
(1) The charging party, with respect to a claim brought under 42 U.S.C. § 3612, or the plaintiff, with respect to a claim brought under 42 U.S.C. §§ 3613 or 3614, has the burden of proving that a challenged practice caused or predictably will cause a discriminatory effect.
(2) Once the charging party or plaintiff satisfies the burden of proof set forth in paragraph (c)(1) of this section, the respondent or defendant has the burden of proving that the challenged practice is necessary to achieve one or more substantial, legitimate, nondiscriminatory interests of the respondent or defendant.
(3) If the respondent or defendant satisfies the burden of proof set forth in paragraph (c)(2) of this section, the charging party or plaintiff may still prevail upon proving that the substantial, legitimate, nondiscriminatory interests supporting the challenged practice could be served by another practice that has a less discriminatory effect.
(24 C.F.R. § 100.500(c) (2014))
However, the 2013 Rule does not clearly address several important concepts, such as causation and proximate cause. It also does not fully articulate limitations on disparate impact claims. Consequently, the U.S. Supreme Court would ultimately weigh in.
In Inclusive Communities, the Court outlined that, while disparate impact applies under the Fair Housing Act, certain conditions first must be met before it applies. First, plaintiffs must demonstrate a “robust causality” and “direct” proximate cause, as opposed to merely showing a discriminatory effect exists where it actually or predictably results in a disparate impact. SeeInclusive Communities, at 542, and Bank of America Corp. v. City of Miami, Fla., 581 U.S. 189, at 202–203 (2017). In Inclusive Communities, the Court stated that a “disparate-impact claim that relies on a statistical disparity must fail if the plaintiff cannot point to a defendant’s policy or policies causing that disparity.” Inclusive Communities, at 542. A robust causality requirement “protects defendants from being held liable for racial disparities they did not create.” Id. Two years later, the Court addressed causation in the context of the Fair Housing Act and ruled that all claims require “direct” proximate cause between the defendant’s challenged conduct and the plaintiff’s asserted injury. City of Miami, Fla., 581 U.S. 189, at 202–203.
The Court also stated that if a plaintiff “cannot show a causal connection between the [defendant’s] policy and a disparate impact—for instance, because federal law substantially limits the [defendant’s] discretion—that should result in dismissal.” Inclusive Communities, at 543. The Court continued: “Governmental or private policies are not contrary to the disparate-impact requirement unless they are ‘artificial, arbitrary, and unnecessary barriers.’” Id. It also said, “Disparate-impact liability mandates the ‘removal of artificial, arbitrary, and unnecessary barriers’” to “avoid the serious constitutional questions that might arise under the FHA, for instance, if such liability were imposed based solely on a showing of a statistical disparity.” Id. at 540. The 2013 Rule is silent about the artificial, arbitrary, and unnecessary limitation on disparate-impact claims.
In contrast, the Court clarified that a “plaintiff who fails to allege facts at the pleading stage … cannot make out a prima facie case of disparate impact” and directed lower courts to “examine with care whether a plaintiff has made out a prima facie case of disparate impact and prompt resolution of these cases is important.” Id. at 543. It also reiterated that “disparate-impact liability must be limited so employers and other regulated entities are able to make the practical business choices and profit-related decisions that sustain a vibrant and dynamic free-enterprise system” and “[e]ntrepreneurs must be given latitude to consider market factors.” Id. at 533, 541, 542.
Ultimately, reinstatement of the 2013 Rule in a post-Inclusive Communities environment will likely raise more questions than it answers.
The practical effect of HUD reinstating the 2013 Rule after Inclusive Communities might be that courts will not give the same deference to HUD’s 2013 Rule as reinstated ten years later. Unfortunately, to arrive at such verdicts, companies may get caught in additional rounds of protracted, costly—and, in some cases, unnecessary—litigation. Such litigation will undoubtedly include administrative action brought by HUD in coordination with the U.S. Department of Justice. It seems inevitable that the “re-litigation of dead issues” will occupy administrative and judicial resources, which arguably should not occur given that the Supreme Court has already spoken in Inclusive Communities.
In celebration of Law Day 2023, the ABA Business Law Section’s Rule of Law Working Group and Pro Bono Committee will be collaborating with Reading Partners, a national nonprofit committed to developing children’s reading skills, to provide a volunteer opportunity at the Business Law Section’s Spring Meeting in Seattle. The goal is to engage elementary school students in topics related to the Rule of Law (civic, history, and government) by having Section members (i) donate books to Reading Partners and (ii) visit an under-resourced school to read and talk with students about these topics.
Our volunteer project in Seattle is just one example of how we, as lawyers, can fulfill our ethical responsibility to “further the public’s understanding of and confidence in the rule of law and the justice system,” as described in the ABA Model Rules of Professional Conduct. It also aligns with this year’s theme for Law Day, which is encouraging the legal profession to lead the way in promoting civics, civility, and collaboration—the cornerstones of our democracy—to restore confidence in our democratic institutions and the judicial system, and to protect the rule of law.
Civics, Civility, & Civil Discourse
Indeed, lawyers can play an important role in advancing civic understanding, civility, and civil discourse. As Judge Alvin Thompson observed in his piece titled “Want a Dysfunctional Rule of Law? Then Neglect Civic Education,” “The beneficial effects of civic education are not only desirable but necessary for our well-being as a nation. Consequently, as members of the legal profession, we should engage in and promote civic education that will support and strengthen the Rule of Law. Doing so is one of the ways we can deliver on the solemn promise we made when we took an oath to support and defend the Constitution and laws of the United States of America.”[1]
In many ways, civic education is a condition precedent to an engaged citizenry and a functional rule of law. If we are to strengthen both, we must ensure that civic education is “comprehensive and engaging to prepare the next generation to be knowledgeable and active leaders.”[2] And yet, a 2018 report by American Progress found that civic curricula tends to focus heavily on knowledge but is devoid of experiential learning or local problem-solving components, which help build skills and agency for civic engagement.[3] Without the knowledge, skills, and disposition necessary to become informed and engaged citizens, we the People are left feeling disengaged, disempowered, and apathetic towards our system of government.
In a piece titled “The road to a stronger democracy begins in the classroom,” Kei Kawashima-Ginsberg and Louise Dubé observed that “[t]he consequences of neglecting civic education are all around us: rampant misinformation, disengagement from democratic action and institutions, acrimonious political divisions that pose a danger to the survival of our system of government, and a sentiment, shared by too many young Americans, that they have no place in American civic life.”[4]
So what can we do? As lawyers, we have an ethical responsibility to advance the rule of law. In fact, the Preamble to the Model Rules of Professional Responsibility sets forth that the reason it is a key responsibility of a lawyer to “further the public’s understanding of and confidence in the rule of law and the justice system” is “because legal institutions in a constitutional democracy depend on popular participation and support to maintain their authority” (emphasis added). In other words, the very existence of our constitutional democracy and its institutions depends on the public’s understanding of and confidence in the rule of law and the justice system.
Pro Bono & Professional Integrity
Lawyers can play an important role in advancing the rule of law by fulfilling their professional responsibility to provide pro bono publico service (Rule 6.1) and by not engaging in discriminatory or harassing conduct (Rule 8.4(g)).
In 2022, the World Justice Project’s Rule of Law Index rated the U.S. at 0.63 out of 1.00 for Civil Justice.[5] Notably, the lowest sub-factors for Civil Justice included accessibility and affordability of civil courts (0.45), and whether the civil justice system discriminates in practice based on socio-economic status, gender, ethnicity, religion, national origin, sexual orientation, or gender identity (0.36), putting it last and second to last among countries with similar incomes.[6] These ratings indicate that lawyers can make an impact with respect to accessibility, affordability, and nondiscrimination in our civil justice system through pro bono work and nondiscrimination efforts.
The Preamble to the Model Rules of Professional Conduct states, “A lawyer, as a member of the legal profession, is a representative of clients, an officer of the legal system and a public citizen having special responsibility for the quality of justice.” Paragraph 6 of the Preamble expounds on the special responsibility of lawyers and provides that lawyers should:
“[F]urther the public’s understanding of and confidence in the rule of law and the justice system” (as discussed above);
“[B]e mindful of deficiencies in the administration of justice and of the fact that the poor, and sometimes persons who are not poor, cannot afford adequate legal assistance”; and
“[D]evote professional time and resources and use civic influence to ensure equal access to our system of justice for all those who because of economic or social barriers cannot afford or secure adequate legal counsel.”
With respect to #1, Rule 8.4(g) identifies as professional misconduct harassment or discrimination by a lawyer based on “race, sex, religion, national origin, ethnicity, disability, age, sexual orientation, gender identity, marital status or socioeconomic status in conduct related to the practice of law.” Rule 8.4(g), Comment [3], recognizes, in part: “Discrimination and harassment by lawyers in violation of paragraph (g) undermine confidence in the legal profession and the legal system. Such conduct also engenders skepticism and distrust of those charged with ensuring justice and fairness.”[7]
With respect to #2 and #3, Rule 6.1 addresses “voluntary pro bono publico service,” the work that we lawyers should aspire to do, and what efforts and endeavors qualify under the Rule. It states that “[e]very lawyer has a professional responsibility to provide legal services to those unable to pay.” By doing so, lawyers can play a role in advancing the rule of law.
Given our terribly low ranking on accessible/affordable civil justice and discrimination in both the civil and criminal legal justice systems, it is clear that lawyers can play a role in strengthening the rule of law with respect to these factors by doing pro bono work and maintaining professional integrity in all of our interactions. At the Spring Meeting in Seattle, we will be discussing these and other ethical obligations in a CLE program titled: “Legal Ethics in the Emerald City: What The Rules of Professional Conduct Say About Brains, Heart, and Courage.”
So What Can You Do to Strengthen the Rule of Law?
First, you can work to eliminate bias, discrimination, and harassment in the practice of law. Consider engaging in diversity, equity, and inclusion efforts at your law firm. Converse with your colleagues about these topics. Collaborate with organizations like Reading Partners, who believe in the power of educational equity to interrupt systemic racism, poverty, and social inequality, and are committed to building a culturally competent and representative team to advance social justice through service in schools and communities.[8]
Second, you can increase access to our justice system by taking on a pro bono case to help an individual or charitable, religious, civic, community, governmental, or educational organization in matters designed primarily to address the needs of persons of limited means. You can provide additional services through participation in activities for improving the law, the legal system, or the legal profession. And if you are attending the Spring Meeting in Seattle, you can support pro bono by hearing from a panel of local pro bono leaders at the Pro Bono Committee’s breakfast on April 28, 2023, at 7:30 AM. The Pro Bono Breakfast will feature two distinguished volunteer attorneys from Communities Rise and an inspiring pro bono manager from Legal Counsel for Youth and Children.
Finally, you can find a way to promote civic education in your local community.
Whether you choose to engage in an activity like our volunteer project in Seattle or choose to support an organization that advocates for sustained and systematic attention to civic education in your state or local community, you, as a lawyer, can make an impact in this space.
Just as Reading Partners recognizes that strong literacy skills are the foundation for all future learning, we, as members of the legal profession, recognize that strong civic literacy skills are the foundation for the future of our constitutional democracy.
As discussed above, the ABA Business Law Section Rule of Working Law Group and Pro Bono Committee are collaborating with Reading Partners to provide a volunteer opportunity for the Spring Meeting in Seattle. Complete this form to volunteer in person and visit a local school during the Hybrid Spring Meeting. You can also support these efforts by donating a book to Reading Partners. Donate online (Civics Books or General Books) or bring a book to the Reading Partners table in the Section Lounge at the Meeting. Thank you for supporting this important initiative!
Special thanks to Judge Alvin Thompson, John Stout, Laksmi Gopal, Tsui Ng, and David Burick for planning this initiative.
This article is part of a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
The statute colloquially known as the Bank Secrecy Act[1] provides for assessment of civil money penalties (“CMPs”) in a variety of contexts. One of these is foreign financial accounts. Any United States person[2] with a financial interest in or signature authority over a foreign financial account (including a bank account, brokerage account, mutual fund, trust, or other type of foreign financial account) containing more than $10,000 is required under the BSA[3] to report the account annually to the Treasury Department by electronically filing a Report of Foreign Bank and Financial Accounts (FBAR) on Financial Crimes Enforcement Network (FinCEN) Report 114.[4]
A recent decision of the U.S. Supreme Court, Bittner v. United States, has eliminated some uncertainties in this area.[5]
Background
FBAR is a calendar year report and must be filed on or before June 30 of the year following the calendar year being reported. The person filing must maintain records of the account(s) in question for five years and be prepared to make them available for inspection.[6]
The requisite contents for the filing are:
the account number (or other designation) of the foreign account and the name in which it is maintained;
the name and address of the foreign bank or other person where the account is maintained; and
the type of account and its maximum value during the annual reporting period.[7]
The FBAR filing requirement applies to all United States persons with direct and certain indirect interests in, or signature authority over, a foreign financial account where the aggregate value of such accounts in any year exceeds $10,000.
Certain filing exceptions are available, including for the following United States persons or foreign financial accounts:
Certain foreign financial accounts jointly owned by spouses
United States persons included in a consolidated FBAR
Foreign financial accounts owned by a governmental entity
Foreign financial accounts owned by an international financial institution
Owners and beneficiaries of U.S. Individual Retirement Accounts (“IRAs”)
Participants in and beneficiaries of tax-qualified retirement plans
Certain individuals with signature authority over, but no financial interest in, a foreign financial account[9]
Trust beneficiaries (but only if a U.S. person reports the account on an FBAR filed on behalf of the trust)
Foreign financial accounts maintained on a United States military banking facility
A complete detailing of available exceptions is available in the FBAR instructions.[10]
The Treasury may assess a CMP[11] of up to $10,000[12] for any nonwillful[13] violation of any provision of the FBAR statute.[14] A question on which the practice of the Internal Revenue Service (IRS) has been inconsistent—and on which the lower federal courts have split[15]—is whether separate penalties or only one penalty should apply to a taxpayer who has multiple overseas accounts that should be described in the annual FBAR filing. In other words, is the $10,000 maximum CMP per FBAR report or per foreign bank account?
The question was recently resolved by the U.S. Supreme Court.[16] The case involved an immigrant from Rumania who became a naturalized U.S. citizen[17] and returned to Rumania after the fall of the communist regime to take advantage of business opportunities. He maintained 272 foreign bank accounts in Rumania. He conducted his business for several years unaware that he was subject to the FBAR reporting requirements for all of those accounts, even though he was not at the time residing in the United States. Once he became aware of this requirement, he hired an accountant to prepare and file FBARs for tax years 2007 through 2011. The IRS imposed a $2.72 million penalty on the theory that each and every undisclosed foreign account constituted a separate violation.
The Supreme Court held that a person who nonwillfully fails to file FBARs is subject to a maximum CMP of $10,000 for each FBAR report—i.e., per report, not per account. For a decision on such a relatively minor—and certainly technical—question of statutory interpretation,[18] the Court was surprisingly split 5–4. The case has garnered little attention thus far. The few press accounts that have appeared have largely focused two extraneous details. One was the minor disruption of the oral argument (back in November 2022) by three abortion rights demonstrators in the Courtroom (who may have been disappointed that the Justices seemed unperturbed by the disruption). The other was the “strange bedfellows” aspect of the votes on the case, which found Justice Alito misaligned with Justice Thomas and Justice Jackson disagreeing with Justices Kagan and Sotomayor.
Writing for the majority, Justice Gorsuch relied on the plain language of the BSA. Section 5314 focuses on the legal duty to file reports, which must include various kinds of information about an individual’s foreign “transaction[s] or relationship[s].” Justice Gorsuch’s opinion trenchantly observed, “Section 5314 does not speak of accounts or their number. The word ‘account’ does not even appear. Instead, the relevant legal duty is the duty to file reports.”[19] Violation of § 5314’s reporting obligation is binary, the majority concluded: One files a report “in the way and to the extent the Secretary prescribes,” or one does not; multiple willful errors may establish a violation of §5314 but even a single mistake, willful or not, constitutes a § 5314 violation.
The Treasury’s position was that because Congress explicitly authorized per-account penalties for certain willful violations,[20] the Court should infer that Congress meant to do the same for analogous nonwillful violations. That position was rejected, however, as incompatible with the well-known canon of statutory construction expressio unius est exclusio alterius. In the willful violations provision, § 5321(a)(5)(D), and in the “due to reasonable cause” exception in § 5321(a)(5)(B)(ii), Congress explicitly contemplated penalties on a per-account basis, thereby demonstrating that Congress knew how to do that but deliberately chose different language in § 5321(a)(5)(B)(i).[21]
The legislative history supported this conclusion. As originally enacted (in 1970), the BSA included penalties only for willful violations. In 1986, Congress authorized the imposition of penalties on a per-account basis for certain willful violations. When the BSA was amended again in 2004 to authorize penalties for nonwillful violations, Congress could have—but did not—simply use language from its 1986 amendment to extend per-account penalties for nonwillful violations.[22]
Finally, the majority found the per-account interpretation as applied to nonwillful violations to be incompatible with the purpose of the FBAR provisions, i.e., to require certain reports and records to assist the government in various criminal and tax intelligence initiatives. That information-seeking purpose was fully effected with a per-report interpretation. To rule otherwise and allow aggregation of nonwillful violations on a per-account basis could lead to an absurd result: A willful violator would incur a lesser penalty than a nonwillful violator.
The dissent, authored by Justice Barrett,[23] highlighted the language in § 5314 requiring FBAR reporting when an individual has a relationship with a foreign financial agency or an account with a foreign bank. That statutory focus on the relationship, the dissent argued, compelled the conclusion that it was each relationship that triggers a separate penalty for nonwillful violation.
That interpretation, although the dissenting Justices seem not to have noticed, would still leave an ambiguity: Is the “relationship” for this purpose with the institution maintaining the account, or the account itself? In other words, one could persuasively argue that 272 accounts at one bank would constitute but a single “relationship.”
Justice Gorsuch’s majority opinion concluded with a brief segment[24] (joined only by Justice Jackson) relying on the rule of lenity, under which, as earlier cases repeatedly explain, “statutes imposing penalties are to be ‘construed strictly’ against the government and in favor of individuals.” A major purpose of the rule of lenity, Justice Gorsuch wrote, is to ensure that taxpayers have “a fair warning … in language that the common world will understand, of what the law intends to do,” an ideal that he contrasted with the absence of any “discuss[ion of] per-account penalties for nonwillful violations” in the statute, together with the government’s “own public guidance documents [that] have seemingly warned of per-report, not per-account, penalties.” Justice Gorsuch emphasized the criminal consequences of the government’s interpretation, which would change the criminal exposure in this case from a $250,000 fine and five years in prison to a $68 million fine and 1,360 years in prison—all for nonwillful violations of the BSA.
The actual name is the Currency and Foreign Transactions Reporting Act of 1970, Pub. L. No. 91-508, 84 Stat. 1114 (1970) (codified as amended in scattered sections of 12, 18, and 31 U.S.C.) [hereinafter referred to as the “BSA”]. ↑
As used in any BSA regulation, the term “person” includes both natural and juridical persons, including “Indian tribe[s] (as that term is defined in the Indian Gaming Regulatory Act), and all entities cognizable as legal personalities.” 31 C.F.R. § 1010.100(mm). Thus a U.S. person encompasses U.S. citizens; U.S. residents; entities, including but not limited to, corporations, partnerships, or limited liability companies, created or organized in the United States or under the laws of the United States; and trusts or estates formed under the laws of the United States. ↑
A “Nostro” account is an account held by a bank in a foreign currency at another bank. Derived from the Latin word for “ours,” Nostro accounts are frequently used to facilitate foreign exchange and international trade transactions. ↑
These include the following: (1) An officer or employee of a financial institution that is examined by any of the three federal bank regulatory agencies or the National Credit Union Administration is not required to report signature authority over a foreign financial account owned or maintained by the financial institution. (2) An officer or employee of a financial institution that is registered with and examined by the SEC or the CFTC is not required to report signature authority over a foreign financial account owned or maintained by the financial institution. (3) An officer or employee of an “Authorized Service Provider” is not required to report signature authority over a foreign financial account that is owned or maintained by an investment company registered with the SEC. (“Authorized Service Provider” means an entity that is registered with and examined by the SEC and provides services to an investment company registered under the Investment Company Act of 1940, as amended, 15 U.S.C. § 80a-1 et seq.). (4) An officer or employee of an entity that has a class of equity securities listed (or American depository receipts listed) on any United States national securities exchange is not required to report signature authority over a foreign financial account of such entity. (5) An officer or employee of a United States subsidiary is not required to report signature authority over a foreign financial account of the subsidiary if its United States parent has a class of equity securities listed on any United States national securities exchange and the subsidiary is included in a consolidated FBAR report of the United States parent. (6) An officer or employee of an entity that has a class of equity securities registered (or American depository receipts in respect of equity securities registered) under section 12(g) of the Securities Exchange Act of 1934, as amended, 15 U.S.C. § 78a et seq., is not required to report signature authority over a foreign financial account of such entity. ↑
31 U.S.C. § 5321(a)(5)(B)(i). No penalty may be assessed, however, if the violation was “due to reasonable cause” and the amount of the transaction or the balance in the account at the time of the transaction was properly reported. Id. § 5321(a)(5)(B)(ii)(I)–(II). ↑
A willful violation or willfully causing a violation of any provision of 31 U.S.C. § 5314 does not enjoy the “due to reasonable cause” exception of § 5321(a)(5)(B)(ii) and is subject to an enhanced penalty of up to $100,000 or 50% of a statutorily defined penalty assessment, whichever is greater. Id. § 5321(a)(5)(C). That statutorily defined penalty is, in the case of a violation involving a transaction, the amount of the transaction, id. § 5321(a)(5)(D)(i), and, in the case of a violation involving the failure to report the existence of an account or any identifying information required to be provided in respect of the account, the balance in the account at the time of the violation (i.e., potential forfeiture of the account balance), id. § 5321(a)(5)(D)(ii). ↑
The taxpayer actually had dual citizenship: U.S. and Rumania. ↑
There was a minor constitutional component in terms of the application to these CMPs of the “rule of lenity.” That rule has due process origins and demands that people must have fair notice of what is proscribed by law before they can be punished for violating it. Only two Justices signed on to that portion of the 5–4 majority opinion, however. ↑
Bittner., slip op. at 6–8. The Court also noted the inconsistent positions the Treasury Department has taken in its guidance purporting to interpret the provision as a per-report penalty. In a 2010 proposed rulemaking, for instance, the Treasury Department indicated that a person who nonwillfully fails to properly file an FBAR faces a civil penalty “not to exceed $10,000.” Id., slip op. at 9–10. ↑
I recently wrote for the ABA’s Business Law Today about structured legal fees for lawyers in “Plaintiff Lawyer Tax Benefits Other Lawyers Don’t Get.” For nearly 30 years, plaintiff lawyers have been structuring their contingent legal fees based on the seminal tax case of Childs v. Commissioner.[1] Only contingent fees can be structured, and their basic idea is to convert an anticipated lump sum contingent fee into a stream of payments. Payments over time can flatten the peaks and valleys of a lawyer’s income and reduce the need to borrow to finance cases.
An annuity company or third party doles out the payments, so a legal fee structure is a little like a tax-deferred installment plan. It doesn’t rely on the credit-worthiness of the defendant or the client, and it can grow pre- rather than post-tax. The contingent fee lawyer must document the deferral of the legal fee before settlement (although immediately before the settlement is okay), can structure some or all, and can call for payment over any number of years, or life. Some companies even allow borrowing.
Whether the structure involves annuities or securities, the format and documents are important, but done properly, it has not been controversial with the IRS. The tax case uniformly cited as establishing the bona fides of attorney fee structures is Childs, and over the last several decades the IRS has often cited it favorably. But in December 2022, the IRS released Generic Legal Advice Memorandum AM 2022-007[2] (a “GLAM”).
The GLAM does not address the precise fact pattern in Childs or call for it to be overturned. Indeed, the hypothetical facts the IRS addresses in the GLAM are somewhat narrow. However, it is safest to read the IRS missive as a general attack on structured legal fees and as a roadmap for what the IRS may argue in audits. Even so, the GLAM is not binding on any taxpayer and is not published authority, unlike an IRS Revenue Ruling, a Treasury Regulation, or a tax case like Childs.
The GLAM is lengthy (25 pages single-spaced), and makes four arguments why the hypothetical structured fee the GLAM describes should not work in the IRS’s opinion. The IRS says it would violate the assignment of income doctrine, the economic benefit doctrine, and section 83 of the tax code (an IRS argument the Tax Court and 11th Circuit rejected in Childs), and that it is a deferred compensation plan violating section 409A of the tax code. Section 409A says some compensation deferred under regular tax rules should nevertheless be currently taxed if it fails to comply with certain rules.
This last argument regarding section 409A is the biggest surprise, for the Treasury Regulations under Section 409A say that the entire provision does not apply to independent contractors who have two or more customers or clients, among other requirements that are usually satisfied for structured fees. Since the time the relevant Treasury Regulation was released in 2007, it has been widely understood to exempt structured legal fees, since most lawyers have two or more clients. In any case, it is not yet clear if the IRS will have any success with its new positions on certain structured legal fees.
Much of the IRS’s discussion seems to rely on distinguishing its hypothetical from the facts in Childs’ structured fee. This suggests that the IRS may face bigger challenges if it tries to attack structured fees more universally. In any event, the GLAM indicates that the IRS is less comfortable with structured legal fees (or at least with some of them) than was previously thought.
So should lawyers continue structuring fees given this IRS shot across the bow? Most tax advisers would probably say yes, and that is my personal answer. But the GLAM does suggest that paying attention to the specific details and documents is important. Of course, most people are never audited, and that is true for lawyers and structured fees too.
But the release of the GLAM by the IRS suggests that if you happen to be audited, there may be more pushback than was previously thought, particularly if your fee structure looks like low-hanging fruit to the IRS. On that point, it is worth asking how the IRS will identify fee structures, since they are often not reported on a tax return until the installment payments are reported and taxed. But if a lawyer’s legal fee deferral is audited, the IRS may make these arguments. That does not mean the IRS will win, and the specific facts and documents in question are going to matter.
IRS audits can be resolved at the audit stage, where the best result is the IRS saying there is no change. The GLAM may make that happy result more difficult now, depending on the facts and documents. Many IRS audits are resolved a step beyond audit at IRS Appeals. IRS Appeals is still part of the IRS system, but it is independent and tries, usually successfully, to resolve disputes between auditors and taxpayers, often by settlement.
It is even possible that we will end up with another tax case reprising the issues discussed in Childs, though if that occurs, it will take years. And like any tax case, it will be based on the facts and documents in that particular case. In the meantime, in my view, there is no reason that plaintiff lawyers or the structured settlement industry need to stop structuring legal fees, as long as they dot their i’s and cross their t’s.
In fact, some structured settlement brokers report that they are seeing a decided uptick in legal fee structures. Ironically, perhaps the GLAM has made some lawyers aware of structured fees for the first time, which is likely not the result the IRS intended. Some lawyers say the GLAM suggests that someday the IRS will take away structured fees, so they want to take advantage of them before it is too late. In any event, if you are a plaintiff lawyer, it is a good time to get some tax advice about these developments.
Robert W. Wood is a tax lawyer and managing partner at Wood LLP. He can be reached at [email protected]. This discussion is not intended as legal advice.
The recent collapse of two large regional banks, and the expedited sale of Credit Suisse due to similar challenges, have left many in the financial services industry uncertain about the future. What should we understand about what happened, and what it might mean for the future of finance?
What Happened?
As everyone has now read about repeatedly, Silicon Valley Bank (SVB) collapsed due to a “run on the bank” involving customers withdrawing (or attempting to withdraw) their funds simultaneously. The run was prompted by fears that SVB could not honor withdrawals due to the decline in market value of long-term treasuries and other long-term assets. The decline in the value of these assets occurred due to the rise in interest rates over the past year, which has caused fixed income investments with lower interest rates to have a lower market value. Signature Bank was shut down by the New York Department of Financial Services and the Federal Deposit Insurance Corporation (FDIC) due to related concerns. At the time of the SVB collapse, the FDIC followed its protocols regarding the shutdown of a depository institution that is not subject to a systemic risk exception. This included shutting down SVB on Friday, March 10, 2023, establishing a new national bank, and guaranteeing access on Monday, March 13, for any deposits up to the FDIC insurance limit. That limit is presently $250,000 per depositor. As to any amounts in excess of $250,000, the FDIC noted an advance dividend would be paid later that week based upon assets sold, and the remaining amounts would be handled through the FDIC’s receivership process.
To put it mildly, SVB depositors and commentators exploded on social media regarding the potential loss or delayed access to significant amounts of business capital, with some noting various companies would be unable to make payroll without access to the funds in their operating accounts. As we now know, the Treasury, Federal Reserve, and FDIC invoked the systemic risk exception for both SVB and Signature Bank on Sunday, March 12, which enabled the agencies to guarantee all deposits of the banks. This exception is designed to enable federal agencies to prevent the adverse economic consequences of broader financial instability.
The Federal Reserve also established a new Bank Term Funding Program designed to provide liquidity to banks. The program allows banks to borrow money secured by U.S. treasuries, agency debt, mortgage-backed securities, and other qualifying assets as collateral. The program also allows banks to borrow funds based upon the par value of the assets, not the lower market value.
The Crystal Ball: What (Regulations) Will Come?
The U.S. banking system functions on consumer confidence that the money will be there when depositors need it. The past month introduced what some have called a new variation on a longstanding risk: a social media-fueled bank run. FDIC insurance was designed to be the primary hedge against bank runs, but it proved inadequate in SVB’s case. This was in significant part due to the low level of FDIC insurance when compared to the capital required to operate a business and the concentration of deposits in a single institution by deposit holders. These facts lead to a couple of potential legislative changes.
First, lawmakers are already proposing bills to increase the FDIC insurance limits. Second, lawmakers and regulators will have to grapple with how to deal with what some have called a social media bank run. (It is worth noting, however, that some commentators minimize social media’s role in adding fuel to the fire.) The federal agencies’ response implies that they will backstop deposits well beyond the largest banks, but it is unclear where (and whether) the agencies could stop if smaller banks face financial difficulties as well. Although the present response is designed to prevent the agencies from needing to answer this question now by backstopping other regional depository institutions, policymakers will have to address what to do in the future if additional bank runs occur.
Regulatory agencies will likely also increase their focus on managing interest rate risk on depository institution balance sheets. Regulatory agencies have faced significantcriticism for failing to detect what some refer to as an obvious balance sheet concern caused by the combination of demand deposits that can be withdrawn immediately and long-term government securities pledged to be held to maturity. In response, the agencies will likely increase the urgency of examinations and stress testing focused on the impact of rising interest rates on depository institution balance sheets.
Some lawmakers have already proposed restoring Dodd-Frank’s stress testing of banks above the $50 billion threshold after these standards were reduced several years ago. We will have to see how far the changes will go. Regulators can force depository institutions to amass a fortress-like balance sheet of short-term treasuries, but those assets pay lower interest rates. Likewise, those requirements only go so far before banking products start to become more expensive for customers and lawmakers call for lower-cost banking products.
The Department of Justice (DOJ) Antitrust Division recently suffered another setback in its most recent effort to secure criminal convictions for labor-side violations of Section 1 of the Sherman Act. Having finally secured a successful criminal conviction, which came by way of a plea deal and with a deferred prosecution agreement, the DOJ proceeded to trial in Maine against four home health executives who the government alleged had conspired to enter into a no-poach agreement and fix wages paid to home health aides. After a two-week trial, the jury acquitted all four of the defendants, marking the third time the DOJ has failed to convince a jury to convict defendants for alleged Section 1 violations in the labor market.
U.S.A v. Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah
On January 27, 2022, a federal grand jury in the U.S. District Court for the District of Maine issued a nine-page indictment, charging Faysal Kalayaf Manahe, Yaser Aali, Ammar Alkinani, and Quasim Saesah (defendants) with one count each of engaging in a conspiracy to violate Section 1 of the Sherman Act.[1] Per the indictment, the defendants entered into an agreement to fix the wages paid to personal support specialists (PSS) employed by their respective home health agencies by agreeing not to hire each other’s workers and to fix their wages at $15 or $16 an hour.[2] The alleged two-month conspiracy was supposedly carried out through various virtual and in-person meetings, and both encrypted and nonencrypted messaging apps.[3] The DOJ alleged the defendants’ agreement constituted a per se violation of Section 1.[4]
Motion to Dismiss
In May 2022, defendant Faysal Kalayaf Manahe filed a motion to dismiss the indictment,[5] which was joined by the other defendants.[6] The defendants asserted multiple arguments for why the indictment should be dismissed, including that the indictment failed to state a per se violation of Section 1, and that the alleged agreement reached by the defendants was an ancillary restraint subject to the rule of reason that was not pleaded in the indictment.[7]
The DOJ opposed the motion to dismiss, arguing the alleged no-poach agreement was a classic example of a horizontal restraint of trade, long held to violate Section 1.[8] It further argued that there was no reason to create an exception to the per se rule for no-poach agreements, and that the defendants’ ancillary-restraint argument lacked merit.[9]
Ultimately, the district court denied the defendants’ motion. The court reasoned that the indictment adequately alleged a per se illegal horizontal conspiracy.[10] The court noted that the defendants were correct “that they have a valid defense to the per se rule if they can show that any restraint resulting from the alleged agreement was ancillary to efficiency-enhancing economic activity.” However, the court ruled that the defendants had the burden of making a factual showing to support that argument at trial, and therefore denied the motion to dismiss.[11]
Jury Acquits
Following a two-week trial, on March 22, 2023, the jury acquitted all four of the defendants.[12] Despite the introduction of evidence in the form of messages and recorded meetings that revealed the defendants discussed an agreement to pay all PSS workers $15 or $16 an hour, it appears the prosecution failed to convince the jury that an agreement was ever actually reached or acted upon by any of the defendants. Part of the prosecution’s difficulty likely stemmed from the fact that in practice, the defendants never reduced the PSS workers’ wages—they actually paid them $18 or $19 an hour. Further, while the alleged agreement was reduced to writing, the writing was never signed by any of the defendants. Notably, the defendants—all of whom were immigrants from Iraq—argued that in their culture, the only way to confirm an agreement is to sign a formal written contract.
This third acquittal may also indicate a more fundamental challenge the DOJ is facing: convincing juries that people should face jail time for agreeing not to solicit and hire competitors’ employees. The DOJ’s record appears to support this theory. To date, the DOJ is zero for three in securing a criminal conviction from a jury for a violation of Section 1 related to a no-poach agreement. The DOJ’s sole conviction in this arena was against VDA OC LLC and came via a plea deal.[13] Notably, even that conviction was not a complete success, as its prosecution against VDA’s former manager Ryan Hee resulted in a deferred prosecution agreement and not a criminal conviction.[14]
Conclusion
Businesses should not expect this most recent loss to slow down the DOJ’s enforcement actions. Despite the DOJ’s difficulty in securing jury convictions, the guilty plea by VDA and the Biden administration’s stated policy of trying to protect employees from what it perceives to be unreasonable restraints suggest that the DOJ will continue to indict businesses and individuals for alleged Section 1 violations involving no-poach agreements or wage fixing. Accordingly, clients should be careful when seeking to limit the movement of their employees in agreement with competitors or discussing their employees’ pay with competitors.
Related Cases Worth Watching
Opening arguments have begun in U.S. v. Mahesh Patel, Robert Harvey, Harpreet Wasan, Steven Houghtaling, Tom Edwards, and Gary Prus.[15] There, the defendants are each charged with one count of conspiracy in restraint of trade in violation of Section 1. The government alleges that each of the defendants, who managed or otherwise controlled the hiring decisions at various unnamed companies, entered into a no-poach agreement regarding their employed aerospace engineers.[16] Notably, the court recently denied the DOJ’s motion in limine, seeking to prevent the defendants from arguing the procompetitive benefits of the alleged agreement.[17] While the court agreed that such evidence could not be used to argue that the agreement had procompetitive benefits because the DOJ alleged a per se violation, the court ultimately ruled that the evidence could be used to rebut the allegations that the defendants “joined the charged conspiracy, whether the conspiracy existed as alleged, and whether defendants had the requisite intent to join the conspiracy.”[18] Time will tell if this ruling will further hinder the DOJ’s attempt to convince a jury to deliver the DOJ its first Section 1 conviction following a trial.
United States v. Manahe, No. 2:22-cr-00013-JAW (D. Me. Jan. 27, 2022), ECF No. 1. ↑
No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 79. ↑
No. 2:22-cr-00013-JAW (D. Me. May 31, 2022), ECF No. 77; No. 2:22-cr-00013-JAW (D. Me. June 1, 2022), ECF No. 81; No. 2:22-cr-00013-JAW (D. Me. June 6, 2022), ECF No. 82. ↑
No. 2:22-cr-00013-JAW, at 1–2 (D. Me. May 31, 2022), ECF No. 79. The defendants also argued that the application of the per se rule against criminal defendants was unconstitutional because it instructed juries that certain facts presumptively established an element of a crime and because it rendered the Sherman Act unconstitutionally vague. ↑
No. 2:22-cr-00013-JAW, at 4–7 (D. Me. June 21, 2022), ECF No. 89. ↑
The Federal Trade Commission (“FTC”) continues to pursue its campaign against non-compete clauses. On January 5, 2023, the FTC voted 3–1 to publish a notice of proposed rulemaking, which, if implemented, would bar employers from entering into non-compete agreements with their workers and require employers to rescind existing non-compete restrictions with current and former workers. Originally, the deadline for submitting comments was March 20, 2023. Recently, the FTC voted 4–0 to extend the public comment period for an additional thirty days following numerous requests from the public. As such, the FTC will now accept comments on the proposed rule until April 19, 2023.
Although all four current commissioners voted to approve the extension, Commissioner Christine S. Wilson—the sole Republican—filed a concurring statement regarding the extension. Commissioner Wilson explained that because of the number of requests the FTC had received to extend the comment period by thirty days and the fact that the proposed rule “is a departure from hundreds of years of precedent and would prohibit conduct that 47 states allow,” she would have supported a longer, sixty-day extension. Commissioner Wilson additionally encouraged the public to submit comments on the proposed rule.
To date, the FTC has received more than 16,000 comments related to the proposed rule, a number that is sure to climb over the coming days.
Scope of the Proposed Rule
The proposed rule supersedes state laws that are less protective of employees, but keeps in effect state law that provides employees greater protection. The proposed rule excludes franchisees from the definition of “worker” and has a single, limited exception that applies to the sale of a business.
First, the FTC’s proposed rule would effectively ban worker non-compete provisions by deeming them an “unfair method of competition” under Section 5 of the FTC Act. The proposed rule would make it unlawful for employers to enter into or keep in place any non-compete provisions with current or former workers. Non-compete provisions are defined as contract terms that “prevent[] . . . worker[s] from seeking or accepting employment” or “operating a business” after their employment with the employer ends.
The proposed rule does not apply to customer or employee non-solicitation provisions or generally to confidentiality or non-disclosure agreements. The proposed rule applies a functional test for determining whether a clause is covered by the rule. A provision is considered a “de facto” non-compete provision if it “has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” The proposed rule includes as an example of a de facto non-compete term a “non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer.”
The proposed rule defines the term “worker” very broadly to include any “natural person who works, whether paid or unpaid, for an employer,” including “independent contractor[s], extern[s], intern[s], volunteer[s], apprentice[s], or sole proprietor[s] who provide a service to a client or customer.”
Notice Obligations Imposed by the Proposed Rule
If the rule becomes effective, employers who have existing non-compete provisions that violate the rule would be required to affirmatively rescind existing non-compete clauses with current workers and give individualized notice to workers that they are no longer subject to the non-compete clause. Employers would also be required to rescind non-compete clauses in effect with former workers, and give former workers notice of such rescission as long as the employer has the former worker’s contact information readily available. Employers would be prohibited from representing to a worker that the worker is covered by a non-compete clause when the employer has no good-faith basis to believe the worker is subject to an enforceable non-compete clause.
Exception for Sale of Business
The proposed rule provides a single, limited exception related to the sale of a business. The exception provides that the rule “shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity.” The exception applies, however, only to a person who owns at least a 25% ownership interest in a business entity at the time the person enters into the non-compete clause. The proposed rule is unclear as to whether the exception applies to existing non-compete terms applied to future sales of a business or only to non-compete terms entered into at the time of the sale.
Relation to State Laws
The proposed rule provides that it supersedes any state statute, regulation, order, or judicial interpretation that is inconsistent with the proposed rule. A state statute, regulation, order, or interpretation is not inconsistent with the proposed rule, however, if it provides greater protections to workers than the proposed rule. As a result, the proposed rule would essentially set a floor for worker protection against non-compete agreements but also keep in effect state and federal law that provides workers greater protection.
Public Comment
The FTC’s extended comment period on the proposed rule runs until April 19. The FTC has asked specifically for comments on several different alternatives to this non-compete ban, such as whether non-compete clauses between employers and senior executives should be subjected to a different rule than non-compete clauses between employers and other workers. The FTC also seeks comments on the possible benefits and costs of the proposed rule, the impact of the proposed rule on businesses, and possible compliance costs should the proposed rule be implemented. Commissioner Wilson’s recent and original statements seek to strongly encourage commenters to submit their views on the proposed rule.
Compliance Date
The proposed rule would establish a separate effective date and compliance date. The proposed rule’s effective date will be sixty days after the final rule is published in the Federal Register. The compliance date will be 180 days after the final rule is published in the Federal Register.
The time between the effective date and the compliance date is the “compliance period,” during which employers will need to be prepared to comply with the proposed rule’s provisions by the compliance date.
Effect on Congress
The FTC’s proposed rule has also sparked movement within Congress. In response to the proposed rule, Sen. Chris Murphy (D-Conn.) reintroduced the Workforce Mobility Act (the “Act”), which was cosponsored by Sens. Todd Young (R-Ind.), Tim Kaine (D-Va.), and Kevin Cramer (R-N.D.). This Act had been previously introduced to Congress in 2018, 2019, and 2021 but stalled each time. The Act, like the proposed rule, seeks to ban the enforcement of non-competes across the United States. However, the Act differs from the proposed rule in many ways. Of note, the Act would not retroactively ban non-compete agreements, whereas the FTC proposed rule would apply to all existing and future non-compete agreements.
The Act is currently sitting in committees for additional review.
What Does This Mean for Employers?
Employers should carefully monitor the status of the proposed rule. It will likely face significant legal challenges, and its fate is far from certain. Employers should consider, however, conducting an audit of their non-compete agreements and practices with respect to such agreements to determine whether and to what extent they may be impacted should the proposed rule become the law of the land.
For example, employers who have previously relied primarily on non-compete restrictions to prevent unfair competition or theft of trade secrets may consider strengthening or modifying their non-solicitation and non-disclosure restrictions. Specifically, employers should evaluate their confidentiality agreements, which are often very broad, to evaluate the risk that they may be considered “de facto non-competes” that are invalidated by the proposed rule and ensure that they comply with the antitrust laws. Employers may also consider conducting an audit to evaluate and identify vulnerabilities within their organization in the event that key current and former employees suddenly have unenforceable non-compete restrictions. Having a contingency plan in place now could save resources and potentially prevent significant impacts to the bottom line.
Additionally, although Section 5 of the FTC Act applies to “persons, partnerships, or corporations,” its definition of the term “corporation” covers only entities “organized to carry on business for [their] own profit or that of [their] members.” Therefore, arguably, the proposed rule would not apply to nonprofit entities. The courts, however, apply a fact-sensitive analysis, suggesting that the nonprofit legal status of an entity is not dispositive of Section 5’s applicability. Further, the FTC can also challenge non-competes under other antitrust statutes, such as the Sherman Act. Nonprofits should tread carefully given the other tools available to the FTC and other state and federal authorities and the apparent skepticism toward non-competes.
Should the proposed rule be adopted in its current state, this will also place much greater importance on policing corporate confidential and trade secret information, as companies would lose the ability to prevent former employees from immediately going to work for a direct competitor. This provides additional incentive for companies to proactively take stock of their confidentiality practices and agreements to ensure they are fully prepared in the event the proposed rule is implemented in its current form by the FTC.
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