If you hope to write off your legal fees, there is some good news from the IRS. Before you rejoice, the bad news is that the complex and confusing rules governing when legal fees are deductible have not gotten any easier. There are still plenty of cases in which deducting legal fees is difficult or when the rules seem to say that you shouldn’t be deducting them at all. Even so, there is some good news, because the mechanics for deducting employment, whistleblower, and civil rights legal fees have been improved, at long last: starting with 2021 tax returns, the IRS is implementing a new Form 1040 that has a line item for attorney fees.
Deductions Were Previously Hard to Claim
The tax code was amended back in 2004 to allow legal fee deductions “above the line” in some cases, which is almost like not having the income in the first place. But the deduction has been quirky to claim ever since. Many taxpayers have trouble; so do accountants and some types of tax return preparation software. That is barely surprising. Since 2004 it has been a kind of write-in deduction, sort of like writing in a political candidate who isn’t on the ballot.
Before and after 2004, the other kind of deduction was below the line. That meant subject to all sorts of limits and thresholds (including the dreaded alternative minimum tax (AMT)). The result was usually that you lost much or even all of your deduction. And starting in 2018, that below the line deduction went away entirely (until 2026, when it is supposed to come back). Talk about confusing. So this above the line deduction was and remains terribly important, which is one reason why how to claim it is so critical.
I have seen plenty of mechanical glitches with these deductions since 2004. I have seen some plaintiffs not properly claim the deductions they deserve and some plaintiffs and their return preparers not claim them at all—sometimes purely or largely because they cannot seem to manage the mechanics. In that sense, the easier mechanics created by the recent IRS update are a big win.
Because the previous versions of Form 1040 did not have a separate line to write in “other” above-the-line deductions, above-the-line deductions involving employment, whistleblower, and civil rights cases had to be written onto the dotted leader line next to the box where the total of the above-the-line deductions was to be calculated. This reporting not infrequently created confusion with the computer systems of state taxing agencies, because their algorithms often didn’t recognize the legal fee deduction reported on the leader line, or outside of any box of the form.
State agencies, like California’s Franchise Tax Board, would regularly send notices to taxpayers who followed the IRS’s instructions asserting that the taxpayers’ tax returns must contain a calculation error: The total of the above-the-line deductions reported in the boxes of the Form 1040 as calculated by the states’ computers simply did not match the taxpayer’s self-reported total on the tax form, they said. Of course, in these cases, the supposed calculation error was simply that the taxpayer’s calculated total correctly included the legal fee deduction written onto the leader line, whereas the state’s calculation did not. Even though these state notices are relatively easy to address, it was obviously frustrating to taxpayers to default into a state income tax examination over a poorly drafted tax form.
Not only was there no proper line for legal fee deductions on the IRS forms, but you had to include a particular code next to your write-in. If your case was an employment case, the code to enter was “UDC” for unlawful discrimination claim. The instructions said:
Write “UDC” and the amount of the attorney’s fees next to line 36 of Form 1040. For example, if you paid $100,000 in attorney fees, write “UDC $100,000” next to line 36.
If your case was a whistleblower case, you put in “WBF” for whistleblower. (I’m not sure what the F stood for, though “fees” seems the most likely candidate).
But at long last, starting with 2021 tax returns, the IRS is finally making it easier with a new Form 1040 that has a line item for attorney fees. For 2021, Schedule 1 to Form 1040 now gives you two lines. Line 24 of Part II, Adjustments to Income, allows for:
(h) Attorney fees and court costs for actions involving certain unlawful discrimination claims $_________
(i) Attorney fees and court costs you paid in connection with an award from the IRS for information you provided that helped the IRS detect tax law violations $_______
Notably, there is still not a separate line item specifically for “WBF” whistleblower fees under Section 62(a)(21). Perhaps that deduction is too rarely claimed to merit its own line. Still, the new form makes life a little better for those claiming “other” above-the-line deductions that do not have their own line on the tax form. The IRS has finally included an “other adjustments” line, Line 24z, where other above-the-line deductions can be reported in an actual box on the form without having to write them onto any leader lines. Hopefully, the inclusion of this catchall line will fix the state “calculation error” notices issue created by the previous versions of the Form 1040.
When the IRS updated the Form 1040, it also updated its instructions for the Form 1040, which now make no mention of the codes (“UDC” and “WBF,” for example) that used to be necessary to identify the deduction on the old forms. That makes sense for UDC deductions under Section 62(a)(20), since they now have their own line and do not have to be identified by a code.
However, this is somewhat puzzling for the above-the-line deductions that have not been given their own lines, since taxpayers will still need to identify the type of “other” deduction claimed on the new catchall Line 24z. It will be interesting to see if tax preparers continue to use “WBF” to identify whistleblower fee deductions out of convention, even though that code is no longer required or mentioned in the form’s instructions.
Plaintiffs Paying Tax on Legal Fees
Why worry about deducting legal fees in the first place? Most plaintiffs would rather have the lawyer paid separately and avoid the need for the deduction. Unfortunately, it is not that simple. If the lawyer is entitled to 40 percent, the plaintiff generally will receive only the net recovery after the fees. Most plaintiffs therefore sensibly assume that the biggest tax they could face would be tax on their net recoveries.
However, regardless of how the checks are cut, the plaintiff must usually contend with 100 percent of the proceeds under Commissioner v.Banks, 543 U.S. 426 (2005). As a result of that seminal case, plaintiffs in contingent fee cases must generally recognize gross income equal to 100 percent of their recoveries, even if the lawyer is paid directly, and even if the plaintiff receives only a net settlement after fees. This harsh tax rule usually means plaintiffs must figure out a way to deduct their 40 percent (or other) fee.
Fortunately, in 2004 shortly before Banks was decided, Congress enacted an above-the-line deduction for employment claims, civil rights claims, and some whistleblower claims. Plaintiffs in employment and civil rights cases can use this deduction for contingent fees, generally ensuring that they are taxed on their net recoveries, not their gross. Even so, many taxpayers and return preparers have had trouble with the mechanics of claiming it, as discussed above. There are also technical limits because a plaintiff’s deduction for fees in employment, civil rights, and qualifying whistleblower cases cannot exceed the income the plaintiff received from the litigation in the same tax year.
If all the legal fees are paid in the same tax year as the recovery (such as in a typical contingent fee case), that limit causes no problem. But this is a problem if the plaintiff has been paying legal fees hourly over several years. In that event, there is no income to offset, so you cannot deduct the fees above the line. Paying back the prior fees and having the lawyer charge them again in the year of the settlement is sometimes suggested to bring the fee payment into the same tax year as the recovery. It is unclear if that kind of circular flow of funds would adequately address the issue, although perhaps it might give a potential return position.
Who Can Claim the Above-the-Line Legal Fee Deduction?
The big question, of course, is what types of cases qualify for the above-the-line deduction? The answer is that only employment, civil rights, and some types of whistleblower claims qualify for it. Some people fear that employment cases based on contract disputes without discrimination might somehow not qualify. Perhaps that fear was fueled by the “UDC” notion that might seem to suggest that only unlawful discrimination claims (as opposed to all employment claims) qualify. However, there is a catchall provision, section 62(e)(18), that seems to cover the waterfront and make the long list of claims unnecessary. In the tax code itself, any claim about employment is actually defined as an unlawful discrimination claim.
Unlawful Discrimination
The above-the-line deduction applies to attorney fees paid because of claims of “unlawful discrimination.” The definition of such claims refers to claims for unlawful discrimination brought under these federal statutes:
the Civil Rights Act of 1991;
the Congressional Accountability Act of 1995;
the National Labor Relations Act;
the Fair Labor Standards Act of 1938;
the Age Discrimination in Employment Act of 1967;
the Rehabilitation Act of 1973;
the Employee Retirement Income Security Act of 1974;
the Education Amendments of 1972;
the Employee Polygraph Protection Act of 1988;
the Worker Adjustment and Retraining Notification Act;
the Family and Medical Leave Act of 1993;
chapter 43 of Title 38 (concerning employment rights of uniformed service personnel);
Section 1981, Section 1983, and Section 1985;
the Civil Rights Act of 1964;
the Fair Housing Act; and
the Americans with Disabilities Act of 1990.
It also refers to claims permitted under any provision of federal law (popularly known as whistleblower protection provisions) prohibiting discharge, discrimination, retaliation, or reprisal, and under any provision of federal, state, local, or common law providing for the enforcement of civil rights or regulating any aspect of the employment relationship.
Catchall Employment Claims
Arguably the most important piece in all this is the section 62(e)(18) catchall provision, which makes a deduction available for claims alleged under:
Any provision of federal, state, or local law, or common law claims permitted under federal, state, or local law —
i. providing for the enforcement of civil rights, or
ii. regulating any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.
This language is very broad. Some people may argue that an employment contract between a company and an executive doesn’t involve alleged discrimination and might not be covered. However, it seems hard to argue that an employment contract dispute does not amount to an employment matter within the meaning of this broad catchall statement. Many people claim these deductions and have been doing so since 2004. Yet so far, there is little guidance on this issue.
In LTR 200550004, however, the IRS ruled that attorney fees and costs rendered to obtain federal pension benefits fell within the catchall category. The case concerned a taxpayer who, after his retirement, discovered that he was being shortchanged on his pension. The IRS found unlawful discrimination. Interestingly, the IRS ruled that the case fell within the catchall category for unlawful discrimination even though the action was brought under ERISA (one of the enumerated types of unlawful discrimination).
Because only actions brought under section 510 of ERISA are expressly allowed under section 62(e), the catchall provision was needed to cover the taxpayer’s case. This ruling suggests an expansive reading of the catchall category, and so does the plain language of the statute.
Whistleblower Recoveries
The “unlawful discrimination” deduction also creates an above-the-line deduction for whistleblowers who were fired from their employment or retaliated against at work. But what about whistleblowers who expended legal fees to obtain a qui tam award but were not fired? Separately from the unlawful discrimination deduction, section 62 allows these qui tam plaintiffs to deduct their attorney fees above the line.
Several features about fees in non-employment whistleblower cases are noteworthy. Originally, the law for non-employment whistleblowers covered only federal False Claims Act cases. In 2006 the above-the-line attorney fees deduction was expanded to include attorney fees paid by tax whistleblowers in cases brought under section 7623 (regarding detection of underpayments of tax, fraud, etc.). In 2018 it was extended to SEC and Commodities Futures Trading Commission whistleblowers. Regarding False Claims Act recoveries, commencing with the 2018 tax year, the above-the-line deduction for attorney fees was extended to cover state whistleblower statutes as well.
Civil Rights Claims
The catchall language in section 62(e)(18) also provides for the deduction of legal fees to enforce civil rights. This unlawful discrimination deduction is arguably even more important than the deduction for fees concerning employment cases. What exactly are civil rights, anyway? You might think of civil rights cases as only those brought under 42 U.S.C. section 1983.
However, the above-the-line deduction extends to any claim for the enforcement of civil rights under federal, state, local, or common law. Section 62 of the Internal Revenue Code does not define “civil rights” for purposes of the above-the-line deduction, nor does the legislative history or committee reports. Some definitions are broad indeed, including:
. . . a privilege accorded to an individual, as well as a right due from one individual to another, the trespassing upon which is a civil injury for which redress may be sought in a civil action. . . . Thus, a civil right is a legally enforceable claim of one person against another. See Volume 15, American Jurisprudence, 2d at Page 281, quoted in In re Colegrove, 9 B.R. at 339 (emphasis added).
Moreover, in an admittedly different context (charitable organizations), the IRS itself has generally preferred a broad definition of civil rights. In one general counsel memorandum, the IRS stated: “We believe that the scope of the term ‘human and civil rights secured by law’ should be construed quite broadly.” Could invasion of privacy cases, defamation, debt collection, and other such cases be called civil rights cases? Possibly.
What about credit reporting cases? Don’t those laws arguably implicate civil rights as well? Might wrongful death, wrongful birth, or wrongful life cases also be viewed in this way? Of course, if all damages in any of these cases are compensatory damages for personal physical injuries, then the section 104 exclusion should protect them, making attorney fees deductions irrelevant.
However, what about punitive damages? In that context, plaintiffs may once again be on the hunt for an avenue to deduct their legal fees. Reconsidering civil rights broadly might be one way to consider fees in the new environment. In any event, the scope of the civil rights category for potential legal fee deductions seems broad.
Conclusion
The IRS gets big points for fixing what has been a tough deduction to claim since 2004. Personally, I’m still not used to the Schedule 1 idea for Form 1040, which may have been part of the effort to make tax returns more akin to postcards. Of course, we know how that turned out. But those issues aside, the IRS change for 2021 returns with the express line item for above-the-line attorney fees is a huge win.
Schedule 1 devotes two lines to these deductions: Line 24 of Part II, Adjustments to Income, for “(h) Attorney fees and court costs for actions involving certain unlawful discrimination claims” and “(i) Attorney fees and court costs you paid in connection with an award from the IRS for information you provided that helped the IRS detect tax law violations.” Don’t overlook them.
In recent months, two courts expressed disapproval of the use of non-consensual third-party releases in plans of reorganization: (i) the Southern District of New York, in In re Purdue Pharma, L.P., and (ii) Eastern District of Virginia, in Patterson v. Mahwah Bergen Retail Group, Inc. These decisions represent a significant shift towards curtailment of the use of non-consensual third-party releases in plans of reorganization. Non-consensual third-party releases arise in Chapter 11 plans and are an uncommon tool in bankruptcy proceedings. Instead of voluntary releases—which are the typical, and preferred, tool in Chapter 11 plans—a non-consensual third-party release is generally sought when the claim(s) against the third party must be released because the third party has a substantial and essential economic contribution that makes such release vital to the plan.
The Southern District of New York’s Decision in In re Purdue Pharma L.P.
On December 16, 2021, Judge McMahon of the Southern District of New York reversed the Bankruptcy Court’s confirmation of the Debtors’ plan of reorganization because of the non-consensual third-party release provisions in the plan.[1] In her decision, Judge McMahon analyzed whether Section 105(a), 1123(a)(5), 1123(b)(6), or 1129 of the Bankruptcy Code authorizes the Bankruptcy Court’s approval of non-consensual third-party releases. Judge McMahon concluded that none of those statutory sections confer authority on the Bankruptcy Court to grant non-consensual third-party releases.
After concluding that the Bankruptcy Code does not expressly authorize the approval of the third-party releases at issue, Judge McMahon considered the Debtors’ argument that the Bankruptcy Court could approve the non-consensual third-party releases because of the lack of any statutory prohibition prohibiting them. Judge McMahon rejected the Debtors’ argument, finding that Congress’s silence on the issue does not mean that the Bankruptcy Court has authority to approve non-consensual third-party releases. In contrast, as Judge McMahon noted, Congress has expressly authorized such releases, assuming certain conditions are met, in asbestos-related cases.[2]
The Eastern District of Virginia’s Decision in Patterson v. Mahwah Bergen Retail Group, Inc.
Following on the heels of the Judge McMahon’s decision in In re Purdue Pharma, Judge Novak of the Eastern District of Virginia similarly disapproved of the use of non-consensual third-party releases in a plan of reorganization in his January 13, 2022 decision.[3] In the underlying bankruptcy case, the Bankruptcy Court approved broad non-debtor releases of—among other claims—securities-fraud claims against the Debtors’ insiders as part of the Bankruptcy Court’s confirmation of the Debtors’ plan of reorganization. Finding the third-party release provisions void and unenforceable, Judge Novak labeled the breadth of the release provisions as “shocking” and cautioned that third-party releases are a “device that lends itself to abuse.”
In reaching his decision, Judge Novak expressed significant concern with the due process implications of non-consensual third-party releases, explaining that the “third-party releases strike at the heart of these fundamental rights.” As the third-party releases would release the claims of—at a minimum—hundreds of third parties without their consent, Judge Novak held that the third-party releases “offended the most fundamental precepts of due process.”
In addition, Judge Novak held that the Bankruptcy Court lacked jurisdiction to approve the broad, third-party releases at issue. Analyzing whether the Bankruptcy Court has constitutional authority to release the claims of third parties under the Supreme Court’s decision in Stern v. Marshall,[4] Judge Novak found that the Bankruptcy Court:
failed to identify whether it had jurisdiction over the released claims; and
lacked jurisdiction over many of the released claims because such claims included claims between non-debtors that have little to no connection to the bankruptcy estate or the administration of the bankruptcy case.
Conclusions & Takeaways
The In re Purdue Pharma and Mahwah Bergen Retail Group decisions add to the growing uncertainty regarding the use of third-party non-consensual releases in a plan of reorganization. Even prior to the In re Purdue Pharma and Mahwah Bergen Retail Group decisions, courts had been split on the issue of third-party non-consensual releases. Judge McMahon’s and Judge Novak’s decisions add to the increasing body of case law that either disfavors or expressly prohibits the use of broad, non-consensual third-party releases.[5] In the wake of these decisions and until the uncertainty regarding the use of third-party of releases is resolved, debtors will have to proceed cautiously before seeking approval of broad, non-consensual third-party release provisions in a plan of reorganization.
Judge McMahon’s decision can be found at In re Purdue Pharma, L.P., 7:21-cv-08566-CM (S.D.N.Y. Dec. 16, 2021). ↑
See, e.g., In re Pac. Lumber Co., 584 F.3d 229 (5th Cir. 2009); In re Lowenschuss, 67 F.3d 1394 (9th Cir. 1995); In re W. Real Estate Fund, Inc., 922 F.2d 592 (10th Cir. 1990). ↑
This article is related to a Showcase CLE program at the ABA Business Law Section’s 2022 Hybrid Spring Meeting. To learn more about this topic, view the program as on-demand CLE, free for Section members.
Traditionally, corporations’ main risk factors were related to business and business environment, and the primary criterion for evaluating corporate action was maximizing shareholder welfare and return. Recently, a new set of risk criteria outside the traditional focus on financial performance is gaining prominence: environmental, social and governance (ESG) risk management. ESG risks are more than just reputational—they can include costly litigation, hefty fines, seizures at U.S. ports, debarment, bank insecurity, and plunging stock value. Bottom line: ESG risks can stop or seriously delay company operations.
On March 31, a panel discussion at the American Bar Association Business Law Section Hybrid Spring Meeting will consider the evolution of ESG concerns and reporting, from philanthropic and discretionary corporate social responsibility (CSR) acts to required disclosure and regulatory focus as an inherent part of valuation. The breadth of shareholder proposals related to ESG and the importance of board governance and oversight will be discussed, along with the need for robust internal ESG governance processes for assessing materiality. The panelists will examine ESG risks through the eyes of not only major company or financial institution general counsel or senior in-house and outside counsel, but also of a diverse group of professionals in this area from several perspectives, including the founder and president of a leading human rights litigation advocacy group. These perspectives include:
Regulatory activity regarding climate risk within the financial services sector, including expectations of the Office of the Comptroller of the Currency and the Federal Reserve Board. In addressing climate risk, financial institutions must analyze physical risk (e.g., the risk associated with the direct impact of climate change on institutions’ physical assets and the physical assets of their borrowers); transition risk (e.g., the risk associated with increased market demand for lower carbon–producing products and services); acute risks (e.g., the risks associated with a specific short-term climate event, such as a natural disaster); and chronic risks (e.g., the risks associated with the increase in frequency of natural disasters over time). The panelists will provide an overview of recent developments and discuss the practical implications for financial institutions and their customers.
Litigation risks for companies as well as board members and officers, whether from regulatory agencies, private plaintiffs, or public interest organizations. Discussion also will include the status of strategic litigation in the human rights arena; other mechanisms underway that can disrupt labor trafficking, such as the Trade Facilitation and Trade Enforcement Act and the Federal Acquisition Regulation; trends in the litigation arena; and the status of extraterritorial application in human rights cases.
Risks springing from the draft E.U. Directive requiring human rights due diligence and remediation of adverse impact issues in supply chain management, and specific contract assurances addressing such human rights initiatives, including the concept of shared responsibility. Recently, shared responsibility was addressed in a unique buyer code of conduct found in Version 2.0 of the Model Contract Clauses to Protect Human Rights in International Supply Chains (the MCCs), which incorporate the UN Guiding Principles on Business and Human Rights (UNGPs) and the Organisation for Economic Co-operation and Development (OECD) guidelines and are drawn from the ABA Model Principles on Labor Trafficking and Child Labor. Published in the Winter 2021–2022 issue of The Business Lawyer, the MCCs integrate human rights due diligence into every stage of the supply chain contract, allow enforcement by every buyer and supplier in the chain (eliminating conventional privity of contract), and prioritize remediation of human rights harms over conventional contract remedies.
Other newly manifest risks that have surfaced in recent years.
The program will emphasize how companies, banks, investors, and advisors take legal risks all the time, but often fail to integrate these risks effectively in an environment that is changing continuously. Those who ignore these and other ESG risks do so at their peril and miss the chance to create long-term value as advocated by BlackRock CEO Larry Fink in his last few annual CEO letters. As the demand for data and transparency with respect to ESG factors increases, the need to break down silos and be sure legal oversight is truly integrated with an organization’s compliance and operations is the only way to create an effective overall enterprise risk strategy. We will also discuss essential, practical tools for measuring, monitoring, and proactively managing a variety of ESG risks and provide ample materials for future reference.
There can be no question that the role of legal counsel is expanding into a proactive role in an organization’s broader enterprise governance, risk management, and compliance (GRC) strategy. The ever-increasing ESG initiatives impacting many aspects of business are evidenced, in part, by the number of ESG-related CLEs at the upcoming Business Law Section Hybrid Spring Meeting. The objective of all these ESG-related CLE programs, listed below, is to be sure business lawyers have the tools to assist clients in coordinated efforts to act with integrity in fulfilling legislative, regulatory, contractual, and even self-imposed obligations.
ESG in the Board Room: Counseling Directors on ESG, April 1, 4:00–5:00 p.m. ET, from the Federal Regulation of Securities, Corporate Social Responsibility Law, Corporate Governance, International Business Law and International Coordinating Committees
Work is nearing completion on proposed amendments to the Uniform Commercial Code (“UCC”) to address a limited set of transactions largely involving emerging technologies, such as virtual (non-fiat) currencies, distributed ledger technologies, and, to a limited extent, artificial intelligence. The principal amendments address so-called digital assets. The rules covering transfers of covered digital assets, including security interests in those assets, are carefully coordinated so that the transactions generate predictable and consistent results.
Background
Since 2019, a Committee appointed by the American Law Institute and the Uniform Law Commission, the sponsoring organizations of the UCC, has been considering and formulating amendments to the UCC to address emerging technological developments. The Committee has included and worked with both lawyers experienced in UCC matters and lawyers whose practices concentrate on digital assets. The work of the Committee has benefitted enormously from the contributions of American Bar Association advisors and more than 300 observers from academia, trade groups, government agencies, law firms, private technology companies, and foreign participants from multinational law reform organizations or who are active in technology-related law reform efforts in their respective countries.
The Committee presented its initial draft of the amendments to the Uniform Law Commission at the Commission’s annual meeting in July of 2021. The ALI Members Consultative Group (“MCG”) met and discussed the draft in October 2021. A revised draft was considered and approved by the American Law Institute Council in January of 2022. The MCG will meet again and consider the latest draft late in April. The Council of the American Law Institute approved the amendments at the Council’s meeting in January 2022. The Committee hopes to obtain approval of the members of the American Law Institute at the Institute’s Annual Meeting in May of 2022, and of the Uniform Law Commission at the Commission’s Annual Meeting in July of 2022. The amendments would then be offered for enactment by the states.
The following is a high-level summary of the current draft of the proposed amendments as they relate to certain digital assets.
Executive Summary
The proposed amendments respond to market concerns about the lack of definitive commercial law rules for transactions involving digital assets, especially relating to:
negotiability for virtual (non-fiat) currencies,
certain electronic payment rights,
secured lending against virtual (non-fiat) currencies, and
security interests in electronic (fiat) money, such as central bank digital currencies.
The proposed amendments address only state commercial law rules. They do not address the federal or state regulation or taxation of digital assets, regulation of money transmitters, or anti-money laundering laws. The amendments look to law outside of the UCC to answer many questions concerning digital assets.
The proposed amendments concern a class of digital assets—defined as “controllable electronic records” (“CERs”)—which would include certain virtual (non-fiat) currencies, non-fungible tokens, and digital assets in which specified payment rights are embedded. The amendments provide for a CER to be in effect negotiable, i.e., capable of being transferred in such a way as to cut off competing property claims (including security interests) to the CER (a “take-free” rule).
The proposed amendments also provide for a security interest in a CER to be perfected by “control” (or by filing a financing statement) and for a security interest perfected by “control” to have priority over a security interest in the CER perfected only by the filing of a financing statement (or another method other than “control”). There are also proposed amendments to address security interests in electronic money.
Definition of “Controllable Electronic Record”
A “controllable electronic record” is a record in electronic form that is susceptible to “control.” For a person to have “control” of a CER, the person must have:
the power to enjoy “substantially all the benefit” of the CER,
the exclusive power to prevent others from enjoying “substantially all the benefit” of the CER, and
the exclusive power to transfer control of the CER.
Moreover, the person must be able readily to identify itself to a third party as the person having these powers. Identification can be made by a cryptographic key or account number. The exclusivity requirement is satisfied even if there is a sharing of these powers through a “multi-sig” or similar arrangement or if changes occur automatically as part of the protocol built into the system in which the CER is recorded.
The amendments include the following language:
A virtual (non-fiat) currency would be an example of a CER. If a person owns an electronic “wallet” that contains a virtual currency, the person would have control of the virtual currency if (a) the person may benefit from the use of the virtual currency as a medium of exchange by spending the virtual currency or exchanging the virtual currency for another virtual currency, (b) the person has the exclusive power to prevent others from doing so, and (c) the person has the exclusive power to transfer control of the virtual currency to another person.
If an electronic record is not susceptible to control, it is outside the scope of the proposed amendments. In addition, the definition of a CER excludes certain digital assets that might otherwise be considered to fall within the definition of that term. These assets are excluded because commercial law rules already exist and generally work well for these assets. They include electronic chattel paper, electronic documents, investment property, transferable records under the federal E-SIGN law or the Uniform Electronic Transactions Act (“UETA”), deposit accounts, and, to some extent, electronic money (discussed below).
Nothing in the proposed amendments, for example, disturbs transacting parties’ current practices of using transferable records under E-SIGN. Nor do the proposed amendments affect transacting parties’ ability, in effect, to “opt-in” to Article 8 of the UCC by arranging for a digital asset to be held with a securities intermediary as a financial asset credited to a securities account. Electronic money is treated separately under the proposed amendments, as described below.
Rights of a Transferee of a Controllable Electronic Record
Proposed Article 12 governs certain transfers of CERs. If a CER is purchased (which consists of a voluntary transaction, including obtaining a security interest in the CER), the purchaser acquires all rights in the CER that the transferor had. In addition, if the purchaser is a “qualifying purchaser,” the purchaser benefits from the “take-free” rule, i.e., the purchaser acquires the CER free from competing property claims to the CER. A “qualifying purchaser” is a purchaser who obtains control of a CER for value, in good faith, and without notice of a property claim to the CER. As with negotiable instruments and investment property, the filing of a financing statement in and of itself is not notice of a property claim to the CER.
This is summarized in the amendments as follows:
Consider again the example of a person in control of a virtual (non-fiat) currency. If the person transfers control to another person, the transferee obtains whatever rights in the virtual currency that the transferor had. If the transferee is a “qualifying purchaser” of the virtual currency, the transferee also benefits from the “take-free” rule.
Tethering and Certain Payment Rights
With one important exception described in the following paragraph, what rights are embodied in the CER, and whether the “take-free” rule applies to those other rights (in addition to the CER itself) upon a transfer of the CER, are all determined by law outside of the proposed amendments. For example, the proposed amendments do not affect copyright law as it relates to someone in control of a non-fungible token “tethered” to intellectual property. Other law would determine the effect of that “tethering.” Similarly, if a CER purported to evidence an interest in real estate, whether the “take-free” rule applies to the interest in the real estate upon a transfer of control of the CER would be determined under other law, presumably the applicable real estate law.
There is one important exception: An “account” or “payment intangible,” as those terms are already defined in Article 9 of the UCC, embodied in a CER is a “controllable account” or “controllable payment intangible” if the account debtor (the person obligated on the account or payment intangible) has agreed to pay the person in control of the CER. If control of a CER with an embedded controllable account or controllable payment intangible is transferred, the controllable account or controllable payment intangible travels with the CER, and the transferee may benefit from the same “take-free” rule that applies to the CER. The effect is to create what is functionally an electronic instrument even though the payment rights would continue to be classified as a “controllable account” or “controllable payment intangible.” If the terms of the CER provide that the account debtor will not assert claims or defenses against the transferee of the CER (as and to the extent permitted by UCC § 9-403 and subject to consumer laws), then the effect is to create the substantial equivalent of an electronic negotiable instrument. These provisions respond to market concerns in the trade finance area that commercial law rules are currently insufficient for electronic promissory notes and electronic bills of exchange.
Consider a buyer of goods who delivers to the buyer’s seller a promissory note in payment for the goods. If the promissory note is in a writing, it might, if certain conditions are met, qualify as a negotiable instrument under Article 3 of the UCC, and potentially a holder of the promissory note could be a holder in due course of the negotiable instrument. But, if the promissory note is in electronic form and even if those conditions are met, Article 3 does not apply because the promissory note is not in a writing. Absent the promissory note qualifying as a “transferable record” under UETA, the rights of a transferee of the promissory note would be governed under normal contract rules and some rules under UCC Article 9. Under the proposed amendments, though, the promissory note (in electronic form) could be a CER, If the promissory note were a CER, the “take-free” rule would apply to a qualifying purchaser of the promissory note. If the buyer also agreed not to assert claims or defenses against a transferee of the promissory note, the electronic promissory note would, subject to applicable consumer laws, have negotiability characteristics similar to those of a negotiable instrument under Article 3.
Secured Lending
The provisions applicable to purchasers of CERs are carefully coordinated with corresponding changes to lending secured by security interests in CERs under Article 9 and are designed to preserve the availability of existing transaction patterns. Under the proposed amendments, there would be no need to change collateral descriptions in security agreements or collateral indications on financing statements. A CER is a “general intangible,” a controllable account is an “account,” and a controllable payment intangible is a “payment intangible,” as those terms are already defined in Article 9 of the UCC. The normal rules for attachment would continue to apply, and a security interest in a CER, a controllable account, or a controllable payment intangible could still be perfected by the filing of a financing statement.
However, under the proposed amendments, a security interest in a CER, a controllable account, or a controllable payment intangible could also be perfected by the secured party obtaining “control” of the CER. A security interest in a CER, a controllable account, or a controllable payment intangible perfected by “control” would have priority over a security interest in the CER, controllable account, or controllable payment intangible perfected only by filing (or by another method other than control). Control would be defined as described above.
Another example may be helpful. SP-1 lends to Debtor, obtains a security interest in Debtor’s accounts, payment intangibles, and other general intangibles, and perfects the security interest by the filing of a financing statement. SP-2 later lends to Debtor, obtains a security interest in a CER in which is embodied what is functionally an electronic promissory note payable to the person in control is embodied, and files a financing statement to perfect its security interest. SP-1’s security interest has priority under the first to file or perfect priority rule of Article 9. If SP-2 obtains control of the CER, SP-2’s security interest in the electronic promissory note is senior to SP-1’s security interest in the electronic promissory note.
Account Debtor Discharge
Similar to current UCC Article 9 provisions for accounts and payment intangibles generally, an account debtor (the obligor on an account or payment intangible) receives a discharge by paying the person formerly in control until the account debtor receives a notification signed in writing or electronically by the debtor or its secured party that the secured party has a security interest in the controllable account or controllable payment intangible and a payment instruction (often referred to a “deflection notification”) to pay the secured party as the person now in control. Following receipt of the deflection notification, the account debtor may obtain a discharge only by paying the secured party and may not obtain a discharge by paying the debtor.
Also, similar to current UCC Article 9, the debtor may ask for reasonable proof that the secured party is the person in control before paying the secured party. However, unlike under current Article 9, for a controllable account or controllable payment intangible the method of providing that reasonable proof must have been agreed to by the account debtor, presumably as part of the CER when it was created. Absent an agreed method of providing reasonable proof, the deflection notification is not effective, and the account debtor may obtain a discharge by continuing to pay the debtor.
As a practical matter, few account debtors question a deflection notification or ask for reasonable proof. However, if an account debtor does ask for reasonable proof, the relevant parties have the flexibility to develop for market acceptance methods for providing the reasonable proof.
Electronic Money
The current definition of “money” in the UCC is sufficient to include a virtual (fiat) currency authorized or adopted by a government, whether token-based or deposit account-based. The definition of “money” would be revised to exclude a medium of exchange in an electronic record (such as Bitcoin) that existed and operated as a medium of exchange before it was authorized or adopted as a medium of exchange by a government. However, a medium of exchange in an electronic record so excluded might still qualify as a CER.
Under current UCC Article 9, a security interest in money can perfected only by possession. However, electronic money is not susceptible to possession. The proposed amendments provide that, if electronic money is credited to a deposit account (even one at a central bank), the normal deposit account perfection rules apply. Electronic money also would exclude money that cannot be subject to “control,” similar to control for a CER. If the electronic money is not credited to a deposit account, a security interest may be perfected by “control”. UCC § 9-332 would be amended generally to provide for a transferee of money, whether tangible or electronic, to take free of a security interest in the money. Otherwise, any “take-free” rule would be determined by the law governing the electronic money.
Choice of Law
The proposed amendments include substantially identical choice-of-law rules for the take-free rules for transferees of CERs and the perfection by control and priority of a security interest in a CER, controllable account, or controllable payment intangible perfected by control. Having the same rules promotes consistent results and predictability.
The amendments generally follow the choice-of-law approach taken in UCC Articles 8 and 9 for financial assets credited to a securities account at a securities intermediary. The application of take-free rules in connection with transfers of CERs and the perfection, effect of perfection or non-perfection, and priority of a security interest in a CER perfected by control would be determined by the law where the CER is deemed to be “located” – i.e., the CER’s jurisdiction. For a CER that expressly provides its jurisdiction, perfection, other than by the filing of a financing statement, and priority are governed by the law of that jurisdiction. Otherwise the CER’s jurisdiction would be the jurisdiction whose law governs the system in which the CER is recorded. If no express provision is made in the CER or the system, the CER would be located in Washington, D.C. If Washington D.C. has not enacted the amendments, the substantive law rules of the Official Text of the amendments would apply. However, in the case of perfection of a security interest by the filing of a financing statement, the normal debtor location rules would apply.
Transition Rules
Transition rules are being developed. These rules will be designed to protect the expectations to parties to pre-amendments effective date transactions and to provide for sufficient time for parties to plan transactions post-amendments effective date.
The transition rules will likely not contain a uniform amendments effective date. for the amendments because some states appear ready to enact the amendments as early as possible. However, a uniform adjustment date is being considered. The adjustment date would give transacting parties a grace period to preserve priorities established on the effective date if the amendments would otherwise affect those priorities.
Other Proposed Amendments
The proposed amendments also contain some provisions relating to chattel paper, “bundled” transactions (involving as a single transaction for the sale or lease of goods, the licensing of software or information, and the provision of services), negotiable instruments, payment systems, letters of credit, documents of title, the meaning of “conspicuous,” and some miscellaneous amendments to the UCC. The amendments unrelated to CERs and electronic money are beyond the scope of this summary.
This article is adapted from a Showcase CLE program titled “Social Justice Intersecting with Sports: Is It Right?” that took place at the ABA Business Law Section’s Hybrid Spring Meeting on Friday, April 1, 2022. To learn more about this topic, view the program as on-demand CLE, free for Section members.
“I have a dream that one day this nation will rise up and live out the true meaning of its creed: “We hold these truths to be self-evident, that all men are created equal.”
“I have a dream that one day on the red hills of Georgia, the sons of former slaves and the sons of former slave owners will be able to sit down together at the table of brotherhood….”
Dr. Martin Luther King, Jr., August 28, 1963
What is social justice? What is its relationship to sports? How do they intersect with the law? Starting with the first question, the term is defined by the John Lewis Institute for Social Justice as: “Social justice is a communal effort dedicated to creating and sustaining a fair and equal society in which each person and all groups are valued and affirmed. It encompasses efforts to end systemic violence and racism and all systems that devalue the dignity and humanity of any person.” While the focus here is on race, social justice can be applied more broadly to include, among other things, gender, ethnicity, religion and sexual orientation.
This article will describe how social justice and sports overlap. But a valid question remains—how does all of this relate to the law? First, social justice inherently relates to fundamental rights of athletes—including the constitutional rights to free speech and to vote. Perhaps the most recent, bold expression of social justice issues in sports litigation is Brian Flores’s lawsuit alleging rampant discrimination in National Football League (NFL) hiring, but many other legal issues come into play. For example, Major League Baseball (MLB) abruptly relocating its All-Star Game in 2021 in response to controversial Georgia legislation making voting more difficult impacted a web of contractual relationships among parties supporting that event. Potentially the most transformative change ever in college athletics is the advent of athletes’ ability to monetize their name, image, and likeness (NIL). This was enabled by a seminal case before the US Supreme Court in 2021 involving antitrust law, NCAA v. Alston. What’s the connection with social justice there? The perception of many and particularly people of color has been the multi-billion-dollar business of major college athletics is a plantation-like model. The belief was the system is leveraged on the backs of unpaid labor, largely that of Black students, who generate funding for less lucrative sports with mostly White participants. And, as reflected in the O’Bannon v. NCAA case, NILs constitute intellectual property.
Over the past half century, the US Supreme Court on other occasions has spoken on subjects relating to or impacting issues of social justice including its decisions in Tinkerv. Des Moines Inde. Cmty. Sch. Dist. (First Amendment does not prevent schools from student speech restrictions) and Floodv. Kuhn (rejecting a player challenge to the MLB reserve clause, which prevented freedom of movement). Further, many social justice issues can be interwoven with collective bargaining agreements (CBAs), league/team rules and other labor-related legal issues that arise in the sports world.
The intersection of social justice with sports has been prominent in the U.S. for over a century. As the two began to overlap, it took time but eventually legal challenges emerged. The MLB “color barrier” was first imposed in 1887. At the 1936 Olympic Games in Berlin, capital of Hitler’s Nazi Germany, several Jewish US athletes opted out in protest. Meanwhile, Black athlete Jesse Owens decided to defy Hitler’s vision of an Aryan nation by competing—quite successfully. After World War II, systematic US racism remained. Yet in 1947, finally a Black baseball player, Jackie Robinson, was promoted to MLB. Robinson’s courage and resilience are the subject of books and films but often overlooked is his civil rights commitment, including his organizing of marches with Dr. King. After all, even after his groundbreaking career was over Black people in many parts of this country continued to be denied basic rights under the Constitution including the right to vote.
In the 1960s, active Black athletes began to speak and engage in acts of protest. Muhammad Ali took center stage, and at the peak of his career became a conscientious objector after being drafted. Ultimately the US Supreme Court overturned Ali’s conviction for draft evasion, but he lost his title and economic livelihood for years. Other courageous Black athletes supported him, including Bill Russell, Lew Alcindor (now Kareem Abdul-Jabbar) and Jim Brown. More events spotlighting social justice in sports arose later in the decade. On the international stage, Americans Tommie Smith and John Carlo protested during the Olympics medal ceremony in 1968 in Mexico City, despite the consequences they would face from the International Olympic Committee (IOC). And yet another prominent professional athlete would bring a challenge all the way to the highest court in the land: MLB player Curt Flood challenged MLB on antitrust grounds, likening the reserve clause in baseball contracts to “being a slave 100 years ago.” Ali and then Flood were legal trailblazers—challenging the US Government and an entire sport in court.
Many overlook the periodic social justice consciousness-raising that took place in sports in the succeeding decades, perhaps partly because it was overshadowed by these earlier athletes but also because the economics of sports changed radically. Players gained free agency gradually, and their earning power grew tremendously. Owners also grew wealthier through valuable revenue sources, including richer broadcast deals. Issues regarding compensation centered around CBAs, lockouts and strikes, with both sides represented by high-priced lawyers, and labor law disputes overshadowed cries for equity and fairness. This is not to ignore the Syracuse 8, the Battle of the Sexes and Title IX, Georgetown coach John Thompson, Arthur Ashe, NBA courtside protests and Proposition 48—much of which went no farther than protests and powerful symbolism but some spilled into courts of law.
However, in the past decade, athletes’ contribution to consciousness-raising regarding race reached a pinnacle. Catalysts were the unjustifiable killings of Black people, first teenager Trayvon Martin and then (among others) Michael Brown, Eric Garner and Freddie Gray, in first instance by a neighbor who avoided conviction and the others by police using unnecessary force. These events put out into the open very legitimate questions about the US legal system and race. Player protests took various forms, including LeBron James and teammates donning hoodies in honor of Martin, NFL players making “don’t shoot” on-field poses, boycotts by collegiate football players and WNBA players wearing “Black Lives Matter” t-shirts. Activism by athletes was spotlighting concerns about law enforcement, prosecutors and courts not giving people of color equal justice.
A pivotal moment was the 2016 NFL season, when Colin Kaepernick began kneeling during the national anthem in protest over US oppression of Black people. Teammates and others followed his lead by kneeling or staying inside the locker room during the anthem. These calls for social justice were well publicized and generated controversy, partly stoked by the former President. Conventional notions of league and team “rules” and collectively bargained employer-employee relationships were suddenly questioned. Kaepernick would soon be unable to find a job in the NFL and filed a grievance against all 32 teams (a procedure required under the NFL’s CBA). He alleged that the teams colluded to keep him out of the league in retaliation for his activism in raising awareness of social justice issues. The matter was settled confidentially in 2019. The result after a tumultuous period appeared to be greater acceptance and awareness of racial issues, and even an agreement between players and the NFL for funding certain initiatives.
Attention to social justice in sports reached a crescendo in 2020 with the tragic murder of George Floyd. Black Lives Matter became an important, historic movement as thousands of protests took place across the US and more White people joined in. There was unprecedented player action across all sports, and partly by leagues and teams themselves. Some action had legal implications, but all stemmed from seemingly systemic issues with unequal treatment in our legal system. The Milwaukee Bucks players elected not to play a game in protest, and the League rescheduled games. In soccer (with its own historical racial issues) domestically and overseas players engaged in acts of solidarity. Even MLB, with its checkered racial history, moved its All-Star Game from Atlanta in light of Georgia’s controversial voting legislation; the untangling of a maze of event-related contracts and avoiding or minimizing the legal consequences followed. Most recently, former NFL coach Brian Flores commenced a class action challenge against the league and three teams alleging racial discrimination. Such a legal challenge by a young Black coach was unimaginable only a few years ago.
Sports and social justice are intersecting more than ever. Will that continue? Yes. The real question is how impactful it will be in causing change and what role the law will play. Is the Flores action a sign the legal issues underlying social justice more frequently will come to the fore in courts of law? We’ll see.
This article is related to a Showcase CLE program at the ABA Business Law Section’s 2022 Hybrid Spring Meeting. To learn more about this topic, view the program as on-demand CLE, free for Section members.
Although the rules of professional conduct differ in each state, all states in the United States have enacted some form of the Model Rules of Professional Conduct adopted by the American Bar Association. Such rules apply not only to lawyers in private practice but also to in-house lawyers. Further, the application of such rules to how lawyers in private practice interact with each other at a law firm also applies to in-house lawyers, as such rules generally define “law firm” (or “firm”) to include “the legal department of a corporation or other organization.” See, for example, Rule 1.0(c) of the ABA’s Model Rules of Professional Conduct (“Model Rules”). Also see Comment [3] to Model Rule 1.0: “With respect to the law department of an organization, including the government, there is ordinarily no question that the members of the department constitute a firm within the meaning of the Rules of Professional Conduct.”
While it is clear that the Model Rules and the rules of professional conduct in most states apply to in-house attorneys, how those rules actually apply is not always clear. Attorneys are generally familiar with the application of the ethical rules to their practices when they work in private practice. In fact, many of the rules contemplate the attorney as an outside legal adviser with multiple clients, and not an employee of a single client. Some of the rules are obvious in their application to in-house attorneys (such as the duty of confidentiality contained in Model Rule 1.6). Certain other rules don’t really apply to the in-house attorney as a practical matter (such as the obligation to maintain trust accounts pursuant to Model Rule 1.15, and the limitations on advertising and solicitation contained in Model Rules 7.1, 7.2, and 7.3).
But some of the rules may have a different or surprising application to many in-house attorneys, due in part to the nature of the employer-employee relationship where the employer is the client (and perhaps the only client) of the in-house attorney, and also due to the mixed role of some in-house attorneys who serve as both a lawyer for the organization and also as a businessperson or principal of the organization. Such rules include the following:
Model Rule 1.7, which precludes an attorney from representing two or more clients if the representation of one client is directly adverse to another client, or if there is a substantial risk that the representation of a client will be materially limited by the attorney’s responsibilities to another client (unless the attorney secures the informed consent, confirmed in writing, from each affected client). Such a conflict situation might arise when the attorney is representing both its employer organization or business entity and one of its officers, directors, or shareholders. Conflicts of interest may also exist among entities within the corporate family and among affiliated entities.
Model Rule 1.9, which precludes an attorney from working on a matter on behalf of a client if that client’s interests are materially adverse to the interests of a former client of the attorney and the attorney represented that former client in the same or a substantially related matter (unless the attorney secures the informed consent, confirmed in writing, of the former client). Such a conflict situation might arise when an in-house attorney finds themselves across the table from a former client (from when the in-house attorney worked at a law firm) or a former employer (if the in-house attorney worked in-house at another company).
Model Rule 1.10, which provides that the conflict of interest of one attorney in a law firm (defined in the Model Rules to include a legal department) is imputed to all other attorneys in the firm, such that none of them may represent a client when any one of them practicing alone would be prohibited from doing so. This is particularly troublesome in a legal department, where the conflict of one in-house attorney may be imputed to all of the other in-house attorneys in the legal department, thereby precluding the in-house team from working on a particular matter on behalf of their employer client.
Model Rule 1.13, which makes clear that an attorney employed or retained by an organization represents the organization acting through its duly authorized constituents (e.g., officers, directors, etc.), although such rule also permits the attorney to represent any such constituent in addition to the organization. However, if the organization’s consent to such a dual representation is required by Model Rule 1.7, the consent must be provided by an appropriate official of the organization other than the individual constituent who is also being represented.
In addition, although the attorney-client privilege generally applies to communications between clients and their attorneys, where an in-house attorney is acting in their capacity as a businessperson or principal of the organization (and not as an attorney), such communications may not be privileged. This same risk may apply to outside attorneys as well if they are also interacting with their entity clients in a non-legal capacity, such as by serving as a member of the entity’s board of directors.
As a result, it is important for both in-house and outside counsel to consider and address the following requirements:
properly identifying who is, and who is not, the client with respect to an entity client;
dealing with conflict of interest in an entity client context, especially with the respect to dealing with entity constituents, the inadvertent creation of attorney-client relationships, possible joint representations, and affiliated entities and joint ventures (Model Rules 1.7, 1.9, 1.10, and 1.13);
addressing Model Rule 1.6 confidentiality, the attorney-client privilege, and the work product doctrine in the entity client context; and
gaining a better understanding of the application of other Model Rules to the attorney (in-house or outside counsel) representing an entity, including Rule 1.8 (business transactions and other relations with a client); Rule 5.5 (the unauthorized practice of law and multi-jurisdictional practice, in the cross-border context); and Rule 1.13(b) and (c) (reporting up and out when representing an entity client).
The increased use of digitalized healthcare technologies amid the global pandemic continues to pique the interest of many institutional healthcare organizations and professionals, emphasizing its utility as an influential healthcare delivery segment; however, telehealth’s accelerated growth and fast-tracked implementation raise many concerns, including physicians’ licensure compliance and fraudulent behavior by healthcare providers.[1] Although the pandemic’s exit is not yet foreseeable, governments are now better equipped to manage its repercussions without imposing another set of stringent lockdowns, which begs the question: what is the future of this potentially robust healthcare sector? Many proponents, such as the American Medical Association (“AMA”), have advocated for Congress to facilitate a smooth transition so patients can continue to address their healthcare needs via telehealth processes.[2]
Prior to the global pandemic, state and federal regulations partially inhibited patients’ and physicians’ ability to convene by utilizing digitalized healthcare systems. Regulations dictated that physicians adhere to state licensure requirements when providing patient care. Moreover, Section 1834(m) of the Social Security Act restricts the usage of telehealth services unless such care is provided at an approved site—a provision that has traditionally been used in rural communities.[3] The Public Health Emergency (“PHE”) declaration partially suspended these strict regulatory requirements. Further, the passage of the CARES Act authorized the Centers of Medicare and Medicaid Services (“CMS”) to waive geographic barriers for the duration of the PHE.[4] As a result, many patients are able to receive medical services from the comfort of their residences instead of strictly at an approved site.[5] As CMS waived many of these geographic barriers in March of 2020, Medicare, Medicaid, private insurance companies, and state governments enabled reimbursements for telehealth services at the same rate as physical visits.[6] Additionally, during the peak of the pandemic, 41 states temporarily suspended licensure requirements, authorizing out-of-state physicians to administer services across state lines by utilizing telehealth infrastructure.
On January 14, 2022, the U.S. Department of Health & Human Services (“HHS”) extended the PHE until April 16, 2022.[7] Coinciding with the continuance of the PHE declaration is the issuance of Section 1135 Waivers of the Social Security Act. Section 1135 grants the HHS the authority to modify or suspend federal requirements for the duration of a PHE. Among the significant modifications issued by the HHS and CMS are state-specific Medicaid waivers, which allow providers to administer care by utilizing telehealth across state lines.[8] Moreover, Medicare telehealth coverage and federal oversight reporting requirements continue to be modified to ensure healthcare accessibility during the PHE.[9] These waivers and similar modifications will cease when the PHE expires; thus, uncertainty looms regarding the future of telehealth and its accessibility. Absent Congressional action, the flexibilities of Medicare reimbursements and temporary suspension of geographic restrictions will cease at the expiration of the PHE.
Some federal developments are under consideration to ensure that access to these services is not inhibited after the PHE expires. For example, legislation has been introduced in the Senate, including the Creating Opportunities Now for Necessary and Effective Care Technologies for Health Act of 2021 (“CONNECT Act”). This act would permanently remove the geographic restrictions under Medicare, allowing patients to access mental telehealth services from their residence rather than an approved location; additionally, the CONNECT Act would also remove the geographic restrictions for rural health clinics and federally qualified health centers.[10] Similarly, H.R. 2903 (a companion bill to the CONNECT Act) amends the Social Security Act to expand access and reimbursement of telehealth services.[11] Although a step in the right direction, these bills have experienced little momentum in their respective houses. As the new PHE declaration will soon expire, and as COVID immunity builds, maybe lawmakers will prioritize this bipartisan and bicameral legislation.
With respect to physicians’ licensure requirements, uniformity is nearly impossible to ensure. As referenced prior, licensing requirements are state-specific. Therefore, state legislatures must determine if they wish to continue, or make permanent, flexible licensure procedures. State legislatures are seeking to make their temporary waiver exemptions permanent, granting out-of-state practitioners the ability to deliver telehealth services across state lines if they comply with local state practices and requirements. Specifically, many states have entered interstate compacts, which allow certain providers to practice across state lines if they remain in good standing with their home jurisdiction.
Notably, 29 states and the District of Columbia are members of the Interstate Medical Licensure Compact.[12] Some states, such as Florida, have allowed temporary waivers to expire.[13] Although this may complicate physicians’ ability to deliver out-of-state care via telehealth platforms, some of these states provide expedited licensing to out-of-state physicians who seek to offer telehealth services. On a federal level, some proponents have argued for a uniform system of physician licensure reciprocity; however, it is unlikely states will individually honor widespread reciprocity. Still, a situation could arise, although unlikely, where the federal government compels states to honor such a reciprocity agreement.[14] For example, the receipt of federal funds, such as Medicaid, could be linked to the acceptance of a federal initiative aimed at implementing a system of widespread state licensure reciprocity.
It is also likely that more precise procedures for providing care when utilizing telehealth platforms will be implemented. As the declaration of the PHE was abrupt and unforeseeable, the delivery method of telehealth services was not a primary concern. But, as restrictions are lifted across the country, state and federal regulations will likely address telehealth delivery methods and their compliance with medical standards.
Lawmakers and medical practitioners must address the exponential increase in the number of patients seen via telehealth outlets. In some instances, physicians are now attending to more than 100 times the number of patients through telehealth practices than they saw in person before the COVID-19, prompting the need for increased safeguards so that physicians and telehealth platforms do not become overwhelmed and overmanipulated. It was not possible to foresee the level of chaos that ensued as a result of the global pandemic. Consequently, to meet patient demands, physicians had to quickly adapt to the new normal by adopting and incorporating telehealth services in their practices. Because physicians had to quickly pivot to keep pace during such a volatile time, there was no easement period.
To alleviate compliance concerns that may have been reasonably neglected, the AMA is asking the federal government to provide physicians with adequate time to meet HIPAA and other compliance measures, rather than immediately subjecting them to enforcement actions and federal audits.[15] This request calls for HHS to provide a one-year glide path to compliance.[16] If implemented, physicians who had to quickly adapt to the global pandemic by utilizing telehealth delivery services will have sufficient time to meet compliance measures.[17] Further, the request also urges telehealth vendors to offer guidance to physicians, thereby ensuring that physicians’ utilization of telehealth technology is compliant with security concerns and standards of patient care.[18]
Telehealth services have proven to be indispensable to health care practitioners and patients during the global pandemic, allowing for greater accessibility and alignment with technological innovation. Still, after the expiration of the PHE, many factors will need to be addressed to ensure an adequate telehealth infrastructure. The potential for rampant fraud is a key concern. On May 26, 2021, the Department of Justice (“DOJ”) embarked on a coordinated action against 14 entities, including physicians, healthcare providers, and telehealth executives, alleging fraudulent Medicare claims totaling over $143 million in false billing.[19] Further, to combat healthcare fraud during the pandemic and abuse of CMS programs, the CMS issued penalties for more than 50 medical providers.[20] In a press release on September 17, 2021, the DOJ announced criminal charges against 138 defendants, spanning across 31 federal districts, for their involvement in alleged healthcare fraud. Of the $1.4 billion in alleged losses, nearly $1.1 billion in fraudulent and falsified claims to Medicare/government insurers was perpetrated via telehealth services. The DOJ’s release emphasizes the inevitable crackdown on providers’ attempts to guise and misrepresent telemedicine services and consultations to exploit the CMS’s expansion of telehealth services during the global pandemic.
With that in mind, federal audits may prove necessary to hinder fraudulent practices and ensure compliance with state and federal laws governing telehealth services. With the emergence of fraudulent practices by providers during the PHE, the HHS’s Office of the Inspector General (“OIG”) started auditing telehealth providers.[21] The auditing procedures initiated by HHS may provide a glimpse into the future of telemedicine while implementing future safeguards and guidelines for patients and providers.[22] Therefore, the OIG’s audits and subsequent recommendations/findings may prove to be an invaluable tool for lawmakers when they consider the future of the telehealth industry.
Overall, there seems to be a consensus that telehealth services will expand to levels of accessibility well above pre-COVID numbers. Hence, regulatory responses to alleviate potential fraudulent behavior are inevitable. With the issuance of new audits of telehealth services by the HHS in 2021, a warning stage has arisen. This seems to point out that the government is preparing to cleanse unscrupulous providers from the market.
Conclusion:
Telehealth is here to stay, but the future of its use remains uncertain. Once the PHE expires, and COVID-19 concerns dissipate, a multitude of adjustments are necessary to ensure that telehealth infrastructures are suitable for long-term, widescale dissemination. First, continued reimbursement for telehealth services must continue, which seems likely. Next, DOJ actions aimed at cleansing the telehealth arena of fraudulent actors and federal audits will signal the necessity of complying with telehealth procedures and protocols to telehealth providers. Lastly, continued cooperation by states via interstate compacts and expedited licensing procedures are vital to the future accessibility of telehealth services.
Although “telehealth” and “telemedicine” may seem to be identical terminology, “telehealth” is much more broad in scope, encompassing many different types of remote health care services. Conversely, “telemedicine” refers to remote clinical services. ↑
A decade ago, the thought of legalized marijuana—even for medicinal purposes—was cutting edge and controversial. In 2021, the conversations around legalized cannabis have dramatically evolved. While there are still critics of legalized cannabis, we have seen a nationwide and largescale embrace of cannabis use ranging from treatment for medical conditions to recreational marijuana. Hemp and CBD products have become mainstream. As of this writing, thirty-seven states, the District of Columbia, and four US territories allow for the use of medical marijuana. Thirteen states and one territory have decriminalized the use of cannabis. Additionally, eighteen states, two territories and the District of Columbia have enacted laws to allow the recreational use of marijuana. Eleven states allow for the use of low THC, high CBD products for medical reasons. These numbers are trending upward, with several states expected to enact various cannabis legalization bills in 2022. Only three states (Idaho, Kansas, and Nebraska) still do not allow the use of cannabis in any capacity.
Despite the overwhelming majority of states allowing for the use of cannabis at some level, the federal legalization structure is lacking. This complex interplay makes it difficult for business lawyers to advise clients whose businesses involve cannabis—whether those clients are legally selling cannabis or if those clients are cannabis-adjacent. This article will explore how the conflict of law between the narrow federal landscape and the expansion of state cannabis laws has created numerous business law complications, including its impact on the banking rules and regulations, and decisions lawyers and bankers must make without clear guidance and direction. Additionally, this article will provide a high-level overview of the questions a business lawyer should be asking, such as: What are the ethical rules that I should be aware of, and what are the areas I need to troubleshoot for my client that I may never have contemplated would be impacted by the changing state-based marijuana laws?
While this article hopes to provide guidance and advice for the business lawyer in the cannabis space, the conflict that exists between federal law and the state laws may present more questions than we can currently answer. However, even with uncertainty in some of the questions raised, this is an area that is growing and evolving, and every business lawyer should be prepared for issues and questions that may arise in this space.
State Law vs. Federal Law
As we examined in the beginning, states have moved towards embracing the use of cannabis. The federal government, meanwhile, has not made the same move. Under federal law, cannabis is still classified as a Schedule I substance under the Controlled Substance Act. This means it is considered to have a high potential for dependency and no recognized medical use. For context, other Schedule I substances include ecstasy, heroin, and LSD. Distribution of a Schedule I substance is a federal offense.
Some progress was made on the federal level with the passage of the 2014 and 2018 Farm Bills. While the Farm Bills did not change the legal classification of cannabis, they did remove hemp from Schedule I of the Controlled Substances Act and permitted states to create industrial hemp programs. There was hope that the Farm Bills would also lead to the Food and Drug Administration (FDA)—which retains regulatory authority over drugs—to issue detailed guidance that would provide clarity on whether (and how) CBD could be used. The Farm Bills, however, have led to more confusion. Many thought that the Farm Bills legalized CBD. The day the 2018 Farm Bill became effective, the FDA released a statement asserting its policy that marketing CBD as foods or dietary supplements remained unlawful. This has led to great consumer confusion and even more uncertainty as the market is now saturated with hemp and CBD products that may or may not actually be allowed under federal law.
In 2021, U.S. Senators Cory Booker, D-NJ, Ron Wyden, D-OR, and Charles “Chuck” Schumer, D-NY, proposed the Cannabis Administration and Opportunity Act as a Discussion Draft (hereinafter the “Draft”). The sponsors indicated that the Draft is in anticipation of a final proposal, which Senate Majority Leader Schumer recently stated would be introduced in April 2022. The Draft would remove cannabis from the Controlled Substances Act and direct the Attorney General to remove cannabis from the list of controlled substances. The Draft would impose a federal excise tax on cannabis products. Importantly, the Draft also contains a number of decriminalization provisions and would allow state-compliant marijuana business to have access to financial services such as bank accounts and loans.
Financial Services Concerns
While this Draft is a significant step towards a comprehensive regulatory scheme, federal action (including its inaction) has already created a conflict of laws in the cannabis space. The federal-state law conflict is particularly evident in the financial services sector. State and federally chartered banks rely on federal agencies for regulatory oversight, insurance and access to funding and payment systems. While a few states have enacted bills intended to protect financial institutions from state financial regulators and other forms of state-wide enforcement in relation to cannabis banking, cannabis remains a federally illegal substance. Thus financial institutions providing banking services to state-licensed cannabis businesses, and even to other companies which sell services and products to those businesses, could find themselves subject to criminal and civil liability under the Controlled Substances Act and subject to regulatory sanctions under certain federal banking statutes.
These risks have significantly inhibited the ability (and willingness) of financial institutions to provide services to cannabis businesses and companies. This limits the ability of cannabis-related businesses—and the financial institutions that want to serve them—to engage in core activities, such as opening accounts, deposits, using checking accounts, accepting credit cards, authorizing electronic transfers, and so on. Some banks and credit unions have cautiously begun entering this market space. While Congress tried to advance a narrow solution through the Secure and Fair Enforcement Banking Act of 2021 (SAFE Banking Act), the bill passed the House of Representatives six times, but has never been taken up in the Senate. Lawyers advising financial institutions that are evaluating whether to offer services to state licensed marijuana-related businesses will need to consider robust risk assessment and compliance programs, along with staying abreast of state and federal law developments.
Other Impacts
In addition to the prime example from the banking space, there are many other areas impacted by the conflict of federal and state laws. For example, the transportation sector is rife with issues. A driver holding federal Department of Transportation certifications and crossing state lines faces a myriad of conflicting state laws and the federal prohibition on cannabis. For example, such a driver could face the loss of their certifications if they test positive for cannabis use, even if they are not intoxicated while driving and if the cannabis was legally used in a state.
There are inherent issues raised in the cannabis space that it is natural for a prudent business attorney to wonder whether they should be doing this work at all. After all, cannabis is still illegal on the federal level. Arguably, a lawyer advising a cannabis company is advising the violation of law and breaking the professional oath they took upon being sworn into the Bar. Most states that have legalized cannabis have provided at least some degree of protection for attorneys who advise clients on how to legally operate within state regulatory frameworks. Some states, like New York, have gone as far as saying that an attorney can not only advise clients, but also accept partial ownership of a recreational marijuana business in lieu of a fee, and when fully legalized, partake of recreational marijuana without jeopardizing their law license. The state rules and regulations are ever evolving, and it is incumbent on any attorney to understand the guiding ethical rules and regulations for the jurisdiction in which they practice. To try to give detailed information in this area is complicated by the ever-changing rules.
Overall, there are many nuances to this ever-evolving issue. The landscape in the cannabis area is constantly changing, and by the time this article is published, some of the information contained herein may have already changed. It is imperative that a business lawyer working in this area stay abreast of each development so that they are properly advising their clients.
Hughes Hubbard & Reed LLP One Battery Park Plaza New York, NY 10004 (212) 837-6126 [email protected] www.hugheshubbard.com
Michael D. Rubenstein
Liskow & Lewis APLC 1001 Fannin Street, Suite 1800 Houston, TX 77002 (713) 651-2953 [email protected] www.liskow.com
§ 1.1. Supreme Court
City of Chicago vs. Fulton, 141 S. Ct. 585 (2021). In the case before the Court, the City of Chicago impounded the debtors’ vehicles for failure to pay fines. The debtors then filed chapter 13 bankruptcy cases. Following the filing of the cases, the debtors requested that the city return the vehicles. The city refused and the bankruptcy court held that those refusals each constituted a violation of the automatic stay. The Seventh Circuit affirmed and held that “by retaining possession of the debtors’ vehicles after they declared bankruptcy,” the city had violated section 362(a) of the Bankruptcy Code by exercising control over the debtors’ property. The Supreme Court granted certiorari “to resolve a split in the Courts of Appeals over whether an entity that retains possession of the property of a bankruptcy estate violates § 362(a)(3).”
The Court began its analysis by noting that the filing of a bankruptcy petition has certain immediate consequences. The first is that it is the creation of an estate that, with limited exceptions, includes all of the debtor’s legal or equitable interests and property as of the commencement of the case. The Court noted that a second automatic consequence of the filing of a bankruptcy petition, again with certain limited exceptions, is that the petition operates as a stay of all efforts to collect from the debtor outside of the bankruptcy case. Among the many efforts prohibited by the state is “any act in possession of property of the estate or of property from the estate or to exercise control over property of the estate.” Justice Alito, writing for the Court, concluded that the language used in section 362(a)(3) suggests that simply retaining possession of estate property does not violate the stay. The Court noted that the stay bars “any act” to exercise control over property of the estate. The Court concluded that the most natural reading of the statutory language was to prohibit affirmative acts that would disturb the status quo of estate property as of the time of the bankruptcy filing. The Court further concluded that any ambiguity in the language of the Bankruptcy Code would be resolved in the non-debtor’s favor because of section 542. That provision, entitled “Turnover of Property to the Estate,” provides for the delivery of estate property to the trustee. Interpreting the automatic stay to cover mere retention of property would, in the Court’s analysis, create two problems. First, it would render section 542 largely superfluous, which would be contrary to basic principles of statutory interpretation. Moreover, this alternative reading of the automatic stay would render the automatic stay and the turnover provisions contradictory. The Court reached this conclusion because section 542 has exceptions for, inter alia, the turnover of inconsequential property. Reading section 362 as the debtors urged would have the automatic stay commanding turnover of property, when the more specific turnover provision would not. Accordingly, the court held that the mere retention of estate property after the filing of a bankruptcy petition does not violate the automatic stay.
In a concurring opinion, Justice Sotomayor emphasized that the Court did not decide whether and when the automatic stay’s other provisions might require a creditor to return a debtor’s property. Justice Sotomayor also noted that the Court did not address how bankruptcy courts should go about enforcing the commands of section 542(a), and that the city’s conduct could very well violate one or both of these provisions. Justice Sotomayor concluded by noting that any gaps in the efficacy of the turnover process would be “best addressed by rule drafters and policy makers, not bankruptcy judges,” and urged the Advisory Committee on Rules of Bankruptcy Procedure “to consider amendments to the Rules to insure prompt resolution of debtors’ requests for turnover under [section] 542(a), especially where debtors’ vehicles are concerned.”
§ 1.2. First Circuit
Union de Trabajadores de la Industria Electrica y Riego v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 7 F.4th 31 (1st Cir. 2021). In one of the latest of many decisions stemming from the proceedings under Title III of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the First Circuit recently affirmed the decision of the court overseeing the Title III proceedings (the “Title III Court”) that section 503(b)(1)(A) of the Bankruptcy Code applies to Title III proceedings, notwithstanding that there is no “estate” in Title III proceedings.
In July 2017, the Financial Oversight and Management Board for Puerto Rico (“FOMB”), established by PROMESA to oversee the restructuring proceedings of Puerto Rico and its various instrumentalities, commenced Title III proceedings for the Puerto Rico Electric Power Authority (“PREPA”) after the public power utility—one of the largest in the United States and the only electrical energy distributor in Puerto Rico—became unable to service its debt. Almost a year later, in June 2018, Puerto Rico passed an act to partially privatize PREPA. As a result, a competitive bidding process was undertaken to find a private entity to assume control over PREPA’s power transmission and distribution system (“T&D System”). Two years later, in June 2020, LUMA Energy (“LUMA”) won the bid and entered into a contract to gradually assume operations and management of PREPA (“T&D Contract”). Under the T&D Contract, LUMA would provide front-end transition services to PREPA that would facilitate LUMA’s operational takeover, for which PREPA would pay an estimated $136 million, plus any late fees that might become due as a result of untimely payments. In addition, PREPA agreed to file a motion with the Title III Court seeking administrative expense treatment for any accrued and unpaid amounts required to be paid by PREPA during the front-end transition period; if the court refused to grant the motion, LUMA reserved the right to terminate the T&D Contract. Various prepetition creditors of PREPA opposed the motion, arguing the fees and expenses due under the T&D Contract could not be given administrative expense priority under section 503(b)(1)(A), notwithstanding that PROMESA incorporates section 503 of the Bankruptcy Code in its entirety, because there is no “estate” to preserve in Title III proceedings. The Title III Court rejected this argument, and determined that both the text and structure of PROMESA made it clear that PREPA’s operating expenses were entitled to administrative expense priority, to the extent that they were to preserve the property of a debtor in Title III debt adjustment proceedings. Nonetheless, the Title III Court denied the motion in part, without prejudice, solely to the extent that the motion sought an allowed administrative expense claim for late payment fees that might be incurred in the future.
The First Circuit agreed with the Title III Court, holding that the creditors’ interpretation would render meaningless 48 U.S.C. § 2161(a), which incorporates various Bankruptcy Code provisions referring to an “estate” into Title III of PROMESA. In addition, the First Circuit rejected the creditors’ argument that 48 U.S.C. 2161(c)(5), which provides that “[t]he term ‘property of the estate,’ when used in a section of [the Bankruptcy Code] made applicable in a case under this subchapter by subsection (a), means property of the debtor,” does not apply to section 503(b)(1)(A) because section 503(b)(1)(A) uses the terminology “estate” rather than the terminology “property of the estate.” Relying on 48 U.S.C. § 2161(b), which states that “[a] term used in a section of [the Bankruptcy Code], made applicable in a case under this subchapter by subsection (a), has the meaning given to the term for the purpose of the applicable section, unless the term is otherwise defined in this subchapter,” the court held that “‘the meaning given to’ the term ‘estate’ for ‘the purposes’ of § 503(b)(1)(A) is the meaning given to it under § 541, which is ‘property of the estate.’” Because the term “property of the estate” is otherwise defined in 48 U.S.C. § 2161(c)(5) to mean “property of the debtor,” there was no reason to read section 503(b)(1)(A) out of PROMESA.
In addition, the First Circuit rejected challenges to the Title III Court’s finding that the T&D Contract fees (other than late fees) satisfied the requirements of section 503(b)(1)(A) and affirmed the Title III Court’s determination that the FOMB had sole jurisdiction to review a fiscal plan for compliance with 48 U.S.C. § 2141(b)(1).
Pinto-Lugo v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 987 F.3d 173 (1st Cir. 2021). In another decision arising from the PROMESA proceedings, the First Circuit applied the doctrine of equitable mootness to dismiss three consolidated appeals of the plan of adjustment for the Puerto Rico Sales Tax Financing Corporation (“COFINA”). In so doing, the First Circuit undertook an analysis of (i) the Supreme Court’s decision in Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019) and whether that decision rendered the doctrine of equitable mootness invalid, and (ii) whether the doctrine of equitable mootness could be applied to a Title III proceeding, or to municipal bankruptcy proceedings generally. On both issues, the First Circuit resolved that equitable mootness was applicable to the current cases in controversy.
Certain holders of COFINA bonds objected to a settlement between the Commonwealth of Puerto Rico and COFINA resolving which entity had the superior right in the Commonwealth’s sales and use tax revenues (the “SUT Revenues”). The settlement, which formed the basis of COFINA’s plan of adjustment, allocated 53.65% of the SUT Revenues to COFINA, while the Commonwealth kept the remainder. To implement the settlement, the Commonwealth was required to pass new bond legislation, reorganizing COFINA, allocating the SUT Revenues as agreed under the settlement, and authorizing COFINA to issue replacement bonds. During the legislative session when the new bond legislation was brought to the floor of the Puerto Rico House of Representatives, a minority party representative stood to oppose the bill, but was ignored by the president of the House. The bill was subsequently passed and signed into law by the governor on November 15, 2018.
One contingent of bondholders (the “Pinto-Lugo Group”) filed a complaint seeking declaratory judgment that the law was invalid, asserting that the treatment of the minority representative amounted to a violation of the Puerto Rico legislative rules and the Puerto Rico Constitution. The complaint also sought a ruling that the predecessor act was invalid because it violated limitations on Commonwealth borrowing under the Puerto Rico Constitution. The action was removed to the Title III Court in January 2019.
Also in January 2019, the Title III Court heard objections to the proposed COFINA plan of adjustment, incorporating the settlement. In addition to an objection by the Pinto-Lugo Group, on grounds similar to the complaint, the plan also drew objections from a separate contingent of COFINA bondholders (the “Elliot Group”) and a single bondholder seeking to assert his individual claim. The Title III Court overruled all objections to the plan and dismissed the individual’s proof of claim as duplicative of an omnibus proof of claim filed on behalf of all bondholders, including the individual. The Title III Court approved the plan on February 5, 2019, and the plan was implemented a week later on February 12, 2019. These appeals followed.
The FOMB and others opposed the appeals on grounds of equitable mootness. The First Circuit considered two arguments raised regarding the threshold applicability of the doctrine before examining the merits of dismissing on the basis of equitable mootness. First, the Elliot Group argued that Mission Product undermined the doctrine of equitable mootness. Examining that holding, the First Circuit determined that, in Mission Product, the Supreme Court addressed the jurisdictional ramifications of equitable mootness, whereas in these appeals, the issue was whether the parties’ inaction and the passage of time rendered the relief sought inequitable. Accordingly, Mission Product did not pose an obstacle to the applicability of equitable mootness in the instant action. Second, the Elliot Group contended that the doctrine of equitable mootness was inapplicable to a municipal bankruptcy, and especially to a Title III case under PROMESA. The First Circuit rejected this argument, noting that all circuits to have considered the applicability of equitable mootness to municipal bankruptcy proceedings had treated it as applicable, and that the reasons for making the doctrine applicable to chapter 11 reorganizations applied equally to adjustments under PROMESA.
On the merits, the First Circuit considered: (i) whether the objectors had pursued with diligence all available remedies to obtain a stay; (ii) whether the challenged plan had proceeded beyond practicable annulment; and (iii) whether providing the relief sought would harm innocent third parties. The court found that both the Elliot Group and the Pinto-Lugo Group had “sat on their hands,” since they did not (a) object to the Bankruptcy Rule 3020(e) waiver in the plan, which permitted the plan to be implemented immediately; (b) move for a stay either before the Title III Court or the First Circuit; or (c) seek to expedite the appeal, but rather sought extensions of the briefing schedules themselves. The Pinto-Lugo Group asserted that they did not need to seek a stay to vindicate “fundamental constitutional rights,” but the First Circuit disagreed, holding that “the presence of underlying constitutional claims does not act as a per se bar to the applicability of the doctrine [of equitable mootness].” The court also found, without difficulty, that there was “no practical way to undo” the implementation of the plan, when the replacement bonds had been traded on the open market for over a year, and that any efforts to unwind the plan would inevitably result in harm to “innocent third parties who, due to the . . . objectors’ lack of diligence, justifiably came to rely on the confirmation order.” Accordingly, the First Circuit dismissed the appeals as equitably moot.
Mayoral v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 998 F.3d 35 (1st Cir. 2021). A third decision from the PROMESA proceedings speaks to the ability of investors in a mutual fund that had invested in bonds issued by the Commonwealth of Puerto Rico to bring a claim against the Commonwealth in its Title III proceedings. Notwithstanding the broad construction of the definition of a “claim” under the Bankruptcy Code, the Title III Court found, and the First Circuit affirmed, that these investors did not have standing to recover their losses against the Commonwealth.
Two individual investors each filed proofs of claim against the Commonwealth for a total of approximately $328,400, asserting as the basis for such claim an “investment in mutual funds.” The FOMB objected to the claims on grounds that these individuals were not creditors of the Commonwealth, and thus did not have standing to assert claims against the Commonwealth. Although the individuals argued that they were “co-owners” of the bonds with the mutual funds, and therefore had standing, the Title III Court agreed with the FOMB and disallowed the claims. After two motions for reconsideration before the Title III Court, the individuals appealed to the First Circuit.
First considering the merits of the Title III Court’s initial order disallowing the claims, the First Circuit found that the individuals were not creditors of the Commonwealth under section 501(a) of the Bankruptcy Code, as applicable to Title III proceedings by virtue of 48 U.S.C. § 2161(a). The Bankruptcy Code defines a “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor.” 11 U.S.C. § 101(10)(A). A “claim” is defined as a “right to payment” or a “right to an equitable remedy for breach of performance if such breach gives rise to a right to payment.” 11 U.S.C. § 101(5). And a “‘right to payment’ . . . ‘is nothing more nor less than an enforceable obligation.’” Id. at 41 (quoting Cohen v. de la Cruz, 523 U.S. 213, 218 (1998)). Because the claimants did not provide any evidence of an enforceable obligation existing between themselves and the Commonwealth, the First Circuit held that they were not creditors of the Commonwealth. Furthermore, the court found no injury separate from any injury the mutual funds may have suffered, creating a further barrier for standing. Accordingly, the First Circuit found no error in the Title III Court’s original holding and no abuse of discretion in connection with the denials of reconsideration.
Kupperstein v. Schall (In re Kupperstein), 994 F.3d 673 (1st Cir. 2021). In a recent examination of the police power exception to the automatic stay as related to contempt proceedings, the First Circuit adopted a liberal approach, determining that the contempt proceedings were not pursued for a pecuniary purpose, but even if there was an element of the proceedings that served a pecuniary purpose, based on the “totality of the circumstances,” the predominant purpose related to enforcement of public policy such that the contempt proceedings fell within the police power exception.
Donald C. Kupperstein was leasing a property belonging to the estate of Fred Kuhn and collecting rents from its tenants. Because the Kuhn estate owed a debt to the Massachusetts Office of Health and Human Services (“MassHealth”), the estate, MassHealth, and Kupperstein ended up in Massachusetts Probate Court. Kupperstein disregarded the probate court’s order to pay “any and all” rents collected from the property to MassHealth, and continued to rent the property for his own gain, despite the court’s order voiding the original transfer of the property to Kupperstein. Between August 2017 and January 2018, the probate court twice held Kupperstein in contempt and set a contempt hearing for early January 2018. The day before his contempt hearing, Kupperstein filed for bankruptcy in the United States Bankruptcy Court for the District of Massachusetts, listing the Kuhn property as his own property. The following day, at his contempt hearing, despite Kupperstein’s argument that his bankruptcy filing automatically stayed the probate court proceedings against him, the probate court jailed Kupperstein for the day for previously violating the court’s orders four times. At the next court date, Kupperstein narrowly avoided a 30-day jail sentence by finally turning over the keys to the property and producing $5,400, which he had been ordered to pay to MassHealth in December 2017. Kupperstein then vanished, and the probate court held him in contempt twice more for missing three court dates and continuing to violate its previous orders. The probate court also ordered Kupperstein to pay over $50,000 in outstanding rents and over $10,000 in attorneys’ fees as sanctions for repeatedly flouting the court’s orders and issued a warrant for Kupperstein’s arrest.
The Kuhn estate and MassHealth both filed motions in the bankruptcy court to lift the automatic stay to permit the state court actions to proceed; Kupperstein (through his counsel, because he was still “at large”) opposed the motions and moved the bankruptcy court to hold MassHealth in contempt and impose monetary sanctions because MassHealth participated in the probate court’s various contempt proceedings in violation of the bankruptcy court’s automatic stay. The bankruptcy court found “good cause” to lift the stay and ordered that the state court actions could proceed, including the assessment by the courts against Kupperstein of any restitution and sanction amounts, but that the Kuhn estate and MassHealth could not seek to enforce against Kupperstein any judgment with respect to a nearly $200,000 MassHealth reimbursement claim or attempt to collect all or any of such amount from Kupperstein. The bankruptcy court also denied Kupperstein’s motion to hold MassHealth in contempt and to impose sanctions, noting that “[a] court’s imposition and enforcement of a monetary sanction for contemptuous conduct is an exercise of its police power and is excluded from the automatic stay by Bankruptcy Code § 362(b)(4).” After the district court affirmed the bankruptcy court’s rulings, Kupperstein appealed to the First Circuit.
The First Circuit, examining whether the police power exception to the automatic stay applied to the probate court’s contempt proceedings and resultant penalties, concluded that the police power exception applied and that the bankruptcy court did not abuse its discretion. Considering the full array of contempt orders issued by the probate court—which included not only monetary fines, but also orders instructing Kupperstein to turn over the keys to the Kuhn property, to cease leasing the property to tenants as the landlord and not to engage in any new leases, and to turn over any documents he had previously executed regarding renting the property—the First Circuit found that the probate court’s contempt orders were “plainly not an attempt to collect money and there [wa]s simply nothing in the ‘pecuniary interest’ test or the Bankruptcy Code, generally, forbidding a court from ordering that a debtor hand over the keys to a house that he does not own.” As to the monetary fines, the First Circuit rejected Kupperstein’s argument that orders involving money were automatically for a “pecuniary purpose,” since such a position elided the distinction between “a judgment prematurely awarding assets to creditors ahead of the process permitted by the bankruptcy court . . . and an order commanding disgorgement of ill-gotten gains accumulated in direct violation of a court order.” Because neither the Kuhn estate nor MassHealth would gain any priority as a result of the probate court’s order, due to the carveout for enforcement of judgments relating to the $200,000 amount, there was no pecuniary purpose to the probate court’s contempt orders. The First Circuit ventured further still, holding that, even if there was some pecuniary purpose to the financial aspects of the probate court’s orders, it would not affect the court’s determination: “Where the application of the police power exception contains various elements, some of which effectuate a public policy and others of which could involve pecuniary interests, we examine the totality of the circumstances and what the governmental action is designed primarily to [do].” (internal citations omitted). Because “Kupperstein’s own refusal of earlier orders that had no money at stake created this situation . . .,” he could not use the automatic stay to forestall the imposition of the probate court’s contempt orders, including the monetary fines.
Miranda v. Banco Popular de P.R. (In re Cancel),7 F.4th 23 (1st Cir. 2021). The First Circuit implicitly re-affirmed the Butner principle in a recent decision arising out of an individual chapter 7 case when the chapter 7 trustee sought to avoid an unrecorded Puerto Rican mortgage.
After initially granting the chapter 7 trustee summary judgment based on Massachusetts law, the bankruptcy court reversed on reconsideration, granting summary judgment in favor of the bank on the basis that Puerto Rico law does not treat an unrecorded mortgage as a property interest.
On appeal, the First Circuit considered the nature of Puerto Rican property law. “Puerto Rico has a fundamentally different scheme of mortgage rights. It uses a Property Registry system. A deed is not ‘recorded’ until the Property Registry judges that the deed is valid.” Accordingly, “[u]nder Puerto Rican law, a mortgage must be recorded for it to confer any interest in the underlying real property.” In addition, the First Circuit considered precedent established by the Supreme Court of Puerto Rico, wherein the court held that “a mortgage-holder does not acquire property rights to the underlying real property until the mortgage is recorded, or at least until the mortgage-holder begins the registration process.”
As such, the First Circuit concluded that an unrecorded mortgage in Puerto Rico does not trigger the trustee’s avoidance powers under section 544 of the Bankruptcy Code.
Roy v. Canadian Pac. Ry. Co. (In re Lac-Megantic Train Derailment Litig.), 999 F.3d 72 (1st Cir. 2021). In a question of first impression for the First Circuit, the court held that the Federal Rules of Bankruptcy Procedure—not the Federal Rules of Civil Procedure—govern the procedures in cases that have come within the federal district courts’ jurisdiction as cases “related to” pending bankruptcy proceedings under 28 U.S.C. § 1334(b).
This case arose out of a tragic train derailment and explosion involving a transnational shipment of crude oil, which caused many deaths, extensive personal injuries, and large-scale property damage. Montreal, Main and Atlantic Railway (“MMA”) eventually assumed responsibility for the rail cars in which the oil was transported, and subsequently sought the protection of the bankruptcy court in the District of Maine. Many lawsuits ensued, which were eventually consolidated in the District of Maine pursuant to 28 U.S.C. § 157(b)(5), which allows a district court having jurisdiction over a bankruptcy proceeding to order the transfer to it of any “personal injury tort and wrongful death claims” related to the bankruptcy proceeding. Eventually, the plaintiffs settled with all of the named defendants except for Canadian Pacific Railway Company (“Canadian Pacific”).
Canadian Pacific moved to dismiss the plaintiffs’ consolidated complaint for, among other reasons, lack of in personam jurisdiction, insufficient service of process, and forum non conveniens. In opposition, the plaintiffs sought leave to file a second amended complaint. The district court granted Canadian Pacific’s motion to dismiss, denied the plaintiffs’ motion to amend, and denied all other pending motions as moot, entering final judgment in favor of Canadian Pacific. Twenty-eight days after final judgment was entered, the plaintiffs moved for reconsideration in the district court of the denial of their motion to file an amended complaint. Canadian Pacific opposed the motion on a number of grounds, including timeliness, arguing that the Bankruptcy Rules—which allow only a fourteen-day window for motions for reconsideration—controlled and that, therefore, the plaintiffs’ motion for reconsideration was untimely. After the district court denied reconsideration, the plaintiffs filed a notice of appeal, purporting to challenge the district court’s denial of their motion for leave to amend.
The threshold issue before the First Circuit was whether the plaintiffs’ appeal was timely, which inquiry was determined by the applicable procedural rules: if the Civil Rules applied, the appeal was timely; if the Bankruptcy Rules applied, the appeal was untimely. The First Circuit began by noting that precedent favored the Bankruptcy Rules: all three of the courts of appeals to have considered the issue concluded that the Bankruptcy Rules apply to non-core, “related to” cases pending in a federal forum and that the leading treatise in the bankruptcy field also endorsed this view. The First Circuit read the statutory text as supporting this view, and noted that a procedural scheme that required a district court adjudicating both core and non-core cases in any given bankruptcy proceeding to simultaneously apply two different sets of rules, or that required a district court reviewing a bankruptcy court’s proposed findings of fact and conclusions of law in a non-core case to apply the Civil Rules after the bankruptcy court had applied the Bankruptcy Rules, “would be in marked tension with the bankruptcy system’s goal of resolving claims efficiently.” The First Circuit thus held that “[t]he text of the Bankruptcy Rules, read in conjunction with Congress’ redesign of the bankruptcy system in 1984, makes pellucid that the Bankruptcy Rules apply to non-core, ‘related-to’ cases adjudicated in federal district courts under section 1334(b)’s ‘related to’ jurisdiction.” As a result of this holding, the plaintiffs’ attempted appeal in the case, which would have been timely under the Civil Rules but not timely under the Bankruptcy Rules, was found to be untimely and had to be dismissed for want of appellate jurisdiction.
§ 1.3. Second Circuit
Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries, Inc.), 998 F.3d 56 (2d Cir. 2021). After a bankruptcy court rejected the debtors’ constitutional challenge to quarterly fees imposed during the pendency of the debtors’ bankruptcy proceeding, the Second Circuit reversed, finding that the fees assessed in judicial districts in which the United States Trustee Program oversees bankruptcy administration (“UST Districts”), which were higher than the fees assessed in judicial districts in which judicially appointed bankruptcy administrators perform the same function (“BA Districts”), violated the uniformity requirement of the Bankruptcy Clause of the United States Constitution.
In 2017, Congress passed an amendment (the “2017 Amendment”) to the statute setting forth quarterly fees in bankruptcy cases. The 2017 Amendment increased quarterly fees in UST Districts only, and BA Districts did not immediately adopt an equivalent fee increase. In 2020, Congress passed the Bankruptcy Administration Improvement Act of 2020 (the “2020 Act”), which mandated that UST Districts and BA Districts charge equal fees. The debtors, who filed for bankruptcy in a UST District in 2017, incurred fees in accordance with the increase set forth in the 2017 Amendment during the period after that amendment but before the effective date of the 2020 Act. Accordingly, although the 2020 Act ensured the uniform application of fees in UST Districts and BA Districts, the Second Circuit was left with the question of whether Clinton was charged unconstitutional fees before the BA Districts fully implemented the 2017 Act’s fee increase.
After addressing the debtor’s standing to bring the constitutional challenge, the Second Circuit turned to the merits of the argument, rejecting the U.S. Trustee’s position that the 2017 Amendment was “an administrative funding measure, not a substantive bankruptcy law,” and thus did not implicate the uniformity requirement of the Bankruptcy Clause. Noting that this argument “has been repeatedly rejected by other courts,” the Second Circuit held that “[t]he subject of the 2017 Amendment plainly fits within the Supreme Court’s broad definition of ‘bankruptcy’ as ‘the subject of the relations between an insolvent or nonpaying or fraudulent debtor and his creditors, extending to his and their relief.’” Because the 2017 Amendment “governs debtor-creditor relations and impacts the relief available, it is a bankruptcy law subject to the Bankruptcy Clause and is constitutional only if ‘uniform.’”
The Second Circuit next addressed the question of whether the 2017 Amendment violated the uniformity requirement of the Bankruptcy Clause. The Second Circuit held that the delayed and inconsistent implementation of the fee increase in BA Districts contravened facially uniform statutory language. The 2017 Amendment stated that designated fees “shall” be imposed on debtors in UST Districts, while stating, by contrast, that the Judicial Conference “may” impose the same fees in BA Districts. The Second Circuit refused to ignore the distinction between “shall” and “may,” finding that there was no ambiguity in the statute’s grant of permissive authority to the Judicial Conference to adjust fees and that the statute was thus unconstitutional.
The Second Circuit also rejected the Trustee’s secondary argument, that a narrowly defined exception to the uniformity requirement—the “geographically isolated problem” exception—justified the fee discrepancy. This “geographically isolated problem” exception was first recognized in Blanchette v. Connecticut Gen. Ins. Corp., 419 U.S. 102 (1974), when the Supreme Court addressed the constitutionality of the Rail Act, which set special laws for bankrupt railroads and expressly applied only to a particular geographic region. Stating that “the uniformity clause was not intended to hobble Congress by forcing it into nationwide enactments to deal with conditions calling for remedy only in certain regions,” the Supreme Court concluded that the Rail Act did not contravene the Bankruptcy Clause’s uniformity requirement because all of the country’s bankrupt railroads at that time were located in the designated region and, therefore, in targeting the national rail transportation crisis, the statute addressed a geographically isolated problem. Other courts have applied the “geographically isolated exception” to uphold the constitutionality of the 2017 Amendment. E.g., In re Buffets, L.L.C., 979 F.3d 366 (5th Cir. 2020); In re Circuit City Stores, Inc., 996 F.3d 156 (4th Cir. 2021). The Fifth Circuit in Buffets, for example, reasoned that “[j]ust as it did in addressing the failure of railroads in the industrial heartland, Congress confronted the problem of an underfunded Trustee Program where it found it: in the Trustee Districts.” 979 F.3d at 378. The Second Circuit split from the Fourth and Fifth Circuits, “concerned . . . that the bankruptcy courts and the Buffets and Circuit City opinions [] overlooked a critical distinction” between the Rail Act in Blanchette and the 2017 Amendment at issue in Buffets, Circuit City, and here.
The Second Circuit acknowledged that, although the Blanchette court held that Congress may “take into account differences that exist between different parts of the country, and…fashion legislation to resolve geographically isolated problems,” 419 U.S. at 159, the Supreme Court later clarified that “[t]o survive scrutiny under the Bankruptcy Clause, a law must at least apply uniformly to a defined class of debtors.” Ry. Labor Execs.’ Ass’n v.Gibbons, 455 U.S. 457, 473 (1982). “In Blanchette, all members of the class of debtors impacted by the statute were confined to a sole geographic area: [t]he statute applied only to bankrupt railroad companies, and there were no bankrupt railroad companies located outside the statutorily designated region. Here, by contrast, the 2017 Amendment’s fee increase applies to the class of debtors whose disbursements exceed $1 million, and there has been no suggestion that members of that broad class are absent in BA Districts.” Clinton Nurseries, 998 F.3d at 68-69 (internal citations omitted). The Second Circuit thus viewed this case as presenting the exact problem avoided in Blanchette: “[t]wo debtors, identical in all respects save the geographic locations in which they filed for bankruptcy, [] charged dramatically different fees.” Id. at 69. Because the distinction between UST Districts and BA Districts appears to exist only because Congress chose to create a dual bankruptcy system, and because the funding shortfall plaguing the UST system was not caused by a “geographically isolated problem” that would place the entire class of affected debtors only in UST Districts, the Second Circuit refused to apply the “geographically isolated problem” exception to the 2017 Amendment, instead finding that prior to the 2020 Act, the 2017 Amendment was unconstitutionally nonuniform on its face because it mandated a fee increase in UST Districts but only permitted a fee increase in BA Districts.
PHH Mortg. Corp. v. Sensenich (In re Gravel), 6 F.4th 503 (2d Cir. 2021). On appeal, the Second Circuit vacated the imposition of punitive sanctions on creditor PHH Mortgage Corporation by the United States Bankruptcy Court for the District of Vermont in three chapter 13 cases, holding that Bankruptcy Rule of Procedure 3002.1 does not authorize punitive monetary sanctions.
This appeal involves punitive sanctions in three chapter 13 cases in Vermont. Rule 3002.1, which governs installment payments on home mortgages in chapter 13 plans, mandates, among other things, that mortgage creditors must serve on the trustee a notice itemizing all fees “within 180 days after the date on which the fees, expenses, or charges are incurred.” Fed. R. Bankr. P. 3002.1(c). If a creditor fails to comply with the 180-day timeline, a bankruptcy court may preclude the creditor from presenting the claim or award the debtor other relief, including expenses and attorneys’ fees. Fed. R. Bankr. P. 3002.1(i). When the Gravels reached the end of their chapter 13 plan, the bankruptcy court issued an order confirming that the Gravels had cured all pre-petition arrearages or defaults existing when the case was filed and made all post-petition payments. Five days later, PHH issued a monthly mortgage statement with an old charge for “property inspection fees,” which had grown to $258.75 over at least 25 monthly statements. The chapter 13 trustee moved for a finding of contempt and sanctions on the ground that the charge violated the bankruptcy court’s order and that each of the 25 charges violated Rule 3002.1. PHH admitted that the fee was not properly noticed, removed it from the mortgage statement, and opposed the motion for sanctions. Around the time the chapter 13 trustee filed its motion in the Gravel case, the same trustee moved for a finding of contempt and sanctions in another chapter 13 proceeding, for the Beaulieus, on the same basis—for late-noticed fees in violation of Rule 3002.1 and the court’s order in that case. The same chapter 13 trustee also moved for sanctions under Rule 3002.1(i) for late-noticed fees in the Knisley case, but did not allege PHH to be in contempt, as no court order had yet been issued in that case. After a consolidated hearing, the bankruptcy court granted the trustee’s motion, finding that PHH had violated Rule 3002.1(c) 25 times in each of the three bankruptcy cases, sanctioning PHH $75,000 pursuant to Rule 3002.1(i), and sanctioning PHH $200,000 in the Gravel case and $100,000 in the Beaulieu case pursuant to its inherent power and section 105 of the Bankruptcy Code for violating the court orders in those cases.
The United States District Court for the District of Vermont vacated both sanctions, holding that the $75,000 and $300,000 sanctions exceeded the bankruptcy court’s statutory and inherent powers because it lacks power to impose serious punitive sanctions. The bankruptcy court then issued a second sanctions order, imposing the same $75,000 sanction for the Rule 3002.1 violation, but reducing the sanctions for violation of the court orders to $150,000 and $75,000, respectively. PHH appealed the second sanctions order to the district court, but the bankruptcy court granted the trustee’s request to certify the order for direct review by the Second Circuit, which then granted the trustee’s petition for direct review.
First addressing the $225,000 sanction for violation of the bankruptcy court’s orders, the Second Circuit held that, because the bankruptcy court relied on its contempt power, its review was limited to whether it abused its discretion in exercising that power. Holding that the court orders were not a clear and unambiguous prohibition on PHH’s sanctioned conduct, the Second Circuit found that the bankruptcy court’s orders thus lacked the requisite clarity that would allow that court to hold PHH in contempt.
The bankruptcy court invoked Rule 3002.1’s authorization to “award other appropriate relief” to impose the $75,000 sanction for PHH’s repeated violations of Rule 3002.1. Presenting an issue of first impression among the circuit courts, the Second Circuit held that Rule 3002.1’s authorization to “award other appropriate relief” does not authorize punitive sanctions. Rule 3002.1 ensures that debtors are informed of new post-petition obligations, such as fees, and ultimately serves to prevent lingering deficits from surfacing after their bankruptcy case ends. The last subdivision of the rule provides for an enforcement mechanism: if a creditor fails to give the requisite notice, the bankruptcy court may preclude the creditor from presenting evidence of its claim in the case, Fed. R. Bankr. P. 3002.1(i)(1), and the court may also “award other appropriate relief, including reasonable expenses and attorney’s fees caused by the [creditor’s] failure [to give the requisite notice].” Fed. R. Bankr. P. 3002.1(i)(2). Because “‘other appropriate relief’ is a general phrase amid specific examples,” the Second Circuit decided that “it is best ‘construed in a fashion that limits the general language to the same class of matters as the things illustrated.’” Sensenich, 6 F.4th at 514 (quoting Canada Life Assurance Co. v. Converium Ruckversicherung (Deutschland) AG, 335 F.3d 52, 58 (2d Cir. 2003)). Noting that reasonable expenses and attorneys’ fees are compensatory forms of relief that expressly remedy harms to the debtor, the Second Circuit interpreted this to suggest that “other appropriate relief” is limited to non-punitive sanctions. Further supporting the Second Circuit’s interpretation of the non-punitive nature of the sanctions authorized under Rule 3002.1, the court reasoned that the other sanction provided for in the enforcement mechanism of Rule 3002.1(i)—preventing a creditor from collecting an improperly noticed claim—makes an exception for harmless non-compliance, and thus prospectively serves the remedial goal of shielding debtors from unforeseen charges, rather than a punitive purpose. Finally, the court noted that other sections of the Bankruptcy Code explicitly authorize punitive damages, whereas Rule 3002.1 does not. On appeal, the chapter 13 trustee argued, in the alternative, that the $75,000 sanction was authorized under the bankruptcy court’s inherent power. However, because the bankruptcy court did not assess whether the sanction was authorized pursuant to its inherent power, the Second Circuit could not properly consider that argument: “[t]he sanction was imposed under Rule 3002.1(i), and [the Second Circuit’s] holding is that the sanction went beyond the relief authorized by that rule.”
§ 1.4. Third Circuit
In re Weinstein Co. Holdings LLC, 997 F.3d 497 (3d Cir. 2021). In a case arising out of the Weinstein Company bankruptcy proceedings, the Third Circuit examined the definition of “executory contracts” in the context of a work-for-hire contract to find that the non-executory contract had been properly sold by the debtors as a non-executory contract, and thus the purchaser was not required to cure existing defaults under the contract.
In June 2018, the Weinstein Company and its affiliates (“TWC”) filed bankruptcy petitions to facilitate the sale of substantially all of their assets to Spyglass Media Group, LLC (“Spyglass”) under section 363 of the Bankruptcy Code. Among the assets sold was TWC’s work-made-for-hire contract with Bruce Cohen (the “Cohen Agreement”) to produce the critically acclaimed 2012 film Silver Linings Playbook. In October 2018, Spyglass filed a declaratory judgment action against Cohen seeking a determination that the Cohen Agreement was not an executory contract. Under the Cohen Agreement, Cohen was entitled to approximately $400,000 in previously unpaid contingent compensation: if the Cohen Agreement was an executory contract, Spyglass would assume the liability as part of the cure amount; if the Cohen Agreement was not an executory contract, the liability remained with the TWC debtors and would be payable on par with other general unsecured creditors of the debtors’ estate for cents on the dollar. On a motion for summary judgment, the bankruptcy court found that the contract was not executory and was properly sold as part of the TWC asset sale to Spyglass. After the district court affirmed the bankruptcy court’s decision, Cohen timely appealed to the Third Circuit.
Applying the Countryman test to determine whether the Cohen Agreement was an executory contract, the Third Circuit analyzed “whether the [Cohen] Agreement ‘contained at least one obligation for both [TWC] and [Cohen] that would constitute a material breach under New York law if not performed.’” Because New York law incorporates the substantial performance doctrine, the court also analyzed whether Cohen had breached the Cohen Agreement such that it would have excused TWC from not paying the contingent compensation then outstanding (i.e., whether Cohen had failed to substantially perform). The Third Circuit held that, “[o]n TWC’s side, its obligation to pay contingent compensation to Cohen is clearly material,” but, on Cohen’s side, “he contributed almost all his value when he produced the movie.” Noting that “other courts agree that the employee in a work-made-for-hire contract usually does not have material obligations after the work is completed despite ancillary negative covenants or indemnification obligations,” the Third Circuit decided that “none of Cohen’s remaining obligations go to the ‘root of the contract’ or ‘defeat the purpose of the entire transaction’ if breached.”
Cohen argued that, because the Agreement stated that TWC must pay contingent compensation provided Cohen was “not otherwise in breach or default,” all of his obligations were material, as even a breach of a technical provision would excuse TWC’s obligation to pay contingent compensation. The Third Circuit acknowledged that parties can indeed contract around the default substantial performance rule but held that Cohen and TWC did not clearly and unambiguously avoid the substantial performance rule under New York law. Thus, the Third Circuit “agree[d] with the Bankruptcy and District Courts that Cohen’s remaining obligations are immaterial and ancillary to the purpose of the contract…[so] the Cohen Agreement is not executory.” Accordingly, Spyglass was not obligated to cure the existing defaults as part of its purchase of the Cohen Agreement.
In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021). The Third Circuit held that section 553 of the Bankruptcy Code, which governs creditor setoffs, requires “strict bilateral mutuality.” In so holding, the Third Circuit decided that creditors cannot set off obligations owed to debtors in bankruptcy against obligations that the debtors owe to creditors’ affiliates, notwithstanding parties’ contracts to the contrary.
Orexigen Therapeutics Inc. (“Orexigen”) entered into a pharmaceutical distribution agreement (“distribution agreement”) with McKesson Corp. Inc. (McKesson), pursuant to which Orexigen sold pharmaceuticals to McKesson. The distribution agreement included broad setoff rights permitting “each of McKesson and its affiliates . . . to set-off, recoup and apply any amounts owed by it to [Orexigen’s] affiliates against any [and] all amounts owed by [Orexigen] or its affiliates to any of [McKesson] or its affiliates.” Orexigen also entered into a services agreement (“services agreement”) with a McKesson subsidiary, McKesson Patient Relationship Solutions (“MPRS”), pursuant to which MPRS advanced funds to certain pharmacies on Orexigen’s behalf. Less than two years after entering into these agreements, Orexigen filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware. As of the petition date, McKesson owed Orexigen almost $7 million under the distribution agreement and Orexigen owed MPRS approximately $9 million under the services agreement, and McKesson sought to exercise its contractual right under the distribution agreement to set off the amount it owed to Orexigen against the amount Orexigen owed to MPRS. The Bankruptcy Court rejected McKesson’s attempt to enforce its setoff right, holding that section 553 of the Bankruptcy Code imposes a mutuality requirement that private parties cannot contract around. The United States District Court for the District of Delaware affirmed the bankruptcy court’s ruling and McKesson appealed.
The Third Circuit affirmed the bankruptcy court and the district court. A question of first impression for the Third Circuit, the Court definitively rejected the permissibility of triangular setoffs under section 553 of the Bankruptcy Code, strictly construing section 553’s mutuality requirement to mean that the debt and claim sought to be setoff must be between the same two parties. The Third Circuit based its decision, in part, on Congress’ “inten[t] for mutuality to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor” and the absence of congressional intent “to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.” Holding that triangular setoffs are prohibited and cannot be contracted around, the Third Circuit observed that McKesson could have enjoyed the mutuality contemplated by section 553 by signing the services agreement itself instead of through its subsidiary, MPRS. The Third Circuit also noted that MPRS’ contract with Orexigen could have provided MPRS with a security interest in Orexigen’s accounts receivable, which, once perfected, would have given MPRS a priority right to the amount that McKesson sought through setoff without running afoul of the Bankruptcy Code.
In re Energy Future Holdings Corp., 990 F.3d 728 (3d Cir. 2021). The United States Court of Appeals for the Third Circuit held that, pursuant to section 503(b)(1)(A) of the Bankruptcy Code, stalking horse bidders may assert administrative expense claims for costs incurred while attempting to close on unsuccessful transactions even if the stalking horse bidders are not entitled to any breakup or termination fees.
Chapter 11 debtors Energy Future Holdings Corp. and its affiliates terminated the merger agreement between them and a stalking horse bidder after the stalking horse bidder failed to obtain the regulatory approval necessary to consummate the agreement. After the Third Circuit affirmed the bankruptcy court’s denial of the stalking horse bidder’s application for payment of a termination fee, the stalking horse bidder then filed an administrative expense application for costs incurred in connection with its unsuccessful efforts to complete the merger. In response to the application for administrative expenses, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. The bankruptcy court granted both motions, which the district court affirmed, and the stalking horse bidder appealed.
The Third Circuit reversed the bankruptcy and district courts. The Third Circuit held that the plain language of the merger agreement permitted recovery of expenses specified under section 503(b)(1)(A) of the Bankruptcy Code. In so holding, the Third Circuit determined that it was appropriate to consider what ultimately transpired in connection with the merger in determining whether the estate received an actual benefit from the expenses incurred by the stalking horse bidder. In other words, the court could evaluate the necessity of the expenses using the benefit of hindsight. Notwithstanding that the contemplated merger was not ultimately realized, the Third Circuit found that the stalking horse had plausibly alleged a benefit to the estate because, among other things, the stalking horse had provided valuable information and paved a path forward for a later, successful transaction. Although the benefit to the estate could not be monetized, the allegations provided a plausible factual basis such that the stalking horse bidder’s application for administrative expenses should not have been denied on a motion to dismiss.
Davis v. California (In re Venoco LLC), 998 F.3d 94 (3d Cir. 2021). Interpreting and extending Supreme Court precedent in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), the Third Circuit held that, where a liquidating trustee brought a bankruptcy adversary proceeding against the State of California and its Lands Commission asserting an inverse condemnation claim, neither the State nor its Lands Commission were entitled to sovereign immunity in the face of such claims.
Debtor Venoco LLC and its affiliates (collectively, “Venoco”) operated an oil drilling rig off the coast of Santa Barbara (the “Offshore Facility”). After being extracted at the Offshore Facility, the oil and gas would then be transported to an onshore processing and refining facility (the “Onshore Facility”). Venoco leased, and did not own, the Offshore Facility, but did own the Onshore Facility. After a pipeline rupture in 2015 and an unsuccessful reorganization attempt in 2016, Venoco filed a second chapter 11 proceeding on April 17, 2017. On the same day, Venoco abandoned its leases pertaining to the Offshore Facility, at which point the California State Lands Commission took over decommissioning the rig and plugging the abandoned wells. Initially, the Lands Commission agreed to pay Venoco approximately $1.1 million per month to continue operating both facilities. When a third-party contractor took over operations for Venoco, a new agreement was reached wherein the Lands Commission would pay Venoco approximately $100,000 per month for access to and use of the Onshore Facility. Eventually, however, the Lands Commission stopped paying and invoked its police powers to continue using the Onshore Facility without making further payments to Venoco.
In May 2018, the Bankruptcy Court confirmed the Venoco plan of liquidation, pursuant to which the estates’ assets, including the Onshore Facility, were transferred to a liquidation trust. Shortly after the plan became effective, the court-appointed trustee of the liquidation trust commenced an adversary proceeding against the Lands Commission and the State (together, the “California Parties”), asserting a claim for inverse condemnation: “a cause of action against a governmental defendant to recover the value of property which has been taken in fact by the government defendant.” Knick v. Twp. of Scott, 139 S. Ct. 2162 (2019). The California Parties filed motions to dismiss, arguing, among other things, that they were immune from suit as sovereigns. The Bankruptcy Court denied the motions. The District Court granted leave for an interlocutory appeal only on the sovereign immunity defense. The District Court then affirmed the Bankruptcy Court, rejecting the California Parties’ assertion of both Eleventh Amendment sovereign immunity and state law immunity from liability.
On appeal, the Third Circuit considered the applicability of the Supreme Court’s decision in Katz. The Third Circuit interpreted Katz to stand for the proposition that, “States cannot assert a defense of sovereign immunity in proceedings that further a bankruptcy court’s in rem jurisdiction no matter the technical classification of that proceeding.” Davis, 998 F.3d at 104. Then, adopting the Eleventh Circuit’s interpretation of Katz, the Third Circuit found that the following constitutes a bankruptcy court’s in rem jurisdiction: “[1] the exercise of exclusive jurisdiction over all of the debtor’s property, [2] the equitable distribution of that property among the debtor’s creditors, and [3] the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.” Id. (quoting In re Diaz, 647 F.3d 1073, 1084 (11th Cir. 2011)). Based on this framework, the court then concluded that the adversary proceeding implicated two of the three Diaz examples of a bankruptcy court’s in rem jurisdiction. First, it implicated the bankruptcy court’s exclusive jurisdiction over the Venoco debtors’ property, because it sought a ruling on rights in the Onshore Facility. Although the suit was for money damages, the Third Circuit focused on the function of the suit—to decide rights in Venoco’s property—over the form of the relief sought. Second, the adversary proceeding facilitated distributions to creditors due to the significance of the Onshore Facility as an asset of the Venoco debtors’ estates. Accordingly, the court would not permit the California Parties to avoid liability using sovereign immunity. The Third Circuit further expanded Katz to apply to assertions of state-law substantive immunity from liability, in addition to Eleventh Amendment sovereign immunity.
§ 1.4. Fourth Circuit
Siegel v. Fitzgerald (In re Circuit City Stores, Inc.), 996 F.3d 156 (4th Cir. 2021). Splitting with the Second Circuit’s decision in Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries, Inc.), 998 F.3d 56 (2d Cir. 2021), the Fourth Circuit held that the 2017 Amendment is not unconstitutionally nonuniform. The Fourth Circuit further held that the 2017 Amendment is not unconstitutionally retroactive.
United States bankruptcy courts operate under two distinct programs for the handling of their proceedings: the Trustee (“UST”) program and the Bankruptcy Administrator (“BA”) program. These bankruptcy court programs utilize distinct funding sources. The judiciary’s general budget funds the BA program whereas the bankruptcy debtors in UST program districts primarily fund the Trustee program through, among other fees, chapter 11 quarterly fees based on the quarterly disbursements that debtors make to their creditors until the cases are converted or dismissed. BA programs and UST programs required chapter 11 debtors to pay quarterly fees consistent with the same disbursement formula from 2002 until January 1, 2018, when an amendment Congress passed (the “2017 Amendment”) to the statute setting forth quarterly fees in bankruptcy cases took effect. The 2017 Amendment altered the quarterly fees formula and increased the fees due in large chapter 11 bankruptcy cases in the UST program only. The UST program implemented the increased fees for disbursements for all cases after January 1, 2018, so both new and pending chapter 11 bankruptcy debtors incurred increased fees beginning in the first quarter of 2018. The Judicial Conference adopted an amended fee schedule in September 2018 and applied the increased fees to those bankruptcy cases filed in the BA program on or after October 1, 2018, such that any debtor in the BA program that filed for bankruptcy prior to October 1, 2018, would not owe increased quarterly fees, regardless of how long the bankruptcy case remained pending.
In 2008, Circuit City Stores, Inc., and its affiliates (collectively “Circuit City”) filed for chapter 11 bankruptcy protection in the Eastern District of Virginia, which is in the UST program. The cases remained pending after the 2017 Amendment went into effect. Although the Circuit City trustee initially paid the increased fees, he later contested them after the Bankruptcy Court for the Western District of Texas ruled in February 2019 that the 2017 Amendment was unconstitutional because it created nonuniform bankruptcy laws in contravention of the Bankruptcy Clause and was unconstitutionally retroactive. The Bankruptcy Court for the Eastern District of Virginia granted the Circuit City trustee’s request for relief, ruling that the quarterly fees could be classified as either a tax or user fee under the Bankruptcy Code and, under either designation, the 2017 Amendment contravened both the Bankruptcy Clause and the Uniformity Clause of the Constitution. The court also addressed Circuit City’s retroactivity contention, finding that the increased quarterly fees in UST programs do not contravene any anti-retroactivity Constitutional principles because the 2017 Amendment is “substantively prospective” rather than retroactive. Following the U.S. Trustee’s appeal to the district court challenging the Bankruptcy Opinion’s ruling that the 2017 Amendment was unconstitutional due to lack of uniformity, and the Circuit City trustee’s cross-appeal of the Opinion’s ruling on retroactivity, the parties jointly sought permission for direct appeals, bypassing the district court, which the Fourth Circuit granted.
The Fourth Circuit began by noting that the case from the Bankruptcy Court for the Western District of Texas—which had persuaded the Circuit City trustee and the Bankruptcy Court for the Eastern District of Virginia that the increased quarterly fees in the UST program were unconstitutional—was reversed on direct appeal to the Court of Appeals for the Fifth Circuit. The Fourth Circuit went on to explain and agree with the Fifth Circuit’s reasoning, holding that “the uniformity requirement does not deny Congress the power to enact legislation that resolves regionally isolated problems.” The Fourth Circuit echoed the Fifth Circuit’s emphasis that the Bankruptcy Clause forbids only “arbitrary” geographic districts and, accordingly, “when Congress determined that it needed to remedy a shortfall in funding for the Trustee districts, it was entitled to ‘solve the evil to be remedied with a fee increase in just the underfunded districts.’” Although “the establishment of separate Trustee and Administrator districts was” admittedly “an ‘irrational and arbitrary’ distinction for which Congress [gave] ‘no justification,’” the Fourth Circuit found that Congress provided “a solid fiscal justification” for the 2017 Amendment, which was to ensure that the UST program was sufficiently funded by its debtors rather than by taxpayers. Thus, the Fourth Circuit reversed the bankruptcy court, finding that the 2017 Amendment does not contravene the uniformity mandate of either the Uniformity Clause or the Bankruptcy Clause.
Turning to the cross-appeal pursued by the Circuit City trustee, the Fourth Circuit affirmed the bankruptcy court’s decision that the 2017 Amendment is not unconstitutionally retroactive. Although the 2017 Amendment increased the quarterly fees large chapter 11 debtors had to pay, the Fourth Circuit reasoned that those debtors were reasonably expected to pay fees pursuant to some formula, and that the 2017 Amendment did not increase a debtor’s liability for past conduct or impose new duties with respect to transactions already completed, and thus did not give rise to Fifth Amendment due process concerns.
§ 1.6. Fifth Circuit
Off. Comm. of Unsecured Creditors of Walker Cnty. Hosp. Corp. v. Walker Cnty. Hosp. Dist. (In re Walker Cnty. Hosp. Corp.), 3 F.4th 229 (5th Cir. 2021). A county hospital filed for Chapter 11 bankruptcy protection and endeavored to auction off its assets. Although thirty-six parties received an offering memorandum, none submitted a bid. However, there was a stalking horse bid. At the time that the stalking horse bid was being considered, an unsecured creditors’ committee was formed. The committee believed that the stalking horse bid was too low. Ultimately, the debtor, the stalking horse bidder, and the committee reached a compromise that would govern the sale of the hospital’s assets. As part of this compromise, the committee agreed to not object to the sale to the stalking horse bidder. A critical component of the bid was that the stalking horse purchaser would receive certain Medicaid payments. After a sale order was entered, the stalking horse’s lender began its due diligence. Because of delays associated with that due diligence and the timing of the Medicaid payment, the debtor filed an emergency motion with the bankruptcy court seeking to amend the sale order. The amended sale order lowered the purchase price and made other adjustments to the transaction. Because time was of the essence to consummate the sale, the debtor asked the bankruptcy court to waive the 14-day stay typically provided by Rule 6004(h) of the Federal Rules of Bankruptcy Procedure. Shortly after the debtor’s motion was filed, the bankruptcy court entered its amended order granting the relief that had been requested. The amended order provided that it was effective immediately upon its entry and authorized the parties to close the transaction immediately. The committee did not seek a stay, but two weeks later appealed the bankruptcy court’s amended sale order to the district court, claiming various bankruptcy rules were not followed and that its procedural due process rights had been violated. The district court dismissed the appeal on grounds of statutory mootness. An appeal to the Fifth Circuit ensued.
The Fifth Circuit based its ruling on section 363(m) of the Bankruptcy Code, and its case law interpreting that section, which it found to be abundantly clear: “[A] failure to obtain a stay is fatal to a challenge of a bankruptcy court’s authorization of the sale of property. . . . And fatal means fatal: challenges to authorized bankruptcy sales are dismissed when the party challenging the sale has not sought a stay. This result is made unmistakable by our precedent.” The court noted that the committee made two interrelated arguments in an attempt to skirt the effects of section 363(m). First, the committee argued that it was only appealing the amended order and not the underlying sale order. Thus, while the sale order was rendered pursuant to section 363(b), the amended order did not mention that subsection or section 363(c), which are the only two subsections that authorize sales to which section 363(m) could apply. The Fifth Circuit found these arguments to be unpersuasive. The committee was correct that the amended order did not mention section 363(b), but this was because it did not authorize a new or different sale, it simply amended the sale order that had previously been entered. That is, the amended order was “integrally linked to, and indeed, inseparable from, the sale order.” The court, therefore, held that section 363(m) foreclosed the appeal when the committee failed to seek the required stay, finding the committee’s argument that it appealed an order not subject to section 363(m) unpersuasive. The court concluded its opinion succinctly: “In short: no stay, no pay.”
Edwards Fam. P’ship, L.P. vs. Johnson(In re Cmty. Home Fin. Servs. Inc.), 990 F.3d 422 (5th Cir. 2021). A bankruptcy court awarded fees to debtor’s counsel for work performed prior to the appointment of a trustee. Creditors appealed that award to the district court and the district court vacated the fee award. The district court’s order was appealed to the Fifth Circuit.
The dispute arose from the bankruptcy of Community Home Financial Services, Inc. (“CHFS”), which was not a party to the appeal. Upon the commencement of the case, CHFS remained the debtor-in-possession and its president was its designated representative. The bankruptcy court approved counsel’s representation of the debtor. Counsel initiated a series of adversary proceedings against the debtor’s principal creditors. Those same creditors objected to the proposed plan of reorganization and moved to appoint a trustee and to convert the case to Chapter 7. While the case was pending, the debtor’s president transferred over $9 million of the debtor’s funds to a Panamanian bank account and fled the country. Counsel then filed a disclosure informing the court of the transfer. Following the disclosure, the bankruptcy court appointed an emergency trustee. Counsel thereafter withdrew. Counsel sought fees for the services they had performed in connection with the adversary proceedings before the appointment of the trustee. The bankruptcy court awarded fees to counsel. The creditors appealed the awards of fees. The district court then affirmed, but remanded for further findings of fact regarding the fees awarded for commencing and litigating the adversary proceedings. On remand, the bankruptcy court again awarded fees to counsel for those adversary proceedings, concluding that they were necessary to the administration of the bankruptcy case and reasonably likely to benefit the estate. A second appeal to the district court ensued and the district court vacated the fee award. The district court concluded that the decision to pursue the adversary proceedings “was not a good gamble.” Counsel and the trustee appealed arguing that the district court improperly evaluated the benefit of the adversary proceedings retrospectively. Counsel settled their fee dispute, but the trustee continued to pursue the appeal. The creditors moved to dismiss the appeal due to lack of standing.
The creditors contended that their settlement with counsel mooted the appeal. The trustee asserted that the case remained live because of her “ongoing duty throughout the pendency of a bankruptcy proceeding to represent the interests of the bankruptcy estate in the award of fees.” The court noted that the requirement of an adverse pecuniary interest is not required of the trustee to establish standing. The trustee “is distinct from all other bankruptcy parties because the trustee is responsible for the administration of the bankruptcy estate.” The court noted that other circuits have concluded that trustees can never establish that they were pecuniarily affected by a bankruptcy order because they did not have pecuniary interests in cases. A trustee’s standing does not arise from his or her own pecuniary interest, but rather from the trustee’s duty to enforce the bankruptcy laws in the public interest. The First, Fourth, Sixth, and Ninth Circuits each have recognized that the pecuniary-interest test does not apply to trustee standing, and the Fifth Circuit’s own precedent has “implicitly recognized that trustee standing does not depend on a pecuniary interest.” Based on the foregoing, the Fifth Circuit held “that the Trustee in this case has standing and this case is not moot because the payment of fees to [counsel] directly affects the administration of the bankruptcy estate.” Having concluded that the case was not moot, the Fifth Circuit turned to the substantive issue and found that the district court’s decision to vacate the fee awards was contrary to clear Fifth Circuit law that the services must be evaluated as of the time they were rendered. “The district court was wrong to vacate the bankruptcy court award based on its own retrospective assessment of the propriety of the adversary proceedings without giving ‘the deference that is the hallmark of abuse-of-discretion review.’” Applying a prospective standard, pursuit of the adversary proceedings was necessary to the administration of the case. Accordingly, the Fifth Circuit reversed the judgment of the district court and remanded for the district court to reinstate the bankruptcy court’s fee award.
Hobbs vs. Buffets, L.L.C. (In re Buffets L.L.C.), 979 F.3d 366 (5th Cir. 2021). In Chapter 11, debtors pay both a filing fee as well as quarterly fees until the bankruptcy case is closed. In 2017, Congress imposed a temporary, but substantial, increase in quarterly fees for Chapter 11 debtors. The fee increase was intended to fund the United States Trustee (“UST”) Program. Accordingly, the fee went into effect in the 88 judicial districts that utilized the UST Program. There was a nine-month lag before a similar fee adjustment was applied in the six judicial districts that did not use the UST Program. Debtors nationwide have challenged the increased fees. In particular, some debtors have claimed that the delayed implementation of the fee in the non-UST Program districts violated the constitutional requirement that Congress establish uniform bankruptcy laws throughout the United States. In the instant case, the debtor filed a Chapter 11 petition in 2016. The petition was filed in the United States Bankruptcy Court for the Western District of Texas, which utilizes the UST Program. The plan of reorganization was confirmed in 2017, but the case remained pending in 2018, after the increased fee became effective. Because the debtor reported over $1 million in total disbursements during each of the first three quarters of 2018, and because the balance of funds in the United States Trustee system was below the threshold amount, the United States Trustee assessed quarterly fees of $250,000 on the debtors. The debtors refused to pay and asked the bankruptcy court to focus on disbursements made under the plan and not those for normal operating expenses. Had the bankruptcy court agreed, the debtors would have been able to avoid the new, higher fees as their disbursements would have been less than $1 million per quarter. The UST objected. In response, the debtors claimed classifying operating expenses as disbursements for purposes of the fee violated the Constitution’s “Fundamental Fairness Clause.”
The bankruptcy court denied the debtors’ motion. When the debtors moved for reconsideration, they also challenged the constitutionality of the increased fees. On reconsideration, the bankruptcy court agreed that the fee increase was unconstitutional: both because of non-uniformity and because the imposition of the fee on a case that was filed before the increase was enacted was an impermissibly retroactive imposition of duties and liabilities for transactions already completed. Both the UST and the debtors appealed and the district court certified questions about the new law’s applicability and constitutionality to the Fifth Circuit.
The Fifth Circuit first addressed the debtors’ contention that the disbursements should be limited to bankruptcy-related expenses, and not ordinary expenses. The court looked to the ordinary meaning of the term “disbursements” and found that such plain meaning would include all payments made by the debtors and not just their bankruptcy-related expenses. The court also found it problematic that adopting the debtors’ interpretation would give the term “disbursements” a different meaning before and after confirmation. Moreover, the Fifth Circuit stated that adopting the debtors’ interpretation of “disbursements” would create a circuit split, and acknowledged that the normal reluctance to create circuit splits is even stronger in the context of bankruptcy law. Accordingly, the court held that disbursements include all payments a debtor makes.
The court then turned to the question of whether the 2017 fee increase applied to cases that were pending when the new fees took effect. The court noted that Congress had passed legislation that explicitly applied the new fees to debtors whose plans were confirmed both before and after the legislation took effect. Accordingly, the court held that new disbursements, not new cases, trigger the higher fees. Because the new fee applies only to future disbursements, which are triggered by the debtor’s conduct occurring after the law’s effective date, the 2017 fee increase was prospective and did not impair rights the debtors had when they filed for bankruptcy.
Finally, the court turned to what it called the “main event”: whether the fee increase violated the constitutional uniformity requirement. Even assuming that the fees are legislation subject to the uniformity requirement of the bankruptcy clause, the court found no uniformity problem. The uniformity requirement does not bar every law that allows for a different outcome depending upon where a bankruptcy is filed. Instead, the uniformity requirement only bars “arbitrary regional differences in the provisions of the Bankruptcy Code.” The court held that as long as the dual systems exist, with some districts having the United States Trustee Program and others utilizing the prior bankruptcy administrator system, each will face unique funding problems. Accordingly, it is reasonable for Congress to have those who benefit from the United States Trustee Program provide for its funding. The court noted that the debtors did not challenge the dual system as unconstitutional. Given this conclusion, the Fifth Circuit held that the fee increase easily survived the rational basis review that was required.
Judge Clement concurred in part and dissented in part. She opined that the majority opinion “relies on a flawed tautology: Congress can justify treating bankrupts differently because it has chosen to treat them differently (higher fees because different programs).” Because grouping some debtors into the UST Program and others into the bankruptcy administrator system is itself “an arbitrary regional difference,” Judge Clement found that the debtors’ argument did include a challenge to the structure of the law (i.e., the dual system) and not just its effects. Judge Clement also noted that the government had addressed the issue in its briefing. In conclusion, Judge Clement wrote: “[f]or no better reason than political influence, debtors in two states enjoy a system subject to lower fees than those in the other forty-eight states. This is the type of ‘regionalism’ the Uniformity Clause was intended to prevent.” (internal citations omitted).
§ 1.7. Sixth Circuit
Eplet, LLC v. DTE Pontiac N., LLC, 984 F.3d 493 (6th Cir. 2021). The Sixth Circuit applied state law to determine whether certain agreements were integrated or severable, and thus whether the debtor’s rejection of certain agreements under section 365 of the Bankruptcy Code eliminated the obligations of a commercial tenant who elected to remain in possession of the property pursuant to section 365(h) of the Code.
General Motors (“GM”) sold a power plant and leased for ten years the land under the plant to an energy company, DTE Energy Pontiac North, LLC (“DTEPN”). DTEPN agreed to sell utilities produced at the plant to GM, maintain the plant according to specific criteria, and take care of any environmental issues caused by the plant. DTEPN’s parent company, DTE Energy Services, Inc., (“DTE Energy”) guaranteed that DTEPN would meet GM’s utility needs and its maintenance and environmental responsibilities or DTE Energy itself would step in to fulfill DTEPN’s obligations. GM filed for bankruptcy two years after the sale and lease to DTEPN, and DTEPN agreed to GM’s rejection of those two contacts while also exercising its right as a tenant to continue occupying the power plant’s grounds. DTEPN remained in possession of the premises until the lease expired, at which time it turned the land over to the environmental trust that was created to assume ownership of some of GM’s industrial property as part of GM’s reorganization. The trust discovered that DTEPN had allowed the power plant to fall into disrepair and contaminate the property and subsequently sued DTEPN and DTE Energy for breach of contract and various other claims. The district court dismissed the claims against DTE Energy based on its findings that (1) the trust’s allegations did not support piercing the corporate veil under Michigan law and (2) DTE Energy’s guaranty terminated after GM rejected the associated contracts in bankruptcy. On appeal, the Sixth Circuit concluded that the district court erred in both of its rulings, and reversed and remanded to the district court.
In reviewing the district court’s first finding, the Sixth Circuit found that DTEPN ignored its maintenance and environmental responsibilities at the direction of DTE Energy. And by allegedly directing its wholly owned subsidiary to stop maintaining the facility, DTE Energy exercised its control over DTEPN in a way that wronged the trust, which, under Michigan law, allows the trust to pierce the corporate veil. Accordingly, the Sixth Circuit held the trust had adequately pleaded facts that supported piercing the corporate veil under Michigan law and that the defendants’ arguments were more appropriate for a summary judgment proceeding rather than a dismissal.
The Sixth Circuit’s review of the district court’s second finding—whether DTE Energy’s guaranty terminated after GM rejected the associated contracts in bankruptcy—began with an overview of section 365, which is the mechanism by which GM rejected the associated agreements. Section 365 of the Code allows a debtor-in-possession to assume or reject any executory contract or unexpired lease, subject to the bankruptcy court’s approval. A further requirement under section 365 is that the contract or lease must be assumed or rejected in its entirety. Section 365(h) of the Code specifically provides that when a debtor rejects a contract leasing real property in which the debtor is the landlord, the tenant may choose either to terminate the lease or remain in possession of the property. Thus, the question for the Circuit Court on appeal was whether the lease and utility services agreement were one integrated contract, such that DTEPN could not assume the lease without also assuming the utility services agreement, on the one hand, or whether the lease and utility agreement were severable, such that DTEPN could assume the lease without also assuming the utility services agreement, on the other. To answer the question of severability, the Sixth Circuit turned to state law. Under Michigan state law, the intent of the parties is the primary consideration in determining severability and the Sixth Circuit ultimately determined that “[g]iven the express language of the agreements, the related subject matters, the interdependent obligations and considerations, and the parties’ positions in GM’s bankruptcy proceedings, the district court erred in finding that the lease and utility services agreement were severable as a matter of law at the motion-to-dismiss stage.”
Alliance WOR Properties, LLC v. Ill. Methane, LLC (In re HNRC Dissolution Co.), 3 F.4th 912 (6th Cir. 2021). The Sixth Circuit recently found that notice by publication did not satisfy the Due Process Clause when considering whether a contract counterparty was given reasonable notice of a section 363 sale “free and clear of all Liens, Claims, encumbrances and other interests” in 2002.
In 1998, the Old Ben Coal Company (“Old Ben”) conveyed its right to “all of the methane gas” in its coal estates to Illinois Methane, LLC (“Methane”), while retaining for itself the coal rights from the block of coal reserves and leases located in Illinois. The conveyance was subject to certain covenants “running with the ownership of the coal and methane gas,” including a covenant that provided that Methane would not explore for or produce methane gas if Old Ben was mining coal in the same area, and in exchange, Old Ben would pay an “adjusted delay rental” to Methane. The deed memorializing this transaction was recorded with the Hamilton County Recorder.
In 2002, Old Ben and a number of affiliates (collectively, the “Debtors”) filed petitions to commence chapter 11 proceedings. During the bankruptcy proceedings, the Debtors moved for an order pursuant to section 363 of the Bankruptcy Code authorizing the sale of substantially all of their assets, including the Hamilton County coal reserves, “free and clear” of all liens, claims, encumbrances and other interests. The Debtors published notice of the impending bankruptcy sale in several regional and national newspapers, but did not provide or attempt to provide notice to Methane directly. The bankruptcy court approved the sale to Lexington Coal Company, finding that the Debtors’ publication notice was sufficient.
The Hamilton County coal reserves eventually came to be held by Alliance WOR Properties, LLC (“Alliance”), which is in privity with Lexington Coal Company. But one of Alliance’s predecessors-in-title applied for a permit to mine coal from a portion of the Hamilton County reserves. This application eventually led Methane to file suit against Alliance in Illinois state court, seeking over $11 million in accumulated delayed rent. Alliance moved to reopen the bankruptcy case, seeking an order from the bankruptcy court that Methane’s efforts to recover against Alliance violated the section 363 sale order. Instead, the bankruptcy court held that the Debtors’ notice by publication did not satisfy due process as to Methane because Methane had a “known” interest in the Hamilton County reserves at the time of the sale, and thus needed notice “sufficient to satisfy constitutional due process.” Accordingly, the bankruptcy court found that the sale order had no effect on Methane’s interest. The district court affirmed, and this appeal followed.
The decision turned on the nature of Methane’s interest in the reserves—whether Methane’s interest was “known” or “unknown” by the Debtors at the time of the bankruptcy proceedings—since “due process generally requires that the debtor attempt to provide notice directly” for “known” parties. Alliance, 3 F.4th at 919 (citing Tulsa Pro. Collection Servs., Inc. v. Pope, 485 U.S. 478, 487 (1988)). Quoting the Third Circuit, the Sixth Circuit explained that “‘[k]nown’ parties are those ‘whose identity’ and interest are ‘either known or reasonably ascertainable by the debtor.’” Id. at 919 (quoting Chemetron Corp. v. Jones, 72 F.3d 341, 346 (3d Cir. 1995)) (internal quotations omitted). Alliance argued that Methane had a speculative, prepetition contingent claim, while Methane argued that it had a vested, non-contingent real property right in the delayed rental obligations. Examining Illinois state law, the Sixth Circuit held that the delayed rental obligations conferred a “vested property interest” on Methane. Accordingly, Methane was a known party and entitled to more than publication notice.
§ 1.8. Seventh Circuit
Algozine Masonry Restoration, Inc. v. Local 52 Chi. Area Joint Welfare Comm. for the Pointing, Cleaning & Caulking Indus. (In re Algozine Masonry Restoration, Inc.), 5 F.4th 827 (7th Cir. 2021). Algozine Masonry Restoration, Inc., employed members of a local union and, pursuant to a collective bargaining agreement (“CBA”) with the union, was required to submit contributions to three employee benefit funds on behalf of employees covered by the CBA. Algozine fell behind on its contributions to the three funds and subsequently filed a chapter 11 bankruptcy petition. The three funds filed separate proofs of claims under section 507(a)(5) of the Bankruptcy Code, which affords priority status up to a specified point to certain types of unsecured claims, including claims for unpaid contributions to an employee-benefit plan. Algozine objected to the funds’ proofs of claims, asserting that the funds erred by applying the priority cap in section 507(a)(5) to each individual fund’s claims rather than the funds’ aggregated claims, while the funds insisted that section 507(a)(5) does not require assessing distinct benefit plans collectively. The bankruptcy court agreed with the funds, as did the district court. Because the Seventh Circuit found that the text of section 507(a)(5) unambiguously supports the conclusions those courts reached, it affirmed the lower courts’ decisions.
When interpreting a statute, the Seventh Circuit stated “we look first to the statutory language… When the language is plain we enforce it without further ado. Other tools come into play if it is ambiguous, but they are unnecessary in the case before us.” The Seventh Circuit noted that section 507(a)(5) allows “each such” employee benefit plan to file priority claims for services rendered within the applicable period, and quoted the bankruptcy court’s observation that section 507(a)(5) “clearly contemplates that, in a single bankruptcy case, more than one ‘employee benefit plan’ may file a claim, i.e., ‘claims for contributions’ and that the priority limit set forth therein applies to ‘each such plan’; which, could only refer to – each claim that is filed in the case by, or on behalf of, an employee benefit plan.”
§ 1.9. Eighth Circuit
FishDish, LLP v. VeroBlue Farms USA, Inc. (In re VeroBlue Farms USA, Inc.), 6 F.4th 880 (8th Cir. 2021). The Eighth Circuit considered the increasingly controversial doctrine of equitable mootness and, while not rejecting it outright, found that the district court did not apply a sufficiently rigorous test to determine whether bankruptcy equities and pragmatics justified foregoing Article III judicial review of a bankruptcy court order confirming a chapter 11 plan, and remanded for further district court proceedings.
VeroBlue Farms USA, Inc., and its affiliated entities, (collectively, the “debtors”) filed a voluntary chapter 11 bankruptcy petition in 2018. FishDish LLP, one of the debtors’ preferred shareholders, appealed the bankruptcy court’s plan confirmation order to the district court, arguing that the plan violated various provisions of the Bankruptcy Code, including the absolute priority rule, the feasibility requirement, and the best interest of creditors test. The plan sponsor and sole shareholder of the reorganized debtors slated to assume management, Alder Aqua, argued that FishDish’s appeal was equitably moot. The district court entered an order dismissing FishDish’s appeal as equitably moot, and FishDish appealed.
The Eighth Circuit reversed the district court after finding that it had made no inquiry into whether the record supported its holding that relief could not be granted without undermining the plan, thereby affecting third parties. Holding that Article III appellate courts have “a virtually unflagging obligation” to exercise subject matter jurisdiction, and concerned that equitable mootness often results in the arbitrary “refusal of the Article III courts to entertain a live appeal over which they indisputably possess statutory jurisdiction and in which meaningful relief can be awarded,” the Eighth Circuit ruled that a sufficiently rigorous test must be applied prior to a determination that “bankruptcy equities and pragmatics justify foregoing Article III judicial review of a bankruptcy court order confirming a Chapter 11 plan.” The Eighth Circuit thus remanded the case to the district court with directions to at least preliminarily review the merits of FishDish’s appeal of the plan confirmation order “to determine the strength of FishDish’s claims, the amount of time that would likely be required to resolve the merits of those claims on an expedited basis, and the equitable remedies available . . . to avoid undermining the plan and thereby harming third parties.”
§ 1.10. Eleventh Circuit
Reynolds v. Behrman Capital IV L.P., 988 F.3d 1314 (11th Cir. 2021). This case arose out of the bankruptcies of Atherotech, which operated a laboratory that conducted blood tests, and its owner, Atherotech Holdings. Artherotech Holdings, in turn, was owned by three shareholders: Behrman Capital IV LP, Behrman Brothers LLC, and Midcap Financial Investment, LP. After the bankruptcy court appointed Mr. Reynolds as the chapter 7 trustee for both bankruptcies, he filed a complaint in Alabama state court, initially naming 30 defendants: Behrman Capital and its 15 limited partners; Behrman Brothers and its 12 members; and MidCap. The defendants removed the case to federal district court, then sought dismissal for lack of personal jurisdiction. The district court allowed Mr. Reynolds to file an amended complaint, which Mr. Reynolds filed against only two of the defendants. Again, the defendants named in the amended complaint moved to dismiss for lack of personal jurisdiction. Mr. Reynolds asserted that there was personal jurisdiction under the Alabama long-arm statute, and alternatively requested that the district court transfer the case to the Southern District of New York pursuant to 28 U.S.C. section 1406 if it concluded that it lacked personal jurisdiction over the defendants. The district court ruled that, under Alabama’s long-arm statute, it could not exercise personal jurisdiction over the defendants and that transfer would be futile “because the derivative removal jurisdiction bars any federal court from acquiring personal jurisdiction over this suit after its removal from a state court that lacked such personal jurisdiction.” Mr. Reynolds filed a notice of appeal in which he named all of the original defendants and sought review of the district court’s dismissal of both his original and amended complaints.
As an initial matter, MidCap—one of the defendants named in the original complaint but not in the amended complaint—argued that Mr. Reynold’s failure to name it as a defendant in the amended complaint constituted a waiver by Mr. Reynolds of any argument that the district court erred by initially dismissing it for lack of personal jurisdiction. The Eleventh Circuit stated that although an amended complaint supersedes and replaces the original complaint, “a plaintiff does not waive his right to appeal the dismissal of a claim in the original complaint by amending the complaint and omitting the dismissed claim.” Because the district court dismissed MidCap from the original complaint, it was clear that it had rejected Mr. Reynolds’ arguments that personal jurisdiction existed over MidCap, and so the Eleventh Circuit held that reiterating those claims against MidCap in the amended complaint would have been “futile.” The Eleventh Circuit thus determined that “[u]nder these circumstances, Mr. Reynolds did not waive his right to appeal the district court’s dismissal of MidCap from the original complaint for lack of personal jurisdiction.”
The Eleventh Circuit next addressed the parties’ dispute as to whether the doctrine of derivative jurisdiction prevented the post-removal use of Bankruptcy Rule 7004(d) to establish personal jurisdiction over the defendants. The Supreme Court previously explained that “[t]he jurisdiction of the federal court on removal is, in a limited sense, a derivative jurisdiction. If the state court lacks jurisdiction of the subject-matter or of the parties, the federal court acquires none, although it might in a like suit originally brought there have had jurisdiction.” Reynolds, 988 F.3d at 132 (quoting Lambert Run Coal Co. v. Baltimore & Ohio R.R. Co., 258 U.S. 377, 382 (1922)). Splitting with a number of other circuits, the Eleventh Circuit narrowly held that “at least in this case,” the doctrine of derivative jurisdiction does not apply to removed cases in which the state court lacked personal jurisdiction over the defendants.
Acknowledging that the Supreme Court has described the doctrine as encompassing both subject-matter and personal jurisdiction, the Eleventh Circuit stated that the Supreme Court has nonetheless applied the doctrine of derivative jurisdiction only in cases where the state court lacked subject-matter jurisdiction. The Eleventh Circuit also looked to the Supreme Court’s decision in Freeman v. Bee Machine Co., 319 U.S. 448 (1943), which acknowledged that while jurisdictional defects are not cured or waived by removal, district courts have the power to cure or fix whatever jurisdictional defects may exist. Accordingly, the Eleventh Circuit held that, under Freeman, the district court to which the defendants had removed the case could have used Bankruptcy Rule 7004(d)—which looks to a defendant’s national contacts and permits nationwide service of process to establish personal jurisdiction—as part of the “full arsenal of authority with which [it has] been endowed” to establish personal jurisdiction over the defendants. The Eleventh Circuit thus held that the district court could exercise jurisdiction following removal—notwithstanding lack of personal jurisdiction over the defendants under Alabama’s long-arm statute—and that it could look to Bankruptcy Rule 7004(d) to decide whether personal jurisdiction existed. The court then remanded the case for further proceedings consistent with its ruling.
USF Fed. Credit Union v. Gateway Radiology Consultants, P.A. (In re Gateway Radiology Consultants, P.A.), 983 F.3d 1239 (11th Cir. 2020). In response to the COVID-19-induced economic fallout, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (“Act”), which was in large part aimed at helping businesses make payroll and pay operating expenses in order to keep people employed throughout the economic downturn. One of the Act’s programs designed to accomplish that goal is the Paycheck Protection Program (“PPP”), which was directed at small businesses with the principal function of providing forgivable loans to them. Under the PPP, loans were given to eligible businesses; if the loaned funds were used for specified expenses, those loans would be forgiven. The Small Business Administration (“SBA”) was responsible for administering the PPP, and was given rulemaking power directly related to the PPP by Congress. Acting on its statutory mandate from Congress, the SBA issued several rules implementing the PPP. Of relevance here are the SBA’s first and fourth interim final rules. The first interim final rule, among other things, addressed borrower eligibility for PPP loans. Although it did not specify that all bankruptcy debtors were ineligible, it required all applicants to submit a PPP application form, on which the first question asked was whether the applicant was “presently involved in any bankruptcy,” and unequivocally stated that if the answer to that question was “yes” the loan would not be approved. The fourth interim final rule stated that “[i]f the applicant or the owner of the applicant is the debtor in a bankruptcy proceeding, either at the time it submits the application or at any time before the loan is disbursed, the applicant is ineligible to receive a PPP loan.”
Gateway, a chapter 11 bankruptcy debtor since May 2019, applied online to USF Federal Credit Union (“USF”) for a PPP loan. In its application, Gateway answered “no” to the first question on the form, asking whether the applicant was presently involved in any bankruptcy. USF subsequently approved a $527,710 loan, believing that Gateway was not in bankruptcy. Because Gateway was a bankruptcy debtor when it applied and was approved for the PPP loan, it was required to obtain the bankruptcy court’s approval to take on the debt, pursuant to section 364(b) of the Bankruptcy Code. Gateway thus filed with the bankruptcy court an emergency motion to borrow the PPP loan, to which the SBA filed a limited objection, “insofar as [Gateway] seeks an Order that [Gateway] is eligible to participate in the PPP, entitled to loan forgiveness, or that SBA must guarantee [Gateway’s] loan.” In response to the SBA’s limited objection, Gateway filed an adversary proceeding against the SBA and USF seeking declaratory and injunctive relief, asking the bankruptcy court to declare that the SBA’s rule could not be enforced against Gateway, to order USF to release the funds, and to order the SBA to guarantee and forgive the loan just as it would a PPP loan to a non-bankrupt small business. The bankruptcy court ruled in Gateway’s favor, finding that the non-bankruptcy eligibility rule was unlawful under the Administrative Procedure Act (“APA”) because the SBA exceeded its authority in adopting the rule and that the rule was arbitrary and capricious. The bankruptcy court subsequently certified a direct appeal to the Eleventh Circuit; Gateway and USF each petitioned for permission to directly appeal, and the Eleventh Circuit granted USF’s petition.
After a lengthy analysis confirming its appellate jurisdiction, the Eleventh Circuit began by applying the two-step Chevron framework to determine whether the SBA exceeded its statutory authority. Under the first Chevron step, the court must determine whether Congress has spoken directly to the question at issue, in which case both the court and agency must give effect to Congress’ clear intent. If the statute is ambiguous, then the second Chevron step is to determine whether the agency’s interpretation of the statute is reasonable, meaning it is rational and consistent with the statute. Under Chevron step two, courts “may not substitute [their] own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.” Under step one, the Eleventh Circuit determined that Congress did not speak directly to the question at issue, which was whether bankruptcy debtors were eligible for PPP loans, and found “good reason to think it intended to delegate authority to the SBA to answer that question.” Based on the location of the PPP, which was added into an existing program administered by the SBA, and the context of the Act and the delegation of general rulemaking authority to the SBA, the Eleventh Circuit found that “[t]here is at least an implicit delegation of authority for the SBA to [determine and apply eligibility requirements]. And Chevron recognizes implicit delegations of authority.” Because the Act did not unambiguously answer the question before the Eleventh Circuit, the court moved on to step two of the Chevron framework and decided that “[g]iven all of the circumstances and the urgency with which it was forced to act, the SBA’s interpretation was reasonable,” noting that “[w]e do not say this is an inevitable interpretation of the statute; but it is assuredly a permissible one.”
The Eleventh Circuit next addressed the bankruptcy court’s finding that the SBA’s first and fourth final interim rules were arbitrary and capricious. Even when an administrative agency does not act in excess of statutory jurisdiction, it may nonetheless have acted arbitrarily and capriciously, which the Eleventh Circuit has defined by the occurrence of one of four things: (1) agency reliance on factors which Congress did not intend it to consider; (2) entire failure by an agency to consider an important aspect of the problem; (3) an offered explanation for an agency’s decision that runs counter to the evidence before the agency; or (4) total implausibility such that an agency’s action could not be ascribed to a difference in view or the product of agency expertise. The economic emergency created by the COVID pandemic deprived the SBA of the benefit of the usual notice and comment period, which led the Eleventh Circuit to state that it could not find that the SBA failed to consider any important aspect of the problem or that it “offered an explanation contradicted by evidence that was put before it—[because] there was no evidence put before it.” The Eleventh Circuit also held that the SBA did not rely on factors which Congress did not intend it to consider, nor was its explanation implausible, “much less…so implausible that it could not have been based on a difference in view or could not be a product of the SBA’s expertise.” The Eleventh Circuit’s findings—that the SBA did not exceed its authority in adopting a rule excluding bankruptcy debtors from PPP eligibility, that the rule did not violate the Act, that the rule was based on a reasonable interpretation of the Act, and that the SBA did not act arbitrarily and capriciously in adopting the rule—resulted in a dismissal and vacatur in part, and remand back to the bankruptcy court for proceedings consistent with the Eleventh Circuit’s opinion.
Pension Benefit Guar. Corp. v. 50509 Marine LLC, 981 F.3d 927 (11th Cir. 2020). In the absence of an on-point ERISA provision or state law, and mindful of ERISA’s scheme and protectionist goals, the Eleventh Circuit created a new common law rule: where the sponsor of an ERISA plan dissolves under state law but continues to authorize payments to beneficiaries and is not supplanted as the plan’s sponsor by another entity, it remains the constructive sponsor such that other members of its “controlled group” may be held liable for the plan’s termination liabilities.
In the late 1980s, Joseph Wortley owned Liberty Lighting Co., Inc. (“Liberty”), a unionized electrical supply manufacturing company, which was the plan sponsor and administrator of the Liberty Lighting Co., Inc. Pension Plan for IBEW Employees (the “Plan”) under Title IV of ERISA. Following financial trouble in the early 1990s, Liberty entered bankruptcy, surrendered its assets to a creditor, and was thereafter administratively dissolved under Illinois state law. Wortley eventually also filed for personal bankruptcy, pursuant to which he surrendered all of his assets to a trustee, including his stock in Liberty, of which he was the sole owner. Wortley nevertheless continued to act as the Plan’s administrator, signing paper on behalf of the Plan at the request of the Plan’s actuary for years after Liberty’s purported dissolution, which signatures were necessary to effect continuing payments to pensioners. In 2012, when the Plan’s funds ran low, the bank administering the Plan notified the Pension Benefit Guaranty Corporation (“PBGC”), the federal agency charged with protecting the retirement incomes of workers in private-sector defined benefit pension plans, of the Plan’s looming insolvency. PBGC and Wortley reached a settlement that represented Liberty as having dissolved in the 1990s and contained language that Wortley believed established a final cutoff date for his remaining liability by conveying all of Wortley’s authority over Liberty and the Plan to PBGC. Six years later, PBGC brought suit in the United States District Court for the Southern District of Florida against nineteen other companies owned by Wortley (“the Companies”), alleging that they were part of a “controlled group” with Liberty and therefore were still liable for Liberty’s unpaid pension benefits, premiums, interest, and penalties. The district court was persuaded by PBGC’s theory that, because Liberty was unable to meet its ERISA obligations to its former employees, Wortley’s other companies must foot the bill, and granted summary judgment to PBGC, which the Companies timely appealed.
The liability for the “controlled group”—other entities under common control with the sponsor of a plan under ERISA— is established by 29 U.S.C. section 1307(e)(2). The purpose and effect of this provision is to prevent the sponsor of a defunct pension plan from funneling its assets into other entities it owns, leaving PBGC “holding the bag” for the plan’s continuing liabilities. ERISA thus provides that if a sponsor is on the hook for unfunded pension obligations, then every other entity sharing a specified percentage ownership interest is also on the hook, jointly and severally. ERISA does not, however, provide for pension liabilities when the sponsor of a plan has dissolved but the plan has continued to operate, nor does Illinois law. Where ERISA is silent, the Eleventh Circuit stated that courts are “required to develop a federal common law of rights and obligations under ERISA-regulated plans… In deciding whether a rule should become part of ERISA’s common law,” the court “must decide whether the rule, if adopted, would further ERISA’s scheme and goals, which are (1) protection of the interests of employees and their beneficiaries in employment benefit plans… and (2) uniformity in the administration of employee benefit plans.” The Eleventh Circuit “follow[ed] the Supreme Court’s instruction” to “fill in ERISA’s gaps with common-law rules…and [held] that where the sponsor of an ERISA plan dissolves under state law but continues to authorize payments to beneficiaries and is not supplanted as the plan’s sponsor by another entity, it remains the constructive sponsor such that other members of its controlled group may be held liable for the plan’s termination liabilities.” Accordingly, the Eleventh Circuit, “[u]nder the narrow rule [it] craft[ed] here,” found that “the Companies are liable to PBGC for the Plan’s termination liabilities for the simple reason that Liberty persisted as the Plan’s sponsor even as it dissolved as an Illinois corporation.” In reaching this rule and conclusion, the Eleventh Circuit was largely motivated by the facts that the Companies did not provide a possible alternative sponsor, PBGC was never notified at the time of Liberty’s bankruptcy or that the company was dissolving so that it could lodge an appropriate claim as a creditor to the bankrupt corporate estate and make provision for protecting retirees’ future benefit payments, and no provision in ERISA contemplates a plan without a sponsor. The Eleventh Circuit expressed concern that “[r]uling for the Companies would mean holding that an extant pension plan may be left without a sponsor for decades, which could have vast ripple effects across even unrelated provisions of ERISA… The implication that an ERISA plan may function without a sponsor risks chaos,” and the Eleventh Circuit “decline[d] the Companies’ invitation to create this uncertainty in ERISA law.”
As the use of captive insurance companies continues to grow, one issue businesses may face is whether to incorporate cells within a captive cell program. This article addresses some of the relevant considerations.
In simple terms, a captive insurance company is an insurance company owned by the entity to which the captive issues insurance. Captive insurance companies can take several different forms. A single-parent captive is one owned by a single entity. A group or association captive is a captive that is owned by two or more different entities. A rental captive is created by a third party and, for a fee, allows other entities to obtain the benefits of captive insurance without needing to form their own captive insurance company. This often takes the form of a captive cell; in that form, each “rental captive” is created as a captive cell within the larger captive such that the assets and liabilities of each cell are shielded from other entities’ “rental captive.”
As an alternative, a single entity could create a captive cell program. In that circumstance, the entity would create a cell captive insurance company and then create captive cells within that company. Cells could be created to segregate different types of insurance, thereby protecting the assets held to insure low-risk types of coverage from those held to insure high-risk types of coverage. Cells may also be created to segregate insurance of different projects.
An issue businesses confront when creating a captive cell is whether to form the cell as an incorporated entity or an unincorporated entity. One possible advantage of unincorporated cells is that they may be easier to form and maintain. An unincorporated cell can avoid the administrative burdens and costs of an incorporated cell. It may not need to prepare more standard formation documents like articles of incorporation or bylaws. In addition, unincorporated cells usually do not need to have officers and directors, hold annual board meetings, or file separate tax returns. Because unincorporated cells are not legal entities, they generally cannot enter into contracts, requiring the core captive to do so. Depending on the jurisdiction, however, captive laws and regulations may still protect the assets and liabilities of an unincorporated cell from those of the core captive and other cells within that core captive.
A potential advantage of an incorporated cell is that it can further establish the goal of segregating cell assets and liabilities. For example, unlike unincorporated cells, incorporated cells can enter into contracts and thus can issue the insurance policies to the policyholder. Likewise, they can sue and be sued. Each of those characteristics of an incorporated cell can further protect the cell’s assets and liabilities from those of other cells and the core captive. However, incorporated cells may impose additional administrative burdens and costs that are not imposed by unincorporated cells.
Case law on these issues is sparse, to say the least. In one of the few decisions addressing the issue, a federal court in Montana ruled on one consequence of an unincorporated cell. Pac Re 5-AT v. Amtrust N. Am., Inc., 2015 WL 2383406, at *4 (D. Mont. May 13, 2015). There, the court found that, without a separate legal identity, and absent a statutory grant to the contrary, the unincorporated cell there lacked the capacity to sue or be sued. Id. As a result, and contrary to the unincorporated cell’s and the core captive’s arguments, the court found that the core captive was properly named as a party in a demand for arbitration for alleged breaches of a captive reinsurance agreement and would be appropriately bound by the results of the arbitration. Id. at *5. However, that court also recognized the Montana statute that protected the assets of a cell from the liabilities of other cells or the core captive. Id. at *4 (quoting Montana Stat. § 33-28-301(4), which provides that “[t]he assets of a protected cell may not be chargeable with liabilities arising from any other insurance business of the protected cell captive insurance company”).
Cell captive insurers could be brought into litigation involving insurance issued by an unincorporated cell. For instance, when a policyholder requests coverage from other insurance companies, those other insurers may argue that the policyholder’s captive insurance must provide coverage first. Those arguments can be based on other-insurance clauses or on contribution principles. They could also involve a policyholder seeking coverage under a vendor’s insurance policy or seeking indemnity from a vendor. In those circumstance, those other insurers may bring the captive insurer into any litigation between the policyholder and those other insurers. But, even if the core captive is a party to the arbitration, its assets may still be protected from paying the liabilities of a protected cell.
Ultimately, the decision of whether to incorporate cells within a captive cell program will likely depend on a variety of factors, including the goals and needs of the business as well as state-specific laws and regulations.
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