When asked to deal with numbers and valuations, most lawyers will say they went to law school for a reason—to avoid math at work. Nevertheless, valuations are an important part of any attorney’s practice. Whether arguing the value of a company’s common stock in a shareholder dispute, evaluating a potential acquisition target for a client, assigning value to assets held in trust, or attempting to determine the ability of a business to reorganize under the Bankruptcy Code, so many different variables must be reviewed and determined, and an attorney may quickly find themselves underwater. For instance, at what point in time should an asset be valued? What valuation methodology should be used? What weight should recent financial data be given compared to projections going forward? These and many other factors must be decided before any reputable valuation can be made, all while running complex calculations that attorneys typically hope to avoid.

With the rise and continued encumbrance of the COVID-19 pandemic, the questions facing those attempting to prove or argue a valuation have become even harder to resolve. For existing, pre-2020 valuations, practitioners must consider the new reality of the pandemic in assessing or disputing now-unrealistic valuations. For valuations completed during the pandemic, questions arise about whether a valuation can project a value of an asset that assumes a general emergence from pandemic depression or whether it instead should give greater weight to recent, concrete financial data (based on the idea that current economic trends are slowly becoming the new “normal” for the economy and markets).

These compounding questions, whether they arise in the middle of an acquisition, in preparation for trial, or in a bankruptcy case, can prove daunting. When faced today with a difficult valuation, there are a few key resources and considerations that attorneys can use to help them wrap their heads around the valuation questions they face. By keeping these resources and considerations in mind, attorneys can go forward more confident in their development or rebuttal of a valuation even in the heart of this seemingly endless pandemic.

If Possible, Hire a Financial Advisor or Valuation Expert

Valuations, particularly of complex assets in high-stakes litigation or acquisitions, are difficult, likely requiring the creation of discount rates, the identification of countless inputs, and in-depth knowledge of relevant industries. Such valuations can therefore quickly outstrip the training or expertise of most attorneys. Additionally, if involved in a valuation dispute preparing for summary judgment or trial, a definitive report, testimony, or additional evidence will likely be needed to prove the party’s proposed value of the asset or claim at issue. Therefore, to the extent possible, a party in need of a valuation (or a party preparing a rebutting valuation) should consider hiring an expert depending on the type of valuation needed—for instance, hiring a financial advisor to prepare projections and a business valuation, or hiring an appraiser for a real estate transaction.

Initially, this expert can lead the valuation process on behalf of the client to ensure the valuation’s efficacy and accuracy. Later, this individual can serve as a party’s expert witness if needed, providing expert testimony and creating a valuation report to submit to the factfinder to support the client’s valuation or refute an opposing party’s valuation.

Without expert assistance, an attorney runs the risk of relying on a questionable or inadequate valuation, lacking sufficient persuasive evidence, or, if the attorney prepares the valuation, being placed in the untenable situation of becoming a fact witness. While valuation experts certainly will cost clients additional funds, the benefit provided will normally outweigh such cost significantly.

Get the Cold, Hard Facts from Your Client

Regardless of whether a valuation expert is retained or the attorney intends to prove a valuation without an expert, an accurate valuation requires the client to disclose all of the cold, hard facts and documents related to the asset, claim, or potential target. Discovering and understanding each of these facts and documents helps to independently verify the actual value of the claim or asset instead of relying solely on the client’s word. While there may be no ill-intent, clients’ financial projections are routinely overly optimistic, and clients often lack a complete understanding of the value of individual assets and the various obligations that may encumber the assets and reduce the equity available. Without the underlying facts and information, an attorney runs the risk of depending on the client’s own projections or valuations.

Zombie companies are perfect examples of the dangers of relying on valuations based on inaccurate facts and underlying data. A “zombie company” is one that is economically unviable or unprofitable but limps along by leveraging various loans from banks and investors, low interest rates, and the leniency of its creditors. These zombie companies have a higher than realistic valuation based on pie-in-the-sky projections for the company that show its ability to pay its debts based on alleged future income. A thorough investigation of a zombie company would uncover red flags, such as leverage above the annual median for its industry, an interest coverage ratio (ICR) below one, or negative real sales growth over the prior three years. If present, a party opposing a valuation of a zombie company or targeting the zombie company for acquisition will not be tricked by the company’s optimistic but unrealistic valuation.

Additionally, accurate facts and information are vital to establishing a strong evidentiary basis for the valuation if the valuation is needed as part of litigation. Proving a valuation is similar to proving any other factual element that must be shown at trial: attorneys must determine what facts are needed to support the valuation, what witnesses will testify regarding those facts, and what exhibits may be used to support the witnesses’ testimony. Overall, when creating the valuation and any corresponding report, it is important to rely as much as possible on concrete facts and documents, such as financial statements, that provide actual data that can be used to prove the validity of the valuation and create a persuasive basis for a potential factfinder.

Consider Whether the Pandemic Economy Is the New Normal

For valuations that occurred prior to the pandemic, the projections did not (and could not) incorporate the effects of the pandemic. Since then, during the pandemic, similar valuations have tended to predict a societal recovery from the pandemic’s lingering economic impacts with the main variation being how long the recovery will take. For the minority of businesses somehow unaffected by the pandemic, pre-2020 valuations may still be accurate. For other businesses, the pandemic’s effect on the business may have already (for the most part) subsided.

However, for the majority of businesses, these valuation scenarios occurring both before and after the start of the pandemic can lead to valuations that ignore present conditions and thus potentially result in overestimations of an asset’s or business’s actual value. Now that the pandemic is nearing its third year and with the next virulent strain seemingly always on the horizon, it begs the question whether the pandemic economy is actually the new “normal” that should be considered a constant in any valuation going forward. While this change in perspective may lead to more reserved valuations of assets or claims, in the long run it may prove more realistic and persuasive as prior valuations continue to underperform due to the pandemic’s sobering effects on the actual value of assets or claims. Unless global circumstances change drastically in the near term, it may not be long until present conditions are considered our new reality.

Conclusion

The valuation of assets or claims has never been an exact science within the legal profession. With the emergence and lingering presence of the COVID-19 pandemic, calculating a formula for an evaluation has grown even harder. Nonetheless, utilizing a financial expert, independently conducting due diligence on the asset or claim, and recognizing current economic reality can provide some clarity to the valuation process going forward. While not foolproof, these considerations create a sound base supporting a secured creditor’s alleged valuation of its claim, a litigant’s valuation of an asset at issue, or a potential purchaser’s valuation of a target company. Without these considerations, a party runs a real risk of falling victim to an unrealistic valuation that could cause significant issues and potential liability down the road.

An opinion that an extension of credit does not violate margin regulations is sometimes requested in loan transactions and certain debt offerings as an aspect of an opinion that the transaction does not violate applicable laws. A typical opinion expressly covering margin regulations may be stated as follows:

The execution and delivery by [the Company] of each [Loan Document] to which it is a party do not, and the performance by [the Company] of its obligations thereunder will not, result in violation of Regulations T, U or X of the Board of Governors of the Federal Reserve System.

Opinion Coverage as a Matter of Customary Practice

The laws that a lawyer exercising customary professional diligence would identify as being applicable when giving an opinion depend on the type of the transaction. In a lending transaction, particularly a loan that will be used to acquire margin stock or that is secured by margin stock, a lawyer might identify the margin regulations as being applicable, and a lender might reasonably expect those regulations to be addressed by the opinion letter, but the coverage of the margin regulations, as part of the securities laws in general, in an opinion letter is not entirely clear. For that reason, when the margin regulations may be applicable to the transaction, a lender may request the margin regulations to be expressly addressed in the opinion letter. On the other hand, if the transaction does not involve margin stock, the opinion letter may not be expected to address the margin regulations. In that case, although the margin regulations may be understood as a matter of customary practice not to be covered unless done so expressly, some lawyers choose to exclude expressly the margin regulations from the opinion letter’s covered law, especially when they are expressly excluding other laws from coverage.^[1]

Margin Regulations; Applicability and Definitions

The margin regulations are Federal Reserve Regulations T, U and X, 12 C.F.R. §220.1 et seq., §221.1 et seq. and §224.1 et seq., respectively, issued by the Federal Reserve Board under Section 7 of the Securities Exchange Act of 1934 (the “Exchange Act”). That section authorizes the Board to issue rules and regulations “for the purpose of preventing excessive use of credit for the purchase and carrying of securities.” Section 7 of the Exchange Act also prohibits banks and broker dealers, with certain exceptions, from extending credit or arranging the extension of credit in contravention of those rules and regulations, and prohibits U.S. persons and foreign persons controlled by or acting on behalf of a U.S. person from obtaining such credit.

Regulation T applies to brokers and dealers as defined in the Exchange Act and members of a national securities exchange, and certain related persons. Regulation U applies to banks and to non-bank lenders who in the ordinary course of business extend credit secured directly or indirectly by margin stock in the amount of $200,000 or more during a calendar quarter or have $500,000 or more of such credit outstanding at any time during a calendar quarter. Regulation X applies to borrowers. It was added to the margin regulations after some borrowers tried to use a violation of the margin regulations applicable to lenders as a defense to payment of the credit.

Regulations T and U prohibit a covered lender from entering into or arranging an extension of credit for the purpose of purchasing or carrying margin stock in an amount in excess of the maximum loan value of the margin stock if the loan is secured directly or indirectly by margin stock. Regulation X prohibits a borrower from entering into a transaction that violates the margin regulations. Credit that is extended for the purpose of buying or carrying margin stock is referred to as “purpose credit.” Margin stock includes equity securities listed or traded on a national securities exchange or qualified for trading in the National Market System. Margin stock also includes warrants or rights to subscribe to margin stock or debt securities convertible into margin stock or carrying a warrant or right to subscribe to margin stock, and certain securities issued by a registered investment company. Margin stock does not include the stock of a borrower’s wholly-owned operating subsidiaries that is not traded in the market.

An opinion that an extension of credit does not violate the margin regulations will turn on whether the credit is purpose credit and whether the credit is directly or indirectly secured by margin stock.

Not Purpose Credit

In a general lending transaction, the loan agreement may include the stated purposes of the loan and may include a provision that the loan may not be used to purchase or carry margin stock. A lawyer’s reliance on the borrower’s obligation to comply with the provisions of the loan agreement may form the basis for the lawyer to conclude that the credit is not purpose credit and thus permit the lawyer to give the opinion that the transaction will not violate the margin regulations. For revolving or multiple draw loans secured directly or indirectly by margin stock, a covered lender is required to obtain from the borrower a completed form FR U-1 (banks), FR T-1 (brokers and dealers) or FR G-3 (other covered lenders) in which the borrower states whether or not any part of the credit is a purpose credit and if not, the purpose of the credit. A representation of the borrower on such a form, or in a separate certificate on which the opinion giver can rely, that the credit will not be used to purchase or carry margin stock may also be the basis for an opinion that the transaction does not violate the margin regulations based on the credit not being a purpose credit. An example of a non-purpose loan representation is:

No proceeds of the [Loan] will be used for the immediate, incidental or ultimate purpose of buying or carrying margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System).

Purpose Credit Indirectly Secured by Margin Stock

If credit is purpose credit and the borrower owns or will acquire margin stock, even if the credit is not explicitly secured, the transaction may still run afoul of the margin regulations if the credit is deemed to be indirectly secured by margin stock. A credit may be deemed to be indirectly secured by margin stock if the borrower has agreed not to pledge any of its assets to secure any other obligation and if the borrower has no other substantial assets than the margin stock. Examples of such a borrower would be a shell acquisition subsidiary with no assets other than the acquired margin stock or a company that is an investment company that has invested in margin stock. On the other hand, if the borrower has substantial assets or cash flow without regard to the margin stock, the unsecured loan with a negative pledge clause may not be deemed to be indirectly secured by the margin stock.

The definition of “indirectly secured” in Regulation U has several exceptions. One of the exceptions is that, if after applying the proceeds of the credit, “not more than 25% of the value (as determined by any reasonable method) of the assets” subject to the negative pledge clause is margin stock. 12 C.F.R. § 221.2. In a close valuation case, the choice of a method for valuing the assets may make a difference whether the 25% safe harbor is available, but where the value of the margin stock is negligible in relation to the other assets of the borrower, the opinion giver may be confident that the safe harbor is available. Depending on the values, a simple certificate from the borrower may be sufficient, or the conclusion in the certificate may need to be supported by calculations showing how the values of margin stock and the borrower’s other assets were calculated. The conclusion of the certificate might state:

As of the Closing Date, the value of the margin stock (within the meaning of Regulation U of the Board of Governors of the Federal Reserve System) constitutes less than 25% of the value of the assets of the [Borrower] that are subject to any limitation on sale, pledge or other restriction under the [Loan Documents].

An additional exception in the definition of “indirectly secured” in Regulation U is that the lender “in good faith, has not relied upon the margin stock as collateral in extending or maintaining the particular credit.” 12 C.F.R. § 221.2. The specific evidence sufficient to support an opinion that the lender is not relying on the margin stock as collateral may depend on the particular facts of the transaction, and might include statements of the lender to this effect on which the opinion giver could rely. Such evidence is more persuasive if other valuable assets of the borrower have been pledged to secure the credit, and the negative pledge clause creating the indirect security on the margin stock is clearly not intended as additional collateral. As an alternative, a lender may accept an opinion that the transaction does not violate the margin regulations based on an expressly stated assumption in the opinion letter as to the lender’s non-reliance on the margin stock as security.

This article originally appeared in the Winter 2021–2022 issue of In Our Opinion, the newsletter of the ABA Business Law Section’s Legal Opinions Committee. Read the full issue and previous issues on the Legal Opinions Committee webpage.

1. See Gail Merel et al., Laws Commonly Excluded from the Coverage of Third-Party Opinions in U.S. Commercial Loan Transactions, 76 Bus. Law. 889, 896 and n. 25 (2021). ↑

ABA Business Law Section
Mergers & Acquisitions Committee, Technology in M&A Subcommittee

 MAC Digital Documentation Protocol

Project Chairs: Anshu Pasricha (formerly of Koley Jessen, P.C., L.L.O.) and Thomas B. Romer (Greenberg Traurig LLP)
Key Contributors: W. Ian Palm and Stefan Nasswetter (Gowlings), Kathy Woeber Gardner and Karen Masterson Dienst (Montgomery Pacific), Tali Sealman (White & Case) and Brittany Sakowitz (Kirkland & Ellis LLP)
Subcommittee Chair and Contributor: Daniel Rosenberg (Charles Russell Speechlys LLP)
Peer Review: Glenn West (Weil, Gotshal & Manges)
Committee Chair: Wilson Chu (McDermott Will & Emery LLP)

Introduction

As in-person closings, much less in-person signings, go the way of livery of siesen,^[1] the Technology Subcommittee of the ABA Mergers and Acquisitions Committee (“MAC”) has prepared a protocol which represents the best practices used by M&A lawyers in arranging for the proper execution and delivery of documents digitally.^[2] The “MAC Digital Documentation Protocol” is not an exclusive means to digitally execute and deliver documents, but rather a set of governing principles counsel can rely on to ensure documents are effectively reviewed, executed and delivered digitally.

The digitization of the M&A agreement process has significantly increased the speed with which documents can be changed and greatly enhanced the ability of parties to fine tune agreements up to the last minute—or even second—before signing. Although there have been few cases to date in which the enforceability of an agreement has been challenged due to the failure of the execution and delivery process that was not held in person,^[3] we believe adherence to the guiding principles of the MAC Digital Documentation Protocol will help parties to avoid potential disputes on issues such as “what was the final version of an applicable agreement” or “that a party never agreed to the terms of the purported final agreement.”

MAC Digital Documentation Protocol Guiding Principles

The MAC Digital Documentation Protocol is comprised of four guiding principles:

• complete documents should to be made available to signatories for review before or at least as they are signed;
• review of complete documents by the signatories should be confirmed;
• execution of documents by electronic means in accordance with applicable law is supported; and
• delivery of reviewed, confirmed and executed documents should be clearly established.

By executing and delivering a document in concert with these guiding principles, we believe sufficient evidence of due execution and delivery of that document has occurred amongst the signatories.

How to use the MAC Digital Documentation Protocol

In our view, simply including a reference to the MAC Digital Documentation Protocol in a transaction document is sufficient to document the parties’ intent to execute and deliver documents in accordance with its guiding principles.

Failure to adhere to the MAC Digital Documentation Protocol, whether or not it has been referenced, should not in-and-of-itself mean a document is not effectively executed and delivered. However, adherence to the MAC Digital Documentation Protocol, whether or not referenced, is intended to be a sufficient means through which documents can be executed and delivered by electronic means and thereby enforceable amongst the parties to such documents.

Including the MAC Digital Documentation Protocol (whether by reference or by including language that reflects its guiding principles) is intended to create a presumption that the parties have complied with the MAC Digital Documentation Protocol absent clear evidence to the contrary.

Sample Language

Sample language to be included in documents consistent with the MAC Digital Documentation Protocol is provided below. Including this language in an agreement is not required to evidence the parties’ intent to execute and delivery documents in accord with the MAC Digital Documentation Protocol. However, incorporating the MAC Digital Documentation Protocol by reference is considered to be sufficient evidence of the parties’ intent.

The MAC Digital Documentation Protocol guidelines are designed to apply to the execution and delivery of any agreement or document that is signed by one or more parties. With the exception of the sample signature page language which is designed to be applicable to any document, the sample language is designed to be incorporated into a purchase or merger agreement and applicable to the documents required to close a transaction.

Incorporation of the MAC Digital Documentation Protocol by Reference

Specific reference to the MAC Digital Documentation Protocol is the clearest way to document the parties’ intent to sign an agreement or close a transaction in accordance with the MAC Digital Documentation Protocol.

Sample Signature Page Language:

The undersigned hereby execute and deliver this Agreement in accordance with the MAC Digital Documentation Protocol as of the day above first written.

Sample Closing Language:

The Closing. On the terms and subject to the conditions of this Agreement, the closing of the transactions contemplated by this Agreement (the “Closing”) shall take place on the Closing Date by the electronic exchange of documents in accordance with the MAC Digital Documentation Protocol (the “Protocol”). No Party shall be required to appear at any specific physical location to effect the Closing. The Closing shall be deemed effective at 12:01 a.m. Eastern Time on the Closing Date (the “Effective Time”).

Principle 1: Making Available Complete Documents to be Executed and Delivered Via Electronic Means.

By incorporating the MAC Digital Documentation Protocol into their agreement, parties are agreeing to make available to each party (or their counsel)^[4] who will be executing and delivering a document electronically the entire contents of that document (together with all addendums, exhibits, annexes, supplements and other materials incorporated by reference)^[5] by:

1. circulating electronic versions of such document (and all referenced materials) via email;
2. providing access to electronic versions of such document (and all referenced materials) via a shared work folder on a mutually agreed secure website; or
3. providing access to such document by any other means in which the document and (and referenced materials) can be accessed and viewed by the signing party.

Sample Language:

Preparation of Final Documents. Unless otherwise agreed by the Parties in writing, prior to Closing, Buyer’s counsel, on behalf of the Buyer, will circulate [by email/by providing appropriate access to a work folder on a mutually agreed upon secure website] final, execution versions of the Purchase Agreement and all other Transaction Documents, together with all addendums, exhibits, annexures and supplements thereto (collectively, “Closing Documents”).

Principle 2: Ensuring Review of Complete Documents to be Executed and Delivered via Electronic Means.

Each party to a document made available pursuant to the MAC Digital Documentation Protocol or their counsel,^[6] will review each document to be executed by that party to ensure that such document manifests the agreement to which such party intends to be bound once executed and delivered.

Sample Language:

Review and Confirmation. Each party will review and confirm that such Closing Documents are acceptable as final documents that can be executed and delivered by the Parties.

Principle 3: Valid Execution of Documents Via Electronic Means.

Execution of a document circulated and reviewed in accordance with the MAC Digital Documentation Protocol or similar means, using a technology that complies with applicable law governing the execution of documents by electronic means^[7] is an acceptable way to execute documents in accordance with the MAC Digital Documentation Protocol.^[8],[9],[10] Though not a required part of the MAC Digital Documentation Protocol, the collection—and holding in escrow—of signature pages to documents by one or more counsel and/or parties to a transaction prior to delivery or release of such signature pages (including prior to finalization of the terms of such documents) is a common practice. Such practices, if the other aspects of the MAC Digital Documentation Protocol are otherwise complied with, do not violate the terms of the MAC Digital Documentation Protocol. Delivery or release of such signatures in accordance with the MAC Digital Documentation Protocol is addressed in Principle 4.

Sample Language:

Execution and Collection of Signatures. On receipt of such confirmation from Seller’s counsel, Buyer’s counsel shall circulate by [email/mutually agreed upon E-Signing Application Service Provider that is compliant with the U.S. federal E-SIGN Act of 2000], all such Closing Documents to all Parties and any other signatories to the applicable Transaction Documents. Prior to the Closing, all Parties and any other signatories to the applicable Transaction Documents shall have executed and circulated the signature pages to the Closing Documents to Buyer’s counsel, to be held in escrow pending release of such signature pages to the Closing Documents in accordance with the terms agreed amongst the Parties and any other signatories to the applicable Transaction Documents.

In addition, a proposed counterparts and e-signatures language could be:

Counterparts and Electronic Signatures. This Agreement may be executed (i) in a single document signed by all parties or (ii) in multiple counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same instrument. Counterparts may be (i) signed in person and delivered in person, via facsimile, or via other means of electronic delivery (including emailing an electronic copy thereof) and/or (ii) signed and delivered by means of employing electronic signature technology that complies with the Electronic Signatures in Global and National Commerce Act of 2000 (E-SIGN), or other Applicable Law governing the execution and delivery of this Agreement through electronic means. Any counterpart executed and delivered in accordance with the terms of this paragraph will be deemed to have been duly and validly executed and delivered by such party.

Principle 4: Effective Delivery of Executed Documents (Release of Signatures).

In order for a document to be enforceable against a party that document must be duly executed and delivered by that party.^[11] A document executed in accordance with the MAC Digital Documentation Protocol will be effectively delivered in accordance with the MAC Digital Documentation Protocol if a party, their counsel or an authorized person affirmatively expresses the intent of the applicable party to deliver (often referred to as release their signature to) the duly executed document to the other party(ies). Any means by which a party or their counsel communicates their intent to deliver a duly executed document that clearly demonstrates both the applicable document they intend to deliver and the required intent to deliver it (whether by electronic means, or via verbal communication in person, by phone, or any other means in which the party or their representative can be heard and can hear the other participants) is acceptable under the MAC Digital Documentation Protocol. Though not required, the MAC Digital Documentation Protocol encourages practitioners to use a secure website, at which the applicable document can be viewed by both the party intending to deliver their executed copy thereof and receiving party, together with a communication (phone or video conference, in person meeting, or email) stating that a signature can be affixed to the posted document and such document may be delivered to the other party. Many websites can track and make available all activity with respect to documents posted to the website which will provide parties and their counsel assurance that a document which has been previously confirmed has not been changed. Emailing or circulating documents in a way that otherwise meets the principles of the MAC Digital Documentation Protocol is also accepted.

Sample Language:

Delivery of Executed Documents (Release of Signatures). On the Closing Date, at a mutually agreed on time, Parties and any other signatories (together with authorized representatives of such parties) shall coordinate a closing teleconference call (“Closing Call”). At such Closing Call, Buyer’s counsel (on behalf of Buyer) and Seller’s counsel (on behalf of Seller) shall confirm that the Parties are satisfied that (i) in the case of signing, all Parties are in agreement that all signature pages shall be released by Buyer’s counsel concurrently, and (ii) in the case of closing, all conditions to Closing have been satisfied or waived in accordance with the terms of the Purchase Agreement, and all Parties are in agreement that all signature pages shall be released by Buyer’s counsel concurrently, subject only to Buyer providing wire transfer confirmations/fed. reference numbers to the Parties promptly (and in any event, no later than [two hours] following the Closing Call).

Archive and Distribution. Buyer’s counsel shall provide a copy of the archived Closing Documents circulated by Buyer’s counsel in accordance with [Section [●]—Preparation of Final Documents]. Buyer’s counsel shall provide a copy of all fully-executed and delivered Closing Documents to Seller and Seller’s counsel.

[1] An English common law ceremony dating back to the Middle Ages in which the selling party intending to convey an interest in real property literally handed to purchasing party a clump of soil, a twig, a key to a building, or other token. The Law of Property Act, passed in 1925 (15 & 16 Geo. 5, ch. 20 [Eng.]), abolished the practice.

[2] Our use of the term “digital” is intended to cover a number of situations ranging from fully digital execution and delivery of documents to hybrid situations where documents are emailed, signed manually, and delivery of those signatures is sent electronically.

[3] See, Kotler v. Shipman Assoc., LLC, (Del. Ch. Aug. 27, 2019) (finding a contract unenforceable despite the agreement being fully executed, because the signature page was attached to a version of the contract that was not the version that the CEO signatory intended to execute); UBEO Holdings, LLC et al. v Drakulic (Del. Ch. April 30, 2021) (finding a forum selection clause unenforceable in part because Drakulic was never provided a copy of the merger agreement and was not informed of the agreement’s forum selection provision or other provisions restricting his livelihood, and Drakulic was intentionally kept in the dark of the contents of the agreement).

[4] Circulating or providing access to documents to counsel only, with the understanding that counsel will circulate or provide access to such documents to their clients is a common and accepted practice. Opposing counsel can assume, absent specific knowledge to the contrary, that a party’s counsel will ensure their client has been provided access to documents to be executed electronically.

[5] Often transaction documents (with attachments) are too bulky and cumbersome to circulate by email. In particular, all attachments to disclosure schedules are unlikely to be circulated via email (unless multiple emails are circulated). As such, consider providing the alternative of uploading to a website.

[6] Review and confirmation by counsel on behalf of their client that a document contains the terms and conditions negotiated by the parties is an accepted practice. Opposing counsel can assume, absent specific knowledge to the contrary, that a party’s counsel will ensure their client has been provided access to documents to be executed electronically.

[7] e.g., The Uniform Electronic Transactions Act (UETA), which is the law in all but a few United States jurisdictions, or the Electronic Signature in Global and National Commerce Act, 15 USCA §§ 7001 et seq. (E-SIGN), which is federal law and preempts state law in certain instances.

[8] Practitioners should confirm that each document to be executed via electronic means may be so executed in accordance with applicable law. Certain documents (such as deeds and negotiable instruments) may not be executed electronically under applicable law.

[9] See TriBar Opinion Comm., Comment Concerning Use of Electronic Signatures and Third Party Opinion Letters, 75 Bus. Law. 2253 (2020). Our European colleagues can comment on the relevance of Regulation (EU) No 910/2014 (the eIDAS Regulation) that applies to EU Member States from 1 July, 2016. Similarly, in Canada, we understand that all provinces and territories have adopted e-commerce legislation providing that an electronic signature is valid and enforceable so long as the electronic signature is reliable for the purpose of identifying the person and the association of the electronic signature with the relevant electronic document is reliable.

[10] Note: In the United Kingdom, the Law Commission (which is the statutory independent body which reviews the law of England and Wales and recommends reform where needed) has recently summarised the English legal position in its September 2019 report (Law Commission report: Electronic execution of documents (Law Com No 386, September 2019)) as being that electronic signatures are capable in law of being used to execute documents (including deeds). This conclusion is based on the provisions of the EU eIDAS Regulation (Regulation (EU) No 910/2014 of the European Parliament and of the Council of 23 July 2014 on electronic identification and trust services for electronic transactions in the internal market and repealing Directive 1999/93/EC), the UK’s Electronic Communications Act 2000 and case law relating to electronic signatures and signatures more generally. However, it also recommended that an industry working group be established to consider practical issues relating to the electronic execution of documents and the law relating to deeds more generally. The UK Government subsequently endorsed these views in March 2020, noting that the timing of a wider review of the English law of deeds would be subject to overall government and Law Commission priorities given the current volume of UK law reform work.

[11] Due authorization is also required but is not within the scope of the MAC Digital Documentation Protocol.

Law firm leaders today are like circus jugglers flipping balls into the air so fast you can hardly see them. Yet most leaders primarily focus on putting out fires to keep themselves afloat.  Issues of the moment include:

• Addressing the Great Resignation: what do employees want?
• Managing the return to office
• Implementing guidelines and processes for a hybrid office
• Reimagining the physicality of the office
• Rethinking safety for humans and cyber-safety for work product

It’s a beginning. Futurists might hope that leaders would think more strategically to address the impact of the tech-driven world we are moving into. But most law firms are not receptive to dramatic change. The typical law firm organization is paramilitary. Lawyers work their way up to equity partner and, once there, set the rules for everyone else without asking for anyone else’s input. It’s top-down decision-making with little regard for input from others.

Law firm leaders will be more comfortable addressing issues as they arise rather than tackling a comprehensive cultural overhaul.

This article looks at the importance of inclusive communication practices as an essential underpinning for any change. The assumption is that the more inclusive, receptive kind of communication required to make any changes “stick” will necessarily chip away at the dictator-leader model. A new kind of communication will foster worker buy-in to small changes that will, over time, lead to more democratic, decentralized, inclusive firm communications.

Communication Basics

“Communicating means establishing good relationships and reaching the right persons with the right messages at the right messages at the right time, usually for the purposes of getting something done.”[1]  Good communication requires preparation and knowledge. “Right persons,” “right messages” and “right timing” presume that the communicator knows the organization, the players, the leaders and the culture—their jargon, their values, their biases, the way they have always done things.

Workplace communications almost always involve an element of persuasion, where the speaker is looking for buy-in. To persuade requires the persuader to:

• Be trusted by those in the audience.
• Be sincere about personal beliefs and use appropriate body language to reinforce that sincerity.
• Use stories to emphasize points that resonate with the audience.
• Use their language and communicate the main “ask” clearly.

Audiences never hear exactly what the speaker says because they process words through their own life experiences, beliefs, and preferences. Workplace leaders create greater alignment with their audience when they seek their involvement. To increase the likelihood that they will hear “real” answers from those lower down on the office ladder, the leader has to create a safe environment for the dialogue.

To achieve audience rapport, the leader should be empathetic, open-minded, non-judgmental, and willing to adjust the original idea to incorporate some of their input. To see how these generalities play out in the law firm environment, let’s look at two of today’s issues: 1) what employees want; and 2) the return to the office.

What Employees Want

The assumption that work could only be done in an office died after two years of productive remote work. The ability to work elsewhere enabled professionals to carry out work assignments as just one among many daily activities. Women tasked with childcare responsibilities could interweave the two activities. For many, it worked.

Of course, while some flourished, others felt isolated, burned out, lonely, and depressed. They found it difficult to separate work and home activities either physically or mentally. Without something as arbitrary as a commute to separate work and life, they overworked. This tendency was made worse by bosses who called innumerable videoconference meetings to compensate for the lack of in-office collaboration.

Employees had time to think about preferable work environments. Especially for younger lawyers and new hires, the absence of in-person mentors and colleagues creates a feeling of isolation—and often depression. Despite a multitude of team meetings, it is difficult to become friends with online colleagues; to understand firm culture; and to behave according to informal office norms.

2021 saw approximately four million workers a month disappear from the workforce either through firing and attrition or worker resignations. As worker shortages grow, employees are in the catbird seat.

They want more than more money. They would like their law firms to accept work as one part of a balanced life rather than the focus of their waking hours. They are asking for:

• Respect
• An understanding that flexibility includes both scheduling and location plus the ability to decide for themselves how to get their work done
• Clarity as to career paths and development of pathways to personal growth
• Leaders willing to include their input when making decisions about their work lives
• Firm values aligned with theirs regarding issues such as climate change, Black Lives Matter, and DEI

Leaders used to docile followers were surprised and disoriented. They were focused on confusing health mandates, client demands, and technology disruptions. Instead, they have to deal with demands for new workplace relationships and opportunities.

The Return to Work

Important concerns complicate any return to office-based work. Firm leaders are faced with the need to:

• Assuage health worries focused on COVID upticks and returning to elevators, shared lunchrooms, and cubicle offices.
• Change firm cultures to meet new worker definitions of an acceptable workplace.
• Reconsider partner-associate and lawyer-staff relationships.
• Deal with the impact of 20^th-century thinking about the role of in-office participation in career success versus the new reality that people want to work asynchronously.

Firms’ knee-jerk response was to offer a hybrid work model that would include the option to work remotely. Less thought was given to details like scheduling and meeting employees’ emotional demands for participation, career success, and well-being.

Culture-changing questions include:

• What needs to be done in the office and what is better done alone?
• For knowledge workers, does the nine-to-five workday still make sense?
• Does everyone in a law firm need to be in the office together all the time?
• How does the autonomy to decide when and where to work coexist with the reality of teams or set work schedules?
• Does choosing remote work need to negatively impact careers, especially for women lawyers?

Law firm leaders have begun to respond to these pressures. Successful responses begin with those good communication skills, that is, the willingness to be authentic; open to others’ ideas; empathetic; and ready to change. Rather than lay down an arbitrary rule, modern leaders will move toward more inclusive decision-making that shows respect, support, and interest in what other people in their firm think.

Questions that guide this kind of conversation include:

• What do you think?
• How can I help?
• Why is that important to you?
• What do you suggest to resolve the issue?
• What can we as a firm do to meet your expectations?

An example of a brief but positive conversation with a complaining employee:

Employee: Complaint.

Leader: I hear you and I understand. I have some thoughts about the issue but I am more interested in how you would resolve the problem. I’d love to hear your ideas. Let’s get together next Wednesday to find a solution. I will send you a calendar invite.

The leader has in four sentences expressed understanding of where the employee is coming from; said she wants to hear their solution; given them time to craft a workable result; and shown respect for the employee’s issue by setting a specific time to resolve the issue.

Conclusion

All the pandemic-induced changes of the past two years have created an opportunity to alter the dynamic between law firm leaders and employees—non-equity partners, associates, and staff. As firms try various solutions in 2022, there is an opportunity to make the best ones permanent: To address a future where lawyers will be paid for their knowledge rather than the process of creating specific products.

In subsequent issues I will discuss specific solutions to the problems raised here.

[1] George de Mare, “Communicating: The key to establishing good working relationships,” Price Waterhouse Review, 1989, p. 32.

Mortgage foreclosure cases sometimes yield surprising and unexpected results,^[1] and the recent opinion issued in Freedom Mortg. Corp. v. Olivera^[2] is no exception. In Olivera, the Appellate Court for Illinois’ Second District ruled that mortgage lenders attempting to foreclose an FHA-insured mortgage must demonstrate strict compliance with a HUD regulation mandating face-to-face meetings within three months of a payment default or “forgive potentially years of monthly payments” because lenders cannot go back in time to correct their alleged noncompliance.^[3] Yet the court openly “agreed to an extent” that its own ruling was “unjust.” This article discusses some of the arguments Illinois foreclosure practitioners should examine to challenge the court’s analysis.

HUD Face-to-Face Meeting Requirements

The National Housing Act of 1934^[4] (Housing Act) created the Federal Housing Administration (FHA) to encourage the construction of affordable housing.^[5] The Housing Act expressly affirmed “the national goal . . . of a decent home and a suitable living environment for every American family.”^[6] The U.S. Department of Housing and Urban Development (HUD) administers the Housing Act’s various housing programs,^[7] including a program that provides mortgage insurance on loans made by FHA-approved lenders to borrowers who may otherwise struggle to qualify for a mortgage.^[8]

In connection with administering the FHA-insured loan program, HUD promulgates regulations governing the servicing of FHA-insured loans.^[9] These regulations include a requirement that, unless excused for specific reasons, lenders must “have a face-to-face interview with the mortgagor, or make a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.”^[10] Under the regulations, a “reasonable effort to arrange a face-to-face meeting” requires at least “one letter sent to the mortgagor certified by the Postal Service as having been dispatched” and “at least one trip to see the mortgagor at the mortgaged property,” unless an exception applies.^[11]

HUD-mandated language in FHA-insured mortgages precludes lenders from “requir[ing] immediate payment in full of all sums secured” when limited by the HUD regulations, and it specifies that the mortgage “does not authorize acceleration or foreclosure if not permitted by [HUD regulations].” The HUD-mandated language for FHA-insured mortgage notes includes substantively identical provisions. Most courts — including some courts in Illinois — hold that these provisions in the mortgage and note incorporate at least some HUD regulations into the parties’ mortgage contract, and most courts agree that they therefore incorporate HUD’s face-to-face meeting requirement.^[12]

Courts holding that the mortgage and note incorporate HUD regulations into lenders’ obligations under the loan documents typically rely on regulatory language found in Section 203.500, which specifies HUD’s intent “that no mortgagee shall commence foreclosure or acquire title to a property until the requirements of this subpart [Subpart C, Sections 203.500 to 203.681] have been followed.”^[13] Similarly, Section 203.606 provides that “[b]efore initiating foreclosure, the mortgagee must ensure that all servicing requirements of [Sections 203.500 to 203.681] have been met.”^[14] Courts predominantly interpret these provisions as requiring substantial compliance with the relevant sections before filing a foreclosure complaint.^[15]

Importantly, HUD itself confirms that it did not intend the language in the loan documents to “incorporate all of HUD’s servicing requirements.”^[16] Instead, according to a 1989 Notice of Policy HUD published in the Federal Register, the loan documents’ reference to the regulations only applies to regulations that “specifically state prerequisites to acceleration or foreclosure.”^[17] And notably, unlike some of HUD’s servicing regulations,^[18] HUD’s face-to-face meeting requirements do not specify they are prerequisites to acceleration or foreclosure.^[19] Therefore, it is reasonable to conclude that HUD did not intend for the loan documents to incorporate the face-to-face meeting requirement according to its own published understanding of the controlling terms and regulations.^[20]

National Trend on Applying HUD Face-to-Face Meeting Requirements

Although the face-to-face meeting regulation does not appear to qualify as a pre-condition to acceleration and foreclosure under HUD’s explicit policy statement on the governing mortgage language, most courts still require lenders to comply with HUD’s face-to-face meeting requirement before foreclosing. Nonetheless, the balance of courts that have considered the issue also recognize that the specific timeframe for compliance is “aspirational” and not mandatory.^[21] In other words, most states require lenders to comply with the HUD regulations before filing a foreclosure complaint, but they do not preclude lenders from ever foreclosing merely because the lender fails to comply with all regulations before three full monthly installments become unpaid.^[22]

The New York Supreme Court’s commonly cited opinion in U.S. Bank Nat’l Ass’n v. McMullin^[23] addresses the issues involved in detail. In McMullin, the borrowers defaulted on their loan payments in March 2009. The lender “did not claim to have had a face-to-face meeting with [the borrowers] before [they] missed three full monthly payments.”^[24] However, the court determined that the lender had “made good-faith, reasonable efforts over a multi-year period to negotiate a consensual resolution of [the borrowers’] longstanding default before commencing [the foreclosure],”^[25] which the court found sufficient to allow the foreclosure to proceed.^[26]

The McMullin court analyzed the standard language in the HUD-approved mortgage and note and concluded that the loan documents “establish[ed] a condition precedent to suit, the occurrence of which [the lender] must establish as part of its prima facie case” to foreclose.^[27] The court continued: “The issue then becomes whether [the lender] has established the occurrence of the condition stated in the mortgage: that the HUD regulations did not prohibit the commencement of this action.”^[28] Noting the difference under New York contract law between express conditions, which “must be literally performed,” and constructive conditions, “which ordinarily arise from language of promise” and “are subject to the precept that substantial compliance is sufficient,”^[29] the court found that the lender had substantially complied with the regulations, and that the regulations therefore did not prohibit commencing the foreclosure action.^[30]

In determining that the lender had substantially complied, the court considered HUD’s regulatory language that “[b]efore initiating foreclosure, the mortgagee must ensure that all servicing requirements . . . have been met.”^[31] The court contrasted that language against the language HUD employed in the next sentence of the regulation: “The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid.”^[32] The court found that the second sentence — addressing the lender’s duty to wait until the borrower missed three monthly payments to foreclose — “employ[ed] the unmistakable language of condition through the use of a term such as unless,”^[33] whereas the first sentence — addressing the lender’s duty to ensure it met all servicing requirements — “is not cast in the form of a clear prohibition.”^[34] “Instead,” the court determined, the first sentence “employs the type of doubtful language that courts routinely interpret as embodying a promise.”^[35]

In other words, the court examined HUD’s language requiring lenders to “ensure that all servicing requirements . . . have been met,” and it concluded that when read in context, the language constituted a constructive condition subject to substantial — not strict — compliance. The court found additional support for its ruling in the “highly inequitable consequences” of a contrary interpretation, noting that “[i]t seems inconceivable that the HUD regulations, promulgated in respect to the federal agency’s role as an insurer of mortgages, were intended to create a permanent and impenetrable barrier to foreclosing” where a lender failed to conduct a face-to-face meeting within three months of the borrower’s default.^[36]

Accordingly, the court held that the lender’s “good-faith, reasonable efforts over a multi-year period to negotiate a consensual resolution” to the default constituted substantial compliance with HUD regulations.^[37] Courts throughout the country that have examined HUD’s face-to-face meeting requirement have employed a similar analysis and reached similar results.^[38]

The Olivera Opinion

Nevertheless, despite mostly widespread agreement on allowing substantial compliance with HUD’s face-to-face meeting requirement from courts in multiple jurisdictions, the Illinois Appellate Court’s Second District recently opted to buck the national trend.^[39] Its ruling creates confusion for Illinois lenders seeking to comply with the face-to-face requirement in good faith.

In Olivera, the lender filed a foreclosure complaint in May of 2017 alleging that the borrower remained in default on the loan since September 2011. The lender had previously dismissed two foreclosure actions without prejudice. In January 2017, prior to filing its May 2017 complaint, the lender had sent the borrower a certified letter trying to arrange a face-to-face meeting with the borrower, and it had sent a representative to visit the property to attempt to arrange a face-to-face meeting. The trial court granted the borrower’s motion to dismiss the third foreclosure action filed in 2017, finding that the lender had failed to meet a condition precedent to filing its complaint when it failed to conduct a face-to-face meeting within three months of the borrower’s default. The Second District affirmed the trial court’s dismissal.^[40]

Refusing to adopt the “common-sense approach” followed in other jurisdictions, the court found that “Illinois authority does not support that the regulations require only substantial compliance before foreclosure actions may proceed.”^[41] However, the court acknowledged that “it would be inequitable to presume that, where a lender fails to comply with the initial three-month time frame, foreclosure is forever barred and that borrowers may simply remain in the premises indefinitely without ever paying their mortgage.”^[42] Accordingly, the court confirmed that its “holding does not . . . mean that [lenders] can never foreclose.”^[43] “Rather, after ‘forgiving’ past missed payments, waiting for potentially more missed payments, and timely complying with the regulations, [lenders] could, legally, file a new complaint with a new default date.”^[44]

Oddly, the court “agree[d] to an extent” that “it would be unjust to require a lender to forgive potentially years of missed payments, simply because we decide that strict compliance with the regulations is required.”^[45] Nevertheless, the court opined that “[t]he payments would not exactly be ‘forgiven.’”^[46] Rather, the court said, forgiving the payments would just decrease “the extent of personal liability resulting in a possible deficiency judgment.”^[47] The court did not appear to have considered the possibility that not all foreclosure sales result in deficiencies. Nor did it explain why wiping away five to six figures of potential financial liability somehow makes the result of its ruling less unjust. In other words, the court accepted that its decision would produce an unjust result, but it purported to help lenders avoid the decision’s inequitable consequences by creating an avenue for them to forgive multiple thousands of dollars of debt and restart their collection efforts after several years of contested litigation.

Third District’s Denton Opinion

The Second District’s Olivera opinion relied heavily on Bankers Life v. Denton,^[48] a 1983 decision from Illinois’s Third District.^[49] In Denton, the Third District considered whether borrowers could raise a lender’s failure to comply with HUD regulations — including the face-to-face requirement — as affirmative defenses to a foreclosure. It held that they could.^[50]

The court acknowledged that HUD regulations imposed a penalty on lenders who refused or failed to comply with HUD regulations but since that penalty did not prohibit lenders from foreclosing delinquent mortgage loans, the court decided that it did “not believe this to be an adequate remedy for the individual mortgagor.”^[51] Accordingly, the court held that borrowers could raise HUD non-compliance as an affirmative defense in a mortgage foreclosure, because “HUD’s withdrawal of a mortgagee’s approval to participate in the mortgage insurance program after repeated violations of the servicing requirements is a useless remedy for the individual faced with the immediate problem of a foreclosure action.”^[52]

Notably, the Denton court never held that HUD regulations mandated strict as opposed to substantial compliance, and it never discussed how courts should apply its ruling to the three-month window for the face-to-face meeting requirement. To the contrary, the court specifically described foreclosure actions where the lender failed to comply with HUD regulations as actions “which could possibly be avoided by . . . further efforts to arrange a revised payment plan.”^[53] In other words, the Denton court appears to have assumed the parties could participate in “further efforts” at loss mitigation after the lender’s non-compliance, which stands in sharp contrast to Olivera’s ruling requiring lenders who miss the three-month window for face-to-face meetings to forgive substantial sums of principal and interest instead. Nevertheless, the Second District relied on Denton to impose a new strict compliance standard for HUD regulations.

The Illinois Supreme Court on HUD Regulations

Importantly, both Olivera and Denton may conflict with earlier Illinois Supreme Court authority explaining how Illinois courts must apply HUD regulations governing FHA-insured mortgage loans.^[54] Notably, neither the Second District in Olivera nor the Third District in Denton recognized or discussed the Illinois Supreme Court’s binding analysis in La Throp v. Bell Federal Savings & Loan on the issue.

In La Throp, borrowers under FHA-insured mortgage loans brought a class action lawsuit against lenders alleging that HUD regulations required lenders to hold escrow funds in trust for borrowers and to pay borrowers any interest accrued on those funds. The Illinois Supreme Court rejected the borrowers’ allegations, noting in part that HUD regulations govern “the relationship between the mortgagee and FHA, rather than the relationship between the mortgagee and the mortgagor.”^[55] Accordingly, the court held that “in an action between a mortgagor and mortgagee (not between the mortgagee and FHA), where the mortgage contract does not specifically incorporate the FHA regulations or expressly indicate agreement thereto, such regulations are not determinative of the content of the contract created between the parties.”^[56]

In the face-to-face meeting situation, the mortgage contract does not specifically incorporate the applicable regulation or expressly indicate agreement thereto, as La Throp requires. Rather, the loan documents prohibit acceleration or foreclosure “if not permitted” by HUD regulations. As the New York Supreme Court recognized in McMullin, the question then becomes not whether the lender timely completed the face-to-face meeting requirements, but whether the HUD regulations at issue would preclude foreclosure if it did not. As discussed above, the court in McMullin applied standard principles of New York contract law to conclude that failing to strictly comply with the face-to-face meeting requirements would not preclude foreclosure. Illinois courts recognize the same standard principles of contract law.^[57]

Constructive Conditions of Exchange Versus Conditions Precedent

Like in New York, Illinois courts have distinguished between constructive conditions and conditions precedent. Illinois courts “define a condition precedent as one which must be performed either before a contract becomes effective or which is to be performed by one party to an existing contract before the other party is obligated to perform.”^[58] “Distinctly different, although analogous to the concept of a condition, are constructive conditions of exchange,” which “play an integral role in assuring the parties to a bilateral contract that they will receive the performance that they have been promised.”^[59] Illinois courts typically apply the concept of constructive conditions of exchange “when one party seeks to justify its own refusal to perform on the ground that the other party has committed a breach of contract.”^[60]

HUD regulations incorporated into an FHA-insured mortgage more closely align with constructive conditions of exchange than with conditions precedent. In the typical mortgage relationship, the borrower receives a loan of several hundred thousand dollars to purchase a home the borrower could not otherwise afford, which the lender provides in exchange for the borrower’s promise to pay the money back as outlined in the agreement. In the face-to-face meeting situation, the lender has already given the borrower the hundreds of thousands of dollars, and the borrower has stopped making payments as outlined in the agreement. When the lender then files a foreclosure action, the borrower seeks to avoid their obligation to repay the money based on the lender’s failure to conduct a face-to-face meeting before the borrower missed three full monthly payments. It is difficult to imagine a better example of “one party seek[ing] to justify its own refusal to perform on the ground that the other party has committed a breach of contract.”

Notably, the appellate district court that decided Olivera recognized the substantial performance doctrine in the context of constructive conditions of exchange.^[61] In MXL Industries v. Mulder, a tenant entered into a five-year commercial lease with an option to terminate the lease following specific procedures. When the tenant tried to terminate the lease, the lender refused, and the tenant filed a declaratory judgment action asking the court to nullify the lease. The Second District discussed the substantial performance doctrine as it relates to constructive conditions of exchange in detail, but it ultimately followed other Illinois courts that had imposed a strict compliance standard on lease termination options.^[62]

However, the option to terminate a lease differs from the face-to-face meeting situation in at least one important and relevant way: an option to terminate a lease allows one party to unilaterally cancel the contract. It makes intuitive sense that a court would require a party seeking to avoid its agreed contractual obligations without the other side’s consent to strictly comply with the contractual provision allowing it to unilaterally cancel the contract. In contrast, the lender in the typical face-to-face meeting situation has already met its obligations under the mortgage contract by loaning the borrower the hundreds of thousands of dollars the borrower needed to purchase a home. The borrower — not the lender — has breached the contract by failing to repay the money as agreed. Requiring the lender, who has already performed to the tune of several hundred thousand dollars, to strictly comply with the face-to-face meeting requirements allows the borrower — not the lender — to unilaterally avoid its agreed contractual obligations.

Relatedly, Illinois courts strictly construe “express conditions precedent” in the contract.^[63] For FHA-insured mortgages, it is important to distinguish what exactly the express condition precedent is that courts must strictly construe. Under the mortgage, the lender may accelerate and foreclose “except as limited by regulations issued by [HUD].” The mortgage “does not authorize acceleration or foreclosure if not permitted by regulations of [HUD].” Thus, strictly construing the condition precedent at issue only precludes acceleration and foreclosure if prohibited by HUD regulations. HUD’s own interpretation published in the Federal Register specifies that it only intended for regulations that “specifically state prerequisites to acceleration or foreclosure” to prevent acceleration or foreclosure.^[64] HUD’s face-to-face meeting requirement does not specifically state that it is a prerequisite to foreclosure,^[65] meaning that strictly construing the mortgage contract’s express condition precedent should not preclude foreclosure.

Applying HUD Regulations with the Force and Effect of Law

Notably, some Illinois courts treat HUD’s regulations as having “the force and effect of law” independent of the parties’ mortgage contract,^[66] despite the Illinois Supreme Court’s unambiguous ruling that “where the mortgage contract does not specifically incorporate the FHA regulations or expressly indicate agreement thereto, such regulations are not determinative of the content of the contract created between the parties.”^[67] Nevertheless, the result should remain the same. Illinois courts “construe administrative rules and regulations under the same principles that govern the construction of statutes,”^[68] and their “primary objective is to ascertain and give effect to the drafters’ intent.”^[69] Importantly, they “may not depart from the plain language of a regulation by reading into it exceptions, limitations, or conditions that the agency did not express.”^[70] Yet this is exactly what the Second District did in Olivera.

Nothing in the plain language of the relevant HUD regulations suggests that the drafters intended to forever bar lenders from foreclosing if they failed to strictly comply with the regulations, or that they intended to require lenders to forgive substantial sums of principal and interest as punishment for any failure to comply with a regulation. To the contrary, Section 203.500 specifies HUD’s intent “that no mortgagee shall commence foreclosure . . . until the requirements of [Sections 203.500 to 203.681] have been followed.”^[71] Similarly, Section 203.606 requires that “[b]efore initiating forecloure, the mortgagee must ensure that all servicing requirements of [Sections 203.500 to 203.681] have been met.”^[72] By precluding foreclosure “until” the lender follows the regulatory requirements and requiring compliance “[b]efore initiating foreclosure,” the plain language of these sections expressly anticipates allowing the lender to take future action to bring itself into compliance.

Importantly, if HUD had intended to prohibit lenders from foreclosing or to force lenders to forgive substantial amounts of debt for servicing errors, it could have done so.^[73] HUD could have drafted Section 203.500 to read: “The mortgagee shall not commence foreclosure unless the requirements of [Sections 203.500 to 203.681] have been met.” It could have drafted Section 203.606(a) to read: “The mortgagee cannot initiate foreclosure if all servicing requirements of [Sections 203.500 to 203.681] have not been met.” It did not. Instead, HUD used different language that specifically contemplated the possibility of future action to correct alleged noncompliance. HUD presumably chose this language for a reason; the agency’s chosen words should matter.

Moreover, HUD itself confirmed in its Notice of Policy published in the Federal Register that only “some regulations [ ] exist which limit a lender’s rights to foreclose,” noting that the language required in its form mortgage “does not incorporate all of HUD’s servicing requirements into the mortgage.”^[74] Rather, HUD explained, the language “simply prevents acceleration and foreclosure on the basis of the mortgage language when foreclosure would not be permitted by HUD regulations.”^[75] HUD continued: “If a mortgagee has violated parts of the servicing regulations which do not specifically state prerequisites to acceleration or foreclosure, [ ] the reference to regulations in the mortgage would not be applicable.”^[76] In other words, unless the regulation at issue specifically states it is a prerequisite to acceleration or foreclosure, then a lender’s failure to comply does not bar foreclosure.

The regulations creating HUD’s face-to-face meeting requirements do not specifically state prerequisites to acceleration or foreclosure, as required for a lender’s failure to comply to bar foreclosure.^[77] To illustrate what constitutes a specific prerequisite to acceleration or foreclosure, HUD highlighted the language from Section 203.606 that “specifically prohibits a mortgagee from foreclosing unless three full monthly payments due on the mortgage are unpaid.”^[78] This language reads: “The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid.”^[79] Section 203.604 — which creates HUD’s face-to-face meeting requirements — has no corresponding prohibition against foreclosure or acceleration.^[80]

By its express terms, Section 203.604 creates a requirement that lenders conduct a face-to-face interview or make reasonable efforts to arrange such an interview, unless specified circumstances exist to excuse the requirement.^[81] The section outlines the time that the lender should conduct or make a reasonable effort to arrange the interview, but it nowhere prohibits the lender from foreclosing if the lender fails to meet the timeline. In fact, under its express terms, the section does not even prohibit the lender from foreclosing if the lender fails to conduct or attempt to arrange the interview at all. According to HUD’s own explanation, a lender’s failure to comply with Section 203.604’s face-to-face meeting requirement therefore does not limit foreclosure or acceleration under the terms of the mortgage.^[82]

As with Sections 203.500 and 203.606, HUD could have used language that made compliance with Section 203.604 a prerequisite to acceleration and foreclosure. For example, it could have written the regulation to read: “The mortgagee shall not commence foreclosure for a monetary default unless it has a face-to-face interview with the mortgagor, or makes a reasonable effort to arrange such a meeting, before three full monthly installments due on the mortgage are unpaid.” It did not. Again, HUD’s chosen words should matter.

Importantly, applying HUD’s Notice of Policy to preclude foreclosure for noncompliance with a regulation only where the regulation specifically states that it is a prerequisite to foreclosure would conform to the rules governing other types of mortgage foreclosures. As already discussed, it would preclude foreclosure until at least three full monthly installments become unpaid, which tracks with CFPB regulations governing other types of mortgage foreclosures.^[83] It would also preclude foreclosure where the lender failed to “notify the mortgagor . . . that the mortgagor is in default and that the mortgagee intends to foreclose unless the mortgagor cures the default,”^[84] which would track with the standard notice of default requirements in non-FHA-insured mortgages.

In other words, interpreting the HUD-mandated language in FHA-insured mortgages in accordance with HUD’s own Notice of Policy provides borrowers with the same protections they would receive under non-FHA mortgages. Illinois courts should not question HUD’s policy decision to treat the mortgage language in this way, and they should not read additional requirements or conditions into the regulations that HUD did not express.^[85]

The Housing Act’s Purpose

The Second District in Olivera did not address the regulations’ plain language, or HUD’s specific explanation about which regulations it intended to bar foreclosure under the mortgage. Instead, the court focused on its own misunderstanding of the Housing Act’s purpose.

Extensively quoting the Third District’s opinion in Denton, the Second District’s Olivera ruling recites the Housing Act’s purpose “to assist in providing a decent home and a suitable living environment for every American family.”^[86] According to Olivera and Denton, HUD’s decision to limit the penalty for a lender’s noncompliance to levying a fine against the lender or withdrawing its status as a HUD-approved lender does not sufficiently protect “the individual faced with the immediate problem of the foreclosure action.”^[87] To correct HUD’s perceived oversight, the court in Olivera improperly departed from the plain language of HUD’s regulations to impose a strict compliance standard on the face-to-face meeting requirement.

Yet both Olivera and Denton misunderstand the Housing Act’s legislative purposes. As discussed above, the Housing Act created the FHA during the Great Depression to achieve “the realization as soon as feasible of the goal of a decent home and a suitable living environment for every American family.”^[88] Congress’s purpose in pursuing policies to realize this goal was to “contribut[e] to the development and redevelopment of communities and to the advancement of the growth, wealth, and security of the Nation.”^[89] The Olivera and Denton courts mistakenly refocus Congress’s purpose away from community development and national growth to individual homeowners, and they seek to equip individual homeowners with extra tools to ensure a lender’s compliance with HUD regulations beyond those HUD itself chose to create.

Put differently, Congress designed the Housing Act to create programs that would help communities grow so “every American family” could have “a decent home and a suitable living environment.” This included programs that would encourage lenders to make financially risky mortgage loans to borrowers who may not otherwise qualify for the financing needed to purchase a home. Interpreting HUD regulations to effectively require lenders to choose between forgiving substantial amounts of principal and interest or losing the ability to promptly foreclose will discourage — not encourage — lenders from making the intended loans. In any event, even if the Olivera and Denton courts disagree with HUD about the appropriate penalties for noncompliance with its regulations, it is not their place to supplant their opinions for HUD’s.^[90] Congress gave the responsibility for administering the Housing Act to HUD, not to the Illinois Appellate Court.^[91]

Impractical and Absurd Results

Similarly, Illinois courts interpret administrative regulations under the same rules applied to statutes,^[92] and the Illinois Supreme Court “has long held that statutes should be construed in such a way as to avoid impractical or absurd results.”^[93] Applying Olivera to real-world scenarios leads to just such impractical and absurd results.

Consider the not-uncommon scenario where a lender acquires its interest in the loan after three full monthly installments have already become unpaid under the regulation. Examining an entire hypothetical foreclosure step-by-step, starting from the beginning, helps illustrate the problem. Let’s say that Borrower takes out a $250,000 mortgage loan from Bank with a 30-year term on July 1, 2012. The loan has an annual interest rate of 2.5%. Borrower’s first payment is due August 1, 2012, and the loan matures on July 1, 2042. An amortization schedule showing the monthly amounts due on the loan is included as Appendix No. 1.

Borrower timely pays on the loan for the first five years, but she defaults on her payment due July 1, 2017. After the first missed payment, Bank’s loan servicer sends Borrower a letter inviting her to apply for loss mitigation and providing her contact information to call to schedule a face-to-face meeting. Bank’s servicer sends one copy by regular mail and another copy by certified mail. It also conducts a field visit to the property, where an agent hand-delivers a copy of the letter to Borrower and offers to go over her loss mitigation options with her in person.

Borrower applies for a loan modification following the instructions in the letter, and the parties spend four months exploring Borrower’s loss mitigation options, with a substantial portion of that time devoted to Borrower gathering and sending in the necessary documents. In late October 2017, Bank approves Borrower for a trial loan modification requiring three timely payments before it will consider Borrower for a permanent modification. The offer sets trial payments to begin November 1, 2017. Borrower makes the November and December 2017 trial payments, but she misses the January 2018 payment, and she makes no more payments on the loan.

During the trial period, Bank sells the loan to Trust, who transfers servicing of the loan to a new servicer. At the end of January 2018, Borrower submits a second loss mitigation application to the new servicer, and she sends all the necessary documents by mid-February 2018. Trust’s servicer determines that Borrower does not qualify for a loan modification and invites her to consider other loss mitigation options such as a deed-in-lieu of foreclosure or short sale. Borrower appeals the loan modification denial, which Trust’s servicer timely reviews and denies.

On May 1, 2018, after nine months of cumulative loss mitigation efforts, Trust’s servicer refers Borrower’s account to foreclosure. It sends Borrower a notice of default advising her of the amount of her delinquency and notifying her that unless she pays the delinquency within thirty days, Trust may accelerate the balance of her mortgage loan and foreclose. After the notice of default’s thirty-day period expires, Trust’s servicer directs its foreclosure attorneys to begin taking the necessary steps to file a foreclosure complaint under Illinois law. The attorneys file the complaint on August 1, 2018, and they serve Borrower on August 15, 2018. Borrower does not answer the complaint, and after sixty days pass from the date of service, Trust moves for a default judgment on October 15, 2018, which the court schedules for hearing on November 15, 2018. At the hearing, an attorney appears for Borrower and requests thirty days to respond to the complaint, which the court allows.

On December 15, 2018, Borrower moves to dismiss the complaint, alleging that Trust lacks standing despite having attached a copy of the blank-indorsed note to its complaint. She obtains a hearing for her motion to dismiss on January 15, 2019. The trial court denies the borrower’s motion to dismiss without briefing, and it gives her another thirty days to answer the complaint. On February 15, 2019, Borrower files her answer and affirmative defenses, alleging for the first time that Trust failed to comply with HUD’s face-to-face meeting requirements. On March 1, 2019, Trust files its reply to the affirmative defenses.

On March 15, 2019, Borrower serves written discovery on Trust. After Trust responds to the written discovery, Borrower sends a notice to depose Trust’s corporate representative. She schedules the deposition for June 1, 2019. Shortly after the deposition, on June 8, 2019, Trust moves for summary judgment. Trust provides copies of the face-to-face letter Bank’s servicer initially sent to Borrower along with the account notes from Bank’s servicer indicating that it sent letters by certified and regular mail. It also provides the account notes from Bank’s servicer describing the field visit. The court sets the motion for presentment on July 1, 2019.

At the hearing, the court enters a briefing schedule giving Borrower twenty-eight days to respond and giving Trust fourteen days to reply. It sets a hearing on the motion for September 1, 2019. Borrower responds by alleging that she only received a copy of the face-to-face letter by regular mail and not certified mail, and she attaches a copy of the letter she received by regular mail to her response. On September 1, 2019, the court enters summary judgment in Trust’s favor and grants Trust’s judgment of foreclosure giving Borrower three months to redeem.

Borrower fails to redeem, and Trust schedules a foreclosure sale for December 15, 2019. After the sale, Trust moves to approve the sale, and it receives a hearing date for its motion on January 7, 2020. The court enters a briefing schedule on the motion giving Borrower twenty-eight days to respond and giving Trust fourteen days to reply. It sets a hearing date for March 1, 2020. Borrower does not file a response to the motion, and on March 1, 2020, the court enters the order approving sale.

On March 30, 2020, Borrower files a notice of appeal challenging the trial court’s ruling. After briefing and oral arguments, the appellate court finds that the question of whether Bank’s servicer sent the letter by certified mail constitutes a material issue of fact. On January 15, 2021, over three and a half years after Borrower’s initial payment default, the appellate court reverses the trial court’s judgment and remands for further proceedings.

Applying Olivera to this hardly unrealistic timeline, Trust would face a decision after the appellate court’s ruling.^[94] It could continue to litigate whether Bank’s servicer sent the face-to-face letter by certified mail, or it could cut its losses and forgive three and a half years of missed payments — amounting to $42,475.50 of combined principal and interest^[95] — to bring the loan current. Importantly, Trust must base this decision not on a definitive ruling that Bank’s servicer failed to comply, but instead on the chance that Trust may not be able to prove Bank’s servicer complied — a prospect that only first arose as a realistic possibility over three years after Borrower’s first payment default.

The Olivera court agreed “to an extent” that this result, i.e. “requir[ing] a lender to forgive potentially years of missed payments,” was “unjust.”^[96] Nevertheless, the court pushed forward, deeming the openly recognized injustice of its holding mitigated because it “simply incentivizes lenders to follow the rules or quickly cure any violation thereof.”^[97] So when should either Bank or Trust in this hypothetical have “quickly cured” the alleged possible violation of HUD’s face-to-face meeting rules by bringing the loan current under Olivera?

Should Bank have brought the loan current after its servicer fully complied with the regulation, while the servicer was negotiating a loan modification with Borrower in response to its HUD face-to-face letter? Should Bank have brought the loan current after it approved Borrower for a trial loan modification? Should Trust have brought the loan current when Borrower defaulted on the trial loan modification, or after it determined Borrower could not qualify for a new modification? Should Trust have brought the loan current after it filed its foreclosure, or after Borrower moved to dismiss the foreclosure complaint on grounds the trial court rejected without briefing? Or should Trust have brought the loan current after Borrower filed her affirmative defenses, or when the trial court ruled in Trust’s favor on the face-to-face issue, or after the trial court confirmed the foreclosure sale, or after the parties finished briefing the appeal, or after the appellate court conducted oral arguments?

Of course, it would not have made sense for either Bank or Trust to “quickly cure” its alleged violation and bring the loan current at any of those points. Bank never had any indication that its servicer failed to comply with HUD’s face-to-face requirement. Indeed, its servicer did comply. The only question is whether Trust — who later purchased the loan — can prove Bank’s servicer complied. Moreover, the first indication Trust had that a court may not accept the prior servicer’s notes alone as proof of certified mailing occurred when the appellate court reversed the trial court’s summary judgment order, and even then Trust still had no definitive reason to believe Bank’s servicer failed to comply with HUD regulations, or even that Trust necessarily could not ultimately prove full compliance. The problem facing Trust is that it now risks having to forgive more principal and interest for every month that goes by while it waits to see what evidence the trial court, and then the appellate court, will accept as proof of compliance.

Yet over three and a half years passed between Borrower’s first payment default and the appellate court’s ruling. Bringing the loan current in accordance with Olivera’s new strict compliance standard would involve forgiving over $40,000 in principal and interest. Trust must therefore decide whether to risk having to forgive even more principal and interest for the possible benefit of not having to forgive any principal and interest at all if it can prove the prior servicer’s compliance — all despite Bank and Trust’s extensive efforts to negotiate a loan modification in good faith, and despite Trust moving as quickly as reasonably possible to finish the foreclosure once it became clear that continued loss mitigation efforts would not bear fruit. Illinois courts should not interpret HUD regulations to compel such an impractical and absurd result.^[98]

Adverse and Unintended Consequences for Borrowers

Importantly, applying the Olivera opinion to real-world fact patterns may also cause adverse and unintended consequences for borrowers. Initially, forgiving over $40,000 in principal and interest in accordance with Olivera could create tax consequences for borrowers that the Olivera court may not have considered.^[99] As other courts have recognized, Congress created the FHA-insured mortgage loan program to help low to moderate income borrowers obtain financing from reputable lenders.^[100] Potentially imputing a significant amount of additional taxable income on low to moderate income borrowers could significantly affect their tax liability, possibly cutting into — or altogether wiping out — tax refunds that many families rely on as part of their yearly income.

The lender could avoid this negative result for borrowers by instead moving up the next payment’s due date, rather than forgiving missed payments outright. Consider Appendix No. 2’s modified amortization schedule for the hypothetical above. In the hypothetical, Borrower first defaulted on her July 1, 2017, payment. Instead of forgiving over $40,000 in principal and interest, Trust could alternatively move the due date for that payment up to January 1, 2021,^[101] which would return Borrower to the position of not having missed three full monthly installments without resulting in a huge potential increase in Borrower’s taxable income. However, that would then create either a balloon payment of $39,684.87 when the loan matured after Borrower’s July 1, 2042, payment,^[102] or Trust would have to reamortize and increase the remaining payments to allow Borrower to pay the full balance by the maturity date. The lender likely could not take either of these actions without the borrower’s agreement.

Notably, the parties’ mortgage contract does not expressly contemplate any of these scenarios, including Olivera’s requirement that lenders forgive monthly payments, which only highlights the problems with applying Olivera to real-world fact patterns. The ruling effectively forces the parties to rewrite their contractual obligations to adjust for the court’s desire to mandate strict compliance with HUD regulations that are not expressly included in the contracts themselves. And this is all despite HUD having specified that it never intended for courts to treat regulations that do not specifically state they are a prerequisite to acceleration or foreclosure, such as the face-to-face meeting requirement, as a bar to foreclosure.^[103]

Alternatively, the lender could also choose not to forgive significant portions of principal and interest and simply leave the entire loan balance as a mortgage lien against the property without foreclosing. At most, reading the mortgage contract together with HUD’s regulations only prevents the lender from accelerating the loan balance and foreclosing for payment defaults. The lender’s failure to strictly comply with HUD’s face-to-face meeting requirements would not invalidate the mortgage against the property, or prevent foreclosure for non-payment defaults.^[104] Rather, the mortgage would remain, continuing to accrue interest and late charges (among other fees), and preventing the borrower from selling the property.^[105] In other words, to purportedly protect borrowers “faced with the immediate problem of” foreclosure, Olivera creates a scenario where borrowers could instead face the long-term problem of being stuck in a house they cannot sell, encumbered by ever-increasing debt they cannot repay or refinance.

Relatedly, Olivera’s impact on the borrower’s ability to sell the property also runs counter to Illinois courts’ longstanding recognition that “law and public policy favor the free alienability and transferability of property.”^[106] The Second District in other contexts has described analytical approaches that leave the lender “without any remedy unless and until the property was sold or transferred” as an “unreasonable and unjust result” that would “reward” the borrower for “defaulting every month” for an extended period of time.^[107] Thus, when applied to real-world fact patterns, Olivera creates an unreasonable and unjust result for lenders that rewards borrowers in the short term for continuing to ignore their payment obligations while harming borrowers in the long term by locking them into property ownership without any ability to sell the property, build equity in the property, or otherwise enjoy the attendant financial benefits.

Further, Illinois courts treat mortgage loans as installment contracts.^[108] “The general rule is that where a money obligation is payable in installments, a separate cause of action arises on each installment and the statute of limitations begins to run against each installment as it becomes due.”^[109] Also: “the party entitled to payments may bring separate actions on each installment as it becomes due or wait until several installments are due and then sue for all such installments in one cause of action.”^[110] Thus, even if HUD’s regulations prevent acceleration and foreclosure under Olivera’s strict compliance standard, the lender could obtain separate judgments against the borrower for each missed installment payment or sue for multiple missed installments at once.

In fact, the lender in the hypothetical above could presumably dismiss its foreclosure after the appellate court’s adverse ruling, accept Olivera’s premise that its alleged failure to comply with the regulation prevented it from properly accelerating the loan, sue on three and a half years of missed unaccelerated installment payments, and then record and foreclose a judgment lien for its judgment on those missed payments.^[111] At that point, the lender’s mortgage would take priority over its separate judgment lien, and the lender could recover the full amount due under its senior mortgage from the proceeds of its judgment lien foreclosure sale.^[112]

Simply put, Olivera does not protect borrowers “faced with the immediate problem of the foreclosure action,” as the court seems to have wanted to do.^[113] Instead, the opinion subjects borrowers to a host of unforeseen adverse and unintended consequences with unpredictable outcomes, from increased tax burdens to defending alternate legal actions. Other appellate districts in Illinois should not follow Olivera down this path.

Conclusion

Olivera creates a new strict compliance standard for interpreting HUD’s face-to-face meeting requirement by reading non-existent terms into the mortgage loan documents. Yet HUD itself specified that it did not intend for regulations not expressly stated as prerequisites for acceleration to bar foreclosure, and the Second District’s contrary ruling creates impractical and absurd results that could ultimately harm borrowers. Illinois practitioners should challenge Olivera as needed to prevent it from becoming commonly accepted practice, and other Illinois courts should decline to follow the opinion’s ill-considered analysis.

1. The opinions expressed in this article are solely those of the author, and they should not be attributed to any other person or entity. Nothing contained in this article represents the official or unofficial position or opinion of any of the author’s current or former employers or clients. The article is not intended as and should not be construed as legal advice. ↑

2. 2021 IL App (2d) 190462. ↑

3. Id., ¶ 40. ↑

4. 12 U.S.C. § 1701, et seq. ↑

5. See, e.g., https://www.fdrlibrary.org/housing. ↑

6. 12 U.S.C. § 1701t (internal quotations omitted). ↑

7. Id., §§ 1701c, 1708; 42 U.S.C. § 1441. ↑

8. See, e.g., Lakeview Loan Servicing v. Schultz, 2019-Ohio-4689, ¶ 10. See also https://www.hud.gov/program_offices/housing/fhahistory. ↑

9. See, e.g., 24 C.F.R. § 203.500. ↑

10. 24 CFR 203.604(b). ↑

11. 24 CFR 203.604(d). ↑

12. See, e.g., Hayes v. M&T Corp., 389 Ill. App. 3d 388, 391 (1st Dist. 2009) (citing Wells Fargo Home Mortg. v. Neal, 398 Md. 705, 721-22 (App. 2007)). ↑

13. 24 C.F.R. § 203.500. ↑

14. 24 C.F.R. § 203.606(a). ↑

15. See, e.g., Olivera, 2021 IL App (2d) 190462, ⁋ 34 (citing U.S. Bank v. McMullin, 47 N.Y.S.3d 882, 890 (Sup. Ct. 2017); Wash. Mut. Bank v. Mahaffey, 2003-Ohio-4422, para. 24). ↑

16. 54 F.R. 27596 (June 29, 1989) (emphasis added). ↑

17. Id. ↑

18. See, e.g., 24 C.F.R. § 203.606(a) (“The mortgagee may not commence foreclosure for a monetary default unless at least three full monthly installments due under the mortgage are unpaid . . . [P]rior to initiating any action required by law to foreclose the mortgage, the mortgagee shall notify the mortgagor . . . that the mortgagor is in default and the mortgagee intends to foreclose unless the mortgagor cures the default.”). ↑

19. See 24 C.F.R. § 203.604(b). ↑

20. See 54 F.R. 27596. ↑

21. See, e.g., Wilmington Sav. Fund Soc’y v. West, 2019-Ohio-1249, ⁋ 23. ↑

22. Id. ↑

23. 55 Misc.3d 1053 (2017). In New York, the Supreme Court is the state’s trial level jurisdiction. ↑

24. Id. at 1061. ↑

25. Id. at 1059. ↑

26. Id. at 1064. ↑

27. Id. at 1061-62. ↑

28. Id. at 1061. ↑

29. McMullin, 55 Misc.3d at 1060 n.9. ↑

30. Id. at 1064. ↑

31. Id. at 1061-62 (citing 24 C.F.R. § 203.606(a)). ↑

32. Id. ↑

33. Id. at 1061 (cleaned up). ↑

34. Id. (emphasis added). ↑

35. McMullin, 55 Misc. 3d at 1061 (cleaned up). ↑

36. Id. at 1062. ↑

37. Id. at 1059, 1064. ↑

38. The Second District itself rightly acknowledged in Olivera that “plaintiff is generally correct that courts in other jurisdictions have held, in essence, that strict compliance with section 203.604’s three-month window is not required and that, as long as the requirements are reasonably performed before the foreclosure is filed, common sense dictates that the regulations should not be construed to command an impossibility.” 2021 IL App (2d) 190462, ¶ 34. See also, e.g., Kuhnsman v. Wells Fargo, 311 So. 3d 980, 985 (Fla. App. Ct. 2020) (“The [borrowers] urge us to conclude that [the lender] failed to strictly comply with the face-to-face interview requirement. They urge too much.”); U.S. Bank v. Cavanaugh, 2018-Ohio-5365, ¶ 29 (“[R]ead together, [Sections 203.604(b) and 203.606(a)] mandate a face-to-face meeting, or a reasonable attempt to arrange such a meeting, before a lender commences foreclosure proceedings.”); Grimaldi v. U.S. Bank, C.A. No. 16-519, 2018 WL 1997277 *3 (D. R.I. Apr. 27, 2018) (unpublished) (lenders “met their contractual obligation to comply with 24 C.F.R. § 203.604” where they sent three letters to the property and made a field visit five years after the default at issue); Rourk v. Bank of America, No. 12-cv-42, 2013 U.S. Dist. LEXIS 147373 *14-*15 (M.D. Ga. Oct. 11, 2013) (unpublished) (“[T]he Court concludes that [the lender] substantially complied with the requirement that it make a reasonable effort to arrange a face-to-face meeting with [the borrower].”). ↑

39. Olivera, 2021 IL App (2d) 190462, ¶ 35. ↑

40. Id., ⁋ 50. ↑

41. Id., ⁋ 35 (cleaned up). ↑

42. Id., ¶ 38 (emphasis in original). ↑

43. Id., ¶ 41. ↑

44. Id. ↑

45. Olivera, 2021 IL App (2d) 190462, ⁋ 40. ↑

46. Id. ↑

47. Id. ↑

48. 120 Ill. App. 3d 576 (3d Dist. 1983). ↑

49. Olivera, 2021 IL App (2d) 190462, ¶¶ 35-36 (“Illinois courts, starting with Denton, have held that failure to comply with HUD’s servicing regulations is a defense to foreclosure.”). ↑

50. Denton, 120 Ill. App. 3d at 579-80. ↑

51. Id. at 579. ↑

52. Id. ↑

53. Id. (emphasis added). ↑

54. La Throp v. Bell Fed. Sav. & Loan, 68 Ill.2d 375 (1977). ↑

55. Id. at 387. ↑

56. Id. at 388. ↑

57. See, e.g., MXL Industries v. Mulder, 252 Ill. App. 3d 18, 25-26 (2d Dist. 1993) (discussing E. Farnsworth, Farnsworth on Contracts (1990)). ↑

58. Id. at 25. ↑

59. Id. at 25-26. ↑

60. Id. at 26. ↑

61. Id. at 25-26. ↑

62. MXL Industries v. Mulder, 252 Ill. App. 3d at 27-28. ↑

63. Associate Asset Mgmt v. Cruz, 2019 IL App (1st) 182678, ¶ 34 (emphasis added). ↑

64. See 54 F.R. 27596. ↑

65. See 24 C.F.R. § 203.604(b). ↑

66. See Olivera, 2021 IL App (2d) 190462, ¶ 35 (“The failure to comply with [HUD’s] servicing regulations which are mandatory and have the force and effect of law can be raised in a foreclosure proceeding as an affirmative defense.”) (quoting Denton, 120 Ill. App. 3d at 579) (cleaned up). ↑

67. La Throp, 68 Ill.2d at 388. ↑

68. Perez v. IDCFS, 384 Ill. App. 3d 770, 772 (4th Dist. 2008). ↑

69. Id. ↑

70. Apostolov v. Johnson, 2018 IL App (1st) 173084, ¶ 24. ↑

71. 24 C.F.R. § 203.500 (emphasis added). ↑

72. 24 C.F.R. § 203.606(a) (emphasis added). ↑

73. See Fish v. Kobach, 840 F.3d 710, 740 (8th Cir. 2016) (“When Congress knows how to achieve a specific statutory effect, its failure to do so evinces an intent not to do so.”) (emphasis in original). ↑

74. 54 F.R. 27596 (emphasis added). ↑

75. Id. ↑

76. Id. (emphasis added). ↑

77. See 24 C.F.R. § 203.604(b). ↑

78. 54 F.R. 27596. ↑

79. 24 C.F.R. § 203.606(a). ↑

80. See 24 C.F.R. § 604(b). ↑

81. Id. ↑

82. 54 F.R. 27596. Even to the extent that the Notice of Policy acknowledged HUD’s “general position recited in 24 CFR 203.500, that whether a mortgagee’s refusal or failure to comply with servicing regulations is a legal defense is a matter to be determined by the courts,” the point remains that HUD plainly did not intend to incorporate regulations that did not specifically prohibit foreclosure as a bar to foreclosing, and the relevant considerations under Illinois law are (1) whether the mortgage contract expressly incorporates the prohibition; and (2) whether HUD intended the regulation to bar foreclosure. See, e.g., Cruz, 2019 IL App (1st) 182678, ¶ 34; Perez, 384 Ill. App. 3d at 772. Moreover, Section 203.500 no longer includes the referenced language recited in the Notice of Policy in any event. See 24 C.F.R. § 203.500. ↑

83. 12 C.F.R. § 1024.41(f)(1)(i) (prohibiting foreclosure until “[a] borrower’s mortgage loan obligation is more than 120 days delinquent). ↑

84. 24 C.F.R. § 203.606(a). ↑

85. See, e.g., Apostolov, 2018 IL App (1st) 173084, ¶ 24. ↑

86. Olivera, 2021 IL App (2d) 190462, ¶ 36 (quoting Denton, 120 Ill. App. 3d at 579). ↑

87. Id. ↑

88. 42 U.S.C. § 1441 (expressly affirmed by the Housing Act at 12 U.S.C. § 1701t). ↑

89. Id. ↑

90. See, e.g., Country Mut. Ins. v. Livorsi Marine, 222 Ill. 2d 303, 319 (2006) (“Balancing dueling policy concerns is a more appropriate role for the legislature than this court.”). ↑

91. 42 U.S.C. § 1441. ↑

92. Perez, 384 Ill. App. 3d at 772. ↑

93. Nowak v. Country Club Hills, 2011 IL 111838, ¶ 21. ↑

94. The Second District previously left open whether “the use of a private carrier [as opposed to certified U.S. mail] can never satisfy section 203.604(d),” and it questioned whether a tracking label showing that the lender prepared the letter for delivery with tracking information could sufficiently demonstrate strict compliance with the regulation. See U.S. Bank v. Hernandez, 2017 IL App (2d) 160850, ¶¶ 32-33. ↑

95. See Appx. No. 1, Lns 60-103. ↑

96. Olivera, 2021 IL App (2d) 190462, ¶ 40. ↑

97. Id. ↑

98. See, e.g., Nowak, 2011 IL 111838, ¶ 21. ↑

99. As a general rule, forgiven debt can qualify as taxable income, although some temporary exceptions may currently apply. See I.R.S. Pub. 4681 (Jan. 26, 2022), available at irs.gov/pub/irs-pdf/p4681.pdf. This article does not address Olivera’s implications under tax law other than to note that its ruling could result in unacknowledged consequences for borrowers now and in the future. ↑

100. See Neal, 398 Md. at 711 n.3. ↑

101. See Appx. No. 2, Ln. 60. ↑

102. Id., Ln. 318. ↑

103. See, e.g., 54 F.R. 27596. ↑

104. Under Illinois statutory law, the mortgage would remain a lien until at least twenty years from the borrower’s last payment, with the option for the lender to extend the lien for an additional twenty years at least once. See 735 ILCS 5/13-116. The standard HUD-approved mortgage form only adopts the relevant regulatory language precluding acceleration and foreclosure in the case of payment defaults. It should allow foreclosure in other situations, including once the loan reaches maturity under its own terms. ↑

105. The standard HUD-approved mortgage form allows foreclosure in most situations where the borrower sells or transfers its interest in the property. ↑

106. Martin v. Prairie Rod and Gun Club, 39 Ill. App. 3d 33, 36 (3d Dist. 1976). ↑

107. Bank of N.Y. Mellon v. Dubrovay, 2021 IL App (2d) 190540, ¶ 38. ↑

108. See, e.g., Wilmington Savings Fund v. Barrera, 2020 IL App (2d) 190883, ¶ 19; Deutche Bank v. Sigler, 2020 IL App (1st) 191006, ¶ 42. ↑

109. Sigler, 2020 IL App (1st) 191006, ¶ 42 (internal quotations omitted). ↑

110. Barrera, 2020 IL App (2d) 190883, ¶ 19 (internal quotations omitted). ↑

111. Illinois courts appear to disagree about how to treat acceleration after a voluntary dismissal in the context of the state’s single refiling rule. Compare, e.g., Dubrovay, 2021 IL App (2d) 190540, ¶ 28 (lender could recover for installment payments that came due after voluntary dismissal of prior foreclosure) and McHenry Savings Bank v. Moy, 2021 IL App (2d) 100099, ¶ 37 (lender could recover for installment payments that came due after an adverse judgment and a dismissal with prejudice in respective prior foreclosures) with Deutsche Bank v. Sigler, 2020 IL app (1st) 191006, ¶ 54 (single refiling rule barred subsequent filing based on different default after more than one voluntary dismissal). However, Olivera’s underlying premise relies on the mortgage contract precluding acceleration if not permitted by HUD regulations. Accordingly, accepting Olivera’s ruling necessarily means that the lender could not have effected acceleration, which should thereby allow it to pursue all of the borrower’s missed installment payments. ↑

112. See, e.g., 735 ILCS 5/12-101 (judgment liens “may be foreclosed . . . in the same manner as a mortgage of real property”); 735 ILCS 5/15-1106(e) (“General principles of law and equity, such as those relating to . . . priority . . . supplement [the Illinois Mortgage Foreclosure Law] unless displaced by a particular provision of it.”). ↑

113. Olivera, 2021 IL App (2d) 190462, ¶ 36. ↑

Appendix No. 1

Amortization schedule showing monthly amounts due on hypothetical loan described in the text. 

Appendix No. 2

Modified amortization schedule showing monthly amounts due on hypothetical loan described in the text.

The COVID-19 crisis continues to cause unprecedented disruptions and damage to the world’s economy and business relationships. At the same time, the crisis has also considerably slowed the resolution of pending court cases and exacerbated the already significant backlog of cases in many courts. Even as U.S. courts re-open and resume in-person proceedings, delays due to the pandemic and prioritization of criminal cases have led to long wait times, especially for commercial litigation. One recent study found that on average across all federal circuits, there is a 13-month expected delay for commercial case resolutions.

Fortunately, there are faster routes to resolution once a dispute arises: parties can bypass court and submit their disputes to an alternative dispute resolution (ADR) process to resolve their disputes and return their focus to business more quickly. Parties can file a “submission agreement” with their preferred dispute resolution body, which allows the parties to submit their dispute to arbitration or mediation in order to take advantage of all the benefits that the ADR process has to offer. Submission agreements are a useful tool that all counsel should add to their toolbox.

BENEFITS OF USING ALTERNATIVE DISPUTE RESOLUTION PROCESSES

Parties can count on faster speed (and therefore lower costs) when using alternative dispute resolution to resolve their disputes. Speed to reaching a decision is often critical so that business planning can continue, and long-term projects can proceed uninterrupted. For example, the average duration for a “full-length” commercial arbitration case from commencement to award is 14.4 months, according to statistics from CPR Dispute Resolution, the ADR provider arm of the International Institute for Conflict Prevention and Resolution (CPR). Currently, the median time from filing to trial in a civil case in the U.S. District Court is 28.3 months—without taking into consideration the additional time an appeal may add to the process. In contrast, arbitration facilitates resolution on a faster track, with a shorter process and truncated deadlines. Moreover, most institutions provide an option for expedited arbitration proceedings, such as the CPR Fast Track Arbitration Rules, which contemplate a 90–180 day proceeding.

Speed and savings are not the only benefits of ADR. Party control of the process is one of the tenets of ADR, allowing the parties to craft their own process to fit their needs. For example, parties may select knowledgeable neutrals with subject-matter expertise, rather than judges or juries without any experience in the subject. By using ADR, parties are afforded greater confidentiality and privacy for sensitive matters, such as proprietary business information, trade secrets, and other intellectual property. ADR offers the possibility of selecting a venue that is neutral to the parties and logistically convenient to both sides. Arbitration offers the certainty of resolution, as awards are generally final and binding (though parties may elect to add an appellate review). Finally, parties will find greater flexibility in ADR processes, which allows them to proceed on their own schedules, rather than a court’s, and provides the option to conduct hearings virtually.

WHAT YOU NEED TO KNOW ABOUT SUBMISSION AGREEMENTS

Parties often assume that, if they have not elected for arbitration or mediation in their business contracts before a dispute arises, they inevitably are left with litigation as their only option. This is not the case. Rather, parties can submit their dispute to ADR at any time after the point of dispute—they may do so when the dispute arises, while the parties are engaged in negotiations toward resolution, or even if the dispute is already being actively litigated in court.

In the submission agreement, the parties agree to submit the specific dispute at issue to ADR. The process is rather straightforward—parties simply need to agree to an alternative process for resolving their dispute, whether it is arbitration, mediation, or a combination of both. Some ADR providers help the parties with this process by providing a simple form that may be filled out by the parties and submitted as a case filing. These forms solicit the basic necessary information to commence a matter, including the names of the parties, a brief statement of the dispute, and the requested location for the mediation or arbitration. In the form, parties can also choose the specific rules or procedures that should govern the resolution of the dispute.  They can also specify the name of the neutral (mediator or arbitrator) that they wish to help resolve the dispute or the process by which the neutral should be selected. The form also provides the required language to submit parties to binding arbitration, if that is the choice of the parties.

Since ADR is a flexible and party-driven process, the simple form is not the only option available to the parties. They may also choose to draft a submission agreement that is more detailed. For parties wishing to draft a submission agreement, they have the benefit of using model clauses that provide standard language and cover various considerations in doing so. Most institutions provide sample language that parties can use in these circumstances. For example, parties can start with the following sample language, provided by CPR Dispute Resolution:

We, the undersigned parties, hereby agree to submit to arbitration in accordance with the International Institute for Conflict Prevention and Resolution (“CPR”) Rules for Administered Arbitration (the “Rules”) the following dispute:

[Describe briefly]

We further agree that we shall faithfully observe this agreement and the Rules and that we shall abide by and perform any award rendered by the arbitrator(s). The arbitration shall be governed by the Federal Arbitration Act, 9 U.S.C. §§ 1 et seq., and judgment upon the award rendered by the arbitrator(s) may be entered by any court having jurisdiction thereof. The place of arbitration shall be (city, state).

In this instance, the parties would incorporate the clause into a signed agreement, which can be filed with the ADR provider institution. Additionally, parties may choose to proceed with arbitration using specialized rules that might be more applicable to the dispute, such as proceeding under Fast-Track Arbitration Rules, International Arbitration Rules, or subject matter rules like Employment Arbitration Rules. Parties likewise may choose a different process altogether, such as Mediation, a Concurrent Arbitration-Mediation process, or Early Neutral Evaluation.  Model clauses are available for all these scenarios from CPR; many other institutions may provide similar options as well. The most common routes for submission agreements include the following processes:

Mediation provides a non-binding process where parties resolve the dispute on terms that the parties agree upon themselves. There is only a resolution if all parties agree to one. The process can go very quickly, as parties can narrow their issues or settle the dispute in just one session.

Fast Track Arbitration asks an arbitrator or arbitrators to resolve the matter for the parties after hearing each party’s positions. Fast Track Arbitration is intended for parties that desire an accelerated, streamlined arbitration with truncated deadlines.

Concurrent Mediation-Arbitration provides parties the option to proceed with mediation and arbitration at the same time, maximizing the opportunity for a settlement informed by both of those proceedings.

Commercial Arbitration is intended for parties that desire a full-length arbitration proceeding, while still completing the process faster than under a court proceeding.

As with any ADR clause, the submission agreement can be further customized to include all the elements that the parties deem important. Because the dispute has already arisen, parties have the benefit of understanding the issues and are in a better position to tailor their process to suit their needs and interests. They should consider the number of arbitrators they wish to have deciding the dispute—noting that with three arbitrators, costs may increase by more than three times those with a single arbitrator. Parties may also wish to incorporate procedural elements into the submission agreement, including the scope of discovery for the proceeding, a procedure for the testimony of witnesses, or whether motions can be filed. Those looking for guidance in this area may consider looking to the Protocol on Disclosure of Documents & Presentation of Witnesses in Commercial Arbitration, offered by CPR, which can be used in disputes administered by any provider. Finally, parties should consider what kind of decision they want from the arbitrator—from a simple, unreasoned award, to a full-length reasoned award, to findings of fact and conclusions of law. Some parties may wish to see that the tribunal has carefully considered the evidence, arguments, and law and issued an objectively “correct” award, and more detailed awards also enable the parties to better understand the award. On the other hand, more detailed awards often take longer and cost the parties more money.

Parties wishing to participate in the ADR process have several options available to them, even when they do not have an ADR provision in their contract. Following the straightforward steps described herein—via a form submission or drafting a submission agreement using model clauses—parties may file their disputes with the ADR provider of their choice, even after a dispute arises. Armed with this knowledge, counsel can help their clients find faster routes to solve their disputes.

The Corporate Transparency Act of 2020 (the “CTA”) was enacted as part of the William M. (Mac) Thornberry National Defense Authorization Act for Fiscal Year 2021.^[1] At the core of the CTA are reporting requirements imposed on substantially every small business organized or registered to conduct business in the United States through any type of limited liability entity. Reporting companies will be required to submit identifying information regarding their owners and individuals who participate in the formation and domestic registration of those businesses. Implementation of the CTA is largely deferred. Its reporting requirements take effect on the date regulations prescribed by the Secretary of the Treasury become effective.^[2] No indication has been given as to when final regulations may be issued, although the proposed regulations discussed later in this article suggest the guidance necessary for implementation is being assembled.

Who is required to report?

Domestic or foreign companies may be required to report under the CTA. Domestic entities subject to reporting requirements include corporations, limited liability companies, and any other entity “that is created by filing of a document with a secretary of state or any similar office under the law of a State or Indian tribe.”^[3] Thus, domestic reporting companies will also include limited partnerships, limited liability partnerships, limited liability limited partnerships, business trusts, and any other entity offering limited liability to its owners by virtue of a State or Tribal charter. Foreign entities that have registered to do business by filing with a secretary of state or similar office of any State or tribal jurisdiction are subject to the same reporting requirements as domestic entities.

What companies are not subject to reporting requirements?

The scope and purpose of the CTA is best understood by recognizing the types of companies that are exempt from its reporting requirements. The proposed regulations identify more than 22 different types of exempt entities. The vast majority of these exempt entities are subject to state or federal supervision, such as companies that report to securities, investment, insurance, and banking regulators.^[4] Exemptions are also extended to public companies issuing securities under § 12 of the Securities Exchange Act of 1934,^[5] governmental authorities, venture-capital fund advisors, public utilities, pooled investment vehicles, tax exempt entities, and entities assisting tax exempt entities. Also exempt are “large operating companies,” defined as any entity that:

• employs more than 20 full-time employees in the United States,
• has an operating presence at a physical office in the United States, and
• filed a federal income tax return or information return for the prior year reporting more than $5 million in gross receipts or sales, excluding gross receipts or sales outside the United States.^[6]

In the case of an entity that reports as part of an affiliated group under a consolidated return, the $5 million threshold applies to the amount reported on the consolidated return for the entire group.^[7] Thus, any privately-held, for-profit business operating through a limited liability entity in the United States will be subject to the reporting requirements of the CTA unless it satisfies the definition of a “large operating company” and or qualifies for another exemption.

Generally, existing entities get no relief and, as explained below, are subject to the same reporting requirements as newly formed entities. However, certain inactive entities are exempt from the reporting requirements of the CTA. Entities are considered “inactive” if such entities were in existence on or before January 1, 2020, and such entities:

• are not engaged in active business,
• are not owned by a foreign person (directly or indirectly, wholly or partially),
• have not experienced any change of ownership in the preceding 12-month period,
• have not sent or received any funds in an amount greater than $1,000 either directly or through any financial account in which the entity or any affiliate of the entity has an interest in the preceding 12-month period, and
• do not otherwise hold any kind or type of assets (including an equity interest in any limited liability entity).^[8]

What information about the company must be reported?

The CTA requires reporting companies to disclose:

• the full name of the reporting company,
• any trade name or “doing business as” name of the reporting company,
• the business street address,
• State or Tribal jurisdiction of formation (or, in the case of a foreign entity subject to CTA reporting, the State or Tribal jurisdiction in which the foreign company first registered), and
• the taxpayer identification number (TIN) under which the reporting company reports to the Internal Revenue Service.^[9] If the reporting company has not yet been issued a TIN, it may instead use the Dunn and Bradstreet Data Universal Numbering System Number of the reporting company or Legal Entity Identifier.^[10]

Which individuals are subject to disclosure by the reporting company?

In addition to the information regarding the reporting company that must be disclosed under the CTA, the reporting company must also provide information regarding every individual who is a beneficial owner and every individual who is a company applicant. The proposed regulations define a beneficial owner as “any individual who, directly or indirectly, either exercises substantial control over such reporting company or owns or controls at least 25 percent of the ownership interests of such reporting company.”^[11]

How is “substantial control” of a reporting company determined?

For purposes of defining a “beneficial owner,” substantial control over a reporting company is defined to include:

• service as a senior officer of the reporting company,
• authority over the appointment or removal of any senior officer or a majority or dominant minority of the members of the board of directors (or similar body),
• direction, determination, or decision of, or substantial influence over, important matters affecting the reporting company as more specifically set forth in the proposed regulations, and
• “[a]ny other form of substantial control over the reporting company.”^[12]

The proposed regulations further clarify the circumstances in which an individual’s authority will be viewed as sufficiently substantial as to require reporting information regarding that individual. Regardless of office or title, substantial control over a reporting company includes the ability to direct, determine, decide, or exercise substantial influence over important matters affecting the reporting company. Such matters include

• the nature, scope, or attributes of the business conducted by the reporting company, including mortgage, lease, sale, or other transfers of its principal assets, reorganization, dissolution, or merger of the reporting company,
• major expenditures or incurring significant debt,
• issuance of any equity interests by the reporting company,
• approval of the operating budget of the reporting company,
• selection or termination of business lines or geographic areas in which the reporting company does business,
• approval of compensation schemes,
• adoption of incentive programs for senior officers,
• approval, performance, or termination of important contracts,
• amendment of any substantial governance documents of the reporting company, including the articles of incorporation, other formation documents,
• amendment of important polices or procedures of the reporting company, or
• exercise of any other form of substantial control over the reporting company.

The person executing the foregoing authority with respect to a reporting company will be subject to the disclosure requirements of the CTA.^[13] The means through which such control is exercised by an individual is irrelevant and such control may be direct or indirect, formal or informal, including simple business relationships. An individual may be deemed to have substantial control for purposes of the CTA if the ability to exercise substantial control (as set forth in the CTA) exists, even if such control is never actually exercised.^[14]

Disclosure of information regarding non-controlling owners is required if their ownership of the reporting company equals or exceeds 25 percent. Ownership interest is broadly defined to include a variety of interests. Any type of equity interest — whether financial or simply voting — including “participation in a profit-sharing arrangement” is sufficient to be measured and considered to identify beneficial owners. In the case of non-corporate entities, any proprietary interest, any interest in capital or profits including limited and general partnership interests must be accounted for. Less direct interests are also considered ownership interests, including convertible debt, warrants, rights to purchase or subscribe to equity interests, and any “put, call, straddle, or other option or privilege of buying or selling” any ownership interest.^[15]

Measuring whether an individual owns or controls 25 percent of the ownership interests of a reporting company requires accounting for “all ownership interests of any class or type, and the percentage of such ownership interests that an individual owns or controls shall be determined by aggregating all of the individual’s ownership interests in comparison to the undiluted ownership interests of the company.”^[16] Consistent with the statute, the proposed regulations are clear that certain equity owners will be exempt and, therefore, not subject to reporting, including:

• minor children (provided the reporting company discloses the required information regarding the parent or legal guardian of the minor child);
• individuals acting as nominees, intermediaries, custodians, or agents;
• employees of reporting companies “acting solely as an employee and not as a senior officer, whose substantial control over or economic benefits from such entity are derived solely from the employment status of the employee”;
• individuals whose only interest is an expectancy through a right of inheritance; and
• creditors of the reporting company.^[17]

With respect to creditors, the proposed regulations make it clear that creditors who are not required to be disclosed are individuals whose beneficial ownership is derived “solely through rights or interests in the company for the payment of a predetermined sum of money…and the payment of interest on such debt.”^[18] If the right or interest in the value of the reporting company is a right or interest in its value or profits, such an obligation is not one “for payment of a predetermined sum” even if it takes the form of a debt instrument. This means participating debt must be accounted for as an ownership interest.

Must the ownership interest in the reporting company be owned by the beneficial owner?

An individual may be deemed a beneficial owner in a reporting company without holding an ownership interest in such reporting company. Not only are the equity and other interests described above sufficient to establish beneficial ownership, whether owned directly or indirectly, but beneficial ownership may also exist when the beneficial owner shares ownership or does not directly or indirectly hold the ownership interest. Specific examples set forth in the proposed regulations include:

• joint ownership,
• control of an ownership interest owned by another, and
• holding an interest as a settlor, trustee, or beneficiary of a trust or similar arrangement that holds the ownership interest.^[19]

In the case of an ownership interest owned or controlled by a trust, the identity of the trustee or other individuals (if any) with the authority to dispose of trust assets will always require disclosure. In addition, if the trust has a single beneficiary that is the sole permissible recipient of income and principal from the trust, the identity and other reporting information regarding such beneficiary must be disclosed. In the case of a trust with more than one beneficiary, disclosure of information is only required of those beneficiaries who have the right to withdraw or demand distributions of substantially all the trust assets.^[20] If the settlor of the trust has the ability to revoke the trust or otherwise withdraw trust assets, the identity and other information regarding the settlor of the trust must be disclosed. Thus, in the right set of circumstances, an ownership interest in a reporting company held through a trust may require disclosure of the trustee, one or more beneficiaries, and the settlor of that trust. It is probably not coincidental that the revocation and withdrawal rights that make settlors or beneficiaries subject to disclosure also make those persons owners of trust income and corpus under the grantor trust rules of subpart E of the Internal Revenue Code.^[21]

Who are “company applicants” requiring disclosure?

For professionals involved in entity formation, the most intrusive aspect of the CTA is the requirement for disclosure of information regarding company applicants. The proposed regulations define the term “company applicant” to mean any individual who files the document that creates the domestic reporting company or registers a foreign reporting company “including any individual who directs or controls the filing of such document by another person….”^[22] Thus, a company applicant is not only the lawyer or paralegal who files the articles of incorporation, certificate of limited partnership, articles of organization, or similar document for establishing a domestic company (or the registration of a foreign entity) with a State or Tribal authority, but also a partner, senior lawyer, or any other person directing the activity of the paralegal or associate undertaking the organization or registration.

What information must be reported regarding beneficiaries and company applicants?

In the case of every individual who is a beneficial owner and every individual who is a company applicant with respect to a reporting company, the reporting company must disclose

• the full legal name of the individual;
• the individual’s date of birth;
• the complete address of either:
  • such individual’s business, in the case of a company applicant who files the document organizing or registering the company in the course of such individual’s business, or
  • in the case of any other individual, the residential street address used by that individual for tax residency purposes; and
• either the passport number, driver’s license number, or other unique identifying number from a non-expired identification document issued to the individual by a State, local, or Tribal government for identification purposes.^[23]

In addition to providing the foregoing information, the reporting company must also provide a picture ID for the beneficial owner or company applicant which includes the disclosed identification number. In lieu of any beneficial owner or company applicant providing the information described above, the individual who is a beneficial owner or company applicant may, instead, provide a FinCEN identifier.^[24] The proposed regulations do not provide guidance regarding how an individual may obtain a FinCEN identifier. Presumably that guidance will be forthcoming and will involve direct submission of the information described above to FinCEN. The proposed regulations require updating and correcting information submitted to FinCEN regarding beneficial owners and company applicants “at the same time and in the same manner” as updated or corrected reports are required to be submitted by reporting companies.^[25]

When is reporting required?

The initial report for domestic or foreign reporting companies must be filed within 14 calendar days of the date of formation (in the case of a domestic reporting company) or within 14 calendar days of registration (in the case of a foreign reporting company).^[26] For entities that pre-exist the effective date of final regulations, the initial report of the company is due not later than one year after the effective date of the final regulations.^[27] In the case of an entity that no longer meets the criteria for exemption, the initial report is due within 30 calendar days after the date the exemption criteria are no longer satisfied.^[28] Initial reports must be updated in a variety of circumstances, including:

• within 30 days of the date on which there is “any change with respect to any information previously provided, including changes with respect to beneficial ownership, as well as any change with respect to the information reported for any particular beneficial owner or applicant”;^[29]
• when the reporting company becomes an exempt entity; and
• within 30 days of settlement of the estate of a deceased beneficial owner.

In addition to updating the initial reports for changes in the status of the company, its beneficial owners, and company applicants, reporting companies are also obligated to correct inaccuracies and information reported within 14 calendar days after the date on which the reporting company becomes aware or has reason to know any required information previously submitted to FinCEN was inaccurate when filed and remains inaccurate.^[30] How reporting companies will know or compel disclosure of corrections to the reporting information of beneficial owners and company applicants remains a mystery.

In what form is information required to be disclosed?

The proposed regulations do not provide any further elucidation as to the manner or form under which reporting will be undertaken other than to specify that it be done “in the form and manner that FinCEN shall prescribe in the forms and instructions for such report or application.…”^[31]

What penalties apply to failures to report completely and accurately?

The proposed regulations do not elaborate on the penalty regime that will apply in the case of failures to report or for inaccuracies in reporting. Consistent with the statue, the proposed regulations simply assert that “it shall be unlawful for any person to willfully provide or attempt to provide, false or fraudulent beneficial ownership information…or to willfully fail to report, complete, or update beneficial ownership to FinCEN in accordance with this section.”^[32] The proposed regulations do make it clear that a willful failure to report is subject to penalty. Persons who direct or control others with reporting obligations will also be held to have violated the CTA.^[33]

Observations

The proposed regulations fill in some, but not all, of the gaps left by the CTA’s statutory language. For example, the proposed regulations provide no definitive guidance with respect to attribution of beneficial ownership other than as described above. Thus, there are no specific rules corresponding to §318 or §958 of the Internal Revenue Code by which constructive ownership would be attributed to a potential beneficial owner. While the proposed regulations require accounting for a broad array of ownership interests — including convertible debt, straddles, jointly owned interests, and beneficial interests in trusts — they provide no guidance as to measurement of these interests for purposes of the 25 percent threshold for disclosure of their owners, although aggregation of such interests with an individual’s other ownership interests is clearly required.

There appear to be multiple ways to avoid the reporting requirements:

• Only entities deriving limited liability through State or Tribal charter (in the case of domestic entities) or registration with State or Tribal authorities (in the case of foreign entities) are subject to reporting.
• Ownership of a reporting company through a non-grantor multi-beneficiary trust with respect to which the beneficiaries do not possess withdrawal rights requires disclosure of information regarding the trustee, but not the settlors or beneficiaries of the trust. Consequently, trusts with Crummey powers will not avoid disclosure of beneficiaries holding powers of withdrawal, nor will section 2503(c) trusts. However, many settlors may be willing to forego annual exclusions for gifts to such trusts if the identity and information regarding beneficiaries can be protected.
• Organization of the reporting company as one of the types of organizations exempted from reporting avoids disclosure of beneficial owners and company applicants, as well. Obviously, this opportunity is limited and may require a willingness to assume other reporting obligations and regulatory oversight. However, in certain cases, regulatory oversight may not exist or may not extend to disclosure of individuals exercising substantial control or satisfying the 25 percent beneficial ownership threshold of the CTA.

Although the information the CTA requires regarding the reporting companies may be seen as not significantly greater than that necessary to organize or register the company with State or Tribal authorities, do not be deceived. The reporting obligations the proposed regulations impose on reporting companies regarding the professionals who organize those companies are clearly intended to compel disclosure of the beneficial owners of those reporting companies. Without proper planning, the corporate curtain of secrecy will be lifted.

The CTA will significantly impact lawyers who organize business entities. The exposure it creates for counsel and their staff involved in preparing and filing organizational documents will require rethinking the information to be gathered and the content of client engagement letters. If a client is unwilling to provide the information the CTA requires, the terms of the law firm’s engagement should permit termination of its representation. It would be prudent to gather the necessary information regarding beneficial owners before the engagement commences and to set forth in engagement letters who will be responsible for updating and correcting information previously filed. New engagement letters will likely be compelled for existing clients when they form new entities and when entities formed prior to the effective date of the CTA are compelled to report to FinCEN.

There is no grandfathering of existing entities unless those entities are “inactive” as defined by the CTA. Making this determination requires the ability to contact the persons who currently operate the reporting company and solicit information regarding its operations, revenues, and expenditures. Every existing entity provided limited liability by a State or Tribal government and every foreign entity registered to do business with a State or Tribal government that is not otherwise exempt must not only provide information about itself, but also must provide information about its beneficial owners. Reluctance to provide required information should be anticipated, as should be possible reluctance to compensate counsel for the effort involved to collect and report that information to FinCEN. Like it or not, the CTA will change the way you practice law.

Robert E. Ward, J.D., LL.M. is a fellow of the American College of Tax Counsel who advises businesses and individuals on U.S. international and domestic tax matters from his firm’s offices in Vancouver, British Columbia and Bethesda, Maryland.

1. Pub. L. No. 116-283 (January 1, 2021) §6403; 31 USC §5336. ↑

2. “The requirements of this subsection shall take effect on the effective date of the regulations prescribed by the Secretary of the Treasury under this subsection, which shall be promulgated not later than 1 year after the date of enactment of this section.” 31 USC §5336(b)(5). ↑

3. 31 CFR §1010.380(c)(1)(i)(C). All citations are to the regulations as proposed and published at 86 Fed. Reg. 69920-69974 (Dec. 8, 2021). ↑

4. The types of exempt entities are identified in Prop. Reg. §31 CFR §1010.380(c)(2). ↑

5. See 15 USC §78l; Prop. Reg. §1010.380(c)(2)(i). ↑

6. 31 CFR §1010.380(c)(2)(xxi). ↑

7. Id. ↑

8. 31 CFR §1010.380(c)(2)(xxiii). ↑

9. 31 CFR 1010.380(b)(1). ↑

10. 31 CFR 1010.380(b)(1)(i)(E)(1), (2). ↑

11. 31 CFR 1010.380(d). ↑

12. 31 CFR 1010.380(d)(1)(iv). ↑

13. 31 CFR 1010.380(d)(1)(iii). ↑

14. 31 CFR 1010.380(d)(2). ↑

15. 31 CFR 1010.380(d)(3). ↑

16. 31 CFR 1010.380(d)(3)(iii). ↑

17. 31 CFR 1010.380(d)(4). ↑

18. 31 CFR 1010.380(d)(4)(v). ↑

19. 31 CFR 1010.380(d)(3)(ii)(C). ↑

20. 31 CFR 1010.380(d)(3)(ii)(C)(2)(i). ↑

21. See IRC §673 and §676 with respect to settlors and §678 with respect to beneficiaries. ↑

22. 31 CFR 1010.380(e)(1). ↑

23. In the case of an individual who does not have one of the foregoing identification documents, a non-expired passport issued by a foreign government to such individual will suffice. 31 CFR 1010.380(b)(1)(ii)(D)(4). ↑

24. 31 CFR 1010.380(b)(5)(ii)(A). ↑

25. 31 CFR 1010.380(b)(5)(ii)(D). ↑

26. 31 CFR 1010.380(a)(1)(i), (ii). ↑

27. 31 CFR 1010.380(a)(iii). ↑

28. 31 CFR 1010.380(a)(iv). ↑

29. 31 CFR 1010.380(a)(2). ↑

30. 31 CFR 1010.380(a)(3). ↑

31. 31 CFR 1010.380(b). ↑

32. 31 CFR 1010.380(g)(1). ↑

33. “A person fails to report complete or updated beneficial ownership information to FinCEN if such person directs of controls another person with respect to any such failure to report, or is in substantial control of a reporting company when it fails to report compete or updated beneficial ownership information to FinCEN.” 31 CFR 1010.380(g)(5). ↑

Federal and state statutes prohibiting credit discrimination, such as the Equal Credit Opportunity Act and Fair Housing Act, generally date from the 1960s and 1970s. Given that most homes lacked a personal computer and with the widespread adoption of the Internet and smartphones still decades away, these laws understandably did not anticipate modern credit practices stemming from our digital world. This created unanticipated pitfalls and challenges for unwary financial institutions.

These risks have recently been brought into sharp relief due to a practice known as “digital targeted marketing.” At its core, digital targeted marketing is a form of marketing whereby advertisements are disseminated through a variety of online platforms such as web services, paid search, banners, and social media using sophisticated data analytics that effectively preselect a precise target audience. Preselection generally occurs either through “self-selecting” or “look alike” programs offered by online platforms such as Facebook. In self-selecting programs, the advertiser itself selects the criteria used to determine recipients based on an array of attributes and characteristics provided by the platform. In contrast, look alike programs are conducted by feeding the advertiser’s existing customer data through a black box of proprietary data analytics provided by the platform to identify recipients that “look like” the advertiser’s customer base. Because the troves of consumer data possessed by these platforms are so large that they are beyond the ability of individuals or even most software to analyze, companies increasingly use “machine learning”—a type of artificial intelligence that learns on its own as it analyzes huge amounts of data—to comb through this data to find predictive attributes and simultaneously improving its own analysis. Financial institutions increasingly use these tools because they allow advertisement placement not only with those most likely to be interested in a given financial product, but also with those most likely to qualify for it.

As with the use of any consumer attribute, fair lending concerns can arise when protected classes are excluded, whether intentionally or unintentionally, from digital targeted marketing offers due to the presence of one or more attributes that align with prohibited bases or their close proxies. A recent flurry of regulatory activity and private litigation aimed at Facebook highlights this risk and includes:

• A 20-month investigation into Facebook’s digital targeted marketing practices by the Attorney General of Washington state. This resulted in a consent order in which Facebook agreed to cease providing advertisers with the option to (1) exclude ethnic groups from advertisements for insurance and public accommodations; or (2) otherwise utilize exclusionary advertising tools that allow advertisers with ties to employment, housing, credit, insurance and/or places of public accommodation to discriminate based on race, creed, color, national origin, veteran or military status, sexual orientation and disability status.^[1]
• A civil suit brought by the National Fair Housing Alliance, the Communications Workers of America and several other consumer groups alleging discriminatory practices in Facebook’s digital targeted marketing practices. This resulted in a settlement of $5 million and an agreement by Facebook to make changes to its look alike campaigns for housing, employment and credit-related advertisements (e.g., prohibiting attributes related to age, gender and zip codes).^[2]
• An ongoing Charge of Discrimination levied by the Department of Housing and Urban Development (“HUD”) alleging discriminatory housing practices in violation of the provisions of the Fair Housing Act that prohibit discrimination based on race, color, religion, sex, familial status, national origin or disability. Specifically, HUD alleges that Facebook (1) enabled advertisers of housing opportunities to target audiences using prohibited bases; and (2) used an ad-delivery algorithm that would independently discriminate based on prohibited bases even where advertisers did not use prohibited bases to target audiences. ^[3]
• An ongoing civil suit in the Northern District of California alleging that Facebook’s direct targeted marketing practices violated the Fair Housing Act, Equal Credit Opportunity Act and California fair lending laws.^[4]

While enforcement and litigation has primarily focused on Facebook and its practices to date,^[5] the New York Department of Financial Services recently expressed interest in investigating financial institutions and “Facebook advertisers to examine…disturbing allegations [of discriminatory practices]…to take whatever measures necessary to make certain that all financial services providers are in compliance with New York’s stringent statutory and regulatory consumer protections.”^[6] This sentiment was echoed in a recent article by the Associate Director and Counsel to the Federal Reserve Board’s Division of Consumer and Community Affairs which highlights the fair lending risk digital targeted marketing poses to financial institutions (i.e., steering and redlining) and notes that the “growing prevalence of AI-based technologies and vast amounts of available consumer data raises the risk that technology could effectively turbocharge or automate bias.”^[7] The commentators further note that it is “important to understand whether a platform employs algorithms — such as the ones HUD alleges in its charge against Facebook — that could result in advertisements being targeted based on prohibited characteristics or proxies for these characteristics, even if that is not what the lender intends.”

With this in mind, financial institutions must evaluate and mitigate not only the risks associated with their own digital targeted marketing activities, but also the activities of the platforms with which they associate. In doing so, they should consider taking the following actions:

• Evaluating the importance of digital targeted marketing to the financial institution and its risk tolerance with respect to same.
• Attempting to obtain as much information as possible about the possible presence of prohibited bases or close proxies in digital-marketing algorithms.
• Requiring indemnification in digital targeted marketing agreements, especially where platforms use proprietary black box analytics.
• Where available, using “special ad audience” programs intended for industries subject to anti-discrimination laws (e.g., housing, credit, employment, etc.).
• Considering using self-selected attribute criteria that avoid prohibited bases or close proxies in lieu of a platform’s look alike program.
• Analyzing and testing responses to digital marketing campaigns for potentially disparate outcomes.

Given their potential benefits, financial institutions are unlikely to cease direct targeted marketing activities. But those that are prudent should engage in reasonable due diligence regarding the platforms they use—weighing the benefits against the risks of their use—while monitoring for future regulatory guidance or legal precedent.

1. In re Facebook, Inc., No. 18-2-18287-5SEA (Consent Order) (Wa. Super. Ct., July 24, 2018). ↑

2. Nat Ives, Facebook Axes Age, Gender and Other Targeting for Some Sensitive Ads, THE WALL STREET JOURNAL (March 19, 2019). ↑

3. HUD v. Facebook, Inc., HUD ALJ No. 01-18-0323-8 (Charge of Discrimination) (U.S. Dept. of Housing and Urban Development Office of Administrative Law Judges, March 28, 2019). ↑

4. Opiotennione v. Facebook, Inc., Case No. 3:19-cv-07185 (JSC) (Complaint) (N.D. Cal., October 31, 2019). ↑

5. HUD is reportedly investigating Google and Twitter for similar violations. See Tracy Jan and Elizabeth Dwoskin, HUD Is Reviewing Twitter’s and Google’s Ad Practices as Part of Housing Discrimination Probe, THE WASHINGTON POST (March 28, 2019). ↑

6. Press Release, Governor Cuomo Calls on DFS to Investigate Claims That Advertisers Use Facebook Platform to Engage in Discrimination (July 1, 2019), available at https://www.dfs.ny.gov/reports_and_publications/press_releases/pr1907011. Emphasis added. ↑

7. Carol A. Evans & Westra Miller, Fed. Reserve Sys., From Catalogs to Clicks: The Fair Lending Implications of Targeted, Internet Marketing, CONSUMER COMPLIANCE OUTLOOK, Third Issue 2019, at 7, available at https://consumercomplianceoutlook.org/2019/. ↑

Big News. On January 27, 2022, the Delaware Legislature passed legislation designed to make captive insurance a viable alternative to traditional D&O insurance. This new development should mean that, over time, the cost of D&O insurance should decline.

The following is a set of FAQs designed to help D&O insurance buyers and beneficiaries understand (1) why there was a problem, (2) what the Delaware legislature did to address the problem, (3) the impact of the change in Delaware law on traditional D&O insurance, and (4) for whom pursuing a captive strategy makes sense.

I. What Was the Problem?

A corporation with a small balance sheet will obviously want to purchase D&O insurance. But why are corporations with hefty balance sheets buying D&O insurance? Can’t they just self-fund any losses?

Some companies with large balance sheets choose to forgo the “balance sheet” protection part of D&O insurance (often referred to as Side B/C coverage) and self-fund any losses they can legally indemnify. In most cases, there is no need to go to the trouble of setting up an indemnification trust, a captive, or anything else. If something is indemnifiable, which is the case for solvent corporations when it comes to defense costs for all claims brought in the US as well as the settlement of securities class action lawsuits, the corporation can just pay these costs directly as incurred.

However, recall that under Delaware General Corporation Law (DGCL) Section 145(b), corporations are not permitted to provide indemnification for breach of fiduciary duty suits brought derivatively. This explains the popularity of “Side A” D&O insurance even for very large, well-funded companies. Side A D&O insurance provides first dollar coverage when something is insurable but not indemnifiable, such as the settlement of derivative suit claims.

Unfortunately, settling derivative suits is getting increasingly expensive. As a result, the cost of stand-alone Side A insurance has gone up dramatically in recent years.

What is a captive?

A captive is a licensed insurance company that provides insurance for designated risks to its corporate parent company. Companies like financing retained risk with captives because of potential benefits such as increased control over the cost of insurance, insulation from market volatility, access to reinsurance markets, and tax efficiency.

Given the high cost of D&O insurance, why weren’t we already using captives for D&O insurance?

The cost of using a captive for D&O insurance was prohibitive for two reasons: (1) onerous capital requirements, and (2) the concern that a captive would not be allowed to respond on behalf of directors and officers to claims that are not indemnifiable as a matter of Delaware corporate law.

Why are D&O captive capital requirements so onerous?

Put simply, captives work best for high-frequency, low-severity risks. When there is a plethora of data for a type of risk, for example workers’ compensation losses, actuaries can model future losses with a high degree of certainty. This is important because a captive must hold adequate capital to backstop the limit of insurance being provided to the parent company. The relative lack of predictability and the potential for outsized losses inherent in D&O claims means that the capital required for a D&O captive is likely to be substantial. Compared to the cost of D&O insurance, even during the current hard market, funding a captive is likely to be burdensome.

Why did everyone think that even if you used a captive, you still had to buy Side A insurance from a traditional commercial insurance carrier?

As noted above, DGCL Section 145(b) exposes directors and officers to the potential of personally paying to settle derivative suits. Thankfully, DGCL Section 145(g) explicitly contemplates using D&O insurance to cover directors and officers against liability “whether or not the corporation would have the power to indemnify such person against such liability under this section.”

What the original text of DGCL Section 145(g) did not do, however, was contemplate the use of captive insurance. While captive insurance is insurance, the concern is that using a parent company’s captive instead of buying commercial insurance arguably looks like the corporation is attempting to fund non-indemnifiable losses since it is the corporation itself that funds the captive. That led most experts to advise that corporations using a captive to protect their directors and officers should also continue to purchase Side A insurance to be certain directors and officers have coverage for non-indemnifiable claims.

II. What Did the Delaware Legislature Do?

What did the Delaware legislature do to make captives a more viable option to replace traditional D&O insurance?

The change just passed by the Delaware legislature amends DGCL Section 145(g) to clarify, that as the term is used by the DGCL, the definition of insurance includes captives. This makes captives a viable alternative to traditional D&O insurance, even Side A D&O insurance, for claims that are not directly indemnifiable by the corporation due to DGCL Section 145(b).

Can a captive provide identical coverage that commercial insurance carriers provide?

As always with D&O insurance, the devil is in the details, and it will take time to understand the details of the change in the DGCL. One observation is that, particularly with respect to independent directors, some of the most advanced D&O insurance policies available have no conduct exclusions of any kind for independent directors.

By contrast, DGCL 145(g) mandates some exclusions from coverage. Some may not consider these exclusions to be problematic, such as the exclusions for “any claim made against any person arising out of, based upon or attributable . . . to or a knowing violation of law by such person, if . . . established by a final, non-appealable adjudication in the underlying proceeding in respect of such claim.”

This will be a business decision for boards to consider. Boards will want to take into consideration how to best attract talented independent directors to their board given the high frequency and severity of claims brought against directors and officers, including very expensive but largely frivolous claims.

III. What Will Be the Impact of the Change in the DGCL on Traditional D&O Insurance?

Are insurance carriers going to be upset about this change?

No. The reason the cost of D&O insurance has gone up so dramatically is that losses have been outpacing premiums for years. The volatile, high-severity nature of outcomes for D&O claims makes underwriting a particularly difficult challenge—especially for the biggest companies. Carriers have long felt that providing D&O insurance for some companies is much like providing fire insurance for mansion-size cabins in the middle of a forest experiencing drought. Smart carriers will welcome the opportunity the change in Delaware law provides to partner with their insureds in more creative ways.

Will the cost of D&O insurance decline?

Yes, the cost of D&O insurance should decline over time. Insurance market conditions are impacted by both the trading market and the technical underwriting results. On the technical side, one factor leading to the increased price of D&O insurance has been huge losses experienced by carriers, leading to poor underwriting results and the need for increased premiums. The trading market has experienced unprecedented demand for the D&O insurance product. There is always a large cohort of mature public companies that seek D&O insurance each year. Adding to that demand more recently has been an unusually large numbers of new seekers of public company D&O insurance resulting from traditional operating company IPOs, direct listings, SPAC IPOs, and companies going public through de-SPAC transactions. Economics 101 tells us that when demand goes up and supply—insurance capital—is relatively inelastic, the cost of the product will go up. The emergence of captives should ease the demand somewhat, so all things being equal DGCL 145(g) should bring down the cost of D&O insurance over time.

IV. Who Should Pursue a Captive Strategy as an Alternative to Traditional D&O Insurance?

What type of companies are the best candidates to use a captive as an alternative to D&O insurance?

The primary qualifications for financing D&O in a captive are (1) a strong corporate balance sheet, and (2) the desire to retain significant, unpredictable D&O risk. Corporations using their captive to cover D&O risk will need to pay the captive an annual premium to cover actuarial expectations for D&O claims. These corporations will also be required to deposit sufficient risk capital into the captive to satisfy regulatory capital requirements and cover claims beyond the actuaries’ estimates up to the full policy limit.

When factoring in the captive premium, the opportunity cost of the risk capital invested in the captive and the captive’s operating costs (captive management, actuaries, accountants), the captive option is likely to be more expensive and operationally onerous compared to simply buying traditional D&O insurance. A careful cost-benefit analysis may show that commercial D&O insurance is still a good deal.

Given that cost of setting up a captive and the work involved, companies that already have a captive in place are the best candidates to consider using a captive as an alternative to D&O insurance.

What type of companies are especially unlikely to use a captive for D&O insurance?

Companies that are not financially stable are unlikely to be good candidates to use a captive.

First, a company with a weak balance sheet is unlikely to have the cash or credit facilities available to fund a captive. In addition, it is not clear that a bankruptcy court would refrain from seizing the captive’s assets, which would adversely affect the ability of the captive to pay a claim brought against a director or officer. If this happened, the company’s directors and officers would have no protection against claims brought against them. By contrast, classic Side A D&O insurance is specifically designed to be able to respond on behalf of directors and officers when a company is in bankruptcy and can no longer indemnify its directors and officers.

Companies for whom investing millions of dollars of risk capital is painful—either because of less than robust balance sheets or because capital is better utilized for other initiatives like acquisitions or capital investment—should also avoid D&O captive strategies.

Organizations looking to use a captive as a short-term antidote to expensive D&O insurance will likely be frustrated. Standing up a D&O-focused captive or adding D&O to an existing captive will require companies to maintain significant regulatory capital for years, not to mention material time and attention from executives. Captives make the most sense for companies that are committed to this strategy. (For this reason, SPACs—which only exist in their original form for two years or less—are not good candidates to use a captive instead of traditional D&O insurance.)

Over time, the change in DGCL Section 145(g) might lead to captive solution innovations beyond a traditional single parent structure for D&O risks, potentially including group captives. Group captives tend to be most appropriate for smaller middle market companies. However, group captives still require considerable capital. Most importantly, group captive solutions typically involve levels of risk sharing among members—something many independent directors might find deeply uncomfortable. Any consideration of D&O offerings from existing captives should be carefully reviewed to understand the fine print and appropriateness of fit to solve the underlying problem.

I have an existing captive. Can I just put my D&O risk into that?

Likely yes, but it is not clear that this will be the best way to go. Directors and officers may be wary of being asked to pivot from having dedicated protection through traditional D&O insurance to facing the risk of their coverage being diluted by workers’ compensation or other claims covered by a company’s captive. If a big D&O claim has to be paid the same year the captive has to pay other claims, it will be too late to back-fill with traditional D&O insurance.

How long does it take to set up a captive?

From soup to nuts, you are typically looking at 45 to 90 days. It is likely that the first few captives for D&O insurance that include coverage for non-indemnifiable loss will take longer as captive domiciles and regulators need to come up to speed on putting D&O risk in a captive. You will also want to build additional time into your planning process for things like getting management and board alignment on whether to pivot to using a captive to replace some or all of your traditional D&O insurance.

What would be a sensible strategy to explore using a captive for my D&O risk?

Rather than, in one year, completely pivoting from a traditional D&O insurance program to a captive, consider setting up a dedicated captive to address part of your risk. This allows everyone to get used to the idea and work out the inevitable kinks in the system before fully committing all the directors’ and officers’ protection to a captive structure.

What are some non-obvious risks my board should consider as it considers replacing traditional D&O insurance with a captive?

See above for comments on attracting and retaining top talent in a competitive market for directors and officers.

When a captive pays a D&O insurance claim, there could be questions of timing, optics, and potentially mischief. Amended DGCL Section 145(g) requires that if notice is required to be given to shareholders of the settlement of a derivative suit, a condition precedent to any payment by a captive is that shareholders be given notice that the payment is being made “under such [captive] insurance in connection with such dismissal or compromise.”

Maybe this will be fine. On the other hand, large settlements rarely leave shareholders feeling charitable towards the directors and officers on whose behalf the settlements are being made. DGCL Section 145(g)’s notification requirement may imply to shareholders that they have the ability to object to the payments—even though there is nothing in the section about objections. The timing of the notification may lead some shareholders to feel that since the claims are being paid by the corporate parent’s captive—which was funded by corporate proceeds—the shareholders are being harmed. One expects that there will be many articles written that will fail to mention that Delaware law explicitly authorized this funding mechanism and will instead attempt to shame directors and officers for “taking advantage” of shareholders.

When D&O insurance pays a claim, there is no shareholder notification process, and certainly no one is writing articles sympathizing with the D&O insurance carriers who paid the claim.

What are good next steps?

Before running too far down the captive path, consider having an informed conversation with your board of directors to test their appetite. D&O insurance prices are already starting to soften, creating a dynamic where your board may not think the squeeze is worth the juice.

You will also want to conduct a feasibility study, the normal first step taken when considering a captive. A feasibility study is a somewhat involved process that typically includes things like a review of the organization’s ability to retain risk, actuarial modeling of the D&O exposure, several years of pro-forma captive financials and a comprehensive financial comparison to traditional insurance accounting for the opportunity cost of capital trapped in the captive.

An earlier version of this article appeared in the Woodruff Sawyer D&O Notebook on February 1, 2022.

Editors

Contributors

Alex Crowley

Associate, IPTech
Baker McKenzie
300 E. Randolph St.
Suite 5000
Chicago, IL 60001
(312) 861-6598
[email protected]

§ 1.1. Introduction

We are pleased to present the second edition of the rapidly growing Chapter on Artificial Intelligence. 

A few years ago, when in my capacity as the Founder and Chair of the AI Subcommittee, I made the original suggestion that the Annual Review should include a new Chapter devoted entirely to AI, I understood from clients that this is an area where they were hungry for guidance.  Over the last decade, AI and Machine Learning have become my passion.  I continue to be fascinated by the various AI/ML issues I am asked by my clients to advise them on, and have watched with interest as US regulators and the plaintiff’s bar have begun to focus their sights on commercial and embedded AI.   The pace of corporate deals involving companies who count AI as their innovation have also increased substantially.  I have tried hard to keep up with the rapid pace of change and have published on many aspects, formulated proposed federal AI legislation that in 2018 became a House of Representatives Draft Discussion Bill, and have been invited to speak and teach on AI at many institutions including MIT/SLOAN, NYU, and Berkeley Law School.

In the absence of substantive federal legislation, case law plays an outsized role in helping shape the contours of the emerging legal issues associated with widespread adoption of AI and Machine Learning.  Tracking relevant case developments from around the country is essential. Last year, we confidently predicted that the developments we report this year would increase exponentially year over year. Our prognostication has proven correct.  This year’s Chapter marks a notable increase in reported cases in the field. 

The goal of this Chapter is to have it become a useful tool for those business attorneys who seek to be kept up to date on a national basis concerning how the courts are deciding cases involving AI.  We again made the same editorial decisions and included relevant legislation and pending legislation.  We also made the same judgments as to what should be included.  A notable example is facial recognition.  Due to the nature of the underlying technology and the complexity of FR, FR necessarily involves issues of algorithmic/artificial intelligence.  However, we did not include every case that references facial recognition when the issue at bar pertained to procedural aspects such as class certification (e.g., class action lawsuits filed under the Illinois Biometric Information Privacy Act (BIPA) (740 ILCS 14)).

Finally, I want to thank my colleagues, Adam Aft and Alex Crowley, for their assistance in preparing this year’s Chapter.  Adam is a knowledgeable and accomplished AI attorney with whom I frequently collaborate, and Alex is a new joiner to our team with a noted exuberance for AI.  

We hope this Chapter provides useful guidance to practitioners of varying experience and expertise and look forward to tracking the trends in these cases and presenting the cases arising in the next several years.

Bradford Newman
Palo Alto, California

§ 1.2. Cases^[1]

§ 1.2.1. United States Supreme Court

Van Buren v. United States, 141 S. Ct. 1648 (Jun. 3, 2021). The dispute underlying this case arose when a police officer violated department policy by using the computer in his patrol car to access information in a law enforcement database for a non-law-enforcement purpose. The Court held that a computer user “exceeds authorized access” under the Computer Fraud and Abuse Act of 1986 (CFAA) “when he accesses a computer with authorization but then obtains information located in particular areas of the computer—such as files, folders, or databases—that are off-limits to him.” Here, the police officer was authorized to access his patrol-car computer and the law enforcement database. But due to the Court’s holding, the officer’s purpose, albeit improper, in accessing the computer and database was not relevant to determining liability under CFAA. This holding resolved a circuit split about how broadly to interpret CFAA. It avoided making “millions of otherwise law-abiding citizens” into criminals simply on the basis that they used their computers in a technically unauthorized way, such as to send personal email from a work laptop.

There were no other qualifying decisions by the United Sates Supreme Court. We note the Court has heard a number of cases foreshadowing the types of issues that will soon arise with respecting to artificial intelligence such as United States v. Am. Library Ass’n (539 U.S. 194 (2003)) in which a plurality of the Court upheld the constitutionality of filtering software that libraries had to implement pursuant to the Children’s Internet Protection Act and Gill v. Whitford (138 S. Ct. 1916) in 2017 in which, if the plaintiffs had standing, the Justices may have had to evaluate the use of sophisticated software in redistricting (a point noted again in Justice Kagan’s express reference to machine learning in her dissent in Rucho v. Common Cause (139 S. Ct. 2484 (2019))). The Court had previously concluded that a “people search engine” site presenting incorrect information that prejudiced a plaintiff’s job search was a cognizable injury under the Fair Credit Reporting Act in Spokeo, Inc. v. Robins (136 S. Ct. 1540 (2016)). These cases are representative of the type of any number of cases that are likely to make their way to the Court in the near future that will require the Justices to contemplate artificial intelligence, machine learning, and the impact of the use of these technologies.

§ 1.2.2. First Circuit

There were no qualifying decisions within the First Circuit.

§ 1.2.3. Second Circuit

Flores v. Stanford, 2021 U.S. Dist. LEXIS 185700 (S.D.N.Y 2021) (compelling disclosure of information related to the COMPAS software (used to assess the likelihood of recidivism and used by courts to inform bail amounts and sentencing) as relevant to inform the plaintiffs class certification given that having transparency and explainability regarding such information and the operation of the applicable algorithm would be potentially central to the plaintiffs’ assertions that the defendants had unconstitutional practices deployed against them in the manner in which the COMPAS software informed their sentencing).

Force v. Facebook, Inc., 934 F.3d 53 (2d Cir. 2019). Victims, estates, and family members of victims of terrorist attacks in Israel alleged that Facebook was a provider of terrorist postings where they developed and used algorithms designed to match users’ information with other users and content. The court held that Facebook was a publisher protected by Section 230 of the Communications Decency Act and that the term publisher under the Act was not so limited that Facebook’s use of algorithms to match information with users’ interests changed Facebook’s role as a publisher.

§ 1.2.3.1. Additional Cases of Note

Clark v. City of New York, 2021 U.S. Dist. LEXIS 177534 (S.D.N.Y. 2021) (denying motion to dismiss first amendment and state law religious discrimination claims against New York City for requiring Muslim women to remove their hijabs for booking photographs after arrest. A primary motivation for the women’s complaint was that forcing them to remove their hijabs for a picture would cause the women to violate their religious belief that men outside of their immediate family were prohibited from seeing the women without their hijabs, even if only via pictures stored in facial recognition databases. The court found that “requiring the removal of a hijab does not rationally advance the City’s valid interest in readily identifying arrestees,” including via facial recognition databases.)

Nat’l Coalition on Black Civic Participation v. Wohl, 2021 U.S. Dist. LEXIS 177589, 2021 WL 4254802 (S.D.N.Y. 2021) (holding that a robocall service provider that allowed users to upload messages to a website for distribution via the service provider’s automated phone calling (i.e., robocall) system was not entitled to neutral publisher immunity under Section 230 because it was not a provider or user of an interactive computer service and the service provider allegedly knew of the discriminatory and false content of the messages and actively helped the users  determine where to distribute the messages).

Nuance Communs., Inc. v. IBM, 2021 U.S. Dist. LEXIS 115228 (S.D.N.Y. 2021) (noting that “This is a breach of contract case arising under New York law. But more than that, this case is a contemporary window into the brave new world of artificial intelligence (“AI”) commercial applications” and finding after a bench trial that IBM had breached its implied covenant of good faith by updating a product outside of the scope of the parties’ agreement in order to avoid making the updates available to Nuance in relation to the product within the scope of the agreement).

Calderon v. Clearwater AI, Inc., 2020 U.S. Dist. LEXIS 94926 (S.D. N.Y. 2020) (stating the court’s intent to consolidate cases against Clearview based on a January 2020 New York Times article alleging defendants scraped over 3 billion facial images from the internet and scanned biometric identifiers and then used those scans to create a searchable database, which defendants then allegedly sold access to the database to law enforcement, government agencies, and private entities without complying with BIPA); see also Mutnick v. Clearview Ai, Inc., 2020 U.S. Dist. LEXIS 109864 (N.D. Ill. 2020).

People v. Wakefield, 175 A.D.3d 158 (N.Y. App. Div. 2019) (concluding no violation of the confrontation clause where the creator of artificial intelligence software was the declarant, not the “sophisticated and highly automated tool powered by electronics and source code.”); see also People v. H.K., 2020 NY Slip Op 20232, 130 N.Y.S.3d 890 (Crim. Ct. 2020) (following Wakefield in concluding that where software was “acting as a highly sophisticated calculator” the analyst using the software was still a declarant and the right to confrontation was preserved).

Vigil v. Take-Two Interactive Software, Inc., 235 F. Supp. 3d 499 (S.D.N.Y. 2017) (affirmed in relevant part by Santana v. Take-Two Interactive Software, Inc., 717 Fed.Appx. 12 (2d Cir. 2017)) (concluding that the BIPA doesn’t create a concrete interest in the form of right-to-information, but instead operates to support the statute’s data protection goal; therefor, defendant’s bare violations of the notice and consent provisions of BIPA were dismissed for lack of standing).

LivePerson, Inc. v. 24/7 Customer, Inc., 83 F. Supp. 3d 501 (S.D.N.Y. 2015) (determining plaintiff adequately plead possession and misappropriation of a trade secret where plaintiff alleged its “predictive algorithms” and “proprietary behavioral analysis methods” were based on many years of expensive research and were secured by patents, copyrights, trademarks, and contractual provisions).

§ 1.2.4. Third Circuit

Zaletel v. Prisma Labs, Inc., No. 16-1307-SLR, 2017 U.S. Dist. LEXIS 30868 (D. Del. Mar. 6, 2017). The plaintiff had a “Prizmia” photo editing app. The plaintiff alleged trademark infringement based on the defendant’s “Prisma” photo transformation app. In reviewing the Third Circuit’s likelihood of confusion factors, the court considered the competition and overlap factor. The court concluded that “while plaintiff broadly describes both apps as distributing photo filtering apps, the record demonstrates that defendant’s app analyzes photos using artificial intelligence technology and then redraws the photos in a chosen artistic style, resulting in machine generated art. Given these very real differences in functionality, it stands to reason that the two products are directed to different consumers.”

§ 1.2.4.1. Additional Cases of Note

McGoveran v. Amazon Web Servs., 2021 U.S. Dist. LEXIS 189633 (D. Del. 2021) (granting motion to dismiss a claim under Illinois’ Biometric Information Privacy Act (BIPA) brought by residents of Illinois against non-Illinois-based companies Amazon Web Services (AWS) and Pindrop Security for collecting callers’ “voiceprints,” which can be used to identify the speaker, when the residents made calls from Illinois using Illinois phone numbers to a company that used AWS and Pindrop services. The court found no “allegations involving conduct that occurred ‘primarily and substantially’ in Illinois” and that “BIPA does not apply extraterritorially.”)

Thomson Reuters Enter. Ctr. GmbH v. ROSS Intelligence Inc., 2021 U.S. Dist. LEXIS 59945 (D. Del. 2021) (denying a motion to dismiss claim of copyright infringement and tortious interference with contract against ROSS Intelligence, a legal research services company, related to ROSS’s alleged obtaining, via a third party contracted with Thomson Reuters, and use of certain Westlaw materials, notably Westlaw’s Headnotes and Key Number System, when developing ROSS’s own artificial intelligence-based legal research software. While ROSS argued “that Westlaw Content is not copyrightable under the government edicts doctrine,” the court nonetheless held that Thomson Reuters at least had a plausible claim for copyright infringement based on Thomson Reuters’ efforts to register its content with the US Copyright Office and a plausible claim of tortious interference with contract due to the manner in which ROSS allegedly obtained the Westlaw content.)

In re Valsartan, Losartan, & Irbesartan Prods. Liab. Litig., 337 F.R.D. 610 (D.N.J. 2020) (requiring the defendants to use an eDiscovery document review protocol that the parties had mostly agreed on rather than letting Teva unilaterally implement its own machine-learning-based document review protocol, suggesting that eDiscovery implementation is a collaborative effort requiring transparency in how document analysis is performed regardless of which technologies are used to conduct the analysis.)

§ 1.2.5. Fourth Circuit

Thaler v. Hirshfeld, 2021 U.S. Dist. LEXIS 167393 (E.D. Va. 2021) (holding that an artificial intelligence machine cannot be considered an “inventor” under the US Patent Act because plain reading of relevant provisions and statutes indicates that inventors must be natural persons.)

TruGreen Ltd. P’ship v. Allegis Global Sols., Inc., 2021 U.S. Dist. LEXIS 33587 (4th Cir. 2021) (granting motions to dismiss counts of negligent misrepresentation and promissory estoppel made based on claims that Defendant failed to perform under the contract. The failure of the defendant’s AI chatbot recruiting tool to perform as defendant promised was one way in which the defendant failed to meet its contractual obligations.)

Sevatec, Inc. v. Ayyar, 102 Va. Cir. 148 (Va. Cir. Ct. 2019). The court noted that matters such as data analytics, artificial intelligence, and machine learning are complex enough that expert testimony is proper and helpful and such testimony does not invade the province of the jury.

§ 1.2.6. Fifth Circuit

Aerotek, Inc. v. Boyd, 598 S.W.3d 373 (Tex. App. 2020). The court expressly acknowledged that one day courts may have to determine whether machine learning and artificial intelligence resulted in software altering itself and inserting an arbitration clause after the fact.

§ 1.2.6.1. Additional Cases of Note

Bertuccelli v. Universal City Studios LLC, No. 19-1304, 2020 U.S. Dist. LEXIS 195295 (E.D. La. 2020) (denying a motion to disqualify an expert who the court concluded was qualified to testify in a copyright infringement case after having performed a “artificial intelligence assisted facial recognition analysis” of the plaintiff’s mask and the alleged infringing mask). But see Bertuccelli v. Universal City Studios LLC, 2021 U.S. Dist. LEXIS 77784 (E.D. La. 2021) (later excluding a portion of the expert witness’s testimony on the basis that plaintiff Bertuccelli failed to timely respond to defendants’ request for additional information about the expert witness’s initial report.)

§ 1.2.7. Sixth Circuit

Cahoo v. Fast Enters. LLC, 508 F. Supp. 3d 162 (E.D. Mich. 2020) (finding that the plaintiff class had sufficiently demonstrated injury-in-fact due to “fraud determinations based on rigid application of UIA’s logic trees coupled with inadequate notice procedures.” The application of the logic trees was too rigid in that such application resulted in significant outcomes—determination of fraud—solely on the basis of plaintiff’s failure to respond to a questionnaire. Whether or not the software using the logic trees constituted artificial intelligence was of little consequence.)

Delphi Auto, PLC v. Absmeier, 167 F. Supp. 3d 868 (E.D. Mich. 2016). Plaintiff employer alleged defendant former employee breached his contractual obligations by terminating his employment with the plaintiff and accepting a job with Samsung in the same line of business. Defendant worked for the plaintiff as director of their labs in Silicon Valley, managing engineers and programmers on work related to autonomous driving. Defendant had signed a confidentiality and Noninterference agreement. The court concluded that the plaintiff had a strong likelihood of success on the merits of its breach of contract claim. Therefore, the court granted the plaintiff’s motion for preliminary injunction with certain modifications (namely, limiting the applicability of the non-compete provision to the field of autonomous vehicle technology for one year because the Court determined that autonomous vehicle technology is a “small and specialized field that is international in scope” and therefore a global restriction was reasonable).

§ 1.2.7.1. Additional Cases of Note

In re C.W., 2019-Ohio-5262 (Oh. Ct. App. 2019) (noting that “[p]roving that an actual person is behind something like a social-networking account becomes increasingly important in an era when Twitter bots and other artificial intelligence troll the internet pretending to be people.”).

§ 1.2.8. Seventh Circuit

King v. PeopleNet Corp., 2021 U.S. Dist. LEXIS 207694 (N.D. Ill. 2021) (remanding plaintiff’s BIPA § 15(a) and (c) claims to state court, and denying defendant’s motion to dismiss plaintiff’s BIPA § 15(b) claim. Re the BIPA § 15(a) and (c) claims, the court found that plaintiff lacked Article III standing because she failed to allege a concrete and particularized injury rather than a general injury not particular to her. Re the BIPA § 15(b) claim, the court found that plaintiff suffered a concrete and particularized injury when defendant, a third-party technology provider, actively collected plaintiff’s biometric facial scans without obtain plaintiff’s informed consent, thereby violating § 15(b).)

Kislov v. Am. Airlines, Inc., 2021 U.S. Dist. LEXIS 194911 (N.D. Ill. 2021) (applying Bryant and Fox, among other cases to hold that plaintiffs lacked Article III standing for their BIPA § 15(a) claim because, like Bryant but unlike Fox, the plaintiffs only alleged that defendant American Airlines “failed to make publicly available any policy addressing its biometric retention and destruction policies” without further alleging a failure to comply with those policies (which the plaintiff in Fox did).^[2] The court remanded the case to state court.)

Jacobs v. Hanwha Techwin Am., Inc., 2021 U.S. Dist. LEXIS 139668 (N.D. Ill. 2021) (dismissing claims brought under BIPA § 15(a), (b), and (d) against a third-party technology manufacturer. Re the BIPA § 15(b) claim, the court found that defendant was not engaged in illegal collection of facial recognition data because it merely manufactured the camera and did not take any active steps to use the camera to collect or retain the data. Re the BIPA § 15(a) and (d) claims, the court found that no evidence to plausibly suggest that defendant, as a mere third-party technology provider, actually possessed or disclosed plaintiff’s biometric data.)

United States v. Bebris, 4 F.4th 551 (7th Cir. 2021) (affirming a district court holding that quashed Bebris’s subpoena made on the basis of an alleged claim that plaintiff’s Fourth Amendment rights were violated and Facebook acted as a government agent when providing results of image recognition analysis to the National Center for Missing and Exploited Children (NCMEC) in compliance with 18 U.S.C. § 2258A(a). The court found that the district court’s holding that Facebook did not act as a government agent was not clearly erroneous because Facebook voluntarily provided the images to the NCMEC (a quasi-governmental organization), no government entity contacted Facebook about Bebris or directed Facebook to take any actions with respect to Bebris, and Facebook had an “independent business purpose in keeping its platform free of child pornography.”)

Hazlitt v. Apple Inc., 2021 U.S. Dist. LEXIS 110556 (S.D. Ill. 2021) (applying Bryant and Fox to hold that plaintiffs had Article III standing for their BIPA § 15(a) and (b) claims, and applying Thornley to hold that plaintiffs lacked Article III standing for their BIPA § 15(c) because they had merely alleged a regulatory violation). Compare Hazlitt v. Apple Inc., 500 F. Supp. 3d 738 (S.D. Ill. 2020) (vacated for reconsideration after the Fox and Thornley decisions published).

Kalb v. Gardaworld Cashlink LLC, 2021 U.S. Dist. LEXIS 81325 (C.D. Ill. 2021) (finding that plaintiff had Article III standing for his BIPA § 15(a) claim because, like Fox and unlike Bryant, plaintiff alleged that not only had defendant failed to publish a data retention and destruction policy, defendant had no such policy at all. Thus, under Fox, plaintiff had alleged a concrete and particularized injury sufficient for Article III standing.)

Stein v. Clarifai, Inc., 2021 U.S. Dist. LEXIS 49516 (N.D. Ill. 2021) (finding no personal jurisdiction for a set of claims alleging that Clarifai violated BIPA § 15 by obtaining images of Illinois users from OKCupid user profiles to use in training facial recognition software. The court found that plaintiff had not alleged sufficient contacts with Illinois to bring a BIPA claim given that the only evidence of Clarifai’s contact with Illinois was obtaining a data set from an investor based in Chicago.)

Wilcosky v. Amazon.com, Inc., 517 F. Supp. 3d 751 (N.D. Ill. 2021) (holding that plaintiffs Wilcosky, Gunderson, and E.G. (a minor) had Article III standing for their BIPA § 15(a) and (b) claims against Amazon’s collection, use, and storage of plaintiffs’ voice biometric data, i.e., “voiceprint,” via the speech and voice recognition capabilities of Amazon’s Alexa virtual assistant. Under Bryant, Amazon’s failure to obtain plaintiffs’ informed consent about Amazon’s collection and storage of their voiceprints was sufficient concrete and particularized injury-in-fact under BIPA § 15(b). Under Fox, Amazon failed to publish and comply with a voiceprint data retention policy, which is a sufficiently concrete and particularized injury under BIPA § 15(a). The court also held that plaintiff Wilcosky’s and Gundersons’ claims were subject to arbitration related to Amazon Alexa given that they had agreed to arbitration when purchasing products from Amazon’s website.)

Thornley v. Clearview AI, Inc., 984 F.3d 1241 (7th Cir. 2021) (affirming that plaintiffs did not have Article III standing to pursue their BIPA § 15(c) claim in federal court against Clearview AI, a facial recognition company that plaintiffs alleged included the plaintiffs’ biometric identifiers or information in Clearview AI’s database. Significantly, the plaintiffs’ only alleged injury was general, statutory aggrievement under BIPA § 15(c). Because the plaintiffs had not alleged a concrete and particularized injury, the court remanded the case back to state court. This case was the court’s first opportunity to consider BIPA § 15(c).)

Fox v. Dakkota Integrated Sys., LLC, 980 F.3d 1146 (7th Cir. 2020) (finding that plaintiff had standing under BIPA § 15(a) because defendant violated plaintiff’s legal right by failing to “comply with data retention and destruction policies—resulting in the wrongful retention of her biometric data after her employment ended, beyond the time authorized by law.” The court distinguished Bryant from this case on the basis that Bryant was focused only on public disclosure of data retention and destruction protocols while this case also relied on an evaluation of compliance with those protocols. Further, the court held that unlawful retention of biometric data was a concrete and particularized injury just like unlawful collection of biometric data.)

Marquez v. Google LLC, 2020 U.S. Dist. LEXIS 199098 (N.D. Ill. 2020) (finding that plaintiff Marquez lacked Article III standing in federal court because he did not plead any particularized harm arising under defendant’s alleged violation of BIPA; rather, he had merely alleged that Google committed a public harm under BIPA § 15(a) by not publishing data retention policies. Thus, under Bryant, the court remanded the § 15(a) claim back to Illinois state court.)

Bryant v. Compass Group USA, Inc., 958 F.3d 617 (7th Cir. 2020). Plaintiff vending machine customer filed class action against vending machine owner/operator, alleging violation of BIPA when it required her to provide a fingerprint scan before allowing her to purchase items. The district court found defendant’s alleged violations were mere procedural violations that cause no concrete harm to plaintiff and therefore remanded the action to state court. The Court of Appeals held that a violation of § 15(a) (requiring development of a written and public policy establishing a retention schedule and guidelines for destroying biometric identifiers and information) of BIPA did not create a concrete and particularized injury and plaintiff therefore lacked standing under Article III to pursue the claim in federal court. In contrast, the Court of Appeals held that a violation of § 15(b) (requiring private entities make certain disclosures and receive informed consent from consumers before obtaining biometric identifiers and information) of BIPA did result in a concrete injury (plaintiff’s loss of the power and ability to make informed decisions about the collection, storage, and use of her biometric information) and therefore she had standing and her claim could proceed in federal court.[3]

Rosenbach v. Six Flags Entertainment Corporation, 129 N.E.3d 1197 (Ill. 2019). Rosenbach is a key Supreme Court of Illinois case answering whether one qualifies as an “aggrieved” person for purposes of BIPA and may seek damages and injunctive relief if she hasn’t alleged some actual injury or adverse effect beyond a violation of her rights under the statute. Plaintiff purchased a season pass for her son to defendant’s amusement park. Plaintiff’s son was asked to scan his thumb into defendant’s biometric data capture system and neither plaintiff nor her son were informed of the specific purpose and length of term for which the son’s fingerprint had been collected. Plaintiff brought suit alleging violation of BIPA. The Supreme Court of Illinois held that an individual need not allege some actual injury or adverse effect, beyond violation of his or her rights under BIPA, to qualify as an “aggrieved” person under the statute and be entitled to seek damages and injunctive relief. The court reasoned that requiring individuals to wait until they’ve sustained some compensable injury beyond violation of their statutory rights before they can seek recourse would be antithetical to BIPA’s purposes. The court found that BIPA codified individuals’ right to privacy in and control over their biometric identifiers and information. Therefore, the court found also that a violation of BIPA is not merely “technical,” but rather the “injury is real and significant.”

§ 1.2.8.1. Additional Cases of Note

Kloss v. Acuant, Inc., 2020 U.S. Dist. LEXIS 89411 (N.D. Ill. 2020) (applying Bryant v. Compass Group (summarized in this chapter) and concluded that the court lacked subject-matter jurisdiction over plaintiff’s BIPA § 15(a) claims because a violation of § 15(a) is procedural and thus doesn’t create a concrete and particularized Article III injury).

Acaley v. Vimeo, 2020 U.S. Dist. LEXIS 95208 (N.D. Ill. June 1, 2020) (concluding that parties made an agreement to arbitrate because defendant provided reasonable notice of its terms of service to users by requiring users to give consent to its terms when they first opened the app and when they signed up for a free subscription plan, but the BIPA violation claim alleged by the plaintiff was not within the scope of the parties’ agreement to arbitrate because the “Exceptions to Arbitration” clause excluded claims for invasion of privacy).

Heard v. Becton, Dickinson & Co., 2020 U.S. Dist. LEXIS 31249 (N.D. Ill. 2020) (concluding that for § 15(b) to apply, an entity must at least take an active step to “collect, capture, purchase, receive through trade, or otherwise obtain” biometric data and the plaintiff did not adequately plead that defendant took any such active step where the complaint omitted specific factual detail and merely parroted BIPA’s statutory language and the plaintiff failed to adequately plead possession because he failed to sufficiently allege that defendant “exercised any dominion or control” over his fingerprint data).

Rogers v. CSX Intermodal Terminals, Inc., 409 F. Supp. 3d 612 (N.D. Ill. 2019) (denying defendant’s motion to dismiss and relied on the Illinois Supreme Court’s holding in Rosenbach (summarized in this chapter) to conclude that plaintiff’s right to privacy in his fingerprint data included “the right to give up his biometric identifiers or information only after receiving written notice of the purpose and duration of collection and providing informed written consent.”).

Neals v. PAR Technology Corp., 419 F. Supp. 3d 1088 (N.D. Ill. 2019) (concluding that the BIPA does not exempt a third-party non-employer collector of biometric information when an action arises in the employment context, rejected defendant’s argument that a third-party vendor couldn’t be required to comply with the BIPA because only the employer has a preexisting relationship with the employees).

Ocean Tomo, LLC v. Patentratings, LLC, 375 F. Supp. 3d 915, 957 (N.D. Ill. 2019) (determining that Ocean Tomo training its machine learning algorithm on PatentRatings’ patent database violated a requirement in a license agreement between the parties that prohibited Ocean Tomo from using the database (which was designated as PatentRatings confidential information) from developing a product for anyone except PatentRatings).

Liu v. Four Seasons Hotel, Ltd., 2019 IL App(1st) 182645, 138 N.E.3d 201 (Ill. 2019) (noting that “simply because an employer opts to use biometric data, like fingerprints, for timekeeping purposes does not transform a complaint into a wages or hours claim.”).

§ 1.2.9. Eighth Circuit

There were no qualifying decisions within the Eighth Circuit.

§ 1.2.10. Ninth Circuit

Klein v. Facebook, Inc., 2021 U.S. Dist. LEXIS 175738 (N.D. Cal. 2021) (resolving disputes between the parties related to the electronically stored information (ESI) protocol to use as part of e-discovery. Notably, the court required the parties to disclose intent to their use technology assisted review (TAR), predictive coding, or machine learning for e-discovery, discuss how those tools would be used, and, if needed, defend the decisions made in using the tools to produce a sufficient set of documents for review. As part of its opinion, the court cited In re Valsartan, Losartan, & Irbesartan Prods. Liab. Litig., 337 F.R.D. 610 (D.N.J. 2020), which was discussed previously in this chapter.)

Gonzalez v. Google LLC, 2 F.4th 871 (9th Cir. 2021) (evaluating multiple complaints alleging that Google and other social media companies such as Facebook and Twitter were directly and secondarily liable for acts of terrorism committed by ISIS because the companies’ platforms facilitated ISIS recruiting and messaging. The court held that the defendants retained publisher immunity under 47 U.S.C.S. § 230. Notably, the court stated that it did “not hold that ‘machine-learning algorithms can never produce content within the meaning of Section 230.’ We only reiterate that a website’s use of content-neutral algorithms, without more, does not expose it to liability for content posted by a third-party. Under our existing case law, § 230 requires this result.” The court also held that the plaintiffs for two of the three complaints failed to state an adequate claim that the companies were liable for aiding and abetting ISIS.)

United States v. Nelson, 2021 U.S. Dist. LEXIS 71421 (N.D. Cal. 2021) (denying a motion to exclude an expert witness’s testimony about the function of an AI-based software program due to Federal Rule 702 and Daubert concerns because expert witnesses do not have to be experts in the algorithms used in certain software to reliably testify about the software’s outputs.)

In re Facebook Biometric Info. Privacy Litig., 522 F. Supp. 3d 617 (N.D. Cal. 2021) (approving a $650 million settlement for the Facebook biometric information privacy litigation, which involved BIPA § 15(a) and (b) claim against Facebook’s collection and retention of Illinois residents’ facial scans (biometric data) for facial recognition purposes.)

Lopez v. Apple, Inc., 519 F. Supp. 3d 672 (N.D. Cal. 2021) (dismissing claims that Apple violated multiple federal and state privacy laws when its artificial intelligence-based virtual assistant “Siri” was accidentally triggered to “listen” to conversations intended to be private. The court held that the plaintiffs lacked Article III standing because their claims were based entirely on a news article that claimed to reveal details about accidental triggering of Siri and resulting subsequent recordings of private conversations. The court also dismissed the each of the plaintiff’s claims for a variety of reasons, including that the plaintiffs’ allegations were conclusory or out of scope of the bounds of a given law.)

Williams-Sonoma, Inc. v. Amazon.com, Inc., 2020 U.S. Dist. LEXIS 163066 (N.D. Cal. 2020) (holding that Williams Sonoma had adequately alleged copyright infringement by Amazon because Amazon’s algorithm selects the “most attractive photos irrespective of rights” and then publishes those photos on its website without input from any other party.)

Patel v. Facebook, Inc., 932 F.3d 1264 (9th Cir. 2019).  Facebook moved to dismiss plaintiff users’ complaint for lack of standing on the ground that the plaintiffs hadn’t alleged any concrete injury as a result of Facebook’s facial recognition technology. The court concluded that BIPA protects concrete privacy interests and violations of BIPA’s procedures actually harm or pose a material risk of harm to those privacy interests.

WeRide Corp. v. Kun Huang, 379 F. Supp. 3d 834 (N.D. Cal. 2019). Autonomous vehicle companies brought, inter alia, trade secret misappropriation claims against former director and officer and his competing company. The court determined the plaintiff showed it was likely to succeed on the merits of its trade secret misappropriation claims where it developed source code and algorithms for autonomous vehicles over 18 months with investments of over $45M and restricted access to its code base to on-site employees or employees who use a password-protected VPN. Plaintiff identified its trade secrets with particularity where it described the functionality of each trade secret and named numerous files in its code base because plaintiff was “not required to identify the specific source code to meet the reasonable particularity standard.”

§ 1.2.10.1. Status of the Vance et al line of cases

(i) Complaints filed in 2020

Vance et al v. Amazon.com, Inc. (W.D. Wa. 2:20-cv-01084); Vance et al v. Facefirst, Inc. (C.D. Cal. 2:20-cv-06244); Vance et al v. Google LLC (N.D. Cal. 5:20-cv-04696); and Vance et al v. Microsoft Corporation (W.D. Wa. 2:20-cv-01082). Chicago residents Steven Vance and Tim Janecyk filed four nearly identical proposed class actions against Amazon.com Inc., Google LLC, Microsoft Corp. and a fourth company called Facefirst Inc., alleging the companies violated Illinois’ Biometric Information Privacy Act by “unlawfully collecting, obtaining, storing, using, possessing and profiting from the biometric identifiers and information” of plaintiffs without their permission. Plaintiffs allege that the tech companies used the dataset containing their geometric face scans to train computer programs how to better recognize faces. These companies, in an attempt to win an “arms race,” are working to develop the ability to claim a low identification error rate. Allegedly, the four tech giants obtained plaintiffs’ face scans by purchasing a dataset created by IBM Corp. (the subject of another suit brought by Janecyk).

Janecyk v. IBM Corp. (Cook County Cir. Ct. Ill. 2020CH00833). IBM Corp. was accused in an Illinois state court lawsuit of violating the state’s biometrics law when it allegedly collected photographs to develop its facial recognition technology without obtaining consent from the subjects to use biometric information. Plaintiff Janecyk, a photographer, said that at least seven of his photos appeared in IBM’s “diversity in faces” dataset. The photos were used to generate unique face templates that recognized the subjects’ gender, age, and race, and were given to third parties without consent.  IBM allegedly created, collected and stored millions of face templates – highly detailed geometric maps of the face – from about a million photos that make up the “diversity in faces” database. Janecyk claimed that IBM obtained the photos from Flickr, a website where users upload their photos. IBM obtained photos depicting people Janecyk has photographed in the Chicago area whom he had assured he was only taking their photos as a hobbyist and that their images wouldn’t be used by other parties or for a commercial purpose. See also Vance v. IBM Corp. (N.D. Ill. 1:20-cv-00577; January 24, 2020) (initial class action complaint); Vance v. IBM (N.D. Ill. 1:20-cv-00577; March 12, 2020) (second amended class action complaint, included both Steven Vance and Tim Janecyk).

(ii) Judicial decisions in 2021

Vance v. Amazon.com Inc., 2021 U.S. Dist. LEXIS 72294 (W.D. Wash. 2021) (denying Amazon’s motion to dismiss the plaintiffs’ BIPA § 15(c) claim and unjust enrichment claim. Re the BIPA § 15(c) claim, the court found that the plaintiffs’ allegations that Amazon’s Recognition software was used by customers such as law enforcement agencies to monitor certain individuals support inferences “that the biometric data is itself so incorporated into Amazon’s product that by marketing the product, it is commercially disseminating the biometric data” and “Amazon received some benefit from the biometric data through increased sales of its improved products.” Nonetheless, the court recognized that additional factual development may reveal that plaintiffs’ allegations are false. Re the unjust enrichment claim, the court applied Illinois law and held that the plaintiffs had sufficiently stated an unjust enrichment claim by alleging increased risk of privacy harm and loss of control over their biometric data, aligning with the Northern District of Illinois District Court’s holding in Vance v. IBM, 2020 U.S. Dist. LEXIS 168610 2020 WL 5530134.)

Vance v. Microsoft Corp., 2021 U.S. Dist. LEXIS 72286 (W.D. Wash. 2021) (applying similar reasoning to Vance v. Amazon.com Inc., 2021 U.S. Dist. LEXIS 72294 to the facts of this case, the court dismissed the plaintiffs’ BIPA § 15(c) claim and denied Microsoft’s motion to dismiss the plaintiff’s unjust enrichment claim. Re the BIPA § 15(c) claim, the court found that the plaintiffs did not allege enough facts to infer that Microsoft “disseminated or shared access to biometric data through its products” or sold the data. Re the unjust enrichment claim, the court applied Illinois law and held that the plaintiffs had sufficiently stated an unjust enrichment claim by alleging increased risk of privacy harm and loss of control over their biometric data, aligning with the Northern District of Illinois District Court’s holding in Vance v. IBM, 2020 U.S. Dist. LEXIS 168610 2020 WL 5530134.)

Vance v. Amazon.com, Inc., 525 F. Supp. 3d 1301 (W.D. Wash. 2021) (holding that there was not enough factual information at that time to (1) dismiss BIPA claims on the basis of extraterritorial effect and (2) determine whether applying BIPA would violate the Dormant Commerce Clause; that BIPA applies to facial scans captured from photographs; and that BIPA § 15(b) applied to downloading biometric data from IBM and using it to improve the downloader’s products. The court requested additional briefing on whether Amazon had profited from the biometric data it possessed and which state law should govern the plaintiffs’ unjust enrichment claim.) See also Vance v. Microsoft Corp., 525 F. Supp. 3d 1287 (W.D. Wash. 2021) (same).

Vance v. Google LLC, 2021 U.S. Dist. LEXIS 27546, *1, 2021 WL 534363 (N.D. Cal. 2021) (granting Google’s motion to stay pending the resolution of Vance v. International Business Machines, Corporation. The court held that the balance of hardships for granting a stay weighed in favor of granting it. The case is stayed until the earlier of February 12, 2022 and the resolution of the IBM action.) Vance v. Facefirst, Inc., 2021 U.S. Dist. LEXIS 212756, *1, 2021 WL 5044010 (C.D. Cal. 2021) (similar reasoning, except the case is stayed until the earlier of February 11, 2022 and the resolution of the IBM action).

Vance v. IBM, 2020 U.S. Dist. LEXIS 168610 2020 WL 5530134 (N.D. Ill. 2020) (among other holdings, the court denied IBM’s motion to dismiss plaintiff’s BIPA claim. The court rejected IBM’s argument that “BIPA expressly excludes photographs and biometric information derived from photographs.”)

§ 1.2.10.2. Additional Cases of Note

Hatteberg v. Capital One Bank, N.A., No. SA CV 19-1425-DOC-KES, 2019 U.S. Dist. LEXIS 231235 (C.D. Cal. Nov. 20, 2019) (relying on advances in technology, including use of artificial intelligence to “deepfake” audio as a basis for denying defendant’s argument that a plaintiff must plead to a higher standard alleging specific indicia of automatic dialing to survive a motion to dismiss in a Telephone Consumer Protection Act case).

Williams-Sonoma, Inc. v. Amazon.com, Inc., No. 18-cv-07548-EDL, 2019 U.S. Dist. LEXIS 226300, at *36 (N.D. Cal. May 2, 2019) (denying Amazon’s motion to dismiss Williams-Sonoma’s service mark infringement case noting “it would not be plausible to presume that Amazon conducted its marketing of Williams-Sonoma’s products without some careful aforethought (whether consciously in the traditional sense or via algorithm and artificial intelligence).”

Nevarez v. Forty Niners Football Co., LLC, No. 16-cv-07013-LHK (SVK), 2018 U.S. Dist. LEXIS 182255 (N.D. Cal. Oct. 16, 2018) (determining that protections exist such as protective orders and the Federal Rules of Evidence that prohibit a party from using artificial intelligence to identify non-responsive documents without identifying a “cut-off” point for some manner of reviewing the alleged non-responsive documents).

§ 1.2.11. Tenth Circuit

There were no qualifying decisions within the Tenth Circuit.

§ 1.2.12. Eleventh Circuit

There were no qualifying decisions within the Eleventh Circuit.

§ 1.2.13. DC Circuit

Elec. Privacy Info. Ctr. v. Nat’l Sec. Comm’n on Artificial Intelligence, No. 1:19-cv-02906 (TNM), 2020 U.S. Dist. LEXIS 95508 (D.D.C. June 1, 2020).  The court concluded that the National Security Commission on Artificial Intelligence is subject to both the Freedom of Information Act and the Federal Advisory Committee Act.

§ 1.2.14. Court of Appeals for the Federal Circuit^[4]

McRO, Inc. v. Bandai Namco Games America, Inc., 837 F.3d 1299 (Fed. Cir. 2016). Patent litigation over a patent which claimed a method of using a computer to automate the realistic syncing of lip and facial expressions in animated characters. The plaintiff owners of the patents brought infringement actions and defendants argued the claims were unpatentable algorithms that merely took a preexisting process and make it faster by automating it on a computer. The court held that the patent claim was not directed to ineligible subject matter where the claim involved the use of automation algorithms and was specific enough such that the claimed rules would not prevent broad preemption of all rules-based means of automating facial animation.

§ 1.3. Legislation

We organize the enacted and proposed legislation into (i) policy (e.g., executive orders); (ii) algorithmic accountability (e.g., legislation aimed at responding to public concerns regarding algorithmic bias and discrimination); (iii) facial recognition; (iv) transparency (e.g., legislation primarily directed at promoting transparency in use of AI); and (v) other (e.g., other pending bills such as federal bills on governance issues for AI).

§ 1.4. Policy

§ 1.4.1. 2021

• [Fed] National Artificial Intelligence Initiative Office (Jan. 2021) Established pursuant to the National Artificial Intelligence Initiative Act of 2020 to lead AI education, research, and development efforts on behalf of the Executive Branch.
• [Fed] Request for Information and Comment on Financial Institutions’ Use of Artificial Intelligence, Including Machine Learning (Mar. 2021). Initiative by federal agencies to research use of AI and machine learning by financial institutions.
• [Fed] Aiming for truth, fairness, and equity in your company’s use of AI (Apr. 2021). Guidance from the FTC about ensuring truth, fairness, and equity when using AI.
• [Fed] Launch of the National Artificial Intelligence Research Resource Task Force (Jun. 2021). Established pursuant to the National Artificial Intelligence Initiative Act of 2020 to develop a roadmap for US AI research.
• [Fed] Call for Nominations to Serve on the National Artificial Intelligence Advisory Committee and Call for Nominations To Serve on the Subcommittee on Artificial Intelligence and Law Enforcement (Sep. 2021). Establishing the National Artificial Intelligence Advisory Committee (NAIAC) pursuant to the National Artificial Intelligence Initiative Act of 2020, to be comprised of members from academic institutions, private companies, nonprofit organizations, and Federal laboratories to help guide US AI education, research, and development efforts.
• [Fed] Notice of Request for Information (RFI) on Public and Private Sector Uses of Biometric Technologies (Oct. 2021). Inviting public comment on use of biometric technologies for purposes related to identification and inference of individual attributes.
• [Fed] U.S. Equal Employment Opportunity Commission Initiative on Artificial Intelligence and Algorithmic Fairness (Oct. 2021). Researching use and impact of AI in hiring and other employment decisions.

§ 1.4.2. 2020

• [Fed] Maintaining Am Leadership in Al (Feb 2019). Executive order 13859 (Feb. 2019) launching “American AI Initiative” intended to help coordinate federal resources to support development of AI in the US
• [Fed] H R Res 153 (Feb 2019). Legislation to support the development of guidelines for ethical development of artificial intelligence.
• [Fed / NIST] US Leadership in Al (Aug 2019). NIST to establish standards to support reliable, robust, and trustworthy AI.
• [Cal] Res on 23 Asilomar Al Principles (Sep 2018). Adopted state resolution ACR 215 (Sept. 2018) expressing legislative support for the Asilomar AI Principles as “guiding values” for AI development.

§ 1.5. Algorithmic Accountability

§ 1.5.1. 2021

• [Fed] Algorithmic Justice and Online Platform Transparency Act. Bills H.R.3611, S.1896 (In committee May 2021). Seeks to prevent discrimination by algorithmic processes and increase algorithmic transparency.
• [CA] Automated Decision Systems Accountability Act. Bill A.B. 13 (In committee Aug. 2021). Restricts state agencies’ use of automated decision-making systems to avoid algorithmic discrimination.
• [CO] Restrict Insurers’ Use Of External Consumer Data. Bill S.B. 169 (Enacted Jul. 2021). Prohibits algorithmic discrimination in insurance practices.
• [IL] Video Interview Demographic. Bill H.B. 53 (Effective Jan. 2022). Seeks to avoid algorithmic discrimination in first-pass hiring interviews conducted using AI.
• [MA] An Act Establishing a Commission on Automated Decision-Making By Government in the Commonwealth. Bill H.119 (similar to S.60) (In committee Mar. 2021). Establishes a committee to help prevent algorithmic discrimination and improve algorithmic transparency in state agencies’ use of automated decision systems.
• [MA] An Act Related to Data Privacy. Bill H.136 (In committee Mar. 2021). Proposes a state data privacy law that includes creating a Massachusetts Data Accountability and Transparency Agency and ensuring algorithmic accountability.
• [MA] An Act Establishing the Massachusetts Information Privacy Act. Bill H.142 (In committee Mar. 2021). Proposes a state data privacy law that includes restrictions on covered entities’ and data processors’ processing of personal information and use of automated decision systems; and provides data rights for subjects.
• [MI] Michigan employment security act. Bill H.B. 4439 (In committee Mar. 2021). Requires auditing the source code, algorithms, and logic formulas of the unemployment agency computer systems.
• [NJ] Prohibits certain discrimination by automated decision systems. Bill S.B. 1943 (Introduced Feb. 2020). Prohibits algorithmic discrimination with respect to the provision of financial services, insurance, and healthcare services.
• [VT] An act relating to State development, use, and procurement of automated decision systems. Bill H.263 (In committee Feb. 2021). Requires Secretary of Digital Services to ensure automated decision systems used by the State do not lead to algorithmic discrimination.
• [VT] An act relating to the creation of the Artificial Intelligence Commission. Bill H.410 (In committee Mar. 2021). Establishes commission to promote ethical AI use and development.
• [VT] An act relating to establishing an advisory group to address bias in State-used software. Bill H.429 (In committee Mar. 2021). Seeks to prevent bias in software.

§ 1.5.2. 2020

• [Fed] Algorithmic Accountability Act (Apr 2019). Bills S 1108, HR 2231 (Apr. 2019) intended to require “companies to regularly evaluate their tools for accuracy, fairness, bias, and discrimination.”
• [NJ] New Jersey Algorithmic Accountability Act (May 2019). Require that certain businesses conduct automated decision system and data protection impact assessments of their automated decision system and information systems.
• [CA] AI Reporting (Feb 2019). Require California business entities with over 50 employees and associated contractors and venders to each maintain a written record of the data used relating to any use of artificial intelligence for the delivery of the product or service to the public entity.
• [WA] Guidelines for Gov’t Procurement and Use of Auto Decision Systems (Jan 2019). Establish guidelines for government procurement and use of automated decision systems in order to protect consumers, improve transparency, and create more market predictability.
• [NY] NYC (Jan 2018). —“A Local Law in relation to automated decision systems used by agencies” (Int. No. 1696-2017) required the creation of a task force for providing recommendations on how information on agency automated decision systems may be shared with the public and how agencies may address situations where people are harmed by such agency automated decision systems.

§ 1.6. Facial Recognition Technology

§ 1.6.1. 2021

• [Fed] Facial Recognition and Biometric Technology Moratorium Act of 2021. Bill S.2052 (In committee Jun. 2021). Requires Federal agencies or officials to receive Congressional approval (i.e., legislation) to use biometric surveillance systems or information derived therefrom.

§ 1.6.2. 2020

• [Fed] Commercial Facial Recognition Privacy Act (Mar 2019). Bill S 847 (Mar. 2019) intended to provide people info and control over how their data is shared with companies using facial recognition tech.
• [Fed] FACE Protection Act (July 2019). Restrict Federal government from using a facial recognition technology without a court order.
• [Fed] No Biometric Barriers to Housing Act (July 2019). Prohibiting owners of certain federally assisted rental units from using facial recognition, physical biometric recognition, or remote biometric recognition technology in any units, buildings, or grounds of such project.
• [CA] Body Camera Account Act (Feb 2019). Bill A.B. 1215 was introduced to prohibit law enforcement agencies and officials from using any “biometric surveillance system,” including facial recognition technology, in connection with an officer camera or data collected by the camera.
• [MA] An Act Establishing a Moratorium on Face Recognition (Jan 2019). Senate Bill 1385 was introduced to establish a moratorium on the use of face recognition systems by state and local law enforcement.
• [NY] Prohibits Use of Facial Recog. Sys. (May 2019). Senate Bill 5687 was introduced to propose a temporary stop to the use of facial recognition technology in public schools.
• [SF and Oakland, CA]City ordinances were passed to ban the use of facial recognition software by the police and other government agencies.(June, July 2019).
• [Somerville, MA] City ordinance was passed to ban the use of facial recognition technology by government agencies (July 2019).

§ 1.7. Transparency

§ 1.7.1. 2021

• [Fed] Mind Your Own Business Act of 2021. Bill S.1444 (In committee Apr. 2021). Seeks to prevent algorithmic bias in high-risk information systems and automated-decision systems, and enables consumers to opt out of tracking by covered entities.
• [Fed] Filter Bubble Transparency Act. Bill S.2024 (In committee Jun. 2021). Requires online platform operators that use algorithms to customize what users see to allow users to opt out of the use of those algorithms.
• [Fed] GOOD AI Act of 2021. Bill S.3035 (In committee Oct. 2021). Establishes AI Hygiene Working Group to ensure that Federal acquisition contracts for AI ensure protection of privacy, civil rights, civil liberties, and data security.
• [WA] Establishing guidelines for government procurement and use of automated decision systems in order to protect consumers, improve transparency, and create more market predictability. Bill S.B. 5116 (In committee Feb. 2021).

§ 1.7.2. 2020

• [CA] BOT Act – SB 1001 (effective July 2019). Enacted bill SB 1001 (eff. July 2019) intended to “shed light on bots by requiring them to identify themselves as automated accounts.”
• [CA] Anti-Eavesdropping Act (Assemb. May 2019). Prohibiting a person or entity from providing the operation of a voice recognition feature within the state without prominently informing the user during the initial setup or installation of a smart speaker device. 
• [IL] Al Video Interview Act (effective Jan 2020). Provide notice and explainability requirements for recorded video interviews.

§ 1.8. Other

§ 1.8.1. 2021

• [Fed] Democracy Technology Partnership Act. Bill S.604 (In committee Mar. 2021). Seeks to develop international partnerships to develop regimes for technology governance, including for AI and machine learning.
• [Fed] Information Transparency & Personal Data Control Act. Bill H.R. 1816 (In committee Mar. 2021). Requires Federal Trade Commission to regulate the protection of sensitive personal information.
• [Fed] AI Scholarship-for-Service Act. Bill S.1257 (In committee Apr. 2021). Creates Federal scholarship to develop AI professionals in government.
• [Fed] Consumer Data Privacy and Security Act of 2021. S. 1494 (In committee Apr. 2021). Federal data protection law.
• [Fed] Artificial Intelligence Capabilities and Transparency (AICT) Act of 2021. Bill S.1705 (Introduced May 2021). Seeks to promote research and development of AI in the US for economic and national security purposes.
• [Fed] Artificial Intelligence for the Military Act of 2021. Bill S.1776 (Introduced May 2021). Requires AI training for certain military personnel.
• [Fed] Next Generation Computing Research and Development Act of 2021. Bill H.R.3284 (In committee May 2021). Promotes Department of Energy research in advanced scientific computing.
• [Fed] SELF DRIVE Act. Bill H.R.3711 (In committee Jun. 2021). Regulates highly automated vehicles to ensure their safe operation.
• [Fed] Consumer Safety Technology Act. Bill H.R.3723 (Passed House Jun. 2021). Requires various Federal agencies to research impact of technologies such as AI and blockchain on consumer product safety and protection.
• [Fed] United States Innovation and Competition Act of 2021. Bill S.1260, H.R.2731 (Passed Senate Jun. 2021). Creates a Directorate for Technology and Innovation in the National Science Foundation tasked with promoting research, innovation, and commercialization of technologies such as AI.
• [Fed] Fellowships and Traineeships for Early-Career AI Researchers Act. Bill H.R.3844 (In committee Jun. 2021). Provides financial support, via university traineeships, to graduate students studying AI.
• [Fed] Data Protection Act of 2021. Bill S.2134 (In committee Jun. 2021). Creates a Federal Data Protection Agency that, among other things, will research and analyze the use of automated decision systems in collecting and processing personal data.
• [Fed] AI for Agency Impact Act. Bill H.R.4468 (In committee Jul. 2021). Requires Executive agencies to implement trustworthy-AI strategies and implementation plans.
• [Fed] AI in Counterterrorism Oversight Enhancement Act. Bill H.R.4469 (In committee Jul. 2021). Enables the Privacy and Civil Liberties Oversight Board to oversee use of AI for counterterrorism.
• [Fed] SAFE DATA Act. Bill S.2499 (In committee Jul. 2021). Federal data protection law.
• [Fed] Intelligence Authorization Act for Fiscal Year 2022. Bill S.2160. (introduced Aug. 2021). Director of National Intelligence to develop modern digital ecosystem plan that includes use of AI for intelligence purposes.
• [Fed] Digital Defense Leadership Act. Bill H.R.4985 (In committee Aug. 2021). Implements National Security Commission on Artificial Intelligence recommendations, including for AI research, development, and use.
• [Fed] Deepfake Task Force Act. Bill S.2559 (In committee Aug. 2021). Creates task force to research and propose methods to reduce digital content forgeries.
• [Fed] Department of Defense Artificial Intelligence Metrics Act of 2021. Bill S.2904 (In committee Sep. 2021). Creates performance objectives and metrics for AI implementation by the Department of Defense.
• [Fed] Healthy Technology Act of 2021. Bill H.R.5467 (In committee Sep. 2021). Allows AI and machine learning technologies to prescribe drugs if approved by the relevant State and the Food and Drug Administration.
• [Fed] United States–Israel Artificial Intelligence Center Act. Bill H.R.5148, S.2120 (In committee Oct. 2021). Promotes AI research and development partnership between US and Israel.
• [Fed] AI Training Act. Bill S.2551 (Introduced Oct. 2021). Requires AI training for certain Executive Branch employees.
• [Fed] Financial Transparency Act of 2021. Bill H.R.2989 (In committee Oct. 2021). Seeks to improve and standardize regulation-imposed financial data collection to, among other things, enable more effective use of AI.
• [Fed] Protecting Sensitive Personal Data Act of 2021. Bill (Introduced Oct. 2021). Empower Committee on Foreign Investment in the United States to regulate the security of sensitive personal information.
• [Fed] Infrastructure Investment and Jobs Act. Bill H.R.3684 (Enacted Nov. 2021). Provides funding for assessing the use of AI and machine learning in mining research and development activities, digital climate solutions, and in manufacturing.
• [AL] Technology, Alabama Council on Advanced Technology, estab., to advise Governor and Legislature, members, duties. Bill S.B. 78 (Passed Apr. 2021). Creates council that advises Alabama’s Governor and Legislature about advanced technology and AI.
• [HI] Relating To Taxation. Bill H.B. 454 (Introduced Jan. 2021). Provide income tax credit for investment in cybersecurity and AI development businesses.
• [IL] Future of Work Task Force. Bill H.B. 645 (Effective Aug. 2021). Creates a task force to study how to help Illinois workers adapt to new technologies such as AI.
• [MS] Computer science curriculum; require State Department of Education to implement in K-12 public schools.. Bill HB 633 (Effective Jul. 2021). Mandates K-12 computer science education in Mississippi, including about AI.
• [NC] An Act to Establish the Study Committee on Automation and the Workforce. Bill S.B. 600 (Introduced Apr. 2021). Creates committee that researches how to help workers adapt to new technologies such as AI.
• [NJ] Requires Commissioner of Labor and Workforce Development to conduct study and issue report on impact of artificial intelligence on growth of State’s economy. Bill A.B. 195 (Received in Senate after passing Assembly Mar 2021).
• [NJ] Establishes Edison Innovation Science and Technology Fund in EDA to provide grants for certain science and technology-based university research; appropriates $5 million. Bill A.B. 2172 (In committee Jan. 2020). Includes grants for AI research.
• [NJ] 21st Century Integrated Digital Experience Act. Bill A.B. 2614, S.B. 2723 (In committee(?) Feb. 2021). Requires State Executive Branch to leverage new technologies such as AI and machine learning to modernize government service delivery.
• [NY] Establishes the commission on the future of work. Bill A.B. 2414 (In committee Jan. 2021). Creates commission that researches how to help workers adapt to new technologies such as AI
• [VA] Consumer Data Protection Act. Bills S.B. 1392, H.B. 2307 (Enacted Mar. 2021). Virginia data protection law. 

§ 1.8.2. 2020

• [Fed] FUTURE of Al Act (Dec 2017). Requiring the Secretary of Commerce to establish the Federal Advisory Committee on the Development and Implementation of Artificial Intelligence.
• [Fed] Al JOBS Act (Jan 2019). Promoting a 21st century artificial intelligence workforce.
• [Fed] GrAITR Act (Apr 2019). Legislation directed to research on cybersecurity and algorithm accountability, explainability, and trustworthiness.
• [Fed] Al in Government Act (May 2019). Instructing the General Services Administration’s AI Center of Excellence to advise and promote the efforts of the federal government in developing innovative uses of AI to benefit the public, and improve cohesion and competency in the use of AI.
• [Fed] Al Initiative Act (May 2019). Requiring federal government activities related to AI, including implementing a National Artificial Intelligence Research and Development Initiative.

[1] In addition to the Federal cases we note, a number of states are dealing with similar evidentiary and explanability issues. See, e.g., Green v. Geico Gen. Ins. Co., No. : N17C-03-242 EMD CCLD, 2021 Del. Super. LEXIS 308 (Super. Ct. Mar. 24, 2021) (granting declaratory relief to plaintiff due to GEICO’s use of automated, rules-based insurance claims analysis tools that were based on “antiquated” rules; the court stated, “until…a system [with rules updated based on relevant case law] is in place, human judgment should not be eliminated from the process.” Note that the court was careful not to “eliminat[e] the ability for insurers to use automated systems to make the claims process more efficient” but wanted those systems to be based on up-to-date rules.); R.L.G. v. State, 322 So. 3d 721 (Fla. Dist. Ct. App. 2021) (holding that a statement made by a machine without any facts provided about how that statement was made (automatically, with human input or interpretation, etc.) was inadmissible hearsay on appeal because the facts on the record did not support a determination otherwise.); People v. Reyes, 2020 NY Slip Op 20258, 69 Misc. 3d 963, 133 N.Y.S.3d 433 (Sup. Ct.) (denying defendant’s motion to preclude testimony that was based on the use of facial recognition software to identify defendant. The court observed that the use of and reliability of facial recognition to date suggested that facial recognition is among “a growing number of scientific and near-scientific techniques that may be used as tools for identifying or eliminating suspects, but that do not produce results admissible at a trial.”); Matter of Phila. Ins. Indem. Co. v. Kendall, 197 A.D.3d 75, 2021 N.Y. App. Div. LEXIS 4393, 2021 NY Slip Op 04284, 151 N.Y.S.3d 392 (observing, “Just as a party may attack a hardcopy settlement offer or acceptance as a forgery, a party that claims an email was the product of a hacker (or of artificial intelligence, or of some other source) may rebut its authenticity.”)).

[2] Demonstrating the wealth of caselaw that has developed related to Bryant and Fox, the court cited as supporting cases “Roberson v. Maestro Consulting Servs. LLC, 507 F. Supp. 3d 998, 1008 (S.D. Ill. 2020) (denying motion to remand Section 15(a) claim where plaintiff alleged that defendant failed to comply with its retention schedule and destruction guidelines); Marsh v. CSL Plasma Inc., 503 F. Supp. 3d 677, 682-83 (N.D. Ill. 2020) (same); Neals v. ParTech, Inc., No. 19-cv-05660, 2021 U.S. Dist. LEXIS 24542, 2021 WL 463100, at *5 (N.D. Ill. Feb. 9, 2021) (same); Heard v. Becton, Dickinson & Co., 2021 U.S. Dist. LEXIS 44160, 2021 WL 872963, at *3-4 (N.D. Ill. Mar. 9, 2021) (same); Wilcosky v. Amazon.com, Inc., 517 F. Supp. 3d 751, 761-62 (N.D. Ill. 2021) (same); Hazlitt v. Apple Inc., 2021 U.S. Dist. LEXIS 110556, 2021 WL 2414669, at *4-5 (S.D. Ill. June 14, 2021) (same); Fernandez v. Kerry, Inc., No. 17-cv-08971, 2020 U.S. Dist. LEXIS 223075, 2020 WL 7027587, at *7-8 (N.D. Ill. Nov. 30, 2020) (concluding that plaintiffs had standing to bring Section 15(a) claims against their employer not only because they alleged unlawful retention of their biometric data, but also because union members have a concrete interest in collective bargaining over biometric data usage) (citing Miller v. Southwest Airlines Co., 926 F.3d 898, 902 (7th Cir. 2019).”).

[3] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted certain BIPA cases that did not add any additional information to those we have presented in this Chapter. See, e.g., Darty v. Columbia Rehabilitation and Nursing Center, LLC, 2020 U.S. Dist. LEXIS 110574 (N.D. Ill. 2020); Figueroa v. Kronos Incorporated, 2020 U.S. Dist. LEXIS 64131 (N.D. Ill. 2020); Namuwonge v. Kronos, Inc., 418 F. Supp. 3d 279 (N.D. Ill. 2019); Treadwell v. Power Solutions International Inc., 427 F. Supp. 3d 984 (N.D. Ill. 2019); Kiefer v. Bob Evans Farm, LLC, 313 F. Supp. 3d 966 (C.D. Ill. 2018); Rivera v. Google Inc., 238 F. Supp. 3d 1088 (N.D. Ill. 2017); In re Facebook Biometric Information Privacy Litigation, 185 F. Supp. 3d 1155 (N.D. Cal. 2016); Norberg v. Shutterfly, Inc., 152 F. Supp. 3d 1103 (N.D. Ill. 2015).

[4] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted several patent cases directed to subject-matter eligibility that we felt did not substantive additional insight to those we have presented in this Chapter. See, e.g., Kaavo Inc. v. Amazon.com Inc., 323 F. Supp. 3d 630 (D. Del. 2018); Hyper Search, LLC v. Facebook, Inc., No. 17-1387, 2018 U.S. Dist. LEXIS 212336 (D. Del. Dec. 18, 2018); Purepredictive, Inc. v. H20.AI, Inc., No. 17-cv-03049, 2017 U.S. Dist. LEXIS 139056 (N.D. Cal. Aug. 29, 2017); Power Analytics Corp. v. Operation Tech., Inc., No. SA CV16-01955 JAK, 2017 U.S. Dist. LEXIS 216875 (C.D. Cal. July 13, 2017); Nice Sys. v. Clickfox, Inc., 207 F. Supp. 3d 393 (D. Del. 2016); eResearch Tech., Inc. v. CRF, Inc., 186 F. Supp. 3d 463 (W.D. Pa. 2016); Neochloris, Inc. v. Emerson Process Mgmt. LLP, 140 F. Supp. 3d 763 (N.D. Ill. 2015).