For lenders dealing with troubled loans, a loan workout agreement is often a great first step to address a tricky situation. A loan workout agreement may be a simple short-term standstill agreement, a mechanism to implement a long-term solution to the borrower’s woes, or a path toward a palatable exit strategy to the relationship. Loan workout agreements, which often take the form of a loan modification agreement or forbearance agreement, may include, among other things, modifications to payment terms, forbearance from exercising certain rights and remedies, pledges of additional collateral, or an agreement to liquidate existing collateral.
Obligors often welcome such an agreement, which can afford them breathing room to get back on the path to compliance. Nonetheless, defaults may nonetheless persist. Two recent decisions from the Tenth and Fifth Circuits illustrate that, even when a workout fails, a well-drafted workout agreement can provide lenders protection against lender liability claims once the relationship turns adversarial.
I. Twiford Enterprises, Inc. v. Rolling Hills Bank & Trust, No. 20-8048, 2021 WL 2879126 (10th Cir. July 9, 2021)
In this case, the borrower operated a cattle ranching business in Wyoming. The borrower refinanced its cattle loans with a new lender, who later convinced the borrower to refinance its real estate loans with the lender the following year.
Thereafter, the lender stopped advancing funds to the borrower on the cattle loans, and those loans went into default. Over the next year, the lender and the borrower entered into several loan modification agreements and forbearance agreements to revise payment terms, extend maturity dates, and provide for additional credit advances. Crucially, all the modification and forbearance agreements contained releases or waiver provisions in which the borrower and the guarantors waived any claims or defenses relating to the loans.
The borrower later filed a Chapter 11 bankruptcy petition, and the guarantors filed an adversary complaint against the lender, alleging breach of contract, breach of the implied covenant of good faith and fair dealing, negligence, fraud, and negligent misrepresentation. The guarantors claimed that the lender misrepresented its confidence in the borrower’s business to induce it to refinance its real estate loan and then the lender manufactured a default.
The trial court granted summary judgment in favor of the lender based primarily on the applicable statute of frauds, but it also held that regardless of the statute of frauds, the claims would be barred by the releases contained in the forbearance agreements.
On appeal, the guarantors did not argue that their claims fell outside of the releases’ scope. Instead, the guarantors asserted that the releases were not enforceable because they were wrongfully obtained through economic duress.
The Tenth Circuit affirmed the trial court’s ruling, noting that under applicable state law, an alleged victim of duress may not obtain part of the benefits of an agreement and disavow the rest. Since the guarantors obtained valuable concessions in connection with the forbearance agreements, such as credit advances, the Court held that they could not evade the releases under an economic duress theory.
II. Lockwood International, Inc. v. Wells Fargo Bank, N.A., No. 20-40324, 2021 WL 3624748 (5th Cir. Aug. 16, 2021)
In this case, the borrower companies obtained two sizable lines of credit from their lenders. Within a year, the borrowers breached some of their obligations. Thereafter, the parties agreed to modify the lines of credit. In connection with the modification, the borrowers’ sole owner executed a personal guaranty. Also, at the lenders’ urging, the borrowers hired a chief restructuring officer (CRO).
Despite the loan modification and the appointment of a CRO, the borrowers’ struggles persisted. The lenders grew frustrated, believing that the borrowers and the guarantor did not fully empower the CRO to address the borrowers’ financial issues. The lenders gave the obligors an ultimatum: fully empower the CRO to operate or right-size the business within 48 hours or face an acceleration of the debt. The obligors agreed, but still defaulted on a sizable loan payment. To stave off acceleration, the obligors then executed a forbearance agreement in which they confirmed that the amended loan agreements were valid and enforceable, and waived and released the lenders from all claims. Before this forbearance period expired, the obligors executed a second forbearance agreement, which contained the same confirmation of the debt and releases in favor of the lender.
After the second forbearance agreement expired, the lenders accelerated the debt. This acceleration led to litigation among the parties that eventually was pared down to the lenders’ breach of guaranty claim against the guarantor.
In his defense, the guarantor claimed the lenders engaged in a bait-and-switch scheme to obtain his guaranty and then install the CRO to control the business. Claiming that he only agreed to execute the guaranty and forbearance agreements under intense business pressure, the guarantor asserted affirmative defenses of fraudulent inducement and duress, both of which were rejected by the trial court on summary judgment.
On appeal, the Fifth Circuit noted that because the guarantor ratified his guaranty in connection with the forbearance agreements, the guarantor would need to invalidate the forbearance agreements before he could escape liability. The court found no basis to support a fraudulent inducement defense since the guarantor signed the first forbearance agreement after he already agreed to cede control over the companies to the CRO.
The Court also held that the guarantor’s duress defense lacked merit. The guarantor argued that he only agreed to relinquish control to the CRO and execute the forbearance agreements because the lenders threatened to accelerate the loans. The court rejected this defense, noting that duress requires a threat of unauthorized action. The lenders were authorized to accelerate the loans and were simply using their leverage to extract a concession that they desired (i.e., installing the CRO). The court further noted that “difficult economic circumstances do not alone give rise to duress.” Indeed, the Court opined that loan modifications would become rare if a borrower could later invalidate the agreement because of the economic pressure that precipitated the modification in the first place.
III. Takeaways
While the crush of loan delinquencies that we feared at the outset of the pandemic has not materialized, many observers believe that defaults and resulting workout volume will increase once government support and intervention wane. Lenders can expect that at least some of their borrowers will assert lender liability claims in the face of enforcement efforts.
To that end, these recent decisions offer a compelling reminder that a well-crafted workout agreement can serve multiple purposes. On the one hand, workout agreements are great opportunities for lenders to develop retention or non-retention strategies for troubled loans. On the other hand, even if the workout strategy fails, these agreements can help mitigate potential exposure to lender liability claims. Moreover, as the Lockwood case illustrates, so long as a lender is acting within the bounds of its loan agreement authority, it may elect to apply its leverage to obtain valuable concessions from a troubled borrower in a workout scenario.
The Boeing Company Derivative Litigation evidences the increased focus on director responsibilities for effective governance. That focus is being driven by investors, other stakeholders, regulators, and—as the Boeing case makes clear—growing litigation risk. In November, Boeing’s board agreed to a $237.5 million settlement in a shareholder lawsuit that alleged board failures in overseeing the company and the safety of its 737 MAX ahead of fatal crashes in 2018 and 2019. The case emphasizes the need to ensure the existence of substantive checks and balances in board governance and to explore opportunities to create governance structures with a harder edge. Such structures can aid in ensuring proper communication and operational interaction between the board, management and others.
In assessing the Boeing Company Derivative Litigation through this lens, we begin with an examination of Delaware Court of Chancery Vice Chancellor Morgan T. Zurn’s September 7, 2021, memorandum opinion in the litigation and her findings regarding Director failures. We then turn to identifying and addressing these fundamental governance breakdowns.
I. MEMORANDUM OPINION, 9/7/21, VICE CHANCELLOR ZURN
Vice Chancellor Zurn sets out in her opinion:
“The narrow question before this Court today is whether Boeing’s stockholders have alleged that a majority of the Company’s directors face a substantial likelihood of liability for Boeing’s losses. This may be based on the directors’ complete failure to establish a reporting system for airplane safety, or on their turning a blind eye to a red flag representing airplane safety problems. I conclude the stockholders have pled both sources of board liability. The stockholders may pursue the Company’s oversight claim against the board.”
In her opinion, the Vice Chancellor stated, “The Board publicly lied about if and how it monitored the 737 MAX’s safety.” The opinion cites 2019 interviews of the Board’s Lead Director, David Calhoun, who became the CEO of Boeing in January 2020, and certain representations he made regarding the 2018 Lion Air crash and the 2019 Ethiopian Airlines crash. The Vice Chancellor’s opinion states, “Each of Calhoun’s representations was false.”
Shortly after the opinion was issued, Boeing’s CEO and other current and former directors asked the Vice Chancellor to clarify her legal opinion that she found the Board “publicly lied.” Those defendants have now settled the case, pending court approval. The finding that they “publicly lied” will be a continuing cloud to be addressed on multiple fronts within and outside of litigation.
II. IDENTIFYING AND ADDRESSING FUNDAMENTAL GOVERNANCE BREAKDOWNS
The Vice Chancellor’s finding of “the directors’ complete failure to establish a reporting system for airplane safety” and her finding of “their turning a blind eye to a red flag representing airplane safety problems” are indicative of a board operating in a “tone at the top” framework where the board may be dictated to/largely directed by the CEO. As we have previously set out,[1] what is required instead of a “tone at the top” approach is a governance structure that incorporates transparency and substantive “checks and balances.” This is not a new concept; members of the board of advisors of Grace & Co. and other experienced business decision-makers addressed it years ago.[2] Yet, a board’s perception of its role as only that of oversight, and at times limited oversight, persists at many boards, often with the support or dictates of the CEO.
To the contrary, boards can make use of internal resources to ensure the boards have access to that information necessary to address their responsibilities. We have discussed the value of these internal resources to boards[3] and recognize that boards can also call on external resources.
Under the proposed $237.5 million agreement to settle the litigation, Boeing’s board has agreed to add a director with safety experience and has adopted other internal measures, such as creating an ombudsperson program to field certain internal complaints. Boeing has agreed to ensure that at least three directors have safety expertise. It may be that the relationship between those board members, and perhaps other board members, and management will be an ongoing interactive relationship where the company can draw on the talents and experience of those board members.
An example of board members participating in addressing management responsibilities arose when Michael Eisner, the CEO of Walt Disney, utilized the chairman of Disney’s compensation committee and another experienced director to handle the employment negotiations with Michael Ovitz and his advisers.[4] Such an interactive relationship between certain directors and members of management helps ensure the quality of the flow of information to the Board and is demonstrative of the nature of the working relationships/checks and balances between the board and management.
III. THE ECONOMICS OF CORPORATE GOVERNANCE
The economics of organization governance point to the responsibilities of ownership and its agents for the governance, oversight, and management of the organization. The board of directors, as owners or agents for ownership, bear the responsibility for the governance, oversight, and management of the organization. The Boeing litigation evidences the increased focus on these fundamental director responsibilities.
The ABA Young Leaders in Securitization and Structured Finance is a growing subcommittee of the Business Law Section (BLS) Committee for Securitization and Structured Finance. The committee and the Young Leaders are at the forefront of discussing and tackling new issues in the growing field of structured finance. Most recently, the Young Leaders hosted a discussion exploring some of the opportunities and career paths in securitization and structured finance available for young lawyers.
The discussion, hosted by the Young Leaders and joined by the panelists Claire Hall, Partner in DLA Piper’s Structured Finance Practice; Kira Brereton, Associate General Counsel at S&P Global Ratings; and Joel Kwan, an Associate at Paul Hastings LLP, was a great opportunity for young lawyers to learn about various career paths available to securitization attorneys. The discussion was well attended and provided a resource for new attorneys to develop a career plan in the securitization and structured finance field.
The BLS Committee for Securitization and Structured Finance and the Young Leaders subcommittee are both planning to hold additional events furthering interest and development in the securitization sector. The Young Leaders also hope to continue to host events for young lawyers who are in the sector or are interested in it.
The Young Leaders are also happy to announce that Carla Potter, of Cassels Brock & Blackwell LLP, is joining the Co-Chairs of the subcommittee and will focus on Diversity and Inclusion initiatives, and Myriam Mossi is joining as Director of Events.
Customers, employees and investors are putting increasing pressure on companies to embrace environmental, social and governance (ESG) initiatives. As businesses take stock of their sustainability efforts to meet new market demands, they may not realize just how much ESG can impact their bottom line and their long-term success. Companies that successfully navigate the world of ESG certifications face incredible opportunity to serve as catalysts for environmental and social responsibility and will be well-positioned to help their clients adopt ESG measures of their own.
ESG certification, however, demands increased scrutiny and accountability to ensure businesses are truly walking the walk. As such, lawyers should be involved in ESG efforts from the outset to guide their companies, clients or their own law firms down the right path.
Understanding Legal Requirements
What separates the ESG efforts of today from corporate social responsibility (CSR) efforts of the past are legal requirements that hold companies to their promises to use their businesses to do good. With ESG certifications such as the B Corporation® certification, businesses must include certain language in their operating and formation documents, providing a legal commitment to operate in sustainable ways and further social and environmental causes.
There are broad-reaching impacts related to how these documents are set up and structured. Having a lawyer involved from the start of ESG certification allows businesses to take a wider look at the core certification process, examining activities, documents and more from a companywide perspective. What’s more, legal counsel must ensure all of a company’s documents meet required ESG framework standards without subjecting the company or its directors and officers to liability and risk. The work doesn’t end there; when exploring ESG solutions, lawyers must remain involved in vendor management and vetting programs to ensure all of a company’s efforts are in line with ESG certification requirements and best practices.
ESG certifications can also include industry-specific requirements. In the accounting industry, for example, firms must include a tax statement relating to tax practitioners. These requirements can be complicated and demand detail from the applicant company or firm, with important legal ramifications.
Clients’ Demand for ESG Efforts Creates Opportunities
Our clients’ own ESG initiatives have begun to put pressure on businesses throughout the supply chain. Law firms and accounting firms have noticed an uptick in requests for ESG-related information in RFPs, and this trend will undoubtedly continue as ESG reporting becomes more mainstream (and potentially required).
Offering transparency to stakeholders and clients requires companies to dig deep into their data, figure out where they stand and report that information. ESG is set to raise the bar in this area, as it will require companies to list more detail about their efforts than ever before. For example, “Does your company recycle?” now becomes a question of what types of materials an organization recycles, and it gives suppliers with offices in LEED-certified buildings that have solid numbers to report on their carbon footprints a competitive advantage.
One of the most exciting things about ESG is its often-unanticipated positive impact on a business’s bottom line and how its customers interact with it. Being environmentally or socially thoughtful helps to improve products and services in a way that can result in cost savings, and clients can even benefit from unintended improvements in risk management. As an example, printing management tools can help with environmental concerns, but by ending the days of documents with confidential information sitting on a printer in a well-traveled area, there’s also a significant benefit to a firm’s compliance with its confidentiality obligations to clients.
Lawyers Can Make an Impact on Governance
Governance is perhaps the least understood piece of the ESG equation, with many frameworks such as B Corporation certification requiring specific language and actions on behalf of companies seeking certification. In addition to including language in organizational documents, good governance efforts must involve lawyers from the start to ensure an organization is meeting this standard from all angles.
Decision-making and policy-making are two parts of good governance that often come into play with ESG efforts. These reflect how a company’s leadership sets an example or even responds to things like disparities in compensation or labor strikes. An insensitive or callous response to these types of issues can put companies in a negative spotlight and potentially a public relations crisis, and it can also put them at risk in terms of ESG certification efforts.
Governance also extends to broad categories, such as how organizations address audits, internal controls and shareholder rights, going beyond corporate structuring or governance on paper to the way an entire organization operates and buys into ESG initiatives.
Whether an organization’s ESG efforts are grassroots, from the bottom up, or influenced from the top down, there must be a meeting in the middle where different perspectives are brought to the table to affect how decisions are made and how a company operates with respect to ESG concerns. As an added benefit, this type of thinking often yields innovation and harmony throughout an organization, another unintended positive consequence of ESG.
How Organizations Can Get Started with ESG
Many business leaders are initially apprehensive about knowing where to start with ESG. Certification processes can seem overwhelming, as they are robust processes that require sound project management and diligence. In reality, these projects are a great fit to be led by legal teams.
A common misconception about ESG certifications is that a company must be selling goods and services that are “green” or explicitly further a social goal to successfully achieve certification. In fact, ESG is a good fit for every organization, and the coming wave of regulations and societal pressure point to ESG as an imperative. Lawyers with broad, in-depth knowledge of an organization can help identify parts of a business’s operations that are a good fit for ESG programs.
Businesses should also know that a successful ESG journey won’t require them to change everything about their products or services, or how they run their company, all at once. Taking incremental steps can help organizations start on the right path, and they often continue to discover opportunities to streamline operations, keep clients happy and add efficiencies that drive revenue and cost savings.
Many companies are interested in how their suppliers are meeting ESG certifications, and often this can spur opportunities for a company to help clients go through the certification process themselves. In the B Corporation community, part of furthering the promise of being a B Corporation is helping other organizations do the same, ensuring they benefit from the shared expertise of others who have gone down this road before. Many certifications also require a periodic evaluation or even recertification, ensuring organizations aren’t resting on their laurels and that they continue to advance ESG efforts and seek continuous improvement.
While the ESG process can be daunting and challenging, it’s important to note that it is incredibly meaningful. Lawyers can help companies take ESG to heart, create opportunities to connect with the issues their clients, people and communities care about most, and hold themselves accountable to do better.
Spotting ethical issues in litigation is usually easy. The direct conflict magnifies tactics on the line between zealous practice and violations of the disciplinary rules, with transgressions quickly raised for the court’s consideration. Corporate transactional practice can also challenge a lawyer’s ethics, but the disciplinary landmines may be hidden in behind-the-scenes struggles for advantage.
Popular fiction, with its extremely stressful situations, can illustrate the lawyer’s dilemma. When the pressure is on, it is easy for professionals to sneak over the ethical line. Only a tiny percentage of novels are built on the intricacies of corporate maneuvering that raise such ethical matters. I hereby offer a tonic for this problem.
This autumn I published my second detective novel, Fistful of Truth, featuring a former lawyer leading a multi-city investigation firm. (Find the novel here.) The action in this book centers around the acquisition of a genetics research company by a huge pharmaceutical corporation. This book is in part an exercise in legal ethics for transactional business lawyers, with a side of mayhem, dirty dealing, and tinkering with the code of life.
The protagonist, Matt Bishop, is conducting a factual investigation of the acquisition target on behalf of the public company prospective purchaser. His client has access to detailed financial records, documentation about secret genetic research and genomics projects, and even computing logs and network records. From the beginning, a transactional attorney wonders, “Why didn’t the lawyers for the target company set limits on this ‘due diligence’ investigation?” In real life, a diligence review under the guise of a potential acquisition may expose the target’s vulnerabilities and secrets whether or not the parties complete the purchase transaction. Then the target is left completely exposed to the former prospective purchaser, often its competitor.
Rule 1.3 of the ABA Model Rules of Ethical Conduct, effectively mirrored in state bar ethics rules, requires an attorney to zealously represent her client. Under this ethical requirement for zealous client representation, the target company’s lawyers should propose limits on what kind of diligence investigations the proposed acquirer may be allowed to conduct, what employees of the target are available to interview and what kind of access investigators can have to the servers of the target. The potentially acquiring company should only be able to review the minimum amount of material needed to confirm its understanding of the target company’s business. It is the job of the target company’s lawyers to enact and maintain those restrictions.
In the book, the investigation itself also raised ethical issues for the lawyers of the acquiring company. Bishop claims he was hired by an outside law firm to conduct this review in order to provide privileged status to the resulting report, yet he never seems to contact the supervising law firm. Under the ethical rules, lawyers are required to closely manage their agents (Ethical Rules 5.1 and 5.3). Failure to do so is not only a violation of disciplinary rules, but can cost the attorney’s client the benefit of attorney-client privilege.
In the recent federal case of In Re Marriott International, Inc. Customer Security Breach Litigation, the court wrote, “For attorney-client privilege to apply, the communication must pertain to legal assistance. Furthermore, the need for legal advice must be a but-for cause of the communication. As such, business advice—such as how Marriott may improve its cybersecurity—is not privileged.” (citations omitted) In the book, Bishop was reporting directly to the pharmaceutical company executives, and not to the lawyers who were supposed to have retained his services. The pharma company lawyers were not exhibiting the required level of competence to maintain a desired privilege and were not directly supervising their non-lawyer agents.
Lack of supervision under Rule 5.3 becomes an even bigger problem for the acquiring company’s outside counsel when their investigating agency acts outside the law and performs hacking activity to find information on behalf of the pharma client. Bishop’s in-house computer forensics team, the Wolf Pack, hacks into business and financial records in the course of pursuing information for the client. Section (c) of Rule 5.3 states that a lawyer is responsible for the conduct of a non-lawyer, if the lawyer supervised or ordered the conduct, or “ratifies” the conduct, or could have prevented or mitigated the effects of the conduct. Clearly, in the book, even if the pharma company’s outside counsel did not order a violation of the Computer Fraud and Abuse Act, it set the investigator loose without closely supervising his activities. The state disciplinary committee could easily impute that violation of law to the lawyers themselves.
A more tenuous case could be made under Rule 4.2 concerning Bishop’s contact with opposing parties that he knows to be represented by counsel. According to the court in the 2020 Minnesota Federal District Court case US vs. Cameron-Ehlen Group, the Rule 4.2 restriction on contact “applies to the conduct of not only attorneys, but also an attorney’s nonlawyer agents, including investigative agents.” So Bishop’s contacts with executives of the target company could be imputed back to his supervising lawyers. One questions whether, as a former private firm lawyer himself, Bishop should have recognized the risks and avoided such contact. In an early scene where Bishop visits the home of the leader of an anti-genetic-manipulation advocacy group, his status as investigative agent for the pharma lawyers should have made him think twice. While the group leader does not state that he is represented by counsel, earlier criminal cases against the advocacy group would imply that he had counsel and Bishop should have known about it.
A corporate acquisition provides a variety of opportunities to run afoul of your state’s attorney disciplinary rules. You may not have the kind of practice that exposes you to this spectrum of ethical issues, so you can keep sharp by issue-spotting in the books you read. Even transactional business lawyers can find books that entertain and help you develop your ethical radar at the same time. Organized crime, government conspiracy, and murder may seem like the gravest misbehavior in Fistful of Truth, but the book demonstrates that even subtle moves by business attorneys can lead to serious consequences.
“Enforcing the Rule of Law in Online Content Moderation” is the fifth article in a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.
Every day, online intermediaries like Facebook, Instagram, and YouTube make decisions about user activity that can result in the removal of a user’s content or restrictions on a user’s account. Platforms often make such decisions based on standards set by national laws or the platform Terms of Service (ToS). Naturally, there are times when users disagree with a platform’s decisions. In such cases, users might seek to challenge whether the platform got its decision right. An affected user might try to appeal such decisions through a platform’s in-house appeal mechanisms, which all major platforms have established. A Facebook user might further pursue the slim chance of review by Facebook’s Oversight Board.
But what about the traditional pathway to justice: the courts? In the US, uniquely, users have few—if any—chances to successfully challenge the content decisions of social media platforms in court. However, in Europe, the picture is different. For some years now, European courts have been working their way through various platforms’ Community Standards, carving out due process rights and legal boundaries for platforms. As a result, many users have successfully sued Facebook and other social media platforms to reinstate content or accounts.
This article explains two landmark decisions to illustrate how German courts have applied contract law to infuse the principles of the rule of law into the decisions governing social media platforms.
The Anomaly of the US’s (Nearly) Total Platform Discretion
In the US, there have been no reported court cases of users successfully suing online platforms for reinstatement of content or accounts.[1] In part, this might be the product of a common law approach to contracts. Some platforms, for example, shield themselves from liability through termination-for-convenience clauses that allow platforms to suspend accounts without legal recourse for users. However, the ultimate reason for the absence of any viable recourse to courts is the current interpretation of § 230 of the Communications Decency Act (CDA). The provision is well recognized as providing immunity to platforms for non-IP-related content decisions, with immunity for inaction, e.g. not removing content,[2] as well as allowing for any good faith decisions to take down content that is “obscene, lewd, lascivious, filthy, excessively violent, harassing, or otherwise objectionable.”[3] This means platforms are protected when they choose not to act as well as when they actually choose to act.
With respect to immunity when taking action, the less prominent feature of § 230, US courts have found robust immunity for social media platforms against suit in § 230. In the words of the 9th circuit, when ruling on redress regarding a platform decision to delete a user profile: “[A]ny activity that can be boiled down to deciding whether to exclude material that third parties seek to post online is perforce immune under section 230.”[4] Courts have interpreted CDA § 230 as granting platforms wide discretion to self-regulate via Community Standards.[5] Given this wide discretion, legal scholars are skeptical as to whether suing social media platforms to reverse moderation decisions can be successful.[6]
Europe’s Middle Ground: User Rights through Contract Law, Cultivated by the Courts
In Europe, there is no legislation comparable to CDA § 230 (a legislative provision unique to the US), and courts, especially civil law courts, have strong tools to squash ToS that do not adequately reflect principles of fairness and rule of law.
In this landscape, unjustified moderation decisions amount to breach of contract, resulting in a claim for reinstatement. But when is a platform’s decision unjustified? In Germany, e.g., answering this question typically boils down to a two-step inquiry: First, is the content/user-behavior in question violating the law or Community Standards? If not, the user can demand reinstatement. Second, if the court does find that the conduct is violating a platform’s Community Standards (but no laws) the court considers whether these Community Standards are valid. If the standards are invalid, the court squashes the relevant standards and the user may claim reinstatement, in the absence of any valid justification for content moderation.
Such judicial review of Community Standards is based on general principles of German contract law: when ToS do not meet minimum standards of fairness, courts will find the ToS invalid and inapplicable. Judicial review of ToS is based on the assumption that the consumer has neither the opportunity nor the bargaining power to re-negotiate the ToS. Substantive judicial review (when contractual disputes arise) is meant to counterbalance this reality. When looking at moderation decisions based on Community Standards, courts will apply this “ToS-review” to Community Standards.
For some years now, users have been bringing actions for reinstatement to German courts, arguing that their content was not violative of any given standards and that even if it were, the relevant portions of the platform ToS / Community Standards were unfair, thus void. It is difficult to derive an exact number, but approximately 50 such court decisions have been reported thus far in Germany. Most often, the claimants seeking reinstatement are men, and disputes center around right-wing content, which the platforms typically categorize as “Hate Speech.” Often, though not always, claimants are successful, and the platforms are required to re-publish the disputed content or to re-establish an account.
July 2021 – Landmark Decisions by the German Federal Court of Justice
In Germany, claims of this nature have already reached the Constitutional Court, which has issued a preliminary injunction requiring Facebook to reverse the suspension of an account belonging to a right-wing political party.[7] While the order was issued in the context of a preliminary proceeding and issued without clarification of the merits of the legal issues at hand, in 2021, the German Federal Court of Justice became the first High Court world over to deliver landmark decisions when reviewing content removal and account suspensions by Facebook.[8]
In one such case, Facebook removed a user’s comments about an online video showing a person (assumed by the user to be an immigrant) refusing to be checked by a female police officer. The plaintiff commented on this video excerpt, stating: “What are these people doing here … no respect … they will never assimilate and will be a taxpayer’s burden forever … these gold pieces[9] are only good for murder … theft … rioting …” Facebook deleted these comments on the grounds that they constituted “Hate Speech.”
In the second such case, the Plaintiff had posted a message which included the following: “Germans get criminalized, because they have a different view of their country than the regime. Immigrants here can kill and rape and no one is interested!” Facebook deleted the post and temporarily restricted the account of the user who posted it, placing the user’s account on read-only mode for 1 month.
In both cases, the Federal Court of Justice reversed the lower courts’ rulings and ordered Facebook to reinstate the content and reinstate user accounts with full privileges. The clarifications of law delivered through these decisions strengthen the Rule of Law in the context of platform moderation powers in the following ways:
1. Holding Parties Accountable to Contractual Terms
To start with, the decisions by the Federal Court of Justice reaffirmed that upon registration, the platform and the user enter into a contract.[10] Under this contract, the platform’s obligation is to allow the user to post content. Accordingly, the platform may not delete content without justification.
2. While Platforms are Not State Actors, Constitutional Guidance may Shine Upon their Moderation Powers
In its decisions, the Federal Court of Justice took an in-depth look at how constitutional rights govern the legal questions at hand. Before these decisions, it had been heavily disputed whether large platforms like Facebook could be bound to fundamental rights like state actors. Some scholars have argued—and courts have found—that a platform like Facebook, while not being a state actor, provides an essential public forum fulfilling functions like the state (the speaker’s corner of the 21st century). Such an argument would jump on an idea which in past precedents, the German Constitutional Court had openly opined about: “where private companies take on a position that is so dominant as to be similar to the state’s position, or where they provide the framework for public communication themselves, the binding effect of the fundamental right on private actors can ultimately be close, or even equal to, its binding effect on the state.”[11]
Notably, the Federal Court of Justice did not find that Facebook’s platform fell into this (narrow) category of state-like providers of frameworks for public communication; although Facebook did provide a substantial means of online communication, it was not found to be the doorkeeper to the internet as such.[12]
After rejecting this argument (of Facebook as being state-like), the Court elaborated how constitutional rights indirectly govern the case. In Germany, under the well-established Drittwirkung-doctrine, fundamental rights serve as a strong guidance for interpreting obligations between private parties, especially when courts must apply abstract terms like the “appropriateness” or “fairness” of certain obligations (which formed the decisive question in the case: Are Facebook’s Community Standards adequately fair?).
Consequently, the Court carefully evaluated which constitutionally protected positions should be brought into balance:
The Court acknowledged the users’ free speech rights and that the constitutional principle of equality before the law supported strong protection against discriminatory treatments by the platform. The Court based its decision to bind Facebook to principles of equal and just treatment of users on three considerations: First, the fact that Facebook is, by its own decision, opening its services to a broad public;[13] second, that at least a portion of citizens highly depend on social networks;[14] and third, due to lock-in-effects users cannot easily substitute one large platform with another.[15]
The Court also found freedom of commerce weighed in favor of Facebook when it acts to self-regulate communication standards to protect the safety and well-being of its users, who themselves could have a valid interest in respectful communication on “their” platform.[16] The court also highlighted Facebook’s own speech rights, when “speaking” by setting Community Standards. Moreover, the Court acknowledged that platforms have a practical need to moderate content and users in order to mitigate liability risks.[17]
3. Within Limits, Platforms Might Self-Regulate by Defining “Permissible Speech”
After all this balancing of interests, the Court then proceeded to its more granular conclusions. It allowed Facebook to self-define communication rules through its Community Standards, which might go beyond speech restrictions of German law (“the police could not arrest you for it, but Facebook might block it”). Thus, platforms might legitimately ban “awful but lawful” hate speech.[18] However, the Court did not grant Facebook total discretion.[19] Instead, it held that restrictions on speech must be grounded on objective reasons. Since Facebook opened its platform to general discourse, political opinions could not be outlawed as such.[20] Though the Court does not explain this finding any further, one might conclude that there is generally little room for viewpoint-based restrictions, but greater flexibility for banning certain (e.g., aggressive) forms of speech.
4. The Articulation of Private Due Process
Furthermore, the Court veritably “invented” strict private due process by arguing that Facebook’s ToS would otherwise be unfair, meaning it would cause undue disadvantage for the user. To prevent undue disadvantage to users, the Court advanced the following framework for platforms seeking to restrict content or accounts:
Diligent Investigation: Platforms must take reasonable efforts to investigate before a decision. To limit the risks of discriminatory behavior,[21] moderation decisions must be reasonably justified, which requires the platform to reasonably examine the situation.
Prompt Information: To bring colliding interests in balance, platforms must inform their users about a decision. For content removal, the Court found that a platform may take immediate action and notify users after the fact.[22] For account suspensions and restrictions (e.g., placing an account in read-only mode), the Court finds that the affected user generally (with some possible exceptions) must be informed before a decision is implemented.[23]
Providing Reasons and Considering Appeals: When informing its user of content- or account-related decisions, the platform must provide a statement of reasons. Moreover, users must have the ability to appeal.[24]
The Court’s Conclusion and its Outlook
On this basis, the German Federal Court of Justice found that, because Facebook’s ToS did not sufficiently include an explicit statement of due process, the relevant provision (§ 3.2. of the ToS: “… We can remove or block content that is in breach of these provisions …”) was unfair and thus inapplicable. On this basis, the Court found that there was no sound legal basis for the content removals and account suspension in question.[25]
On a more abstract level, the decisions are a win for both users and social media platforms as well. First and foremost, this is because the Court did not treat Facebook as a state actor, instead reaffirming that even Facebook is—within limits—allowed to self-define communication standards. Moreover, even though the decisions created some bureaucratic burdens, they have also created valuable legal certainty. Platforms now know what to do; the court has given them instructions: what to write into their ToS and how to safeguard sufficient due process for their users when making moderation decisions. One can expect that other European courts will follow this precedent.
Reconsidering CDA § 230 in light of the European Approach
If we look from Europe across the Atlantic: might American users and businesses benefit from the German solution found by focusing on injecting due process through contract law?
The Culture War over CDA § 230
Certainly, the temperature is rising around whether § 230 delivers just outcomes for businesses and users alike. For some time now, politicians from both sides of the aisle in the US have been considering limitations on the protections that CDA § 230 grants to online platforms. Originally, most critics of § 230 focused on holding platforms accountable when they did not act or amplified harmful content, especially through their algorithms.
However, especially after major platforms took action to suspend former President Donald Trump, concerns have been raised over whether platforms should—in part—be stripped of their protection on the other side of the coin; that is, for when they do take action—what this paper is about. These concerns about the platforms’ moderation powers are often politicized and often frame California-based big tech as pushing a (left-wing) political agenda. Content moderation is described as viewpoint discrimination and ideological censorship. Such a narrative, of course, might overshadow reflections on reasonable grounds for the platforms’ actions.
For this side of the coin, a wide range of suggestions are on the table,[26] from requiring platforms to be more transparent about their moderation decisions, to safeguarding more uniform decisions, to narrowing the scope of the moderation liability exemption, or drastically limiting content moderation powers by introducing must-carry obligations.[27] Notably, in this debate, some voices argue against watering down of platform immunity for moderation decisions: platforms could become ungovernable when being held to First Amendment standards.[28] While this argument seems convincing, it does not argue against finding a middle ground: holding platforms accountable at least to minimum due process. Others are rightfully pointing out that loosening § 230’s immunity for making decisions undercuts its principal benefit—namely, cheap and reliable defense wins.[29] I find this generally convincing, too. Indeed, rising costs of moderation decisions could make platforms reluctant to take reasonable actions, or even lead to “over-put-back”: if you know that certain actors, e.g., white supremacist groups, are going to challenge every content decision, this might incentivize the platform to restore (“put-back”) content even though it is against the platform’s Community Standards. However, this shouldn’t be an argument against at least injecting minimum due process into moderation decisions, which would leave platforms sufficient immunity for taking good faith decisions.
Can Company Promises and User Expectations Help Re-interpret CDA § 230?
One wonders: Is there no middle path even under the existing CDA § 230(c)(2)(A)? Does the wording of § 230(c)(2)(A) necessarily grant immunity for all content moderation? And, even if it does: might not contract law be relied upon to work, at least in part, around § 230? Would this result in middle-ground outcomes like in Europe as I have described above?
At its core, the European approach is about translating what today’s mega-platforms are and what they promise to be. They are no longer underground bulletin boards where one might expect his or her content to stay online as long as the administrator is in a good mood or too busy. To the contrary, modern platforms present themselves as public forums where speech restrictions should not be arbitrary, as the motto is: “You should be able to speak your mind.”[30] Users rightfully expect any sanctions not to be based on Mark Zuckerberg’s whims or preferences, but (only) upon reasoned grounds. Indeed, the Facebook ToS is tied to legitimate concerns: “We want people to use Facebook to express themselves …, but not at the expense of the safety and well-being of others …”[31] User expectations of platform self-restraint are reaffirmed through the platform ToS: “You therefore agree not to engage in the conduct described below … We can remove or block content that is in breach of these provisions.”[32] Platform Rule of Law is strongly justified as we are talking about a non-altruistic relationship: Users “pay” for using the platform with their data and by accepting advertisements.
A change in user expectation regarding platform governance is no coincidence, as platforms increasingly accept their role as community governors, that is, enforcing values and norms, as Kate Klonick has described thoroughly.[33] But this, of course, goes hand in hand with self-restraint in adherence to common values and norms—one could say the rule of law.
Could this, in the US, translate into the legal sphere?
Eric Goldman has described potential theoretical pathways,[34] though he obviously would reject the following conclusions which seem moderate from a European’s perspective:
Revisit “objectionable content” and “good faith.” In its plain words, CDA § 230(c)(2) does not provide blanket immunity for any moderation decision, but regarding “obscene, lewd, lascivious, filthy, excessively violent, harassing, or otherwise objectionable” material and only for moderation decisions taken “in good faith.” If the platform erred in its assessment about a violation of its ToS, courts could question whether the content can amount to being “otherwise objectionable.”[35] Moreover, courts could inject due process through the “good faith” requirement: if a platform does not inform a user and does not listen to defense (denying appeal), this could amount to “bad faith.”[36]
“Promissory estoppel” through abstract promises. Theoretically, online platforms should be free to waive their discretion for content moderation (which is otherwise backed by § 230), especially through marketing representations and contract provisions.[37] Courts have affirmed that a user-specific individual promise could lead to promissory estoppel, thus waiving the protection of CDA § 230.[38] Lawyers could test waters beyond individual promises: If counsel would find that platforms abstractly “promise” to act on reasonable grounds only (see above), one could conclude that they waive § 230’s subjective total discretion standard with no due process.
The suggested interpretation would merely hold platforms accountable to their own rules and inject minimum due process. Such modest self-restraint is something that nowadays even Facebook seems to suggest as a threshold for § 230 CDA. If platforms still want to hold on to full discretion, they would be free to do so, as long as they are explicit and non-ambivalent about this.
Of course, given the common platform-friendly interpretation of § 230, the suggested interpretation (waiving § 230 in parts through abstract promises of due process) faces an uphill battle, as courts are generally (rightfully) reluctant to translate unclear contract provisions and marketing representations into estoppel of privileges (one does not give up rights through warm words).
However, as user expectations of platform self-restraint (Rule of Law-inspired, perhaps) continue to grow, these questions invite reinterpretation. In Europe, as I have shown, lawyers and courts have been pushing large platforms towards more Rule of Law in moderation decisions. Maybe, there is a similar, as yet untraveled, road ahead under current US law, too.
[4] Riggs v. MySpace, Inc., 444 F. App’x. 986 (9th Cir. 2011), citing Fair Hous. Council of San Fernando Valley v. Roommates.com, LLC, 521 F.3d 1157, 1170-71 (9th Cir. 2008).
[5]See, e.g., Green v. Am. Online, 318 F.3d 465, 471 (3d Cir. 2003): “allows … to establish standards of decency;” Langdon v. Google, 474 F. Supp. 2d 622, 631 (D. Del. 2007): “provides … immunity for … editorial decisions regarding screening and deletion.”
[8] Federal Court of Justice, decisions of 29 July 2021 – III ZR 192/20 and III ZR 179/20.
[9] The term “gold pieces” is used as a sarcastic description of refugees. It refers to a former statement of German politician Martin Schulz, who in 2016 argued in favor of welcoming refugees as follows: “The way we benefit from these people, is more valuable than gold, it is the unperturbed belief in the dream of Europe.”
[10] Federal Court of Justice, decision of 29 July 2021 – III ZR 192/20, para 40.
[11] Decision of 6 November 2019 – 1 BvR 16/13 “Right to be forgotten I,” para 88 (English version here).
[12] Federal Court of Justice, decision of 29 July 2021 – III ZR 192/20, para Rn. 71.
[23] Federal Court of Justice, decision of 29 July 2021 – III ZR 179/20, para 87.
[24] Federal Court of Justice, decision of 29 July 2021 – III ZR 192/20, para 97.
[25] The Court briefly considered whether the content in question was illegal according to Criminal Law (which would have yielded a right to remove it irrespective of the ToS). However, the Court found it did not, so it ordered Facebook to reinstate the content and to refrain from restricting accounts for the given reasons again.
[26] A good overview is to be found on the Wikipedia page for § 230.
[27]See, e.g.,Eugene Volokh, “Treating Social Media Platforms Like Common Carriers?”, 1 Journal of Free Speech Law, 377 (2021).
[28] Jack M. Balkin, Free Speech is a Triangle, 118 Colum. L. Rev., pp. 2011, 2026 (2018).
[35] This implies strengthening an objective understanding of CDA § 230(c)(2), which is disputed, Id. at 662. Goldman even argues that platforms might not be able to waive § 230 protection.
[36] Id. at 665 and pointing towards Smith v. Trusted Universal Standards in Elec. Transactions, No. 09-4567 (RBK/KMW), 2011 WL 900096, at *25–26 (D.N.J. Mar. 15, 2011).
[38] Barnes v. Yahoo!, Inc., 570 F.3d 1096 (9th Cir. 2009): “under the theory of promissory estoppel, subsection 230(c)(1) of the Act does not preclude … cause of action” (action was brought against the provider for not taking action after user-specific promise to do so).
In its heyday, the common law treated injury causes of action[1] as purely personal in character.[2] From this assumption followed the hoary doctrine, naturally entombed in Latin (Actio personalis moritur cum persona), that held all such claims to be extinguished upon the death of the injured individual.[3] Ironically, this theorem may have encouraged the most maleficently negligent to evade liability by ensuring the victim’s injuries were so severe as to lead to their untimely expiration.[4] To foreclose the realization of similar ghoulish possibilities, every state as well as the District of Columbia eventually adopted so-called survival statutes.[5] Where these enactments reign, “no cause of action dies with the person.”[6] As such, in the modern United States, a decedent’s state-law claim for damages for a proven injury routinely continues as an asset of an estate for some specified period of time,[7] with libel and slander frequently excluded by legislative enactment[8] or judicial interpretation.[9]
In the decades after these laws’ explosive spread petered out, Congress codified a diverse array of rights in federal statutory law over the last 50 years. Yet, as to causes of action created by these enactments, its ruling majorities seldom, if ever, wrestled with the eldritch problem otherwise resolved by the prototypical survival act.[10] Compelled to confront this omission, federal courts opted to adopt a unique set of principles to guide their determination of which third parties enjoy the standing to assert a decedent’s cause of action under various federal consumer protection statutes, including the Fair Debt Collection Practices Act (FDCPA), Truth in Lending Act (TILA), and Real Estate Settlement and Practices Act (RESPA). This article devotes itself to clarifying this jurisprudence’s general doctrines and elucidating their specialized application to the FDCPA.
Born in 1929, Ms. Gladys J. Finch died on October 21, 1989, at the age of 60, survived by two daughters and three sons. At the time, she lived with one daughter, Ms. Betty Wright. In April 1990, a court appointed Wright as executrix of her mother’s estate. After Finch’s passing, Finance Service of Norwalk, Inc. (Finance Service), a debt collection agency, sent 14 letters addressed to Finch in an attempt to collect $112 from her for an allegedly overdue, and long since forgotten, medical bill. Acting as executrix for Finch’s estate, Wright admittedly opened and purportedly read every one of these communiques. Only after receipt of the 14th such missive did she contact Finance Service with news of her mother’s death, prompting the apologetic entity to put a stop to any future dispatches. Having tabulated 30 purported violations of the FDCPA, Wright replied in the American manner: she launched a lawsuit against Finance Service in the United States District Court for the Northern District of Ohio in the fall of 1990.
B. The Walkers
Nearly a decade later, James Walker moved into his mother’s weather-beaten mobile home, serenely parked upon the Colorado Plateau and within the Arizona borders of the Navajo Nation, soon after her death. Long before that dark night, Walker’s mother had signed a retail installment contract and security agreement for her wheel-graced house; by the time of her death, a sizable arrearage had formed. Ultimately, R. Ruben Gallegos, an attorney based in Albuquerque, New Mexico, filed a Petition for Order Allowing Repossession of Collateral in one of the Navajo Nation’s district courts (Navajo Court) on behalf of the creditor who then possessed the relevant financial instruments encumbering Walker’s latest homestead. Crucially, this petition named Walker as the defendant due to his ongoing occupation of and control over his mother’s former home. In response, Walker sued Gallegos under the FDCPA based on the latter’s purported misrepresentations to the Navajo Court as to the nature—indeed, the reality—of Walker’s responsibility for his mother’s past financial lapses. Walker’s underlying theory lacked either complexity or novelty: by pegging him and him alone as a defendant even though he “was not a party to the financing contract and had never assumed the debt for the mobile home after his mother’s death,” Gallegos had flouted the FDCPA’s prohibition on knowing misrepresentations.
III. Statutory Background: The FDCPA
A. Design and Purpose
The chief federal statute regulating debt collection since it went into effect on March 20, 1978, the FDCPA establishes the general standards for verboten collector conduct, defines and restricts certain collection acts, and affords consumers specific rights and remedies.[12] As Congress explained in 1977, “abundant evidence of the use of abusive, deceptive, and unfair debt collection practices by many debt collectors” could be marshalled, these “[a]busive debt collection practices contribut[ing] to the number of personal bankruptcies, to marital instability, to the loss of jobs, and to invasions of individual privacy.”[13] In the preceding years, “[e]xisting laws and procedures for redressing these injuries” had proven “inadequate to protect consumers”[14] in that creditors allegedly preferred these tactics, “carried on to a substantial extent in interstate commerce and through means and instrumentalities of such commerce,” to “[m]eans other than misrepresentation or other abusive debt collection practices . . . [otherwise] available for the effective collection of debts.”[15] So animated, the FDCPA strives to achieve three goals: “eliminat[ing] abusive debt collection practices by debt collectors, . . . insur[ing] that those debt collectors who refrain from using abusive debt collection practices are not competitively disadvantaged, and . . . promot[ing] consistent State action to protect consumers against debt collection abuses.”[16] In spite of this determination to eliminate certain prevalent practices in accordance with these aims, in its drafting of the FDCPA, Congress shied away from innovation and instead mostly supplemented and expanded upon existing debt-collection regulations.[17] As a result, a rough equipoise lies within the FDCPA’s core: a strict liability statute, with consumers able to prove a violation concurrently empowered to win summary judgment against a debt collector, the FDCPA was not fashioned to allow these same consumers to circumvent freely assumed and legally valid payment obligations.[18]
B. Scope
The FDCPA limits its scope to “debt collector[s]” pursuing “consumer[s]” and “acting on behalf of, but unaffiliated with, the actual creditor.”[19] For its purposes, “‘consumer’ means any natural person obligated or allegedly obligated to pay any debt,”[20] and “‘debt’ means any obligation or alleged obligation of a consumer to pay money arising out of a transaction in which the money, property, insurance, or services which are the subject of the transaction are primarily for personal, family, or household purposes, whether or not such obligation has been reduced to judgment.”[21] As a result of its codification of these sweeping denotations and inclusion of the adverb “allegedly,” the FDCPA thus applies to all obligations to pay money that arise out of consensual consumer transactions, regardless of whether credit has been offered or extended,[22] and holds debt collectors liable for various abusive, deceptive, and unfair debt collection practices, regardless of whether the debt is valid.[23]
Less obvious than the foregoing definitions, the FDCPA used “the term ‘creditor’” to “mean[] any person who offers or extends credit creating a debt or to whom a debt is owed, but . . . does not include any person to the extent that he receives an assignment or transfer of a debt in default solely for the purpose of facilitating collection of such debt for another.”[24] Instead, “debt collector[s],” explicitly defined as “person[s] who use[] any instrumentality of interstate commerce or the mails in any business the principal purpose of which is the collection of any debts, or who regularly collect[] or attempt[] to collect, directly or indirectly, debts owed or due or asserted to be owed or due another,” fall into the latter category.[25] In effect, the FDCPA damns as “debt collectors” such entities as “debt collection agencies, creditors using false names or collecting for other creditors, collection attorneys, purchasers of delinquent debts, repossession companies, and suppliers or designers of deceptive forms.”[26]
Reasonably enough, not all aspects of the typical debt collection process concerned the FDCPA’s original congressional advocates and thus came within its ken. Instead, this statute generally prohibits only abusive or deceptive activities once, if not still, commonly undertaken in the collection of consumer debts.[27] To wit, commercial obligations lie outside its purview.[28] Further limiting its reach, the FDCPA’s delineation of “debt collector” has always excluded “[a] consumer’s creditors” and both “a mortgage servicing company, or any assignee of [a predefaulted] debt.”[29] Overall, five entities—creditors collecting their own debts, banks, retail stores, finance companies, and government employees—and one financial instrument—business debt—still consistently fall outside of the FDCPA’s various environs.
C. Explicit Prohibitions: Consumers and Third Parties
As a practical matter, the FDCPA places restrictions on the manner in which debt collectors may contact consumers regarding a consumer debt, specifying where, when, and how a debt collector may communicate with any burdened consumer.[30] It prohibits three broad classes of behavior: “any conduct the natural consequence of which is to harass, oppress, or abuse any person in connection with the collection of a debt,” with six nonexclusive examples adumbrated;[31] “any false, deceptive, or misleading representation or means in connection with the collection of any debt,” with sixteen examples adduced;[32] and “unfair or unconscionable means to collect or attempt to collect any debt,” with eight examples appended.[33] Sections regarding the validation of debts,[34] priority of payments made by consumers with multiple debts,[35] proper venue,[36] and furnishing of “certain deceptive forms”[37] round out the act’s consumer-centric provisions.
In spite of its consumer cynosure, the FDCPA regulates debt collectors’ communications with other “person[s]” too.[38] In point of fact, it painstakingly proscribes collector contact with such third parties except in closely regulated situations.[39] Thus, if contacting this coterie for “the purpose of acquiring location information about the consumer,” a debt collector must avoid certain behaviors and provide precisely delineated information, as set forth in section 1692b.[40] For example, a debt collector may “not communicate with any such person more than once unless requested to do so by such person or unless the debt collector reasonably believes that the earlier response of such person is erroneous or incomplete and that such person now has correct or complete location information.”[41] Similarly, once “the debt collector knows the consumer is represented by an attorney with regard to the subject debt,” the FDCPA forbids any further communications with a third person “unless the attorney fails to respond within a reasonable period of time to communication from the debt collector.”[42] Beyond this provision, the FDCPA bars a debt collector from “communicat[ing], in connection with the collection of any debt, with any person other than the consumer, his attorney, a consumer reporting agency if otherwise permitted by law, the creditor, the attorney of the creditor, or the attorney of the debt collector” unless prior consent or judicial permission has been given or such contact is “reasonably necessary to effectuate a postjudgment judicial remedy.”[43]
IV. Precedent’s Explication
Absent a specific statutory directive,[44] federal common law settles the question of survival of a federal statutory cause of action upon the demise of the alleged victim.[45] Over the last 30 years, without the aid of any meaningful congressional guidance, federal courts have molded a peculiar series of rules as to the propriety of that cause’s descent. As precedent demands,[46] these jurists have first looked to the relevant statutory language, but proceeded to weigh other contextual factors, including embedded purpose, in the hope of a consensus’s construction, always consulting federal common law even as to statutes with state analogues or derived from state predecessors.[47] In spite of persistent outliers, this effort ultimately netted a coherent, if complicated, approach to this macabre dilemma.
A. Prevalent Approach: Construction of Related Federal Statutes
By custom and command, any construction of a nonconsumer’s standing under the FDCPA must begin with its particularly defined classes of possible claimants: “consumer” and any “person other than the consumer.”
As utilized within the FDCPA, these terms’ expansive ambits pointedly contrast with the narrower classifications central to other federal consumer statutes’ operations. For example, the Equal Credit Opportunity Act (ECOA) renders “[a]ny creditor who fails to comply with any [of its] requirement[s] . . . liable to the aggrieved applicant for any actual damages sustained by such applicant acting either in an individual capacity or as a member of a class.”[48] Accordingly, “only ‘applicants’ have the ability to sue for ECOA violations.”[49] As “[t]he term ‘applicant’ means any person who applies to a creditor directly for an extension, renewal, or continuation of credit, or applies to a creditor indirectly by use of an existing credit plan for an amount exceeding a previously established credit limit,”[50] ECOA’s “plain language . . . unmistakably provides that a person is an applicant only if she requests credit.”[51] Pursuant to this prevalent reading, ECOA cannot be read to allow for derivative standing by any successor, even a legal one, to the original “aggrieved applicant.” Another similarly designed statute—RESPA—restricts its coverage to “borrowers,”[52] thereby stripping a cause of action from any third party not identified as a “borrower” in the relevant contracting documents,[53] including a potential plaintiff who receives title to the property solely as a result of a familial borrower’s death.[54] A general presumption girds these decisions: “A person who is not a party to a contract does not have standing either to seek its enforcement or to bring tort claims based on the contractual relationship.”[55] Consequently, at least as to these statutes with superficially narrow definitions, courts have not hesitated to constrict third parties’ standing to pursue a cause of action technically held by a related “borrower” or “applicant.”
When a federal statute codifies more expansive meanings than those in RESPA or ECOA, however, a far more liberal interpretive penchant has been readily indulged. At least one law closely related to the FDCPA, for instance, has been consistently construed: TILA. Enacted as part of the Consumer Credit Protection Act of 1968 and codified at 15 U.S.C.S. § 1601 et seq., TILA renders “[a]ny creditor who fails to comply with any requirement imposed under this part. . . with respect to any person . . . liable to such person.”[56] Certainly, in contrast with “borrower” or “aggrieved applicant,” TILA’s “person” is an inherently nebulous and infinitely malleable term. Moreover, in light of the “generally remedial purpose of TILA,”[57] courts treat this statute as meriting an expansive construction informed by the congressionally recognized need to “remedy abuses resulting from consumer ignorance of the nature of credit arrangements.”[58] In light of these twin facts—its reference to “persons” and its nonpenal character—most federal courts allow TILA actions to survive the obligor’s death and to be maintained by their legally recognized successor, including an estate’s administrator or personal representative.[59] Crucially, however, occasional cacophony disrupts even this noticeably popular construal.[60]
B. Return to the FDCPA
1. Overview: Debt Collectors’ Liability to Third Parties
In FDCPA jurisprudence, these disparate jurisprudential strains reappear, with the analytical prominence of each dependent upon a court’s understanding of two longstanding juridical verities. First, unlike ECOA or RESPA but similar to TILA, the FDCPA renders a “debt collector” liable to “any person,”[61] but “does not define what it means for a failure of compliance to be ‘with respect to any person.’”[62] Second, the FDCPA seeks “to protect consumers who have been victimized by unscrupulous debt collectors”;[63] accordingly, a debt collector’s unsavory activities and their negative effects on consumers both individually and as a class mattered most to Congress in 1968 and demand the most diligent judicial solicitude through the present day. Consistent with this aim, courts tend to imbue section 1692k, “couched in the broadest possible language,”[64] with sufficient elasticity to permit “[a]ny person who comes in contact with proscribed debt collection practices” to bring an FDCPA claim.[65] Guided by these touchstones—and thus unfettered by the explicitly tailored denotations enthroned in ECOA and RESPA and inclined to view the FDCPA as an essentially remedial statute—federal courts have consistently extended liability under this statute’s nonconsumer-specific provisions[66] to nonconsumer third parties whenever those persons (1) stand in the shoes of the debtor as a matter of law, or (2) plead a statutorily cognizable injury, often inadvertently inflicted during a debt collector’s attempt to contact the contractually bound consumer.[67]
2. First Method: Outright Substitution
The first basis has proven far less problematic in application but more controversial in practice. Courts invoking it have taken “a section-by-section approach to standing under the FDCPA”[68] and accorded this status to such third parties under sections 1692d and 1692e as a decedent’s executor[69] or the estate’s representative[70] as well as any person who, at the time of the suit, actually enjoyed control over the deceased debtor’s assets.[71] Within this jurisprudence, any person who bears actual responsibility for paying any decedent’s debt can be tagged as a “consumer” automatically endowed with the derivative ability to sue even a debt collector ignorant of the original debtor’s passing.[72] Tellingly, in applying this doctrine, these similarly inclined courts have split over the one FDCPA section—section 1692c—to refer to such common third parties. For the majority, section 1692c affords a decisive textual anchor in that it explicitly defines the term “consumer” to include “the consumer’s spouse, parent (if the consumer is a minor), guardian, executor, or administrator.”[73] Emphasizing the implicit intention of this explicit expansion of “consumer,” some courts limit third-party standing under this section to these named classes,[74] effectively barring any expansion of their third-party standing doctrine as to both this section and correspondingly worded analogues.[75] However, where no such express reference to “consumer” appears (and as one circuit noted, 1692c “appears to be the most restrictive of the FDCPA’s provisions” in that others “are not limited to ‘consumers,’ and thus are broader than § 1692c”[76]), these courts imbue executors and representations, spouses and parents, and all persons who wield legal authority over an estate’s assets, whether by contract, statute, or judicial writ, with the requisite standing to sue for a debt collector’s FDCPA violations against another.[77]
3. Second Method: Independent and Derivative Injury
Enamored of an alternative rationale, other courts find standing only when the person who was not alleged to be the debtor suffered some direct action, subject to the FDCPA, undertaken by a debt collection agency in its attempts to track down the actual named debtor.[78]
Examples of this approach abound. Thus, in Thomas v. Consumer Adjustment Co., the third party found to have standing to sue endured two direct phone conversations with the debt collector.[79] In another case, the oft-cited Whatley v. Universal Collection Bureau Inc. (Florida), the parents of a debtor gained their standing due to the debt collector’s decision to leave threatening messages to the debtor and his parents on the family answering machine.[80] The decision in Dutton v. Wolhar rested its conclusion on the uncontested fact that a letter that formed the basis of the FDCPA claim was sent to the plaintiffs at their home address attempting to collect a debt owed by the plaintiffs’ deceased parents.[81] And in West v. Costen, the mother of a debtor received, addressed to her at her address, a collection letter attempting to collect on her son’s debts.[82] Simply put, “[p]ersons who do not owe money but are subject to improper practices by debt collectors are covered by the FDCPA,”[83] a position defended as consistent with this statute’s legislative history.[84] Arguably, the Supreme Court’s decision in Spokeo, Inc. v. Robins[85] allows for no other form of third-party standing.[86]
For certain adherents of this approach, a corollary follows: “[a] third-party, non-debtor” simply “does not have standing to assert a FDCPA violation based on collection efforts aimed at someone else,” even if they themselves suffered the purportedly verboten conduct.[87] As this story goes, by enacting the FDCPA, Congress “did not intend to provide damages to those who did not experience any abusive behavior.”[88] Instead, the FDCPA punishes debt collectors for contacts with third persons, other than to obtain a debtor’s location, that “result in serious invasions of privacy, as well as loss of jobs.”[89] If one construes the FDCPA in accordance with this singularly verifiable purpose, a third-party nondebtor must be conferred statutory standing only when the alleged debt collection practices were actually directed towards that specific person.[90] By such contextual routes, these courts depart from the growing number who afford far more purely derivative standing to noninjured parties related only to an actually impacted consumer.
V. Conclusion
The Haitian-derived “zombie” myth[91] infiltrated American pop culture via the colorful and satirical imagination of George A. Romero in the late 1960s and 1970s,[92] more than 30 years after 1932’s White Zombie seeded the notion in the fertile American imagination.[93] Never the focus of the U.S. creative class, the typical survival act bequeathed such a posthumous existence to countless legal claims and denied a few from such a Lazarus-like fate. Unlike the states, however, Congress has not passed any similar laws or included any similar provisions—its habitual inattention leaving the federal courts free to decide which claims under which laws merit such post-mortem treatment. In explicating the FDCPA, this assemblage has relied upon rationales drawn from their RESPA, TILA, and ECOA precedents. A named debtor’s death, this majority has now proclaimed, will not nullify all possible liability in every case—death’s once automatic consequence circumvented by virtue of incantations not nearly as haunting (and, just maybe, more effective) as the still occasionally emitted chants of the latest generation of bokors and caplatas.[94]
* A former law clerk to federal judges in California, Florida, Louisiana, and New York, Amir Shachmurove is an associate at Reed Smith LLP. As common sense and custom dictate, the views expressed and the mistakes made herein are his alone and should be attributed to neither friends nor employers, past or present. Similarly, having been written solely for information purposes, nothing in this article is intended to be and should be taken as legal advice.
[1] In the esoteric debate over this deathly issue, commentators have drawn a distinction between a cause of action and an action pending at the time of death. Luke DeGrand, Note, Challenging the Exclusion of Libel and Slander from Survival Statutes, 1984 U. Ill. L. Rev. 423, 424 n.10 (1984). Within this literature, and here, the former refers to the right to sue, the latter to a suit already filed. Id.
[2] Harris v. Nashville Tr. Co., 162 S.W. 584, 586–87 (Tenn. 1913) (summarizing the common law’s presumptions); Bowen E. Schumacher, Rights of Action under Death and Survival Statutes, 23 Mich. L. Rev. 114, 114 (1924) (discussing historical background of modern survival laws).
[3] Schumacher, supra note 2, at 114. Confusingly, courts sometimes deemed the cause to have survived, but denied the capacity to assert it to the decedent’s noninjured successors.
[4] Robert D. VanHorne, Wrongful Death Recovery: Quagmire of the Common Law, 34 Drake L. Rev. 987, 988–89 (1985–86).
[7]See Henry Woods, Comparative Negligence in Oklahoma—A New Experience, 28 Okla. L. Rev. 1, 13–14 (1975) (canvassing many of these early statutes).
[8] Ariz. Rev. Stat. Ann. § 14-3110. The Arizona statute also exempts actions for breach of promise to marry, seduction, separate maintenance, alimony, loss of consortium, and invasion of the right of privacy. Id.
[9]See, e.g., Mitsubu Publ’g Co. v. State, 620 P.2d 771, 772 (Haw. 1980) (parsing Hawaii’s survival statute); Carter v. Morrow, 48 S.E.2d 814, 818 (S.C. 1948) (construing South Carolina’s version).
[10]See Note, Survival of Actions Brought under Federal Statutes, 63 Colum. L. Rev. 290, 290 (1963) (so observing).
[11] Though drawn from two cases, Wright v. Fin. Serv., 22 F.3d 647 (6th Cir. 1994), and Walker v. Gallegos, No. CV 00-1231 PCT PGR, 2002 U.S. Dist. LEXIS 25682, 2002 WL 31990400 (D. Ariz. Dec. 19, 2002), the stories recounted in this section have been edited for emphasis and effect.
[29] Lal v. Am. Home Servicing, Inc., 680 F. Supp. 2d 1218, 1224 (E.D. Cal. 2010).
[30] 15 U.S.C. § 1692c(a), (c). Notably, “for the purpose of this section, the term ‘consumer’ includes the consumer’s spouse, parent (if the consumer is a minor), guardian, executor, or administrator.” Id. § 1602c(d).
[31] 15 U.S.C. § 1692d; Harvey v. Great Seneca Fin. Corp., 453 F.3d 324, 329–30 (6th Cir. 2006).
[45] Smith v. No. 2 Galesburg Crown Fin. Corp., 615 F.2d 407, 413 (7th Cir. 1980); cf. Fed. R. Civ. P. 25(a)(1) (“If a party dies and the claim is not extinguished, the court may order substitution of the proper party.”). Once contested, this rule is now firmly established.
[46]See Amir Shachmurove, Purchasing Claims and Changing Votes: Establishing “Cause” Under Rule 3018(a), 89 Am. Bankr. L.J. 511, 528–33 (2015) (setting forth the courts’ regnant interpretive paradigm).
[47]Cf. Smith v. No. 2 Galesburg Crown Fin. Corp., 615 F.2d 407, 413 (7th Cir. 1980) (holding that federal common law governs whether a claim under TILA survives in favor of the administrator of a deceased plaintiff); James v. Home Constr. Co. of Mobile, Inc., 621 F.2d 727, 729 (5th Cir. 1980) (same).
[51] Hawkins v. Cmty. Bank of Raymore, 761 F.3d 937, 942 (8th Cir. 2014) (refusing to classify “guarantors” as applicants), aff’d w/o opinion, 136 S. Ct. 19, 192 L. Ed. 2d 988 (2015). Multiple federal courts have concurred with this natural construction. See, e.g., Alexander v. AmeriPro Funding, Inc., 848 F.3d 698, 707 (5th Cir. 2017) (citing Hawkins, 761 F.3d at 941); Germain v. M&T Bank Corp., 111 F. Supp. 3d 506, 528 (S.D.N.Y. 2015) (same); cf. Evans v. First Fed. Sav. Bank of Ind., 669 F. Supp. 915, 922 (N.D. Ind. 1987) (“The[] statutory provisions [under the ECOA] clearly indicate that Congress meant to protect those individuals who actually apply for credit.”).
[53]See, e.g., Johnson v. Ocwen Loan Servicing, 374 F. App’x 868, 873–74 (11th Cir. 2010) (holding that plaintiff was not a borrower and thus lacked the essential standing); Estate of Dawson v. Ditech Fin., LLC, No. 4:17-cv-93, 2017 U.S. Dist. LEXIS 128148, at *8, 2017 WL 3471425, at *3 (E.D. Va. Aug. 11, 2017) (citing cases construing § 2605(f)); see also, e.g., Correa v. BAC Home Loans Servicing LP, 853 F. Supp. 2d 1203, 1207 (M.D. Fla. 2012) (“[A] defendant’s liability in a civil action under RESPA is limited to borrowers.”); Mitchell v. Mortg. Elec. Registration Sys., Inc., No. 1:11-cv-425, 2012 U.S. Dist. LEXIS 45083, at *4, 2012 WL 1094671, at *2 (W.D. Mich. Mar. 30, 2012) (following those cases holding that non-borrowers have no standing to bring claims under RESPA).
[54]E.g., Nelson v. Nationstar Mortg. LLC, No. 7:16-CV-00307-BR, 2017 U.S. Dist. LEXIS 45276, at *7–9, 2017 WL 1167230, at *3 (E.D.N.C. Mar. 28, 2017); Green v. Cent. Mortg. Co., No. 14-cv-04281-LB, 2015 U.S. Dist. LEXIS 117241, at *14–15, 2015 WL 5157479, at *4–5 (N.D. Cal. Sept. 3, 2015).
[55] Ambers v. Wells Fargo Bank, N.A., No. 13-cv-03940 NC, 2014 U.S. Dist. LEXIS 28291, at *13, 2014 WL 883752, at *4 (N.D. Cal. Mar. 3, 2014).
[57]Smith, 615 F.2d at 413; accord Perry v. Beneficial Fin. Co. of New York, Inc., 88 F.R.D. 221, 222 (W.D.N.Y. 1980).
[58]Smith, 615 F.2d at 414; see also Deutsche Bank Nat’l Trust Co. v. Segarra, No. CV085018505S, 2011 Conn. Super. LEXIS 2941, at *4–5 (Conn. Super. Ct. Nov. 15, 2011) (collecting cases).
[59]James, 621 F.2d at 730; Abel v. Knickerbocker, 846 F. Supp. 445, 448 (D. Md. 1994).
[60]See, e.g., Wilson v. JP Morgan Chase Bank, No. CIV. 2:09-863 WBS GGH, 2010 U.S. Dist. LEXIS 63212, at *16–17, 2010 WL 2574032, at *6 (E.D. Cal. June 25, 2010) (plaintiff has no standing to request rescission because she was “not a party to the loan contract”); White v. Deutsche Bank Nat’l Trust Co., No. 09 CV 1807 JLS (JMA), 2010 U.S. Dist. LEXIS 89328, at *8–9, 2010 WL 3420766, at *3 (S.D. Cal. Aug. 30, 2010) (plaintiffs did not have standing under TILA because they were not owners of the property encumbered by the loan); Johnson v. First Fed. Bank of Cal., Nos. C 08-01796 PVT, C 08-00264 PVT, 2008 U.S. Dist. LEXIS 111020, at *8–11, 2008 WL 2705090, at *5 (N.D. Cal. Jul. 8, 2008) (holding a party who was not named in the loan papers was not a “consumer” under TILA and therefore had no standing to bring a TILA claim).
[67]Wright, 22 F.3d at 649–50; Sibersky, 155 F. App’x at 11–12; Guillory v. WFS Fin., Inc., No. C 06-06963 JSW, 2007 U.S. Dist. LEXIS 24910, at *6–7, 2007 WL 879017, at *2–3 (N.D. Cal. Mar. 21, 2007); Walker, 2002 U.S. Dist. LEXIS 25682, at *7, 2002 WL 31990400, at *1; Whatley v. Universal Collection Bureau, Inc., 525 F. Supp. 1204, 1204 (N.D. Ga. 1981).
[68] Barasch v. Estate Info. Servs., LLC, No. 07-CV-1693 (NGG)(MDG), 2009 U.S. Dist. LEXIS 79338, at *6, 2009 WL 2900261, at *2 (E.D.N.Y. Sept. 2, 2009).
[70] Anderson v. Good Shepherd Hosp., Inc., No. CV 2:09-CV-112 (TJW), 2011 U.S. Dist. LEXIS 23457, at *12–14, 2011 WL 846091, at *5 (E.D. Tex. Mar. 7, 2011).
[71]Walker, 2002 U.S. Dist. LEXIS 25682, at *1–7, 2002 WL 31990400, at *2–4.
[72] Montgomery v. Huntington Bank, 346 F.3d 693, 697 (6th Cir. 2003).
[73] 15 U.S.C. § 1692c(d); see Montgomery, 346 F.3d at 697 (drawing a distinction between this section and sections 1692d and 1692e).
[74]Barasch, 2009 U.S. Dist. LEXIS 79338, at *4–10, 2009 WL 2900261, at *2–4.
[75]See Bank v. Pentagroup Fin., LLC, No. 08-CV-5293 (JG) (RML), 2009 U.S. Dist. LEXIS 47985, at *15, 2009 WL 1606420, at *4 (E.D.N.Y. June 9, 2009) (“Due to the broad language of § 1692k and the plain language of § 1692d, which is not limited in its applicability to consumers, a plaintiff who is not a consumer may have standing to assert a claim brought pursuant to § 1692d.”).
[77]E.g., Burdett v. Harrah’s Kan. Casino Corp., 294 F. Supp. 2d 1215, 1227 (D. Kan. 2003); Wenrich v. Robert E. Cole, P.C., No. 00-2588, 2000 U.S. Dist. LEXIS 18687, at *8–12, 2001 WL 4994, at *3–4 (E.D. Pa. Dec. 21, 2000); Whatley, 525 F. Supp. at 1205–06.
[78]E.g., Thomas v. Consumer Adjustment Co., 579 F. Supp. 2d 1290, 1298 (E.D. Mo. 2008); Conboy v. AT&T Corp., 84 F. Supp. 2d 492, 504 n.9 (S.D.N.Y. 2000); Dewey v. Associated Collectors, Inc., 927 F. Supp. 1172, 1174–75 (W.D. Wis. 1996); Dutton v. Wolhar, 809 F. Supp. 1130, 1134–35 (D. Del. 1992); Riveria, 682 F. Supp. at 175; Whatley, 525 F. Supp. at 1205–06.
[86]But see, e.g., Smith v. Aitima Med. Equip., Inc., No. ED CV 16-00339-AB (DTBx), 2016 U.S. Dist. LEXIS 113671, at *9, 2016 WL 4618780, at *3 (C.D. Cal. July 29, 2016) (denying motion to dismiss and faulting defendant for “mixing particularization with concreteness, two distinct requirements for standing”).
[87] Prophet v. Joan Myers, Myers & Assocs., P.C., No. H-08-0492, 2009 U.S. Dist. LEXIS 43232, at *10, 2009 WL 1437799, at *3 (S.D. Tex. May 21, 2009) (emphasis added); accord King v. Trott & Trott P.C., No. 07-11359, 2008 U.S. Dist. LEXIS 111688, at *13–15, 2008 WL 2063555, at *5 (E.D. Mich. Mar. 28, 2008).
[89] West v. Nationwide Credit, Inc., 998 F. Supp. 642, 645 n.2 (W.D.N.C. 1998) (quoting S. Rep. No. 95-382, at 1977).
[90]Prophet, 2009 U.S. Dist. LEXIS 43232, at *8–11, 2009 WL 1437799, at *3–4 (distilling case law); accord Dewey, 927 F. Supp. at 1174.
[91] Jon Henley, Haiti: A Long Descent to Hell, The Guardian, Jan. 14, 2010. Even centuries later, the recorded horrors that spawned this legend still chill and inflame.
[93]See Jamie Russell, Book of the Dead: The Complete History of Zombie Cinema (2014) (charting the history of the walking dead from the monster’s origins in Haitian voodoo through its cinematic debut in 1932’s White Zombie, up to blockbuster World War Z and beyond).
[94]See R. Murray Thomas, Roots of Haiti’s Vodou-Christian Faith: African and Catholic Origins 74 (2014) (defining “bokor” (male) and “caplata” (female) as a male or female voodoo witch whose black magic included the creation of zombies).
When a lawyer is retained as counsel by the founders of a new business, it is fundamentally important that the lawyer determine who is—and who is not—the client for purposes of the engagement. And because the various constituents may reasonably have different views as to the identity of the client(s), it is also important that the lawyer communicate clearly to such constituents whether or not they are clients.
Lawyers should be familiar with Rule 1.13 (Organization as Client) of the American Bar Association’s Model Rules of Professional Conduct. Paragraph (a) of Rule 1.13 provides that a “lawyer employed or retained by an organization represents the organization acting through its duly authorized constituents.” But, as made clear by paragraph (g) of Rule 1.13, such retention does not mean that the lawyer cannot also represent other constituents: “A lawyer representing an organization may also represent any of its directors, officers, employees, members, shareholders or other constituents, subject to the provisions of Rule 1.7 [Conflict of Interest: Current Clients].”
Further, paragraph (f) of Rule 1.13 makes clear that “[i]n dealing with an organization’s directors, officers, employees, members, shareholders or other constituents, a lawyer shall explain the identity of the client when the lawyer knows or reasonably should know that the organization’s interests are adverse to those of the constituents with whom the lawyer is dealing.”
This establishes a duty for lawyers who would represent both an organization and certain constituents to clearly disclose both the existence and scope of the lawyer’s representation. While a lawyer is permitted, under the Model Rules of Professional Conduct, to represent both the organization and certain constituents, the lawyer must be vigilant about conflicts of interest.
Start-Ups
The analysis as to the identity of the client becomes somewhat complicated when the organization or entity for the new business has not yet been formed. Can the lawyer have an entity that does not yet exist as a client? And, if not, does that necessarily mean that the founders must be the clients (at least initially)?
Business lawyers are often retained with the understanding that they will be the lawyer for the to-be-formed entity, and that the founders are not clients. As a practical matter, such understanding is defined by contract among the parties. However, this contractual agreement can be complicated by several factors. For one, the founders might not understand the nature of the engagement. For another, the entity might never be formed, or other procedural issues might preclude the contract from completing as intended. Therefore it is important that the lawyer clearly define who is and who is not the client(s), and perhaps when the lawyer-client relationship begins or ends.
Equity Ownership in the Client
Working with start-up or emerging entity clients, lawyers often are in a position to acquire an equity ownership in the client. This can occur through the lawyer’s participation in a fundraising round along with other preferred investors, or through the acquisition of stock or stock options in lieu of fees. Such transactions implicate Model Rule 1.8(a), which prohibits a lawyer from entering into a business transaction with a client unless certain conditions are satisfied.
The conditions on a transaction through which a lawyer acquires equity ownership in a client include: (1) the transaction and its terms are fair and reasonable to the client, and are fully disclosed in writing in a manner that can be reasonably understood by the client; (2) the client is advised in writing of the desirability of seeking, and is given a reasonable opportunity to seek, the advice of independent legal counsel; and (3) the client gives informed consent, in a writing signed by the client, to the essential terms of the transaction.
In addition, if the equity interest is conveyed to the lawyer as payment for legal fees, the transaction can also implicate Model Rule 1.5, which prohibits a lawyer from charging or collecting an unreasonable fee. The fairness of any lawyer investment in a client will depend on the essential terms of the transaction: what value did the lawyer provide, and what value did the lawyer receive in return? This determination becomes more complicated when stock is provided as payment for legal services. The value of the stock is determined as of the time of the transaction, which means later success can create a situation where the value of the lawyer’s equity stake far exceeds the value of services originally provided. And there is the resulting potential issue that, if a lawyer continues to provide services to a client in which the lawyer has an equity interest, the lawyer’s self-interest may create a conflict of interest under Rule 1.7.
Working with Early-Stage Companies
When advising growth companies on equity financings and other transactions, the business lawyer must continue to keep the duties and interests of board members, shareholders and investors separate and distinct from the duties, obligations, and interests of the company as the client. Such situations also raise issues under Model Rules 4.1 (Truthfulness in Statements to Others), 4.2 (Communication with Person Represented by Counsel) and 4.3 (Dealing with Unrepresented Person). All of these become doubly complicated if the lawyer also represents certain constituents.
In addition, under certain circumstances, the lawyer may have an obligation to “report up the corporate ladder.” Paragraph (b) of Model Rule 1.13 provides that:
If a lawyer for an organization knows that an officer, employee or other person associated with the organization is engaged in action, intends to act or refuses to act in a matter related to the representation that is a violation of a legal obligation to the organization, or a violation of law that reasonably might be imputed to the organization, and that is likely to result in substantial injury to the organization, then the lawyer shall proceed as is reasonably necessary in the best interest of the organization. Unless the lawyer reasonably believes that it is not necessary in the best interest of the organization to do so, the lawyer shall refer the matter to higher authority in the organization, including, if warranted by the circumstances to the highest authority that can act on behalf of the organization as determined by applicable law.
This obligation can create ramifications for the lawyer if the issues he or she must report are matters which he or she only encountered in the course of representing a constituent, or the client company.
Identity of Client in Exit Transactions
Exit transactions can also raise issues as to the identity of the client, and possible conflicts of interest for the lawyer. The crux of this issue is the type of transaction, and the identity of the parties to the transaction.
For example, a lawyer for a closely-held company may be retained to work on a transaction pursuant to which the company’s business is being sold to a third-party buyer. Such a transaction typically is structured as either an asset sale, a stock sale or a merger. When the company is a party to an exit transaction structured as an asset sale or merger, the lawyer’s role as company counsel is clear.
If, however, the transaction is structured as a stock sale, the lawyer’s role becomes more complicated. In an exit transaction structured as a stock sale, the stockholders are the parties to the transaction, and typically the company itself is not a party. As a result, the lawyer may be acting for the direct benefit of the stockholders, and not for the company. Working on such a transaction may create conflicts of interest for the lawyer, both during the transaction and for any post-closing work as well.
Conclusion
Lawyers must be able to identify who is, and who is not, their client in order to comply with their professional obligations. Clearly communicating this to clients is essential. Lawyers should be mindful of the ways their representation can morph during a business’s early phases, whether their contract is affected by the company’s failure to launch, or if they are called upon to handle exit transactions. The identity of clients—whether it be the company or constituents—affects other considerations, including a lawyer’s duties during representation. And unexpected factors, such as the nature of a stock sale transaction, can create perilous situations for business lawyers.
The Supreme Court decided a number of significant business cases in the 2019 and 2020 terms. To outside observers, the decisions are characterized largely by continuity and incrementalism—we did not see a swinging pendulum of opinions in these terms—though some may find some of the outcomes surprising. This term saw Justice Amy Coney Barrett join the Court, replacing the late Justice Ruth Bader Ginsburg, and it also saw continuing use of the shadow docket to shape the law.
At least three overall themes emerge. First:textualism. Justice Elena Kagan, eulogizing her friend Justice Antonin Scalia, remarked “[w]e are all textualists now.” Reading the Court’s majority and dissenting opinions in Bostock v. Clayton County,[1] this seems to be true. Although the Court’s 6-3 decision prompted vigorous dissents, all 9 justices adopted a purely textualist approach. Their disagreements turned instead on the type of textualism the Supreme Court should employ and how to apply it.
Regardless of the type of textualism, however, the high court’s trend seems to suggest much of our statutory interpretation courses of yore are obsolete. Bostock appears to focus narrowly on the bare language of a statute, almost without regard to historical context and common usage at the time of enactment. It is clear that accepting textualism does not eliminate disagreement.
This term also saw Judge Barrett’s textualism debut with her majority opinion in Van Buren v. United States.[2] The case, like Bostock, is a good example of how the justices may disagree even within the textualism world. The majority adopted a narrow reading of the Computer Fraud and Abuse Act of 1986, stating that the Act “covers those who obtain information from particular areas in the computer—such as files, folders, or databases—to which their computer access does not extend,” not those who have “improper motives for obtaining information that is otherwise available to them.” Justice Thomas dissented, joined by Chief Justice Roberts and Justice Alito, in a very literal sense over the implications of the word “so.” Justice Thomas, looking to text and history, wrote that the law prohibits a person from exceeding his or her scope of authority when using a computer that belongs to someone else.
In Nestlé USA, Inc. v. Doe I,[3] Justice Thomas did not hesitate to apply textualism when writing for the majority in this case involving the Alien Tort Act of 1789 (“ATS”). The ATS gives federal district courts jurisdiction over “any civil action by an alien for a tort only, committed in violation of the law of nations or a treaty of the United States.” In Part III of his opinion, Justice Thomas (joined by Justices Gorsuch and Kavanaugh) proposed “that federal courts should not recognize private rights of action for violations of international law beyond the three historical torts [previously] identified,” because “creating a cause of action to enforce international law beyond [the] three historical torts invariably gives rise to foreign-policy concerns,” warranting deference to Congress. Note that this textualist analysis did look to history, context and usage.
Bostock, Van Buren, and Nestlé suggest that the Court’s focus on textualism is here to stay. What the implications are remains to be seen. Is it possible that the Court’s insistence on following the precise words of a statute will stimulate Congress to draft more carefully?
Second, separation and limitation of powers under the Constitution. This continues to be a paramount concern of the Court. Three business-related cases illustrate the Court’s ongoing focus on the importance of separation of powers and of constitutional limits on government.
In TransUnion LLC v. Ramirez,[4] Justice Kavanaugh’s majority opinion provided a detailed historical analysis of Article III standing requirements, and critically emphasized that while Congress can create causes of action for what it identifies as injuries, it is for the courts to decide whether an alleged injury satisfies Article III’s injury-in-fact requirement.
In United States v. Arthrex,[5] the Court grappled with the Appointments Clause in the context of administrative patent judges (“APJs”) of the Patent Trial and Appeal Board. It ultimately held that the unreviewable authority of the APJs takes them out of any executive review and, therefore, conflicts with the Appointments Clause’s purpose of preserving political accountability.
Cedar Point Nursery v. Hassid[6] upheld property rights as a limit on government action. The Court held that under the Fifth Amendment’s Takings Clause, California’s regulation that required property owners to allow labor organizations to access their property amounted to an appropriation of private property and, thus, a per se physical taking.
Third: procedure. Finally—like any other Court—the Supreme Court cares about procedure. As always, arbitration continues to be a hot topic for this Court. In GE Power v. Outokumpu,[7] the high court unanimously held the New York Convention does not preclude a nonsignatory’s enforcement of arbitration agreements under the doctrine of equitable estoppel.
In the 2020 return trip of Henry Schein v. Archer & White[8] to the Court, the case was argued only to have certiorari dismissed as improvidently granted, and sent back down to the Fifth Circuit. In the context of class actions, Goldman Sachs v. Arkansas Teacher Retirement System[9] clarified the standards for class certification under Rule 23 in the context of 10(b) securities fraud. The Court focused on the need for truly common questions of law and fact.
In addition to the cases under the headers of the three main themes, the Court also decided two significant intellectual property cases. Google v. Oracle[10] clarified how “fair use” concepts apply to application programming interfaces under copyright law. PTO v. Booking.com[11] held that the combination of a generic term (“booking”) with a top-level domain name (“.com”) can be protected as a trademark even if neither alone could be protected.
We all pay taxes, and we all talk about them, especially how we wish they were lower. A surprising number of people also express tax opinions to others. Lawyers often speak with authority, but sometimes, they make tax comments that turn out to be less than accurate. Here are some of the more common tax fallacies I’ve heard, and why I think they’re mistaken.
1. “Putting the money in our lawyer client trust account isn’t taxable. It can’t be taxed until we take it out of our trust account.”
Actually, when settlement monies go into a lawyer’s trust account, it is treated for tax purposes as received by the lawyer and received by the client. It is actual receipt of fees to the lawyer, and constructive receipt of the client’s share to the client. If a case settles and funds are paid to the plaintiff’s lawyer trust account, both the client and the lawyer can be taxed.
2. “My client can’t be taxed on money in our trust account. It isn’t received by the client until I pay the client.”
This is a variation on #1. Taxes can often precede actual physical receipt. The IRS says a lawyer is the agent of his or her client, so absent exceptional circumstances, the client is treated as receiving funds when the lawyer does. It can create problems when settlement funds arrive in late December, but the client’s check isn’t dispatched until January. It may be possible to treat the funds as January income, and documentation can help. But if push comes to shove, the IRS can say it was payment in December.
3. “If a settlement agreement calls for payment in the future, the client has constructive receipt now.”
Actually, you can call for payment in the future in many common circumstances without triggering taxes before the payment is made. Suppose that a client agrees orally to settle a case in December, but specifies in the settlement agreement that the money will be paid in January. Is the amount taxable in December or January? The answer is January.
The mere fact that the client could have agreed to take the settlement in December does not mean the client has constructive receipt. The client is free to condition the execution of a settlement agreement on payment later. The key will be what the settlement says before it is signed. But if you sign the settlement agreement first and then ask for a delay in payment, you have constructive receipt.
4. “Don’t worry, the defendant won’t issue a Form 1099 for this.”
Be careful: you never really know what IRS Forms 1099 will be issued unless the settlement agreement makes it clear. Do you know if the defendant has your law firm’s or your client’s tax ID number? If a Form 1099 is issued in January, you usually will not be able to convince the defendant to undo it without express tax language in the settlement agreement that negates a Form 1099.
If the settlement agreement is explicit and negates a Form 1099, you can say that the Form 1099 breaches the settlement agreement. In my experience, defendants always fix this quickly, issuing a corrected Form 1099. In contrast, if the settlement agreement is not explicit, you are out of luck. Forms 1099 are issued for most legal settlements, except payments for personal physical injuries and for capital recoveries.
5. “I have to pay tax on the lawyer’s fees I receive, so the IRS can’t possibly tax the plaintiff on the same legal fees. That would be unconstitutional.”
Both the client and the lawyer have to take legal fees into income, and that is not unconstitutional. In Commissioner v. Banks, 543 U.S. 426 (2005), the U.S. Supreme Court held that plaintiffs in contingent fee cases generally must recognize gross income equal to 100 percent of their recoveries. Even if the lawyer is paid separately by the defendant, and even if the plaintiff receives only the net settlement after legal fees, 100% of the money is treated as received by the plaintiff.
This harsh tax rule usually means that plaintiffs must figure out a way to deduct their legal fees. Of course, the legal fees are gross income to the lawyer, too. It may not seem fair, but this isn’t double taxation, and it isn’t unconstitutional.
6. “The defendant can’t issue a Form 1099 to the plaintiff for 100% of the settlement and issue another Form 1099 to the plaintiff lawyer for 100%. That would be double reporting of income.”
Wrong again. In fact, the IRS regulations on Forms 1099 expressly say that defendants should usually issue two Forms 1099, each for 100% of the money when the defendant does not know exactly how much each is receiving. If the defendant issues a joint check to the lawyer and the client, the plaintiff will usually receive a Form 1099 for 100%, and so will the lawyer.
7. If a plaintiff law firm receives an IRS Form 1099 for 100% of a settlement, the law firm must pay tax on 100%, even if it immediately pays out 60% to the plaintiff.
No, the plaintiff law firm merely pays tax on its fee—40% in this example. The confusion often centers on IRS Form 1099. Generally, amounts paid to a plaintiff’s attorney as legal fees are includable in the income of the plaintiff, even if paid directly to the plaintiff’s attorney by the defendant. For tax purposes, the plaintiff is considered to receive the gross award, including any portion that goes to pay legal fees and costs. See Commissioner v. Banks, 543 U.S. 426 (2005).
The IRS rules for Form 1099 reporting bear this out. Under current Form 1099 reporting regulations, a defendant or other payer that issues a payment to a plaintiff and a lawyer must issue two Forms 1099. The lawyer should receive one Form 1099 for 100 percent of the money. The client should also receive a Form 1099, also for 100 percent.
The lawyer’s Form 1099 will usually be a gross-proceeds Form 1099; gross proceeds paid to an attorney are currently reported in Box 10 of Form 1099-MISC. However, until 2020, they were reported in Box 14 of Form 1099-MISC; the change came when new Form 1099-NEC were created for independent contractors.
Lawyers should take note that gross proceeds reporting (Box 10 of Form 1099-MISC) is the best reporting for a lawyer. Money reported as gross proceeds paid to a lawyer is not classified as income by the IRS. That is, unlike Form 1099-MISC box 3 (other income) or Form 1099-NEC, the IRS does not match the taxpayer ID number for gross proceeds paid to an attorney with the lawyer’s tax return to be sure it is income.
A portion of the payment reported to the lawyer may be income to the lawyer. However, the amount could also be for a real estate closing or some other client purpose. The IRS does not track amounts reported as gross proceeds paid to an attorney on Form 1099 in the way it treats say “other income” on from 1099-MISC Box 3. Therefore, the lawyer should simply report whatever portion of the reported payment (if any) is income to the lawyer.
8. “Your damages are for pain and suffering so they are tax free.”
The phrase “pain and suffering” may mean something under state tort law. But this well-worn phrase doesn’t mean much in tax law. In fact, far from being a helpful phrase for tax purposes, the IRS generally treats it as code for emotional distress, and that is not enough for tax-free treatment. To be tax-free, compensatory damages must be for personal physical injuries or physical sickness (discussed further in the next section).
Stay away from ambiguous “pain and suffering” language in settlement agreements. Ideally, you want the defendant to pay on account of personal physical injuries, physical sickness and emotional distress therefrom.
9. “Emotional distress damages are not taxable.”
This fallacy remains surprisingly prevalent, even though Congress amended section 104 of the tax code back in 1996 to state that emotional distress damages are taxable. That’s right, emotional distress damages are usually fully taxable. Only if the emotional distress emanates from physical injuries or physical sickness are the damages tax free. That’s why you might commonly see the phrase “physical injuries, physical sickness and emotional distress therefrom” in settlement agreements.
That sounds simple, but exactly what injuries are “physical” turns out to be messy. If you make claims for emotional distress, your damages are taxable. If you claim that the defendant caused you to become physically sick, those damages should be tax free. Yet if emotional distress causes you to be physically sick, even that physical sickness will not spell tax-free damages. That is because the emotional distress came first; the sickness is a byproduct of the emotional distress.
In contrast, if you are physically sick or physically injured, and your sickness or injury itself produces emotional distress, those emotional distress damages should be tax free. It is a confusing and nuanced subject. In the real world, of course, these lines are hard to draw, and sometimes can seem contrived.
In fact, of all the tax issues facing litigants, this one is probably the thorniest. Plaintiffs often think that their headaches and insomnia should lead to tax-free dollars. But you need to have something more serious that is a real “physical sickness.” Post-traumatic stress disorder is probably enough to be physical, although there is no tax case yet that expressly so holds.
10. “If you lose money or property and sue to recover it but don’t have a net gain, you can’t be taxed.”
This fallacy sounds perfectly logical. If you lost something worth $1 million and only get back $500,000, how could you possibly be taxed? Unfortunately, you can still be taxed even if you don’t break even in the case.
In investment loss and property damage or destruction cases, taxpayers need to consider their tax basis in the property, as well as its fair market value. For example, suppose that you had a million-dollar stock portfolio that was churned by your investment adviser, dropping its value to $200,000. That sounds like an $800,000 loss, right? If you recover, say, $500,000, isn’t it clear that you can’t be taxed?
Before you give a knee-jerk answer, we need to know your tax basis in the property. You had a $1M stock portfolio, and let’s say that you previously paid $1M for these investments. Thus, that was your tax basis and also the fair market value of the investments. In that event, you still lost money, so you would probably use the $500,000 to reduce your tax basis in the assets. However, what if your tax basis in the $1M portfolio was only $100,000?
In other words, you had $900,000 in untaxed capital gain before the mismanagement. You lost money when your investment adviser mis-stepped, but if you get back $500,000, with only a $100,000 tax basis, you have a big gain and taxes to pay. That is true even though you had a portfolio with a market value of $1M that was mismanaged, and even though you only got a portion of your money back.
The same kind of thing happens with other property cases, such as wildfire cases and many others. Where there are taxes to pay, in some cases there may be section 1033 involuntary conversion benefits possible.
Conclusion
Talking about taxes is natural, but be careful. There are many elements involved in resolving lawsuits and pre-litigation disputes. For lawyers and especially for clients, the situation can be difficult and emotionally charged. Extra tax uncertainties can add to the pressure, especially when they turn out to be big and unpleasant surprises later. Be careful out there.
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