Principal, Litigation Chair of North America Trade Secrets Practice Baker McKenzie 600 Hansen Way Palo Alto, CA 94304 (650) 856-5509 [email protected]
Assistant Editor
Adam Aft
Partner, IPTech Co-Chair Global Technology Transactions Baker McKenzie 300 E. Randolph St., Suite 5000 Chicago, IL 60001 (312) 861-2904 [email protected]
Contributor, Legislation Section
Yoon Chae
Senior Associate, IPTech Baker McKenzie 1900 N. Pearl Street, Suite 1500 Dallas, TX 75201 (214) 965-7204 [email protected]
Introduction
We are pleased to present the inaugural Chapter on Artificial Intelligence. For years, I have been at the forefront of advocating for rational federal regulation of AI and have published on AI ethics and fairness.I frequently represent clients with legal issues related to both commercial and embedded AI. Additionally, I am the host of the ABA’s AI.2day Podcast. In 2018, my proposed legislation, The AI Data Protection Act, was formalized into a House of Representatives Draft Discussion Bill. In 2021, the ABA will publish my book which is designed to be an AI field guide for business lawyers.
So I was thrilled when the Section agreed that the Annual Review should include a new Chapter devoted entirely to AI. Before any substantive federal legislation is enacted, many legal issues related to AI will play out in state and federal courts around the country. As applications of artificial intelligence, including machine learning, continue to be deployed in a myriad of ways that impact our health, work, education, sleep, security, social interaction, and every other aspect of our lives, many critical questions do not have clear cut answers yet. Companies, counsel, and the courts will, at times, struggle to grasp technical concepts and apply existing law in a uniform way to resolve business disputes. Thus, tracking and understanding the emerging body of law is critically important for business lawyers called on to advise clients in this area. As with other areas of emerging technology, the courts will be faced with applying legal doctrines in new ways in view of the nature of the technology ranging from the use of AI in criminal cases to the impact of AI on patentable subject matter.
The goal of this Chapter is to serve as a useful tool for those business attorneys who seek to be kept up to date on a national basis concerning how the courts are deciding cases involving AI. Micro and macro trends can only be identified by surveying cases around the country. We confidently predict the cases we report will increase exponentially year over year.
As this is our first installment of the AI Chapter in a burgeoning field, we made some editorial decisions: (i) we included a few cases older than the past year; (ii) unlike other Chapters, we have included cases of note recently filed in the lower courts which we will track in subsequent editions; and (iii) we included legislation and pending legislation in our summary.
We also made certain judgments as to what should be included. A notable example is facial recognition. Due to the nature of the underlying technology and the complexity of facial recognition, the subject matter necessarily involve issues of algorithmic/artificial intelligence. However, we did not include every case that references facial recognition when the issue at bar pertained to procedural aspects such as class certification (e.g., class action lawsuits filed under the Illinois Biometric Information Privacy Act (BIPA) (740 ILCS 14).
Finally, I want to thank my two colleagues, Adam Aft and Yoon Chae, for their assistance in preparing this inaugural chapter. Adam and Yoon are both knowledgeable and accomplished AI attorneys with whom I frequently collaborate. We are excited to add many colleagues from other firms around the country to next year’s Chapter.
We hope this Chapter provides useful guidance to practitioners of varying experience and expertise and look forward to tracking the trends in these cases and presenting the cases arising in the next several years.
Bradford Newman
United States Supreme Court
There were no qualifying decisions by the United Sates Supreme Court. We note the Court has heard a number of cases foreshadowing the types of issues that will soon arise with respect to artificial intelligence, such as United States v. Am. Library Ass’n (539 U.S. 194 (2003)), in which a plurality of the Court upheld the constitutionality of filtering software that libraries had to implement pursuant to the Children’s Internet Protection Act, and Gill v. Whitford (138 S. Ct. 1916(2017)), in which, if the plaintiffs had standing, the Justices may have had to evaluate the use of sophisticated software in redistricting (a point noted again in Justice Kagan’s express reference to machine learning in her dissent in Rucho v. Common Cause (139 S. Ct. 2484 (2019))). The Court had previously concluded that a “people search engine” site presenting incorrect information that prejudiced a plaintiff’s job search was a cognizable injury under the Fair Credit Reporting Act in Spokeo, Inc. v. Robins (136 S. Ct. 1540 (2016)). These cases are representative of the type of any number of cases that are likely to make their way to the Court in the near future that will require the Justices to contemplate artificial intelligence, machine learning, and the impact of the use of these technologies.
First Circuit
There were no qualifying decisions within the First Circuit.
Second Circuit
Force v. Facebook, Inc., 934 F.3d 53 (2d Cir. 2019). Victims, estates, and family members of victims of terrorist attacks in Israel alleged that Facebook was a provider of terrorist postings where they developed and used algorithms designed to match users’ information with other users and content. The court held that Facebook was a publisher protected by Section 230 of the Communications Decency Act and that the term “publisher” under the Act was not so limited that Facebook’s use of algorithms to match information with users’ interests changed Facebook’s role as a publisher.
Additional Cases of Note
Calderon v. Clearview AI, Inc., 2020 U.S. Dist. LEXIS 94926 (S.D.N.Y. 2020) (stating the court’s intent to consolidate cases against Clearview based on a January 2020 New York Times article alleging defendants scraped over 3 billion facial images from the internet and scanned biometric identifiers and then used those scans to create a searchable database, which defendants then allegedly sold access to the database to law enforcement, government agencies, and private entities without complying with BIPA); see also Mutnick v. Clearview AI, Inc., 2020 U.S. Dist. LEXIS 109864 (N.D. Ill. 2020).
People v. Wakefield, 175 A.D.3d 158 (N.Y. App. Div. 2019) (concluding no violation of the confrontation clause where the creator of artificial intelligence software was the declarant, not the “sophisticated and highly automated tool powered by electronics and source code”); see also People v. H.K., 2020 NY Slip Op 20232, 130 N.Y.S.3d 890 (Crim. Ct. 2020) (following Wakefield in concluding that, where software was “acting as a highly sophisticated calculator,” the analyst using the software was still a declarant and the right to confrontation was preserved).
Vigil v. Take-Two Interactive Software, Inc., 235 F. Supp. 3d 499 (S.D.N.Y. 2017) (affirmed in relevant part bySantana v. Take-Two Interactive Software, Inc., 717 Fed.Appx. 12 (2d Cir. 2017)) (concluding that BIPA doesn’t create a concrete interest in the form of right-to-information, but instead operates to support the statute’s data protection goal; therefore, defendant’s bare violations of the notice and consent provisions of BIPA were dismissed for lack of standing).
LivePerson, Inc. v. 24/7 Customer, Inc., 83 F. Supp. 3d 501 (S.D.N.Y. 2015) (determining plaintiff adequately pleaded possession and misappropriation of a trade secret where plaintiff alleged its “predictive algorithms” and “proprietary behavioral analysis methods” were based on many years of expensive research and were secured by patents, copyrights, trademarks and contractual provisions).
Third Circuit
Zaletel v. Prisma Labs, Inc., No. 16-1307-SLR, 2017 U.S. Dist. LEXIS 30868 (D. Del. Mar. 6, 2017). The plaintiff had a “Prizmia” photo editing app. The plaintiff alleged trademark infringement based on the defendant’s “Prisma” photo transformation app. In reviewing the Third Circuit’s likelihood of confusion factors, the court considered the competition and overlap factor. The court concluded that, “while plaintiff broadly describes both apps as distributing photo filtering apps, the record demonstrates that defendant’s app analyzes photos using artificial intelligence technology and then redraws the photos in a chosen artistic style, resulting in machine generated art. Given these very real differences in functionality, it stands to reason that the two products are directed to different consumers.”
Fourth Circuit
Sevatec, Inc. v. Ayyar, 102 Va. Cir. 148 (Va. Cir. Ct. 2019). The court noted that matters such as data analytics, artificial intelligence, and machine learning are complex enough that expert testimony is proper and helpful and such testimony does not invade the province of the jury.
Fifth Circuit
Aerotek, Inc. v. Boyd, 598 S.W.3d 373 (Tex. App. 2020). The court expressly acknowledged that one day courts may have to determine whether machine learning and artificial intelligence resulted in software altering itself and inserting an arbitration clause after the fact.
Additional Cases of Note
Bertuccelli v. Universal City Studios LLC, No. 19-1304, 2020 U.S. Dist. LEXIS 195295 (E.D. La. Oct. 21, 2020) (denying a motion to disqualify an expert the court concluded was component to testify in a copyright infringement case after having performed an “artificial intelligence assisted facial recognition analysis” of the plaintiff’s mask and the alleged infringing mask).
Sixth Circuit
Delphi Auto, PLC v. Absmeier, 167 F. Supp. 3d 868 (E.D. Mich. 2016). Plaintiff employer alleged defendant former employee breached his contractual obligations by terminating his employment with the plaintiff and accepting a job with Samsung in the same line of business. Defendant worked for the plaintiff as director of its labs in Silicon Valley, managing engineers and programmers on work related to autonomous driving. Defendant had signed a confidentiality and noninterference agreement. The court concluded that the plaintiff had a strong likelihood of success on the merits of its breach of contract claim. Therefore, the court granted the plaintiff’s motion for preliminary injunction with certain modifications (namely, limiting the applicability of the non-compete provision to the field of autonomous vehicle technology for one year because the Court determined that autonomous vehicle technology is a “small and specialized field that is international in scope” and, therefore, a global restriction was reasonable).
Additional Cases of Note
In re C.W., 2019-Ohio-5262 (Oh. Ct. App. 2019) (noting that “[p]roving that an actual person is behind something like a social-networking account becomes increasingly important in an era when Twitter bots and other artificial intelligence troll the internet pretending to be people”).
Seventh Circuit
Bryant v. Compass Group USA, Inc., 958 F.3d 617 (7th Cir. 2020). Plaintiff vending machine customer filed class action against vending machine owner/operator, alleging violation of BIPA when it required her to provide a fingerprint scan before allowing her to purchase items. The district court found defendant’s alleged violations were mere procedural violations that cause no concrete harm to plaintiff and, therefore, remanded the action to state court. The Court of Appeals held that a violation of § 15(a) (requiring development of a written and public policy establishing a retention schedule and guidelines for destroying biometric identifiers and information) of BIPA did not create a concrete and particularized injury and plaintiff lacked standing under Article III to pursue the claim in federal court. In contrast, the Court of Appeals held that a violation of § 15(b) (requiring private entities make certain disclosures and receive informed consent from consumers before obtaining biometric identifiers and information) of BIPA did result in a concrete injury (plaintiff’s loss of the power and ability to make informed decisions about the collection, storage and use of her biometric information) and she, therefore, had standing and her claim could proceed in federal court.[1]
Rosenbach v. Six Flags Entertainment Corporation, 129 N.E.3d 1197 (Ill. 2019). Rosenbach is a key Supreme Court of Illinois case answering whether one qualifies as an “aggrieved” person for purposes of BIPA and may seek damages and injunctive relief if she hasn’t alleged some actual injury or adverse effect beyond a violation of her rights under the statute. Plaintiff purchased a season pass for her son to defendant’s amusement park. Plaintiff’s son was asked to scan his thumb into defendant’s biometric data capture system and neither plaintiff nor her son were informed of the specific purpose and length of term for which the son’s fingerprint had been collected. Plaintiff brought suit alleging violation of BIPA. The Supreme Court of Illinois held that an individual need not allege some actual injury or adverse effect, beyond violation of his or her rights under BIPA, to qualify as an “aggrieved” person under the statute and be entitled to seek damages and injunctive relief. The court reasoned that requiring individuals to wait until they’ve sustained some compensable injury beyond violation of their statutory rights before they can seek recourse would be antithetical to BIPA’s purposes. The court found that BIPA codified individuals’ right to privacy in and control over their biometric identifiers and information. Therefore, the court found also that a violation of BIPA is not merely “technical,” but rather the “injury is real and significant.”
Additional Cases of Note
Kloss v. Acuant, Inc., 2020 U.S. Dist. LEXIS 89411 (N.D. Ill. 2020) (applying Bryant v. Compass Group (summarized in this chapter) and concluding that the court lacked subject-matter jurisdiction over plaintiff’s BIPA § 15(a) claims because a violation of § 15(a) is procedural and, thus, does not create a concrete and particularized Article III injury).
Acaley v. Vimeo, 2020 U.S. Dist. LEXIS 95208 (N.D. Ill. June 1, 2020) (concluding that parties made an agreement to arbitrate because defendant provided reasonable notice of its terms of service to users by requiring users to give consent to its terms when they first opened the app and when they signed up for a free subscription plan, but the BIPA violation claim alleged by the plaintiff was not within the scope of the parties’ agreement to arbitrate because the “Exceptions to Arbitration” clause excluded claims for invasion of privacy).
Heard v. Becton, Dickinson & Co., 2020 U.S. Dist. LEXIS 31249 (N.D. Ill. 2020) (concluding that, for § 15(b) to apply, an entity must at least take an active step to “collect, capture, purchase, receive through trade, or otherwise obtain” biometric data and the plaintiff did not adequately plead that defendant took any such active step where the complaint omitted specific factual detail and merely parroted BIPA’s statutory language and the plaintiff failed to adequately plead possession because he failed to sufficiently allege that defendant “exercised any dominion or control” over his fingerprint data).
Rogers v. CSX Intermodal Terminals, Inc., 409 F. Supp. 3d 612 (N.D. Ill. 2019) (denying defendant’s motion to dismiss and relying on the Illinois Supreme Court’s holding in Rosenbach (summarized in this chapter) to conclude that plaintiff’s right to privacy in his fingerprint data included “the right to give up his biometric identifiers or information only after receiving written notice of the purpose and duration of collection and providing informed written consent”).
Neals v. PAR Technology Corp., 419 F. Supp. 3d 1088 (N.D. Ill. 2019) (concluding that BIPA does not exempt a third-party non-employer collector of biometric information when an action arises in the employment context, rejecting defendant’s argument that a third-party vendor couldn’t be required to comply with BIPA because only the employer has a preexisting relationship with the employees).
Ocean Tomo, LLC v. PatentRatings, LLC, 375 F. Supp. 3d 915, 957 (N.D. Ill. 2019) (determining that Ocean Tomo training its machine learning algorithm on PatentRatings’ patent database violated a requirement in a license agreement between the parties that prohibited Ocean Tomo from using the database (which was designated as PatentRatings confidential information) from developing a product for anyone except PatentRatings).
Liu v. Four Seasons Hotel, Ltd., 2019 IL App(1st) 182645, 138 N.E.3d 201 (Ill. 2019) (noting that “simply because an employer opts to use biometric data, like fingerprints, for timekeeping purposes does not transform a complaint into a wages or hours claim”).
Eighth Circuit
There were no qualifying decisions within the Eighth Circuit.
Ninth Circuit
Patel v. Facebook, Inc., 932 F.3d 1264 (9th Cir. 2019). Facebook moved to dismiss plaintiff users’ complaint for lack of standing on the ground that the plaintiffs hadn’t alleged any concrete injury as a result of Facebook’s facial recognition technology. The court concluded that BIPA protects concrete privacy interests, and violations of BIPA’s procedures actually harm or pose a material risk of harm to those privacy interests.
WeRide Corp. v. Kun Huang, 379 F. Supp. 3d 834 (N.D. Cal. 2019). Autonomous vehicle companies brought, inter alia, trade secret misappropriation claims against former director and officer and his competing company. The court determined the plaintiff showed it was likely to succeed on the merits of its trade secret misappropriation claims where it developed source code and algorithms for autonomous vehicles over 18 months with investments of over $45M and restricted access to its code base to on-site employees or employees who use a password-protected VPN. Plaintiff identified its trade secrets with particularity where it described the functionality of each trade secret and named numerous files in its code base because plaintiff was “not required to identify the specific source code to meet the reasonable particularity standard.”
Additional Cases of Note
Hatteberg v. Capital One Bank, N.A., No. SA CV 19-1425-DOC-KES, 2019 U.S. Dist. LEXIS 231235 (C.D. Cal. Nov. 20, 2019) (relying on advances in technology, including use of artificial intelligence to “deepfake” audio, as a basis for denying defendant’s argument that a plaintiff must plead to a higher standard alleging specific indicia of automatic dialing to survive a motion to dismiss in a Telephone Consumer Protection Act case).
Williams-Sonoma, Inc. v. Amazon.com, Inc., No. 18-cv-07548-EDL, 2019 U.S. Dist. LEXIS 226300, at *36 (N.D. Cal. May 2, 2019) (denying Amazon’s motion to dismiss Williams-Sonoma’s service mark infringement case noting “it would not be plausible to presume that Amazon conducted its marketing of Williams-Sonoma’s products without some careful aforethought (whether consciously in the traditional sense or via algorithm and artificial intelligence)”).
Nevarez v. Forty Niners Football Co., LLC, No. 16-cv-07013-LHK (SVK), 2018 U.S. Dist. LEXIS 182255 (N.D. Cal. Oct. 16, 2018) (determining that protections exist such as protective orders and the Federal Rules of Evidence that prohibit a party from using artificial intelligence to identify non-responsive documents without identifying a “cut-off” point for some manner of reviewing the alleged non-responsive documents).
Tenth Circuit
There were no qualifying decisions within the Tenth Circuit.
Eleventh Circuit
There were no qualifying decisions within the Eleventh Circuit.
D.C. Circuit
Elec. Privacy Info. Ctr. v. Nat’l Sec. Comm’n on Artificial Intelligence, No. 1:19-cv-02906 (TNM), 2020 U.S. Dist. LEXIS 95508 (D.D.C. June 1, 2020). The court concluded that the National Security Commission on Artificial Intelligence is subject to both the Freedom of Information Act and the Federal Advisory Committee Act.
McRO, Inc. v. Bandai Namco Games America, Inc.,837 F.3d 1299 (Fed. Cir. 2016). Patent litigation over a patent which claimed a method of using a computer to automate the realistic syncing of lip and facial expressions in animated characters. The plaintiff owners of the patents brought infringement actions, and defendants argued the claims were unpatentable algorithms that merely took a preexisting process and made it faster by automating it on a computer. The court held that the patent claim was not directed to ineligible subject matter where the claim involved the use of automation algorithms and was specific enough such that the claimed rules would not prevent broad preemption of all rules-based means of automating facial animation.
Filed Cases
Kraus v. Cegavske, No. 82018, 2020 Nev. Unpub. LEXIS 1043 (Nov. 3, 2020). A lawsuit filed challenging, on behalf of President Trump, use of AI to authenticate ballot signatures.
Williams-Sonoma Inc. v. Amazon.com, Inc. (N.D. Cal. 3:18-cv-07548). Williams-Sonoma asserted a copyright infringement claim against Amazon related to how Amazon sells Williams-Sonoma’s products. Amazon argued that Williams-Sonoma didn’t state a claim for direct copyright infringement because it didn’t plead that Amazon engaged in “volitional conduct” where the algorithm chooses the disputed images. Williams-Sonoma argued that the Copyright Act covers “anyone” who violates it and the term encompasses artificial intelligence and “software agents.”
Asif Kumandan et al. v. Google LLC (N.D. Cal. 5:19-cv-04286). Plaintiff Google Assistant users filed a wiretapping class action against Google, alleging they were recorded without their consent or knowledge when the artificial intelligence voice recognition program allegedly recorded their conversations when plaintiffs never uttered the trigger words.
Vance et al v. Amazon.com, Inc. (W.D. Wa. 2:20-cv-01084); Vance et al v. Facefirst, Inc. (C.D. Cal. 2:20-cv-06244); Vance et al v. Google LLC (N.D. Cal. 5:20-cv-04696); and Vance et al v. Microsoft Corporation (W.D. Wa. 2:20-cv-01082). Chicago residents Steven Vance and Tim Janecyk filed four nearly identical proposed class actions against Amazon.com, Inc., Google LLC, Microsoft Corp., and a fourth company called Facefirst Inc., alleging the companies violated Illinois’ Biometric Information Privacy Act by “unlawfully collecting, obtaining, storing, using, possessing and profiting from the biometric identifiers and information” of plaintiffs without their permission. Plaintiffs allege that the tech companies used the dataset containing their geometric face scans to train computer programs how to better recognize faces. These companies, in an attempt to win an “arms race,” are working to develop the ability to claim a low identification error rate. Allegedly, the four tech giants obtained plaintiffs’ face scans by purchasing a dataset created by IBM Corp. (the subject of another suit brought by Janecyk).
Janecyk v. IBM Corp. (Cook County Cir. Ct. Ill. 2020CH00833). IBM Corp. was accused in an Illinois state court lawsuit of violating the state’s biometrics law when it allegedly collected photographs to develop its facial recognition technology without obtaining consent from the subjects to use biometric information. Plaintiff Janecyk, a photographer, said that at least seven of his photos appeared in IBM’s “diversity in faces” dataset. The photos were used to generate unique face templates that recognized the subjects’ gender, age and race, and were given to third parties without consent. IBM allegedly created, collected and stored millions of face templates—highly detailed geometric maps of the face—from about a million photos that make up the “diversity in faces” database. Janecyk claimed that IBM obtained the photos from Flickr, a website where users upload their photos. IBM obtained photos depicting people Janecyk has photographed in the Chicago area whom he had assured he was only taking their photos as a hobbyist and that their images wouldn’t be used by other parties or for a commercial purpose.
Jordan Stein v. Clarifai, Inc. (Cook County Cir. Ct. Ill. 2020CH01810). Clarifai, Inc., an artificial intelligence company, allegedly violated Illinois’ privacy law when it captured and profited from the profile photos of OKCupid Inc. users without their permission or knowledge, according to a lawsuit filed in Illinois state court. The company allegedly harvested the profile photos of tens of thousands of users, scanned the facial geometry to create face templates, and used the data to develop and train its facial recognition technology.
K. et al v. Google, LLC (N.D. Cal. 5:20-cv-02257). A proposed class action filed in California federal court alleged that Google violated federal privacy laws by selling and distributing Chromebooks that collect and store students’ facial and voice data. The complaint alleged that Google violated BIPA and the federal Children’s Online Privacy Protection Act (COPPA). Chromebooks come with a “G Suite for Education” platform through which Google collects face templates, or scans of a person’s face, as well as voice data, location data and search histories without permission, the complaint says. Google never informed the parents of the purpose and length of term for which their children’s biometric identifiers and information would be collected, stored and used. The complaint proposes two classes: (1) a BIPA class and (2) a COPPA class. The BIPA class seeks an injunction requiring Google to comply with BIPA and destroy data it has collected, plus monetary damages. The COPPA class seeks an injunction requiring Google to obtain parental consent to collect biometric data and delete data already collected without consent. The plaintiffs have moved to dismiss the case without prejudice.
Williams et al. v. PersonalizationMall.com LLC (N.D. Ill. 1:20-cv-00025). An online gift platform, PersonalizationMall.com, owned by Bed Bath & Beyond, moved to dismiss or stay an action against it accusing the online retailer of violating its rights under BIPA. Plaintiffs allege that they were never informed in writing that PersonalizationMall.com was capturing, collecting, storing or using their biometric information and they never signed a release consenting. The company moved for dismissal or, in the alternative, moved for the court to stay the case pending Illinois’ Appellate Court decision on whether the Illinois Workers’ Compensation Act (IWCA) preempts claims under BIPA. The company argues that plaintiffs’ claims clearly arose from their employment because they are challenging PersonalizationMall.com’s requirement that warehouse workers use their fingerprints to track hours and breaks.
Legislation
We organize the enacted and proposed legislation into (i) policy (e.g., executive orders); (ii) algorithmic accountability (e.g., legislation aimed at responding to public concerns regarding algorithmic bias and discrimination); (iii) facial recognition; (iv) transparency (e.g., legislation primarily directed at promoting transparency in use of AI); and (v) other (e.g., other pending bills such as federal bills on governance issues for AI).
Policy
[Fed] Maintaining Am Leadership in AI (Feb 2019). Executive order 13859 (Feb. 2019) launching “American AI Initiative” intended to help coordinate federal resources to support development of AI in the US.
[Fed] H R Res 153 (Feb 2019). Legislation to support the development of guidelines for ethical development of artificial intelligence.
[Fed / NIST] US Leadership in AI (Aug 2019). NIST to establish standards to support reliable, robust and trustworthy AI.
[CA] Res on 23 Asilomar AI Principles (Sep 2018). Adopted state resolution ACR 215 (Sept. 2018) expressing legislative support for the Asilomar AI Principles as “guiding values” for AI development.
Algorithmic Accountability
[Fed] Algorithmic Accountability Act (Apr 2019). Bills S 1108, HR 2231 (Apr. 2019) intended to require “companies to regularly evaluate their tools for accuracy, fairness, bias, and discrimination.”
[NJ] New Jersey Algorithmic Accountability Act (May 2019). Require that certain businesses conduct automated decision system and data protection impact assessments of their automated decision system and information systems.
[CA] AI Reporting (Feb 2019). Require California business entities with more than 50 employees and associated contractors and vendors to each maintain a written record of the data used relating to any use of artificial intelligence for the delivery of the product or service to the public entity.
[WA] Guidelines for Gov’t Procurement and Use of Auto Decision Systems (Jan 2019). Establish guidelines for government procurement and use of automated decision systems in order to protect consumers, improve transparency, and create more market predictability.
[NY] NYC (Jan 2018). —“A local law in relation to automated decision systems used by agencies” (Int. No. 1696-2017) required the creation of a task force for providing recommendations on how information on agency automated decision systems may be shared with the public and how agencies may address situations where people are harmed by such agency automated decision systems.
Facial Recognition Technology
[Fed] Commercial Facial Recognition Privacy Act (Mar 2019). Bill S 847 (Mar. 2019) intended to provide people information and control over how their data is shared with companies using facial recognition technology.
[Fed] FACE Protection Act (July 2019). Restrict federal government from using a facial recognition technology without a court order.
[Fed] No Biometric Barriers to Housing Act (July 2019). Prohibiting owners of certain federally assisted rental units from using facial recognition, physical biometric recognition, or remote biometric recognition technology in any units, buildings or grounds of such project.
[CA] Body Camera Account Act (Feb 2019). Bill A.B. 1215 was introduced to prohibit law enforcement agencies and officials from using any “biometric surveillance system,” including facial recognition technology, in connection with an officer camera or data collected by the camera.
[MA] An Act Establishing a Moratorium on Face Recognition (Jan 2019). Senate Bill 1385 was introduced to establish a moratorium on the use of face recognition systems by state and local law enforcement.
[NY] Prohibits Use of Facial Recog. Sys. (May 2019). Senate Bill 5687 was introduced to propose a temporary stop to the use of facial recognition technology in public schools.
[SF and Oakland, CA] City ordinances were passed to ban the use of facial recognition software by the police and other government agencies (June, July 2019).
[Somerville, MA] City ordinance was passed to ban the use of facial recognition technology by government agencies (July 2019).
Transparency
[CA] B O T Act – SB 1001 (effective July 2019). Enacted bill SB 1001 (eff. July 2019) intended to “shed light on bots by requiring them to identify themselves as automated accounts.”
[CA] Anti- Eavesdropping Act (Assemb. May 2019). Prohibiting a person or entity from providing the operation of a voice recognition feature within the state without prominently informing the user during the initial setup or installation of a smart speaker device.
[IL] AI Video Interview Act (effective Jan 2020). Provide notice and explainability requirements for recorded video interviews.
Other
[Fed] FUTURE of AI Act (Dec 2017). Requiring the Secretary of Commerce to establish the Federal Advisory Committee on the Development and Implementation of Artificial Intelligence.
[Fed] AI JOBS Act (Jan 2019). Promoting a 21st century artificial intelligence workforce.
[Fed] GrAITR Act (Apr 2019). Legislation directed to research on cybersecurity and algorithm accountability, explainability and trustworthiness.
[Fed] AI in Government Act (May 2019). Instructing the General Services Administration’s AI Center of Excellence to advise and promote the efforts of the federal government in developing innovative uses of AI to benefit the public, and improve cohesion and competency in the use of AI.
[Fed] AI Initiative Act (May 2019). Requiring federal government activities related to AI, including implementing a National Artificial Intelligence Research and Development Initiative.
[1] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted certain BIPA cases that did not add any additional information to those we have presented in this Chapter. See, e.g., Darty v. Columbia Rehabilitation and Nursing Center, LLC, 2020 U.S. Dist. LEXIS 110574 (N.D. Ill. 2020); Figueroa v. Kronos Incorporated, 2020 U.S. Dist. LEXIS 64131 (N.D. Ill. 2020); Namuwonge v. Kronos, Inc., 418 F. Supp. 3d 279 (N.D. Ill. 2019); Treadwell v. Power Solutions International Inc., 427 F. Supp. 3d 984 (N.D. Ill. 2019); Kiefer v. Bob Evans Farm, LLC, 313 F. Supp. 3d 966 (C.D. Ill. 2018); Rivera v. Google Inc., 238 F. Supp. 3d 1088 (N.D. Ill. 2017); In re Facebook Biometric Information Privacy Litigation, 185 F. Supp. 3d 1155 (N.D. Cal. 2016); Norberg v. Shutterfly, Inc., 152 F. Supp. 3d 1103 (N.D. Ill. 2015).
[2] As noted in our introduction, we made certain judgment calls with respect to which cases to include. For example, we omitted several patent cases directed to subject-matter eligibility that we felt did not substantiate additional insight to those we have presented in this Chapter. See, e.g., Kaavo Inc. v. Amazon.com, Inc., 323 F. Supp. 3d 630 (D. Del. 2018); Hyper Search, LLC v. Facebook, Inc., No. 17-1387, 2018 U.S. Dist. LEXIS 212336 (D. Del. Dec. 18, 2018); Purepredictive, Inc. v. H20.AI, Inc., No. 17-cv-03049, 2017 U.S. Dist. LEXIS 139056 (N.D. Cal. Aug. 29, 2017); Power Analytics Corp. v. Operation Tech., Inc., No. SA CV16-01955 JAK, 2017 U.S. Dist. LEXIS 216875 (C.D. Cal. July 13, 2017); Nice Sys. v. Clickfox, Inc., 207 F. Supp. 3d 393 (D. Del. 2016); eResearch Tech., Inc. v. CRF, Inc., 186 F. Supp. 3d 463 (W.D. Pa. 2016); Neochloris, Inc. v. Emerson Process Mgmt. LLP, 140 F. Supp. 3d 763 (N.D. Ill. 2015).
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Introduction
The ongoing coronavirus pandemic has impacted nearly every aspect of Americans’ lives since mid-March, and the virus’s disruption to the world of real estate has been especially large and widespread. Governmental authorities at all levels and in all areas of the country began taking swift and decisive measures to respond to the emergency at hand, often requiring citizens to shelter at home and ordering non-essential businesses of all types to close their doors or otherwise substantially scale back their operations. In order to protect the interests of people who had lost their jobs and the businesses who could not operate at full capacity, many jurisdictions also imposed temporary eviction and foreclosure moratoria to stay in effect during the pandemic. The effects of these actions on the basic functioning of the real estate market has been dramatic. Many businesses and people could not meet their rent and mortgage obligations. Landlords could no longer, for the most part, evict their tenants for nonpayment of rent. Ongoing real estate purchase and financing transactions were put on hold indefinitely. The ability to hold foreclosure sales was made much more difficult. Real estate attorneys very quickly needed to become experts on the doctrine of force majeure.
As with any disruptive force, the COVID-19 pandemic soon resulted in a wave of lawsuits by individuals, companies and organizations who were negatively impacted by it. This article will take an in-depth look at several of the prominent lawsuits that have thus far been fought and decided in the wake of the pandemic, to see how courts from all around the nation have tried to find the right balance between the interests of various parties who have been affected by these unprecedented events.
Part I – State and Local Challenges
As authorities at each of the federal, state, county and local levels enacted a broad range of measures to combat the spread of COVID-19 in their communities and to mitigate the negative effects of lockdowns and business closures on their citizens, many of these governmental regulations specifically targeted the rights and obligations of owners and renters of real property. Not surprisingly, several parties who were especially harmed by these emergency regulations and who felt that their rights were being violated sought help from the courts to protect their interests, challenging the constitutionality of these laws, ordinances and orders. Part I of this article will examine several significant decisions handed down in lawsuits challenging state and local COVID-19 regulations.
Elmsford Apartment Associates, LLC v. Cuomo
In Elmsford Apartment Associates, LLC v. Cuomo, three residential landlords brought suit in the United States District Court in New York seeking an injunction against Executive Order No. 202.28 on the grounds that the Executive Order violated their rights under the Takings Clause, Contracts Clause, Due Process Clause and Petition Clause of the United States Constitution.[1]
On March 2, 2020, in response to the first reported cases of COVID-19 in New York state, the legislature passed Senate Bill S7919, giving Governor Andrew Cuomo the power to suspend statues or regulations and issue accompanying directives “necessary to cope with the disaster,” provided that such measures are “in the interest of the health or welfare of the public,” “reasonably necessary to aid the disaster effort,” and “provide for minimum deviation” from existing laws.[2] On March 20, 2020, Governor Cuomo issued Executive Order 202.8, the first of several orders issued to temporarily prohibit evictions and foreclosures of residential and commercial tenants. One such subsequent order, Executive Order 202.28 (“EO 202.28”), was issued on May 7, 2020, allowing any tenant to use its security deposit (and any interest accrued on the deposit) as payment for rent under such tenant’s lease, and also suspending landlords’ ability to commence eviction proceedings for nonpayment of rent.[3] The plaintiffs in Elmsford brought suit to challenge the constitutional validity of EO 202.28.
The Elmsford court first dismissed the plaintiffs’ claim that the eviction moratorium constitutes a physical taking of their property. Citing various precedent from both the U.S. Supreme Court and the Second Circuit, the court reasoned that “[g]overnment action that does not entail a physical occupation, but merely affects the use and value of private property, does not result in a physical taking of property,” and that “a state does not commit a physical taking when it restricts the circumstances in which tenants may be evicted.”[4] Importantly, because the eviction moratorium is “temporary on its face, and does not disturb the landlords’ ability to vindicate their property rights”[5] at a later time (since rent arrearages will continue to accrue during such period and landlords will be able to evict their tenants once the moratorium expires), EO 202.28 does not constitute a physical taking of the plaintiffs’ property.
The court then concluded that EO 202.28 also does not constitute a regulatory taking of the plaintiffs’ property. Regulatory takings fall into two categories – categorical and non-categorical. A categorical regulatory taking occurs only when no productive or economic use of a property is permitted. Since the plaintiffs still enjoyed many economic benefits of ownership, the court easily concluded that EO 202.28 is not a categorical taking. As for a non-categorical taking, the court employed the three-pronged test established in Penn Central Transportation Co. v. New York City, weighing: (i) the economic impact of the regulation, (ii) the extent to which the regulation interferes with investment-backed expectations, and (iii) the character of the governmental action.[6]
The court’s evaluation of the economic impact of EO 202.28 was somewhat inconclusive, stating that “[i]t is difficult to quantify the precise economic impact that the eviction moratorium and security deposit provisions have had on Plaintiffs’ property,”[7] while also recognizing that the Order did not prevent the plaintiffs from making any economic use of their property. With regard to the plaintiff’s investment-backed expectations, the court noted that the plaintiffs understood that residential real estate is a heavily regulated industry with a broad range of pre-existing laws and rules governing all manners of the landlord-tenant relationship. As such, “[t]he Order’s temporary adjustment of those rules, which does nothing more than defer the ability of the landlord to collect (or obtain a judgment for) the full amount of the rent the tenant freely agreed to pay, does not disrupt the landlords’ investment-backed expectations.”[8] Finally, with respect to the character of the government action, the court concluded that “state governments may, in times of emergency or otherwise, reallocate hardships between private parties, including landlords and their tenants, without violating the Takings Clause.”[9] Based on these evaluations, the Elmsford court also dismissed the plaintiffs’ claims that EO 202.28 constitutes a taking of their property.
The court then turned to the plaintiffs’ Contract Clause claims. While the U.S. Constitution does prohibit states from passing any law “impairing the Obligation of Contracts,”[10] the Contracts Clause’s prohibition “does not trump the police power of a state to protect the general welfare of its citizens, a power which is ‘paramount to any rights under contracts between individuals.’”[11] Here the court employed another three-pronged test, this one established under Buffalo Teachers Federation v. Tobe, asking whether: (i) the contractual impairment is substantial, (ii) the law serves a legitimate public purpose, and (iii) the means chosen to accomplish this purpose are reasonable and necessary.[12]
The Elmsford court again noted that because residential real estate is a heavily regulated industry, it is foreseeable that the state may impose future regulations on the industry and these potential future regulations are therefore “priced into [any] contracts formed under the prior regulation,”[13] and that “the foreseeability of additional regulation allows states to interfere with both past and future contracts.”[14] The court went on to reason that EO 202.28 also sufficiently safeguards the plaintiffs’ ability to realize the benefit of their bargain. With regard to the security deposit provisions of EO 202.28, since “the Order does not displace the civil remedies always available to landlords seeking to recover the costs of repairs or unpaid rents still owed at the end of a lease term,”[15] the security deposit provisions therefore “do not prevent Plaintiffs from ‘safeguarding or reinstating [their rights]’ as soon as the Order expires.”[16] As it relates to the eviction moratorium portion of EO 202.28, the court concluded that it merely postpones but does not eliminate a landlord’s ability to seek eviction as a remedy, and also does not eliminate a tenant’s obligations under their lease, such that “the landlord may obtain a judgment for unpaid rent if tenants fail to honor their obligations.” For these reasons, the court also concluded that EO 202.28 does not violate the Contracts Clause.
Finally, the Elmsford court quickly rejected both the plaintiffs’ Due Process and Petition Clause claims. On the Due Process claim, the court reasoned that the plaintiffs failed to demonstrate substantial impairment of their property rights, as a mere potential decrease in value of such property is not sufficient to prevail on a due process claim. Further, since the plaintiffs will be able to initiate new legal proceedings with respect to their leases once EO 202.28 is no longer in effect, they have also not been denied due process on this basis. Similarly, the plaintiff’s Petition Clause claim failed since “mere delay to filing a lawsuit cannot form the basis of a Petition Claus violation when the plaintiff will, at some point, regain access to legal process”[17] and the “Plaintiffs’ right to collect both the monetary remedies and injunctive relief they would seek through an eviction proceeding has not been completely foreclosed.”[18]
Auracle Homes, LLC v. Lamont
In Auracle Homes, LLC v. Lamont, the United States District Court in Connecticut considered a similar challenge to the one decided by the Elmsford court. In this case, numerous owners of residential property in Connecticut challenged the state’s Executive Order Nos. 7G, 7X and 7DDD on the grounds that they violate the Takings Clause, Contracts Clause and Due Process Clause of the U.S. Constitution.[19]
On March 10, 2020, Connecticut Governor Ned Lamont issued a declaration of public health and civil preparedness emergencies and proclaimed a state of emergency due to the COVID-19 outbreak in Connecticut and the United States, allowing the Governor to modify any statute that the Governor finds to be “in conflict with the efficient and expeditious execution of civil preparedness functions or the protection of public health.”[20] On March 19, 2020, Governor Lamont issued Executive Order 7G, which suspended non-critical court operations.[21] On April 10, 2020, Governor Lamont issued Executive Order 7X, which (i) temporarily bars residential landlords from delivering a notice to quit to their tenants or from serving any action for nonpayment of rent in most situations, (ii) provides for an automatic sixty-day grace period for April rents and a sixty-day grace period for May rents upon request, and (iii) allows renters who paid a security deposit of more than one month’s rent to apply such portion in excess of one month’s rent to any rent due for April, May or June.[22] On June 29, 2020, Governor Lamont issued Executive Order 7DDD, which extends and expands the notice to quit prohibition and the security deposit provision of Executive Order 7X.[23] In seeking to enjoin application of the Executive Orders, the plaintiffs in Auracle Homes argued that the “complete ban on all residential eviction proceedings imposed by Defendant’s Executive Orders nullifies Connecticut’s established statutory eviction procedures,”[24] having the effect of “leaving the Plaintiffs with no recourse, no process to follow, no venue to have their rights adjudicated, and nowhere to appeal.”[25] The plaintiffs further argued that the Governor’s actions were “unreasonable and inappropriate” since the State “is fully capable or providing monetary relief to those tenants who are ultimately unable to pay on-going rent, either through direct payments to landlords, or by grants to tenants.”[26]
As in Elmsford, the Auracle Homes court quickly ruled out the possibility of a categorical regulatory taking and moved to an analysis of a non-categorical taking by applying the Penn Central factors described above. Citing Elmsford, the court concluded that the plaintiffs’ claims did not “support a finding that the Executive Orders have a ‘constitutionally significant economic impact.’”[27] As for the plaintiffs’ investment-backed expectations, the court reasoned that the Executive Orders merely regulate the terms governing how the plaintiffs may use their property as previously planned during a pandemic, and since the Executive Orders do not permanently relieve tenants from their obligations under their leases, “[t]he Executive Orders are a temporary adjustment of the status quo, and only defer the ability of residential landlords like Plaintiffs to collect, or obtain a judgment for, the full amount of rent the tenants agreed to pay.”[28] As to the third prong of the Penn Central test, the court concluded that “the character of the governmental action also weighs against a finding that Plaintiffs have suffered a regulatory taking, because the Executive Orders are ‘part of a public program adjusting the benefits and burden of economic life to promote the common good.’”[29] For all of these reasons, the court rejected the plaintiffs’ Takings Clause claims.
Turning next to the plaintiffs’ Contracts Clause claims, the Auracle Homes court also applied the Buffalo Teachers test to the Connecticut Executive Orders. In deciding against substantial impairment of the plaintiffs’ rental contracts, the court again concluded that because residential real estate is a heavily regulated industry, some sort of legislative action in this field was foreseeable, and therefore both the eviction moratorium and the security deposit provisions could not be wholly unexpected.[30] Further, as to the eviction moratorium, “the Executive Orders do not eliminate Plaintiffs’ contractual remedies for evicting nonpaying tenants; Plaintiffs instead have to wait” before taking action.[31] In determining the second part of the Buffalo Teachers test as to whether the Executive Orders serve a legitimate public purpose, the court evaluated whether the state was “acting like a private party who reneges to get out of a bad deal, or is governing, which justifies its impairing the plaintiff’s contracts in the public interest.”[32] Since the Executive Orders impair private contracts that do not directly involve the State, the court accorded “substantial deference” to the State’s stated reasoning that it was acting to promote the public interest.[33] Therefore, even if the Executive Orders did create a substantial impairment of the plaintiffs’ leases, their claims would nevertheless fail because the Executive Orders promote a significant public purpose. In determining the third and final factor in the Buffalo Teachers test as to whether the State acted reasonably in issuing the Executive Orders, the court argued that when governmental entities undertake actions “in areas fraught with medical and scientific uncertainties, their latitude must be especially broad.”[34] Since there was “nothing in the record to suggest that Governor Lamont acted unreasonably,” the plaintiffs also failed this part of the analysis. For all of the reasons summarized above, the Auracle Homes court wholly rejected the plaintiffs’ Contracts Clause claim.
The final analysis came with respect to the plaintiffs’ substantive and procedural Due Process claims, and much like the Elmsford court, the Auracle Homes court quickly rejected these claims. Because the plaintiffs “failed to demonstrate a substantial impairment of their property rights”[35] or “an independent liberty or property interest”[36] requiring protection, the safeguards afforded by the principles of both substantive and procedural due process did not apply to the plaintiffs’ claims.
HAPCO v. City of Philadelphia
In HAPCO v. City of Philadelphia, an association of Philadelphia residential property owners and managers brought suit to enjoin the City of Philadelphia from implementing several temporary emergency laws enacted in response to the COVID-19 pandemic.[37] On July 1, 2020, Philadelphia Mayor James Kenney signed into law a series of five separate bills collectively known as the Emergency Housing Protection Act (“EHPA”), which (i) temporarily prohibits landlords from evicting residential tenants and small business commercial tenants that can provide a certificate of hardship due to COVID-19, (ii) allows tenants who prove they have suffered a financial hardship due to COVID-19 to be able to pay past due rent on a set plan through May 31, 2021, (iii) requires landlords to attend mediation before taking steps to evict residential tenants who have suffered a financial hardship due to COVID-19, and (iv) temporarily bars landlords from charging late fees and interest to residential tenants who have suffered a financial hardship due to COVID-19.[38] The plaintiffs sought to invalidate the EHPA on the grounds that it violates the Takings Clause, Contracts Clause and Due Process Clause of both the U.S. and Pennsylvania Constitutions.
The HAPCO court did not rule on the plaintiffs’ likelihood on the merits of its Takings Clause claims. It ruled that, even if the plaintiffs were able to successfully argue that the EHPA constituted a governmental taking, the plaintiffs would be able to obtain other relief from the government in the form of just compensation for such taking, making an injunction on this basis inapplicable.
The plaintiffs argued that the EHPA violates the Contracts Clause because it compel[s landlords] to enter into contractual arrangements [the City has] devised, give up rights [landlords] had negotiated in pre-existing leases, and surrender their right to seek redress in a court of law.”[39] The court applied the two-part Contracts Clause test set forth by the U.S. Supreme Court in Sveen: (i) whether the state law has created a “substantial impairment of a contractual relationship”[40], and (ii) if it has, then “whether the state law is drawn in an appropriate and reasonable way to advance a significant and legitimate public purpose.”[41] Like Elmsford and Auracle Homes before it, the HAPCO court relied on the fact that real estate is a heavily regulated industry at each of the federal, state and local levels, subject to the real possibility of ongoing legislation, which should be foreseeable to the parties to any contract involving real property.[42] Further, considering that the provisions of the EHPA are temporary in nature, meaning that “the tenants are still bound to their contracts, the contractual bargain is not undermined and landlord rights are safeguarded.”[43] Given these factors, the court did not find a substantial impairment of the contractual relationship existed. The court in HAPCO further concluded that, even if a substantial impairment had existed, the EHPA “is a reasonable way to advance a significant and legitimate purpose” to address the housing and public health emergency caused by the COVID-19 pandemic.[44] Finally, the court reasoned that the EHPA is “an appropriate and reasonable way to advance the City’s purpose,” especially “[c]onsidering the deference owed to [the] legislative judgment” of the City to address the current emergency.[45]
Turning to the plaintiffs’ Due Process Clause claim, the court in HAPCO reasoned that this clause “generally does not prohibit retrospective civil litigation, unless the consequences are particularly harsh and oppressive,”[46] and that “state laws need only be rational and non-arbitrary in order to satisfy the right to substantive due process.”[47] Because the EHPA meets all of these requirements, the court denied the plaintiffs’ due process claims as well.
Baptiste v. Kennealy
In Baptiste v. Kennealy, three landlords filed for a preliminary injunction with the United States District Court, District of Massachusetts, against the “Act Providing for a Moratorium on Evictions and Foreclosures during the COVID-19 Emergency,” enacted by the Massachusetts state legislature on April 20, 2020.[48] The Act (i) prohibits all “non-essential evictions,” including residential evictions for a tenant’s failure to pay rent (without a tenant needing to certify that they are unable to pay rent due to the coronavirus pandemic), (ii) prohibits landlord from sending tenants notices to quit or any notices requesting or demanding that a tenant who has not paid rent leave the premises, and (iii) prohibits Massachusetts courts from accepting for filing any eviction case or taking any action in any pending eviction case.[49] The plaintiffs brought suit, alleging that the Act violates the Takings Clause, Contracts Clause and Petition Clause of the U.S. Constitution, as well as the First Amendment to the U.S. Constitution because of the limits placed by the Act on the types and subject matter of notices that landlords could send to their tenants (which First Amendment arguments will not be analyzed here, as they are outside the scope of this article).[50]
With regard to the plaintiffs’ Takings Clause claim, the Baptiste court applied the same three-factor Penn Central test as used in Elmsford, Auracle Homes and HAPCO, and largely came to the same conclusions that: (i) no physical taking occurred[51], (ii) the economic impact of the Act does not support the finding of a taking because the effect on the plaintiffs’ property was only temporary and that “mere diminution in the value of property…is insufficient to demonstrate a taking,”[52] and (iii) the character of the government action does not support the finding of a taking because the moratorium is a “public program adjusting the benefits and burdens of economic life to promote the common good.”[53] The only place in the takings analysis where the Baptiste court differed from the decisions reached in Elmsford, Auracle Homes and HAPCO was that the Baptiste court concluded that the moratorium does significantly interfere with the plaintiff’s investment-backed expectations, since “a reasonable landlord would not have anticipated a virtually unprecedented event like the COVID-19 pandemic and the ensuing six-month ban on evicting and replacing tenants who do not pay rent.”[54] Despite this difference, however, the court in Baptiste ultimately reached the same conclusion reached in Elmsford, Auracle Homes and HAPCO that the Act did not constitute a regulatory taking of the plaintiffs’ property.[55]
In analyzing the plaintiffs’ Contracts Clause claim, the court applied the same two-factor test as the Elmsford, Auracle Homes and HAPCO cases summarized above, but noted that “[i]t is a close question whether the Moratorium substantially impairs the contracts that plaintiffs’ leases represent,” and also “a close question whether the Moratorium is a reasonable means of addressing the undisputed significant and legitimate need to combat the spread of the COVID-19 virus.”[56] Regarding the substantial impairment question, the court also noted here that residential real estate is a heavily regulated industry, but also (in departing from the Elmsford, Auracle Homes and HAPCO courts’ analyses) that “a reasonable landlord would not have anticipated a virtually unprecedented event such as the COVID-19 pandemic that would generate a ban on even initiating eviction actions against tenant.”[57] Regarding the reasonableness question, the Baptiste court recognized that the Act was more burdensome to landlords than the laws enacted in New York (as affirmed by Elmsford), Connecticut (as affirmed by Auracle Homes), and Philadelphia (as affirmed by HAPCO), leading to the conclusion that Massachusetts couldhave enacted a less restrictive law.[58] In the final analysis, however, the court in Baptiste dismissed the plaintiffs’ Contracts Clause claim, citing the fact that the moratorium is only temporary, recognizing that the proper standard to judge the reasonableness of the law is whether there was a rational basis for enacting it rather than requiring the law to be drafted in the least restrictive way possible, and further reasoning that, because in the case at hand “the state is not an interested party, courts give deference to elected officials as to what is reasonable and appropriate.”[59]
Other Takings and Contracts Clause Suits
Several other lawsuits in various jurisdictions have also been filed to challenge the constitutionality or authority of state and local orders, law and restrictions enacted to combat the COVID-19 pandemic that do not directly involve regulation of real estate-related matters, but which lawsuits have asserted Takings Clause claims. For instance, in TJM 64, Inc. v. Harris, filed in the United States District Court in the Western District of Tennessee, Western Division, several owners of bars and limited-service restaurants brought an action against officials in Shelby County, Tennessee challenging an order issued by the County Health Department requiring all such bars and limited service restaurants to close in an effort to combat the COVID-19 pandemic.[60] In Friends of Danny DeVito v. Wolf, filed with the Supreme Court of Pennsylvania, several business owners and one individual in Pennsylvania filed an emergency ex parte application challenging Governor Tom Wolf’s March 19, 2020 Executive Order requiring the closure of the physical operations of all non-life-sustaining businesses in order to reduce the spread of the coronavirus within the State.[61] In Lebanon Valley Auto Racing Corp. v. Cuomo, filed with the United States District Court in the Northern District of New York, five operators of outdoor auto racing facilities in the State of New York sought to invalidate Executive Order 202.32, which included a ban on spectators at racetracks in the state, on a Takings Clause claim.[62] Finally, in Blackburn v. Dare County, filed in the United States District Court in the Eastern District of North Carolina – Northern Division, a couple who lived in Virginia but owned a vacation home in North Carolina brought suit against Dare County and several towns within the County to overturn a County declaration prohibiting nonresident visitors from entering the County in an effort to slow the spread of the coronavirus, by declaring that such prohibition constituted a taking of their private property.[63]
One additional suit of note that did directly implicate real estate was filed in California in San Francisco Apartment Association v. City and County of San Francisco, challenging Ordinance No. 93-20 enacted by the San Francisco Board of Supervisors that, among other things, permanently protects tenants from eviction for nonpayment of rent that was unpaid due to COVID-19 if the rent became due between March 16, 2020 and September 30, 2020. In a one-page order, the judge in this case dismissed the plaintiffs’ Takings Clause and Contracts Clause claims along similar lines as the cases discussed above, as “a reasonable exercise of police power to promote public welfare.”[64]
All of the lawsuits noted above met the same fate as the Elmsford, Auracle Homes, Baptiste and HAPCO cases summarized above – namely, their Takings Clause claims were rejected, and the validity and authority of all of the laws or orders being challenged were upheld. The analyses in these additional cases followed a similar track as the cases summarized above, in which the respective courts analyzed the Penn Central factors and reached the overarching conclusion that, since the contested laws or orders were temporary in nature, were an exercise of the governmental authority’s police power, were enacted with the intention of providing a public benefit and protecting citizens, and were drafted to be reasonably related to these goals, that they were all constitutionally valid.
Interestingly, each of the courts reached the same ultimate decision to uphold the laws or orders as written, even though certain courts differed on specific elements of the Penn Central analysis. For instance, in TJM 64, the court concluded that the closure orders did “interfere in a significant way with Plaintiffs’ investment-backed expectations in their properties, despite their status as highly regulated entities.”[65] However, even though the court conceded “that Plaintiffs will suffer devastating economic impacts if the Closure Orders remain in effect,”[66] the court nonetheless determined that such impacts did not rise to the level of a taking because of the government’s fundamental interest in promoting the common good, and recognizing that [l]abeling Defendants’ Order a taking would require the state to compensate every individual or property owner whose property use was restricted for the purpose of protecting public health [emphasis in original].”[67] In Friends of Danny DeVito, the court convincingly distinguished between a government taking and the government’s legitimate use of its police power, stating that “[e]minent domain is the power to take property for public use…The police power, on the other hand, involves the regulation of property to promote the health, safety and general welfare of the people.”[68] In Lebanon Valley, the court concluded that the economic impact of the regulation on the plaintiffs was substantial enough to weigh in favor of allowing the takings claim to proceed on that factor.[69] However, because the state has issued the order to promote the common good in order to address an existing public health emergency, “[t]he character of the relevant governmental action therefore strongly favors Defendants.”[70] Finally, the Blackburn court sided with the plaintiffs on the first two prongs of the Penn Central test, concluding that “plaintiffs do allege some unspecified amount of economic loss, which…would provide some support of plaintiffs’ takings claim,”[71] and that “Defendant County’s regulation did temporarily interfere with plaintiffs’ right to personally travel to their vacation property, diminishing plaintiffs’ right to use the property.”[72] In the final analysis, however, the County’s interest in reducing the spread of the coronavirus and the reasonable relation of the declaration to this objective superseded the individual property rights that were negatively impacted by such regulation: “Defendant County’s concededly legitimate exercise of its emergency management powers under North Carolina law to protect public health in the ‘unprecedented’ circumstances presented by the COVID-19 pandemic, weighed against loss of use indirectly occasioned by preventing plaintiffs from personally accessing their vacation home for 45 days, does not plausibly amount to a regulatory taking of plaintiffs’ property.”[73]
Part II – Challenging The CDC Moratorium
On September 4, 2020, the Centers for Disease Control and Prevention (“CDC”), a division of the Department of Health and Human Services (“HHS”), issued a temporary eviction moratorium through December 31, 2020 with the intent of helping to prevent the spread of COVID-19 in the United States. Although the moratorium prohibits evictions of certain renters covered by the order, it also “does not relieve any individual of any obligation to pay rent, make a housing payment, or comply with any other obligation that the individual may have under a tenancy, lease or similar contract.”[74] Since the CDC order was enacted, “an array of lawyers and lobbyists have inundated federal, state and local courts” with lawsuits challenging the validity of the moratorium as well as HHS’s and the CDC’s authority in issuing it.[75] While many of these lawsuits remain pending at this time (including a recent case filed by the National Association of Home Builders in the Northern District of Ohio), Part II will discuss the most prominent case that has been brought and adjudicated with respect to the CDC moratorium.
Richard Lee Brown v. Alex Azar
The plaintiffs in Richard Lee Brown v. Alex Azar, made up of the National Apartment Association (representing a membership group of 85,000 landlords nationwide) and four landlords in different states seeking to evict tenants from their respective properties, brought suit in the United States District Court in the Northern District of Georgia, Atlanta Division, to enjoin enforcement of the CDC order. The plaintiffs’ suit alleged that the CDC order (i) lacks a statutory and regulatory basis, (ii) is arbitrary and capricious, and (iii) violates the plaintiffs’ rights to access the courts.[76]
The plaintiffs first contended that “the CDC acted without statutory and regulatory authority because (1) the Order is not reasonably necessary to prevent the spread of the disease; and (2) the Order does not show that the state and local laws were insufficient to prevent the spread of the disease.”[77] On the first point above, the court ruled that, since Congress gave the Secretary of HHS (and by extension the CDC) broad power to issue regulations to prevent the spread of diseases, and because the CDC’s order is necessary to help control the COVID-19 pandemic, the CDC was authorized to issue it.[78] Regarding the second point above, so long as the CDC reasonably determines that the measures taken by any local state or local government are insufficient to prevent the spread of the disease, the court will give deference to the CDC’s determination and confirm its statutory and regulatory authority on these grounds.[79]
The court next analyzed the plaintiffs’ claim that the issuance of the CDC order was arbitrary and capricious. The plaintiffs argued that “the Order is arbitrary and capricious because it is not supported by substantial evidence or relevant data” to demonstrate that the eviction moratorium would help to prevent the spread of COVID-19 or to demonstrate that existing state and local measures were insufficient to prevent such spread.[80] The court disagreed with this argument, noting that “the Order explains, in detail, why a temporary eviction moratorium is reasonably necessary.”[81] Specifically, the CDC order notes that as many as 30 to 40 million people in the U.S. could be at risk of eviction without a moratorium in place, which would result in many more people who would move to shared housing or other congregate settings or who would become homeless, which increases the risk of spread of the virus.[82] Based on this evidence, the court concluded that “the CDC has shown what it needs to: that an eviction moratorium for individuals likely to be forced into congregate living situations is an effective public health measure that prevents the spread of communicable diseases because it aids the implementation of stay-at-home and social distancing directives.”[83] The court then disagreed with the plaintiffs’ assertion that the CDC did not show that existing measures taken by state and local government were insufficient. To the contrary, “the Order plainly states that the measures in state and local jurisdictions that do not provide protections for renters equal to or greater than the protections provided for in the Order are insufficient to prevent the spread of COVID-19.”[84] In fact, “the CDC did analyze each state’s eviction restrictions, and the evidence suggested that in the absence of eviction moratoria, tens of millions of Americans could be at risk of eviction on a scale that would be unprecedented in modern times.”[85]
Finally, the plaintiffs then argued that the CDC order unlawfully strips them of their constitutional right to access the courts. The court, however, pointed out that “the Order does not apply to every person renting a property,” “does not apply to every reason a landlord may evict a tenant,” “does not prohibit Plaintiffs from seeking a different remedy to recover their losses,” and “does not apply to all procedural aspects of the eviction proceedings,” since landlords may still serve notices to quit and commence eviction proceedings under the CDC order; rather, “[t]he Order only delays the actual eviction.”[86] Citing both the Elmsford and Baptiste decisions (which the court also noted involved state orders that were more restrictive against landlords than the CDC order), the court concluded the CDC order does not violate the plaintiffs’ constitutional right to access the courts because (i) a landlord maintains the right to pursue other legal remedies against a non-paying tenant, such as a breach of contract claim, and (ii) the eviction moratorium is only temporary, and mere delay does not amount to a denial of a landlord’s rights when they will “at some point, regain access to legal process.”[87]
Part III – Force Majeure, Impossibility and Frustration of Purpose
With the COVID-19 pandemic forcing most retail and restaurant businesses either to temporarily shut down altogether or otherwise significantly reduce their operations, it has become nearly impossible for many of these businesses remain profitable, in turn making it much more difficult for such businesses to stay current on their lease and mortgage payments. Many of these struggling companies have taken the position that the pandemic (and the shutdowns ordered in response to it) constitute a force majeure event, excusing their obligations to pay rent under their leases (or other payment obligations under instruments such as mortgages and purchase agreements). In addition to the force majeure argument, many renters have also invoked the legal concepts of impossibility and frustration of purpose to make the case that their rent payment obligations should be suspended during the pandemic. For their part, landlords have fought back to enforce the terms of their leases as written. Part III will discuss several notable cases in which tenants (and in one case, a buyer under a purchase contract) have attempted to assert one or more of the force majeure, impossibility and frustration of purpose defenses for their benefit.
In Re: Hitz Restaurant Group
A creditor under the above-named bankruptcy case petitioned the United States Bankruptcy Court in the Northern District of Illinois – Eastern Division, to enforce the obligation of debtor Hitz Restaurant Group to pay post-petition rent and to modify the automatic stay. The debtor argued that its obligation to pay any post-petition rent was excused by the force majeure clause contained in the lease between the debtor and such creditor and by the creditor’s failure to make necessary repairs to the leased premises.[88] The debtor argued that the lease’s force majeure clause was triggered on March 16, 2020, when Illinois Governor J.B. Pritzker issued Executive Order 2020-7 to mitigate the effects of the coronavirus pandemic in the state.[89] The Executive Order stated, in part, that “all businesses in the State of Illinois that offer food or beverages for on-premises consumption…must suspend service for and may not permit on-premises consumption. Such businesses are permitted and encouraged to serve food and beverages so that they may be consumed off-premises.”[90]
The Hitz court concluded that the Executive Order did in fact trigger the force majeure clause under the lease, which clause reads as follows: “Landlord and Tenant shall each be excused from performing its obligations or undertakings provided in this Lease, in the event, but only so long as the performance of any of its obligations are prevented or delayed, retarded or hindered by…laws, governmental action or inaction, orders of government….Lack of money shall not be grounds for Force Majeure.”[91] The court reached its conclusion that “[t]he force majeure clause in this lease was unambiguously triggered by”[92] the Executive Order because the Order “unquestionably constitutes both ‘governmental action’ and issuance of an ‘order’ as contemplated by the language of the force majeure clause,”[93] the Order “unquestionably ‘hindered’ Debtor’s ability to perform,”[94] and the Order “was unquestionably the proximate cause of Debtor’s inability to pay rent.”[95]
In response to the creditor’s position that the lease’s force majeure clause was not triggered because the Executive Order did not shut down the banking system or post offices in Illinois, meaning that the debtor was still physically able to send rental payments to the creditor, the court called this argument “specious” and rejected it “out of hand.”[96] The court also rejected the creditor’s argument that the debtor’s failure to perform arose merely from a lack of money, which was expressly carved out of the force majeure provision in the lease. The court instead agreed with the debtor’s position that the proximate cause of the tenant’s failure to pay rent was not mere lack of money, but rather the Executive Order’s shutdown of most of the debtor’s business that was the proximate cause of the debtor’s inability to generate revenue and therefore pay rent.[97] However, because the Executive Order did not completely stop the debtor from conducting its business, since carry-out, delivery and pickup services were still allowed, the court concluded that the debtor was responsible for partial payment of its rent in proportion to the amount of the leased space that was still usable under the Executive Order for such allowed services (i.e., the kitchen), which amounted to 25% of the space (and therefore 25% of the rent owed).[98]
Martorella v. Rapp
Martorella v. Rapp arises from a case originally filed in the Massachusetts Land Court in 2017 entitled Stark v. Martorella, which was an action for the partition of real property located at 15 Wigwam Road in Nantucket.[99] Defendant Stuart Rapp was the court-appointed commissioner in Stark, tasked with recommending the best way to partition the Wigwam Road property.[100] Commissioner Rapp conducted a public auction of the property on February 14, 2020, at which the plaintiff Christopher Martorella was the winning bidder.[101] The terms of Mr. Martorella’s winning bid, as memorialized in a purchase and sale agreement signed upon the conclusion of the auction, provided for him to pay an initial deposit at the time of the auction and a second deposit four days later, with the remaining balance of the purchase price in the amount of $1,644,300 to be paid “at the time of the delivery of the Deed.”[102] Pursuant to the terms of the purchase agreement, the delivery of such Deed was to have occurred on March 16, 2020 (which was later extended to March 23, 2020 and then April 6, 2020 upon the mutual agreement of the parties), and the agreement did not provide for any financing or other contingencies to the completion of the sale in Mr. Martorella’s favor, nor did the agreement confer any unilateral right upon Mr. Martorella to extend the time for his performance thereunder.[103]
Due to the effect of the coronavirus pandemic on the economic markets, Mr. Martorella experienced difficulty obtaining financing for the purchase and requested to postpone the closing again to May 5, 2020, which the Land Court in Stark denied.[104] Mr. Martorella then brought the entitled action against Commissioner Rapp, claiming the doctrine of impossibility due to the COVID-19 pandemic. The Martorella court reasoned that the core of the question of impossibility is the determination “whether the risk of intervening circumstance was one which the parties may be taken to have assigned between themselves.”[105] In answering this question, the court referenced Massachusetts case law stating that “[o]nce one party has made itself responsible for the disposition of the subject matter of a contract, it cannot later claim that the occurrence in question was not in the contemplation of the parties at the time of contract.”[106] Therefore, since the purchase agreement contained no contingencies to Mr. Martorella’s obligation to perform thereunder, which he acknowledged, Mr. Martorella “knowingly assumed the risk of delivering $1,644,300 at closing.”[107] As such, the court ruled that Mr. Martorella was not excused from performing under the purchase agreement due to impossibility, and deemed him to be in default under the agreement.[108]
Other Notable Cases
Richards Clearview, LLC v. Bed Bath & Beyond, Inc. involved a commercial eviction proceeding by the owner of an indoor shopping mall in Metairie, Louisiana against tenant Bed Bath & Beyond, which paid only partial rent in April, 2020 and no rent in May, 2020 after the Governor of Louisiana issued Emergency Proclamation 33 JBE 2020 ordering all malls to close, “except for stores in a mall that have a direct outdoor entrance and exit that provide essential services and products.”[109] Even though the tenant believed its rent was partially excused due to the force majeure provision in its lease, the tenant did attempt to pay all of its stated rent in full after it received a notice of default from its landlord; however, the landlord refused to accept such late payments and moved to terminate the lease.[110] The court here invoked the Louisiana doctrine of “judicial control,” which is “an equitable doctrine by which courts will deny cancellation of a lease when the lessee’s breach is of minor importance, is caused by no fault of his own, or is based on a good faith mistake of fact.”[111] Because (i) there was a good faith question in the lease as to how much rent was owed (due to certain ambiguous co-tenancy clauses in the lease), (ii) the tenant attempted to remedy the default in a reasonable amount of time given the circumstances caused by the COVID-19 pandemic, (iii) the tenant was continuing to sell certain essential products such as soap, hand sanitizer and first aid equipment to the public during the pandemic, and (iv) the landlord was not materially harmed by the delay in payment, the court elected to exercise judicial control and ruled against cancellation of the lease.[112]
In Palm Springs Mile Associates, Ltd. v. Kirkland’s Stores, Inc., the owner of a shopping center in Hialeah, Florida sued its tenant for past due amounts and accelerated rent under its lease after the tenant stopped paying rent under the lease, with the tenant arguing that the restrictions against non-essential activities and business operations put in place by Miami-Dade County were a force majeure event that suspended its obligation to pay rent.[113] In ruling in favor of the landlord, the court explained that “force majeure clauses are narrowly construed, and “will generally only excuse a party’s nonperformance if the event that caused the party’s nonperformance is specifically identified.’”[114] Because the tenant failed to explain how the regulations actually and directly resulted in its inability to pay rent, the court ruled that there was no force majeure event under the lease.[115]
In BKNY1, Inc., d/b/a 132 Lounge v. 132 Capulet Holdings, LLC, a New York landlord sued to terminate its tenant’s lease of for failure to pay rent, which tenant argued that the state’s Executive Order No. 202.3 requiring its restaurant business to close excused it from its obligation to pay rent under the doctrines of frustration of purpose and impossibility.[116] The court first addressed the tenant’s frustration of purpose defense. Citing the principle that “financial hardship does not excuse performance of a contract,” the court concluded that the two-month temporary closure of the tenant’s business required by the Executive Order could not have frustrated the overall purpose of the lease with a term of nine years.[117] In also rejecting the tenant’s impossibility defense, the court quoted the express language of the lease, which stated in part that the tenant’s obligation to pay rent “shall in no wise be affected, impaired or excused because Owner is unable to fulfill any of its obligations under this lease…by reason of…government preemption or restrictions.”
Part IV – Seeking Equitable Remedies
Much like COVID-19’s far-reaching effects on the daily lives of people across the United States, the pandemic has also had far-reaching effects on jurisprudence and the disposition of legal cases in many different areas of law, whether directly or only tangentially involving real estate. Whether relating to bankruptcy cases, home purchases, or UCC foreclosure sales, no part of the law has been able to avoid the need to account for COVID-19 in determining just outcomes for those individuals and companies utilizing the court system during these times. Part IV of this article will look at several different courts’ attempts to grapple with this very question of how to deal with the pandemic’s effects to arrive at equitable answers for those affected by it.
In Re: Dudley
The debtor in a Chapter 7 bankruptcy case filed in the United States Bankruptcy Court in the Eastern District of California petitioned the court for an extension of the six-month statutory reinvestment period for debtors to use proceeds from the sale of exempt homestead property in order to acquire another homestead property. When Clay Dudley, the debtor in the above-referenced bankruptcy case, sold his residence in Chico, California on February 7, 2020, by statute he had six months to reinvest those sale proceeds in another residence to maintain the homestead exemption on the initial sale of his residence.[118] The debtor claimed that he intended to purchase a replacement property and had been diligent in his efforts to do so, but that his efforts were severely hindered by the COVID-19 pandemic[119] and the State of California’s response to the pandemic, including specifically the statewide “stay at home” order issued by Governor Gavin Newsom under Executive Order N-33-20.[120]
California exercised an option under the Federal Bankruptcy Code to opt out of certain federal bankruptcy exemptions and adopt its own exemptions in their place, which California did in providing for a six-month reinvestment period for the homestead exemption. Therefore, the bankruptcy court in Dudley applied California state law to determine whether the reinvestment period could be tolled or otherwise extended once it started to run.[121] Although the court did not find (and the debtor did not cite) any California statutory authority to permit an extension or tolling of the six-month reinvestment period, since the trustee of the bankruptcy estate did not oppose the debtor’s request for such extension, the court looked to equitable remedies to determine whether an extension would be warranted.[122]
The court cited several prior instances under California case law where the six-month reinvestment period was equitably tolled when, through no fault of their own, claimants lacked possession or control over homestead proceeds following an involuntary or voluntary sale of the homestead, or when circumstances beyond the debtor’s control prevented the reinvestment of homestead proceeds within the six-month timeframe.[123] In referencing these prior decisions, the Dudley court recognized California’s intent to create a liberal construction homestead statute for the benefit of debtors to ensure people’s homes are not lost through a technicality.[124] Turning to the case at hand, the Dudley court also concluded that the unique circumstances surrounding the current pandemic warranted an equitable extension of the six-month reinvestment period for the homestead exemption, consistent with prior California case law and equitable principles, “reflect[ing] a public policy and legislative effort to protect real property interests, generally, and, specifically, to prevent the loss of residential occupancy and ownership rights due to the COVID-19 pandemic and resulting state of emergency.”[125]
In Re: Pier 1 Imports, Inc.
Pier 1 Imports, Inc. and certain of its related entities, the debtors under a Chapter 11 filing in the United States Bankruptcy Court in the Eastern District of Virginia – Richmond Division, filed their voluntary bankruptcy petition on February 17, 2020, and then saw “their stores shuttered [and their] revenue dr[y] up overnight” during the COVID-19 pandemic.[126] As a result, the debtors took various actions to preserve their liquidity, but “found that they needed additional relief from the Court to reduce outgoing expenses even further and to preserve the status quo.”[127] The debtors proposed a temporary period of limited business operations in which only enumerated critical expenses would be paid, meaning that rent payments to certain landlords would be temporarily deferred or reduced during this period, with all accrued rent being paid back over time after the conclusion of the limited business operations period.[128] Several landlords objected to this proposal.
In considering the debtors’ motion, the court noted that the affected landlords may be entitled to “adequate protection” under the Federal Bankruptcy Code, which is “designed to compensate a non-debtor to the extent any proposed lease ‘results in a decrease in the value of such entity’s interest in such property.’”[129] However, the court concluded that the “Debtors’ deferred payment of rent while they continue use of the leased premises, does not decrease the value of any Lessor’s interest in the property”[130] since all “insurance payments, security obligations, utility payments, and other similar obligations of the Debtors typically made in the ordinary course of business are continuing to be made by the Debtors.”[131]
In the court’s final conclusion in approving the debtors’ motion, the court recognized the dire situation brought about by the COVID-19 pandemic, stating that “[t]here is no feasible alternative to the relief sought in the Motion. The Debtors cannot operate as a going concern and produce the revenue necessary to pay rent because they have been ordered to close their business. The Debtors cannot effectively liquidate the inventory while their stores remain closed….Any liquidation efforts would be ineffective and potentially squander assets that could otherwise be administered for the benefit of all creditors in this case.”[132]
1248 Assoc Mezz II LLC v. 12E48 Mezz II LLC
In 1248 Assoc Mezz II LLC v. 12E48 Mezz II LLC, the New York Supreme Court ruled that Executive Order 202.8 (described above in this article under the discussion of the Elmsford Apartment Associates case), which placed a moratorium on the “foreclosure of any residential or commercial property for a period of ninety days,”[133] did not apply to a proposed foreclosure of an equity interest in a mezzanine borrower entity to be conducted under the Uniform Commercial Code.[134]
The original mezzanine UCC foreclosure sale that was scheduled for May 1, 2020 was temporarily enjoined by the New York Supreme Court on April 30, 2020 on the grounds that the terms of the foreclosure sale were not commercially reasonable in light of the coronavirus pandemic and that Executive Order 202.8’s prohibition on foreclosures extends to UCC foreclosures of mezzanine debt. The court then issued a final decision in 1248 Assoc Mezz II LLC on May 18, 2020, vacating its prior temporary restraining order and ruling that the scheduled UCC foreclosure could move forward, as it was not prohibited by Executive Order 202.8.[135] The court reached this conclusion by noting that, “had the Executive Order intended to prohibit sales of collateralized assets…governed by the UCC, such prohibition would have been explicitly provided for within that Executive Order.”[136] The court then went on to concur with the mezzanine lender’s argument that the foreclosure of a mortgage is “a judicial proceeding, whereas the proposed (and Noticed) sale addresses a disposition of collateral pursuant to Article 9 of the UCC, a non-judicial proceeding,”[137] ultimately concluding that Executive Order 202.8 “addresses enforcement of a judicially ordered foreclosure,”[138] which does not cover foreclosures conducted under the UCC.
D2 Mark LLC v. Orei VI Investments LLC
In D2 Mark LLC v. Orei VI Investments LLC, the court considered the question of what constitutes a commercially reasonable UCC foreclosure sale in light of the COVID-19 pandemic. The action involved the Mark Hotel located on the Upper East Side of Manhattan, which was subject to a senior mortgage loan serviced by Wells Fargo Bank, and where 100% of the equity interest in D2 Mark Sub LLC, which was the indirect owner of the hotel, was pledged to the defendant pursuant to a mezzanine loan made by the defendant to the plaintiff. [139]The hotel “suffered significant financial hardship as a result of the COVID-19 pandemic when it was forced to temporarily close on March 27, 2020,”[140] resulting in the plaintiff missing its April and May loan payments under the senior loan and triggering a default under both the senior loan and the defendant’s mezzanine loan.[141]
On May 18, 2020, the defendant gave notice of a UCC foreclosure sale of the plaintiff’s 100% membership interest in D2 Mark Sub LLC, which sale was to occur on June 24, 2020, which was 36 days from the date of the notice of sale.[142] On June 8, 2020, New York City entered Phase I of reopening, which allowed the hotel to eventually reopen on June 15, 2020, which in turn allowed potential foreclosure auction bidders to tour and inspect the hotel premises prior to the sale. New York City then entered Phase II of reopening on June 22, 2020, two days before the scheduled auction, allowing for expanded operations within the hotel and increased ability for potential bidders to perform due diligence on the hotel premises.
The plaintiff filed suit against the defendant mezzanine lender alleging, among other things, that the terms of the proposed UCC foreclosure auction were unreasonable in light of the coronavirus pandemic and seeking to enjoin the sale until September 8, 2020. In evaluating whether such foreclosure sale terms were reasonable, the court cited the text of the Uniform Commercial Code requiring that “[e]very aspect of a disposition of collateral, including the method, manner, time, place, and other terms, must be commercially reasonable.”[143]
Given the totality of the facts and circumstances involving the proposed foreclosure sale, including the pandemic’s effect on bidding on and buyers performing due diligence on the property, the D2 Mark court concluded that such proposed sale was in fact not commercially reasonable and granted a preliminary injunction to delay the sale.[144] Specifically, the court agreed with the analysis of plaintiff’s UCC foreclosure sale expert, who opined that UCC foreclosure sales for complex commercial assets such as the hotel would typically provide for 60 to 90 days’ notice (as opposed to the 36 days’ notice provided by the defendant), and that the property would not sell at close to its maximum price without potential buyers being afforded a reasonable opportunity to perform in-person due diligence and inspections on the property, which opportunity was severely affected by the coronavirus pandemic and the business closures that the pandemic necessitated.[145] The court further agreed with the expert’s assertion that the foreclosure sale was “‘rigged’ so that, as a practical matter, only defendant can obtain the Collateral.”[146] Examples of such rigging include the fact that the entire purchase price for the hotel was to be due and payable within 24 hours of the completion of the auction, and that plaintiff was barred from participating in the auction, “which is per se unreasonable.”[147] Additionally, the fact that only two out of 115 potential bidders submitted financial statements to the defendant in connection with the proposed auction sale gave further credence to the conclusion that the terms of the foreclosure sale were unreasonable.[148]
Conclusion
There are presently dozens, if not hundreds, of other lawsuits throughout the United States currently being litigated relating to the coronavirus pandemic, which will provide us with many more answers on how COVID-19 is changing the legal landscape of the country. However, even with so much being unknown at this time as to the contents of these future decisions, orders and opinions to be written, several discernible patterns have emerged from the cases that have been decided thus far and discussed above in this article. Courts have clearly given deference to federal, state and local lawmakers to enact laws and regulations to protect the community at large, both from a public health perspective in preventing the spread of the virus, as well as from the perspective of protecting those individuals and businesses who have been hurt financially by the virus and its ripple effects. Given this well-deserved deference, any current or future litigation challenging the authority or constitutionality of such laws and regulations will face a steep uphill climb to have them overturned.
Similarly, in cases involving contracts between private parties, courts have generally given deference to the terms of those agreements and have avoided reading generous force majeure clauses into them or applying broad interpretations of impossibility or frustration of purpose to them. While the Hitz case stands out as a clear anomaly of this group, many legal scholars have opined that the result in Hitz was mostly the result of the odd formulation of the force majeure language in that particular lease, which allowed force majeure to be applied more broadly than one would typically see, as opposed to a more common description of force majeure in leases and contracts stating that a force majeure event does not excuse any payments due under such lease or contract. Therefore, the specific wording of a lease’s or other contract’s force majeure clause will be a key factor in whether a court will provide relief to a tenant or other party to a contract based on such clause. In furtherance of this point, we note that as of the writing of this article, a partial ruling just issued by a bankruptcy court in Texas (ruling on a lease governed by California law) held that the lease’s force majeure clause which included the term “unusual government restriction, regulation or control” warranted a reduction in rent under the tenant’s lease.[149]
When courts have had more leeway to apply equitable principles in their cases, they have generally given a certain amount of latitude to those parties who have been negatively affected by the pandemic, recognizing the sheer unforeseeability of our current situation. The bankruptcy cases and the two UCC foreclosure cases discussed above bear this out. This latitude was also demonstrated in the Richards Clearview case, which, although it was decided in favor of the tenant, was notable in that (a) the court applied the equitable concept of judicial control in its decision, and (b) the court did not conclude that the tenant’s rent was suspended or reduced by a force majeure event, but rather that the lease could stay in place since the tenant attempted to repay all of the prior rent that had not been paid.
As future real estate-related cases involving COVID-19 are litigated and decided, we expect these same three patterns of deference to lawmakers’ regulation, deference to existing written contracts, and application of equitable principles when available, to continue.
[1]Elmsford Apartment Associates, LLC v. Cuomo, 2020 WL 3498456, at *1.
[74]Richard Lee Brown v. Alex Azar, in his official capacity as Secretary, U.S. Department of Health & Human Services, 2020 WL 6364310, at *1.
[75] “Landlords, lobbyists launch legal war against Trump’s eviction moratorium, aiming to unwind renter protections,” by Tony Romm, The Washington Post, October 12, 2020.
[149] “How Force Majeure Was Successfully Used by a Tenant in Court,” by Patrick Trostle and Alan Gamza, www.globest.com, November 19, 2020 (discussing In Re: CEC Entertainment, Inc., Ch. 11 Case No. 20-33163 (MI) (Bankr. S.D. Tex.)).
“The hand of history lies heavy upon the tort of conversion.” Prosser, The Nature of Conversion, 42 Cornell LQ 168, 169 (1957). With roots dating back to the Norman Conquest of England in 1066, the cause of action had its original underpinnings as an alternative to deciding rightful ownership of disputed property by “wager of battle”—a physical altercation or duel between alleged victim and thief. Ames, The History of Trover, 11 Harv. L. Rev. 277, 278 (1897).
While life-and-death duels aren’t required anymore to ascertain ownership, the stakes of modern litigation over disputed property interests often carry existential consequences for the parties’ business interests. Despite being an ancient cause of action, conversion claims continue to impact present-day business disputes. Dozens of purported class action lawsuits pending in multiple jurisdictions seek to use the tort of conversion as a mechanism for adjudicating the proper ownership of billions of dollars the federal government paid for Paycheck Protection Program (PPP) loans pursuant to the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Some courts have begun to assess how conversion claims may apply to disputes over blockchain cryptocurrencies. Still other recent decisions assess the cause of action’s applicability to everything from membership interests in limited liability companies, to theft of a manuscript that played a key role in exposing movie producer Harvey Weinstein’s history of committing sexual assault and rape.
§ 1.2 The Development of the Cause of Action
§ 1.2.1 Brief History of Conversion, and Its Gradual Expansion to Include Some Forms of Intangible Property.
Conversion is an intentional act of “dominion or control over a chattel which so seriously interferes with the right of another to control it that the actor may justly be required to pay the other the full value of the chattel.” Restatement (Second) of Torts § 222A[1] (1965). Originally, this meant interferences with or misappropriation of only tangible “goods”—personal property capable of being lost or stolen. See W. Page Keeton et al., Prosser & Keeton on the Law of Torts § 15, at 90 (5th ed. 1984). Because intangible rights could not be “lost or found” in the eyes of the common law, the general rule was that “an action for conversion [would] not normally lie, when it involves intangible property” because there was no physical item that could be misappropriated. SeeSporn v. MCA Records, 58 N.Y.2d 482, 489, 462 N.Y.S.2d 413, 448 N.E.2d 1324 (1983).
Despite this long-standing reluctance to expand conversion beyond the realm of tangible property, most courts have determined there was “no good reason for keeping up a distinction that arose wholly from that original peculiarity of the action” and allowed conversion claims to reach “things represented by valuable papers, such as certificates of stock, promissory notes, and other papers of value.” SeeAyres v. French, 41 Conn. 142, 150, 151 (1874) (emphasis added). This, in turn, led to recognition of conversion when an intangible property right can be united—or “merged”—with a tangible object. New York’s highest court explained:
[F]or practical purposes [the shares] are merged in stock certificates which are instrumentalities of trade and commerce…. Such certificates ‘are treated by business men as property for all practical purposes.’ … Indeed, this court has held that the shares of stock are so completely merged in the certificate that conversion of the certificate may be treated as a conversion of the shares of stock represented by the certificate.
SeeAgar v. Orda, 264 N.Y. 248, 251, 190 N.E. 479 (1934); see alsoSporn, 58 N.Y.2d at 489, 462 N.Y.S.2d 413, 448 N.E.2d 1324 (plaintiff could maintain conversion claim where defendant infringed plaintiff’s “intangible property right to a musical performance by misappropriating a master recording—a tangible item of property capable of being physically taken”).
To some courts, the “lack of a compelling reason to prohibit conversion for redress of a misappropriation of intangible property underscores the need for reevaluating the appropriate application of conversion.” Thyroff v. Nationwide Mut. Ins. Co., 8 N.Y.3d 283, 291, 864 N.E.2d 1272, 1277 (2007). This reevaluation has led some courts to hold that conversion claims can embrace purely intangible property. See, e.g., Kremen v. Cohen, 337 F.3d 1024, 1033–1034 (9th Cir. 2003) (internet domain name; applying California law); Shmueli v. Corcoran Group, 9 Misc.3d 589, 594, 802 N.Y.S.2d 871 (Sup. Ct., N.Y. County 2005) (computerized client/investor list); Town & Country Props., Inc. v. Riggins, 249 Va. 387, 396–397, 457 S.E.2d 356, 363–364 (1995) (person’s name).
The Restatement (Second) of Torts recognizes this development, noting as to “Conversion of Documents and Intangible Rights”:
Where there is conversion of a document in which intangible rights are merged, the damages include the value of such rights.
One who effectively prevents the exercise of intangible rights of the kind customarily merged in a document is subject to a liability similar to that for conversion, even though the document is not itself converted.
Restatement (Second) of Torts § 242 (1965). Yet, the restatement cautions that this “final step” in the law of conversion “does not accord very well with the traditional common law limitations of conversion; and courts which prefer to adhere to the older theory may prefer to regard the liability as one for an intentional inference with the right, which is not identical with conversion, but is similar to it in its nature and legal consequences.” Id. § 242, comment e.
Prosser and Keeton similarly recognize “[t]here is perhaps no very valid and essential reason why there might not be conversion of” intangible property. Prosser & Keeton § 15, at 91–92. Yet they admonish that although “[t]he American economy has experienced an increasing use of intangible ideas. … it would seem preferable to fashion other remedies, such as unfair competition, to protect people from having intangible values used and appropriated in unfair ways.” Id. at 92.
Accordingly, some courts still insist that conversion claims cannot reach purely intangible rights. See, e.g., Allied Inv. Corp. v. Jasen, 354 Md. 547, 562, 731 A.2d 957, 965 (1999) (secured interests in corporation stock, collateral assignment of a partnership interest, and proceeds from each); Northeast Coating Tech., Inc. v. Vacuum Metallurgical Co., Ltd., 684 A.2d 1322, 1324 (Me. 1996) (interest in information contained in prospectus); Montecalvo v. Mandarelli, 682 A.2d 918, 929 (R.I. 1996) (partnership interest). Even courts that adhere to this more traditional view, however, frequently recognize exceptions—for example, “when a plaintiff can allege that the defendant converted specific segregated or identifiable funds, a conversion claim for money may survive.” See, e.g.,Sage Title Grp., LLC v. Roman, 455 Md. 188, 203, 166 A.3d 1026, 1035 (2017) (citation, internal quotation marks omitted). However, a claim for conversion will fail if the plaintiff cannot establish his right to the funds held in the segregated account. See, e.g., Cumis Ins. Soc., Inc. v. Citibank, N.A., 921 F. Supp. 1100, 1110 (S.D.N.Y. 1996) (dismissing conversion claim where “there is no allegation of any wrongful or improper act of dominion by [defendant] in contravention of [plaintiff’s] rights. The alleged acts constituting a conversion are specifically permitted under U.C.C. Article 4–A.”). Moreover, if a defendant diverts funds from a segregated account, the plaintiff proves his right to those funds, but the defendant satisfies an adverse judgment through use of other funds; there is no liability for conversion, because the plaintiff has suffered no damages. See Patel v. Strategic Grp., LLC, — N.E.3d —, 2020 WL 6193637, at *8 (8th Dist. Ct. Cuyahoga Cty. Ohio, Oct. 22, 2020) (“Once the trial court returned the full value of the alleged converted property to Patel — as occurred when the trial court awarded Patel $50,000 on his breach of contract claim — Patel suffered no damages pursuant to his conversion action.”).
§ 1.2.2 Elements, Defenses, and Available Remedies
A common thread runs through each jurisdiction’s unique recitation of the elements of conversion—“a wrongful taking, detention, or interference with, or an illegal assumption of ownership or possession, or illegal use or misuse, of the personal property of another. The gist of the tort is the exercise, or intent to exercise, dominion or control over the property of another in denial of, or inconsistent with, his or her rights in the property.” 7 American Law of Torts § 24:1. At its most basic, conversion is “any distinct act of dominion wrongfully exerted over the property of another, in denial of the plaintiff’s right, or inconsistent with it.” Mian v. Sekerci, No. CV N17C-05-585 JRJ, 2019 WL 4580024, at *4 (Del. Super. Ct. Sept. 13, 2019).
The two “key elements” of conversion are (1) the plaintiff’s possessory right or interest in the property and (2) a defendant’s dominion over the property or interference with it, in derogation of plaintiff’s rights. Palermo v. Taccone, 79 A.D.3d 1616, 913 N.Y.S.2d 859 (4th Dep’t 2010); see also Burlesci v. Petersen (1998) 68 Cal.App.4th 1062, 1066, 80 Cal.Rptr.2d 704 (elements are “(1) the plaintiff’s ownership or right to possession of the property; (2) the defendant’s conversion by a wrongful act or disposition of property rights; and (3) damages”).
Some jurisdictions additionally require that the plaintiff must have demanded return of the property, and the defendant refused. SeeCypress Creek EMS v. Dolcefino, 548 S.W.3d 673 (Tex. App. Houston 1st Dist. 2018), petition for review filed, (July 17, 2018) (listing elements). Under that analysis, without a demand for possession there’s been no deprivation, and accordingly no harm. Community Bank, Ellisville, Mississippi v. Courtney, 884 So. 2d 767 (Miss. 2004).
Other courts require demand and refusal only when the defendant’s original possession came about lawfully. SeeIn re Rausman, 50 A.D.3d 909, 910, 855 N.Y.S.2d 263, 265 (2008) (absent some indication that defendant’s original withdrawal of funds from a Swiss bank account pursuant to the power of attorney was unlawful, conversion claim could not have accrued until a demand was made); Lange-Fitzinger v. Lange, No. A153791, 2019 WL 3424959, at *5 (Cal. Ct. App. July 30, 2019). (“when the defendant’s original possession of the property was not tortious … plaintiff must prove that defendant refused to return the property after a demand for its return”). But even then, exceptions may apply. Cuprys v. Volpicelli, 170 A.D.3d 1477, 1478, 97 N.Y.S.3d 325, 327 (2019) (“If possession of the property is originally lawful, a conversion occurs when the defendant refuses to return the property after a demand or sooner disposes of the property.”) (emphasis added); see alsoCIT Commc’ns Fin. Corp. v. Level 3 Commc’ns, LLC, No. CIV.A.06C-01-236 JRS, 2008 WL 2586694, at *2 (Del. Super. Ct. June 6, 2008) (although “Delaware law does support the notion that if a party was once in lawful possession of the plaintiff’s property, the plaintiff must first make a demand … for return of the property[, t]his requirement is excused when the alleged wrongful act is of such a nature as to amount, in itself, to a denial of the rights of the real owner.”) (internal quotation marks omitted).
Just as in any other tort action, a plaintiff alleging conversion bears the burden of proving the extent of the damages he or she suffered. Dileo v. Horn, 189 So. 3d 1189 (La. Ct. App. 5th Cir. 2016). Damages awarded in an action for conversion are determined by the value of the property converted, and if disputed, the plaintiff bears the burden of proof. Gould v. Ochsner, 2015 WY 101, 354 P.3d 965 (Wyo. 2015). See Restatement (Second) of Torts § 242, Comment e (in cases involving intangible property there is “very little practical importance whether the tort is called conversion, or a similar tort with another name” because “[i]n either case the recovery is for the full value of the intangible right so appropriated”).
When it comes to defenses, “[c]onversion is a strict liability tort. The foundation of the action rests neither in the knowledge nor the intent of the defendant. Instead, the tort consists in the breach of an absolute duty; the act of conversion itself is tortious. Therefore, questions of the defendant’s good faith, lack of knowledge, and motive are ordinarily immaterial.” Pegues v. Raytheon Space & Airborne Sys., No. 217CV05420DSFGJSX, 2018 WL 8062690, at *3 (C.D. Cal. Dec. 3, 2018) (quoting Burlesci v. Petersen, 68 Cal. App. 4th 1062, 1066 (1998)). Nor, generally, can an after-the-fact attempt to return converted property “cure” the conversion. IBM Corp. v. Comdisco, Inc., 1993 Del. Super. LEXIS 183, *41, 1993 WL 259102.
Actual consent or acquiescence is a complete defense to a claim of conversion. In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), amended on reconsideration, 2018. Absence of damage to the plaintiff is a good defense, see Baye v. Airlite Plastics Co., 260 Neb. 385, 618 N.W.2d 145 (2000), as is abandonment of the property by the plaintiff. Toll Processing Services, LLC v. Kastalon, Inc., 880 F.3d 820 (7th Cir. 2018); Boaeuf v. Memphis Station, L.L.C., 107 N.E.3d 817 (Ohio Ct. App. 8th Dist. Cuyahoga County 2018); Lowe v. Rowe, 173 Wash. App. 253, 294 P.3d 6 (Div. 3 2012); Greenpeace, Inc. v. Dow Chemical Co., 97 A.3d 1053 (D.C. 2014). Similarly, a defendant who possessed the property to accommodate plaintiff has a complete defense to conversion when the property was wrongfully removed by a third person. Williams v. Edwards, 82 Ga. App. 76, 60 S.E.2d 538 (1950).
Other defenses which may mitigate the damages, but do not constitute a complete defense, include:
possession originally acquired in a lawful manner,
bona fide purchase without notice,
lack of profit or benefit to the defendant,
benefits conferred by the defendant on the plaintiff by making voluntary payments on the plaintiff’s obligations,
reasonable care in handling the property by the defendant,
defendant’s failure to use the property,
plaintiff’s indebtedness to the defendant,
plaintiff’s intention prior to the conversion to use the property unlawfully, or
negligence on the part of the plaintiff.
90 C.J.S. Trover and Conversion § 68. “Other claims which are not a defense include that the defendant is not in possession of the property sued for, the property is in legal custody, advice of counsel, contributory negligence, the First Amendment, lack of consideration, and commingling of the property with other property before the conversion.” Id.
§ 1.3 Recent Case Developments
As conversion claims grew to encompass intangible property, the Restatement noted “[t]he law is evidently undergoing a process of expansion, the ultimate limits of which cannot as yet be determined.” Restatement (Second) of Torts § 242 (1965). It remains so, as new cases seek to apply the ancient cause of action to pressing modern circumstances.
COVID-19, the CARES Act, and PPP Reimbursement Litigation
As noted above, dozens of purported class action lawsuits pending in multiple jurisdictions seek to use the tort of conversion as a mechanism for adjudicating the proper ownership of billions of dollars the federal government paid for Paycheck Protection Program (PPP) loans pursuant to the Coronavirus Aid, Relief, and Economic Security (CARES) Act. See, e.g., In re Paycheck Prot. Program Agent Fees Litig., No. MDL 2950, 2020 WL 4673430, at *1 (U.S. Jud. Pan. Mult. Lit. Aug. 5, 2020) (denying consolidation of 62 federal lawsuits pending in 26 districts).
To assist businesses struggling with the effects of the COVID-19 pandemic, Congress sought to incentivize those businesses to keep workers on their payroll by guaranteeing PPP loans made through Small Business Administration (“SBA”)-approved lenders (and offering forgiveness under certain conditions). “Congress didn’t create the PPP from whole cloth. Rather, it ‘temporarily add[ed] a new product,’” to the SBA’s “existing [Section] 7(a) Loan Program.” Lopez v. Bank of Am., N.A., No. 20-CV-04172-JST, 2020 WL 7136254, at *1 (N.D. Cal. Dec. 4, 2020) (citing Business Loan Program Temporary Changes; Paycheck Protection Program Interim Final Rule (the “SBA Rule”), 85 Fed. Reg. 20811 (Apr. 15, 2020)).[1]
However, the CARES Act created an unorthodox system for paying “agents” who assisted the small businesses in obtaining a PPP loan (e.g., attorneys; accountants; consultants; brokers; other persons or entities who prepare an applicant’s application for financial assistance, or who assist a lender with originating, disbursing, servicing, liquidating, or litigating SBA loans). See, e.g., U.S. Dep’t of Treasury, PPP Information Sheet Lenders, https://home.treasury.gov/system /files/136/PPP%20Lender%20Information%20Fact%20Sheet.pdf (last visited Jan. 12, 2021).
To further assist distressed businesses, the CARES Act prohibited agents from collecting fees directly from any PPP applicant. But rather than have the SBA compensate those agents directly, the Act required the SBA to pay processing fees to the lenders according to a sliding percentage driven by the loan’s size, and for agents to then pursue payment from those lenders out of the fees the lenders received from the SBA. According to SBA guidance (id.):
Processing fees will be based on the balance of the financing outstanding at the time of final disbursement. SBA will pay lenders fees for processing PPP loans in the following amounts:
Five (5) percent for loans of not more than $350,000;
Three (3) percent for loans of more than $350,000 and less than $2,000,000; and
One (1) percent for loans of at least $2,000,000.
Agent fees will be paid out of lender fees. The lender will pay the agent. Agents may not collect any fees from the applicant. The total amount that an agent may collect from the lender for assistance in preparing an application for a PPP loan (including referral to the lender) may not exceed:
One (1) percent for loans of not more than $350,000;
50 percent for loans of more than $350,000 and less than $2 million; and
25 percent for loans of at least $2 million.
Unsurprisingly, disputes arose between lenders and agents over how much, if at all, various agents were entitled to be paid out of funds the lenders had received from the SBA. Those disputes led to a blizzard of litigation, in which the agents advanced conversion claims as one theory of recovery, alleging that the CARES Act and related SBA regulations gave agents “a right to immediate possession of the agent fees,” out of funds that lenders “refused to provide … to Plaintiff and the class….” See Prinzo & Assoc’s, LLC v. BMO Harris Bank, N.A., Case No. 1:20-cv-3256 (N.D. Ill. 2020) (Complaint, ¶¶ 86–92). “By withholding these fees,” the lenders were alleged to have “maintained wrongful control over [agents’] property inconsistent with [agents’] entitlements under the SBA regulations,” amounting to “civil conversion by retaining monies owed to Plaintiff and Class members.” Id.
In Leigh King Norton & Underwood, LLC v. Regions Fin. Corp., No. 2:20-CV-00591-ACA, 2020 WL 6273739, at *12 (N.D. Ala. Oct. 26, 2020), the court dismissed plaintiffs’ conversion claims. The court noted that “under Alabama law, a conversion claim for money will survive only if “the money itself, not just the amount of it, [is] specific and capable of identification.” Id. at *11 (quoting Edwards v. Prime, Inc., 602 F.3d 1276, 1303 (11th Cir. 2010) (alteration in original)). And to be capable of identification, the money must be “traceable to a special account” or come from “segregated sources.” Id. Plaintiffs contended that because the funds “emanated” from a specifically identified source—i.e., the processing fees the SBA pays lenders under the PPP—the funds were sufficiently specific and identifiable. The court disagreed, holding “the fact that money ‘emanates’ from a specific source is not enough; the funds themselves must be identifiable, either because they are physically identifiable or because they have been entirely sequestered from all other funds.” Id. at *12 (emphasis added). Accordingly, the court dismissed plaintiffs’ conversion claims.
Similar lawsuits saw the courts dismiss plaintiffs’ conversion claims on the ground that where agents failed to comply with separate SBA rules, neither the CARES Act nor any SBA rule implementing the PPP created an entitlement to the fees—and without an immediate right to possession, conversion claims cannot stand. For example, in Lopez v. Bank of Am., N.A., supra, a sole proprietor bookkeeper helped his client apply for a PPP loan by compiling the client’s payroll information, reviewing the numbers to determine the appropriate loan amount, and filling out an application with Bank of America on his client’s behalf. 2020 WL 7136254 at *4. His client received a PPP loan in the amount of $70,243, and he sought to recover his fee ($702.43, or 1%) from Bank of America out of the origination fee it had received from the government. Id.
Bank of America refused, arguing that plaintiff never entered into a compensation agreement with Bank of America, and neither the CARES Act nor the SBA Rule entitled an agent to fees from a lender in the absence of such a direct agreement between agent and lender. Id. at *7. Plaintiff therefore sued on behalf of a purported class, alleging that the defendant lender was “obligated to set aside money to pay, and to pay, agents in accordance with PPP Regulations for work performed on behalf of a client in relation to the preparation and/or submission of a PPP loan application that resulted in a funded PPP loan.” Id. at *5.
The court disagreed. Pre-existing SBA rules required an agent “must execute and provide to SBA a compensation agreement,” which “governs the compensation charged for services rendered or to be rendered to the Applicant or lender in any matter involving SBA assistance.” Id. at *2 (citing 13 C.F.R. § 103.5(a)). And because nothing in the CARES Act superseded this rule, the court “conclude[d] that the CARES Act and the SBA Rule do not require lenders to pay agent fees for assistance with PPP loan applications, except as required under a written compensation agreement.” Id. at *8. Accordingly, because the plaintiff “was not entitled to agent fees under the CARES Act or SBA Rule, he had no ‘right to possession of the property,’” without which the conversion claim necessarily failed. Id. at *9.
Several other courts have employed a similar analysis. See Am. Video Duplicating Inc. v. Citigroup Inc., No. 20-cv-03815-ODW (AGRx), 2020 WL 6712232, at *4 (C.D. Cal. Nov. 16, 2020) (citing Sanchez, PC v. Bank of S. Tex., No. CV-20-00139, 2020 WL 6060868 (S.D. Tex. Oct. 14, 2020); Johnson v. JPMorgan Chase Bank, N.A., No. CV-20-4100 (JSRx), ––– F.Supp.3d ––––, 2020 WL 5608683 (S.D.N.Y. Sept. 21, 2020); Sport & Wheat, CPA, PA v. ServisFirst Bank, Inc., No. 20-cv-05425-TKW-HTC, ––– F.Supp.3d ––––, 2020 WL 4882416 (N.D. Fla. Aug. 17, 2020)).
Cryptocurrency Disputes
A Bitcoin is a unit of virtual currency, or “cryptocurrency” that exists only on the internet, without direct ties to any single nation’s monetary systems (though Bitcoins are regularly exchanged for sovereign currencies like the U.S. Dollar and the British Pound). Bitcoins are stored in virtual “wallets” created by the official Bitcoin software, which can store Bitcoins of a single user, or of multiple users using built-in “Accounts” functionality that tracks each user’s Bitcoin balance independently.
The currency is highly volatile—on March 12, 2020, as the COVID-19 pandemic first began to impact the United States, one Bitcoin traded for $3,858; on January 12, 2021, it traded briefly for more than $36,604 per Bitcoin. Seehttps://www.coinbase.com/price/bitcoin (last visited Jan. 12, 2021). The currency is based upon a blockchain[2] that contains a public ledger of all the transactions in the Bitcoin network. Initial interest in the currency was small, limited initially to those seeking to engage in transactions that could not be easily traced. Over time, as the currency gained wider exposure, retailers opened up to using bitcoin in 2012 and 2013. See https://www.investopedia.com/articles/forex/121815/bitcoins-price-history.asp (last visited Jan. 12, 2021).
Bitcoin is now traded on a number of non-centralized independent exchanges, and the currency can also be bought and sold through broker-dealers. Id. As Bitcoin has become more prevalent, courts are being asked to resolve whether it’s something that conversion claims can reach, which requires asking (and beginning to answer) questions as foundational as: is Bitcoin tangible, or intangible, property?
Ox Labs, Inc. v. Bitpay, Inc., No. CV 18-5934-MWF (KSX), 2020 WL 1039012, at *5–6 (C.D. Cal. Jan. 24, 2020).[3] Bitcoin is quasi-tangible property.
Plaintiff provided an advanced trading platform to exchange cryptocurrency, including Bitcoin. Defendant’s business involved regularly purchasing and selling Bitcoins—including on plaintiff’s platform—to enable other businesses to accept the cryptocurrency for online payments. At the conclusion of several transactions, plaintiff inadvertently credited Defendant with 200 additional Bitcoins. The error went unnoticed for over a year, when plaintiff realized approximately 200 Bitcoins were missing from its accounts, but could not locate the source of the missing Bitcoins. Months later, defendant also identified the error as part of an internal accounting review, and alerted the plaintiff. Negotiations ensued as to the correct valuation of the 200 Bitcoins, which had appreciated substantially since the initial error—on the date of the error the value was about $260-$300 per Bitcoin on the markets; when the error was identified by defendant, the value was about $1,050 per Bitcoin. Defendant offered payment based on the lower amount, but plaintiff refused. By the time plaintiff filed suit, nearly three years after the initial error, the value was more than $6,623 per Bitcoin.
Because California’s statute of limitations for conversion is longer for tangible property (3 years) than intangible property (2 years), the court had to decide a fairly metaphysical question: what sort of thing is Bitcoin, really? Defendant argued that Bitcoin is intangible property (and thus subject to a shorter limitations period), “because it is a digital currency without a tangible form.” But according to plaintiff, “Bitcoins do not exist in the detached realm of ideas; rather, they are digital currencies that rely on a shared public ledger … which records all confirmed transactions.” Plaintiff relied on Fabricon Products v. United California Bank, 264 Cal. App. 2d 113, 70 Cal. Rptr. 50, 53 (1968), where the California Court of Appeal determined that a check for money is tangible property subject to the three-year statute of limitations.
The court agreed with plaintiff, stating: “Bitcoin is not merely an ‘idea’ that is entirely divorced from any physical form. Rather, it is dependent on blockchain, a public ledger which records all the transactions.” The Court also found support in another decision that concluded Bitcoins are commodities that can be regulated by the Commodities Futures Trading Commission. See CFTC v. McDonnell, 287 F. Supp. 3d 213, 228 (E.D.N.Y. 2018) (“Virtual currencies are ‘goods’ exchanged in a market for a uniform quality and value. They fall well-within the common definition of ‘commodity’ as well as the [Commodity Exchange Act]’s definition of ‘commodities’ as ‘all other goods and articles … in which contracts for future delivery are presently or in the future dealt in.’”). Accordingly, the longer limitations period applied.
BDI Capital, LLC v. Bulbul Investments LLC, 446 F. Supp. 3d 1127 (N.D. Ga. 2020). Unlike money, Bitcoin is “specific intangible property” which can be recovered under a conversion theory.
In this case, an owner of Bitcoin sued the operator of a cryptocurrency exchange, alleging that the defendant unlawfully retained plaintiff’s Bitcoin, and asserting a claim for conversion. Defendant operated a trading platform that allowed its users to buy and sell Bitcoins against U.S. Dollars. In 2013, plaintiff set up an account on defendant’s trading platform. In 2017, plaintiff attempted to withdraw all of its Bitcoins stored on defendant’s platform, but was met with error messages. After various unsuccessful efforts to resolve the issue, plaintiff learned that defendant was in the process of shutting down or had already shuttered its trading platform. Defendant allegedly decided to close its trading platform because the banks it used had elected to discontinue their business with entities involved with cryptocurrencies.
Plaintiff, through counsel, issued a demand letter to defendant for all balances in plaintiff’s virtual wallet. When defendant failed to respond to the letter, plaintiff filed suit, arguing defendant should be held liable for conversion because it failed to return plaintiff’s Bitcoin upon demand. Noting that no Georgia court had addressed “whether bitcoins, as virtual, intangible cryptocurrency, may be the subject of a conversion action at all,” the court noted potential analogues—although generally “specific intangible property may be the subject for an action for conversion, … as fungible intangible personal property, money, generally, is not subject to a civil action for … conversion.” (citations omitted). The court accordingly inquired whether Bitcoins were “money” (and thus incapable of recovery through a conversion theory) or something different. The court ultimately was persuaded that Bitcoins could be the subject of a conversion action, because of each Bitcoin’s specificity and identity—the Bitcoin blockchain providing “a giant ledger that tracks the ownership and transfer of every Bitcoin in existence.” (quoting Kleiman v. Wright, No. 18-CV-80176, 2018 WL 6812914, 2018 U.S. Dist. LEXIS 216417 (S.D. Fla. Dec. 27, 2018)). According to the court, Bitcoins therefore are sufficiently identifiable to be considered “specific intangible property” subject to an action for conversion.
Other Notable Decisions
McGowan v. Weinstein, No. 219CV09105ODWGJSX, 2020 WL 7210934 (C.D. Cal. Dec. 7, 2020). In this case the court found a private espionage operation that stole an advance copy of Rose McGowan’s memoir exposing Harvey Weinstein as a rapist—for the purpose of informing a public relations effort to discredit McGowan—did not state a claim for conversion of her intellectual property.
For many years, the defendant used his power in the movie industry to sexually victimize women. According to the plaintiff, when defendant learned that plaintiff planned to expose him as her rapist in her memoir, Brave, he and his agents mobilized a complex scheme to protect his reputation. Part of the alleged scheme included using a private intelligence company, known as Black Cube, to obtain the content of Brave before its publication to help inform the smear campaign against its author.
Plaintiff alleged that the defendants were liable for conversion (among other counts) because they “planned to and did implement a scheme to obtain as much of Brave as possible before the book was published, causing interference with [McGowan]’s possession of the confidential manuscript.” Defendants moved to dismiss on grounds that (1) plaintiff failed to allege a complete dispossession of the manuscript; and (2) her claim was preempted by the Copyright Act. In opposition, McGowan argued that (1) intangible property can be subject to conversion even if it can be duplicated; and (2) a conversion claim did not require her to have been completely dispossessed of her copy of the manuscript. According to plaintiff, when Black Cube stole a copy of much of her manuscript—“and was apparently paid handsomely for that theft”—it disturbed and disrupted her right to maintain sole and exclusive possession of the intellectual property until its publication.
The court found plaintiff’s conversion claim preempted by the federal Copyright Act. “[W]here a plaintiff is only seeking damages from a defendant’s reproduction of a work—and not the actual return of a physical piece of property—the claim is preempted.” Because “the essence of her claim is that Defendants made an unlawful reproduction of her manuscript of Brave and interfered with her right to be the only person in possession of a copy,” plaintiff’s claim sounded in copyright. “[W]rongful possession of copies does not typically give rise to a conversion claim if the rightful owner retains possession of the original or retains access to other copies.” According to the court, “possession of copies of documents—as opposed to the documents themselves—does not amount to an interference with the owner’s property sufficient to constitute conversion.” And where “the alleged converter has only a copy of the owner’s property and the owner still possesses the property itself, the owner is in no way being deprived of the use of h[er] property.”
Mahon v. Mainsail LLC, No. 20-CV-01523-YGR, 2020 WL 6750150, at *9 (N.D. Cal. Nov. 17, 2020). An unfulfilled demand for return of unauthorized copies of intellectual property can overcome Copyright Act preemption concerns, regardless of whether the demand came before filing suit.
An independent filmmaker who created the film “Strength and Honor” entered into an agreement with defendant to distribute the film and provided master copies of the film. However, the Film was released with unauthorized covers and trailers, which plaintiff alleged violated the agreement. Plaintiff immediately sent “cease and desist” letters instructing defendant to remove the film from distribution. The Film continued to be distributed around the world, which Mahon claims could only occur based on master copies provided to defendant. Indeed, plaintiff learned that defendant’s subcontractor had shipped copies of the film to companies around the world, on defendant’s instruction, after plaintiff’s “cease and desist” letter.
Plaintiff filed suit, asserting claims for direct and contributory copyright infringement, illicit trafficking in counterfeit labels, fraud, and conversion against Mainsail. The Court initially dismissed the conversion claim as preempted by the Copyright Act, because it was based solely on conversion of intangible property (copyrights). The Court noted, however, that “claims for conversion of intangible property that includes an ‘extra element,’ such as demand for return of tangible property, [are] not preempted.” Plaintiff amended his complaint reasserting the conversion claim, but added allegations that defendant obtained master copies (i.e., tangible property) of the film and never returned them. According to the court, this sufficiently stated a claim for an “extra element”—allowing plaintiff to seek recovery of tangible property (the master copies), as opposed to merely asserting unauthorized copying of the intangible property.
Still, defendant argued that plaintiff’s conversion claim should fail because plaintiff purportedly authorized defendant’s use of the master copies. The court rejected this argument, noting that even if plaintiff initially authorized defendant to use master copies “it strains credulity that [defendant] could have innocently relied on that authorization [through seven years] of litigation and numerous ‘cease and desist’ letters from the [plaintiff].” Moreover, the court “fail[ed] to see any law … that requires [plaintiff] to have asked [defendant] for return of the property before filing his suit.” Accordingly, the Court denied defendant’s motion to dismiss the amended conversion claim.
Bamford v. Penfold, L.P., No. CV 2019-0005-JTL, 2020 WL 967942 (Del. Ch. Feb. 28, 2020). In this case Delaware’s Chancery Court confirmed that conversion claims may encompass membership interests in a limited liability company, no differently than stock in a corporation.
The defendant was plaintiff’s financial advisor and longtime friend—“a relationship that was closer than most brothers,” according to the complaint. Because of his great trust in the defendant, plaintiff did not inquire further when the defendant (falsely) advised him to waive the conversion feature in debt issued by the entity they co-owned in connection with a reorganization. Through that reorganization, the defendant obtained complete control of the entity, and, the plaintiff alleged, engaged in misappropriation and self-dealing.
Plaintiff asserted that the defendant’s actions amounted to conversion of plaintiff’s membership interests in the LLC. Defendant moved to dismiss, arguing that the intangible property at issue should be treated differently than other intangibles, such as shares of stock, of the kind customarily held to have been merged into a tangible document.
The court disagreed, holding “[t]here is no basis for treating a share of stock in a corporation and a membership interest in an LLC differently for purposes of conversion. A share of stock represents a bundle of rights defined by the laws of the chartering state and the corporation’s certificate of incorporation and bylaws. A membership interest in an LLC represents a bundle of rights defined by the laws of the chartering state, any substantive provisions in the certificate of formation (typically none), and the LLC agreement. Just as a share of stock is subject to conversion, so too is a membership interest in an LLC.”
Voris v. Lampert, 7 Cal. 5th 1141, 1153, 446 P.3d 284, 292 (2019), reh’g denied (Oct. 23, 2019). Lost wages are not recoverable under a theory of conversion.
For over a year, plaintiff worked alongside defendant to launch three start-up ventures, partly in return for a promise of later payment of wages. After a falling out, plaintiff was fired and the promised compensation never materialized. Plaintiff sued the companies and won, successfully invoking both contract-based and statutory remedies for the nonpayment of wages. He then sought to hold defendant personally responsible for the unpaid wages on a theory of common law conversion. Plaintiff asserted that by failing to pay the wages, the companies converted his personal property to their own use and that defendant was individually liable for the companies’ misconduct.
The Superior Court for Los Angeles County entered judgment on the pleadings for defendant. On appeal, California’s Supreme Court further affirmed the trial court, finding that conversion “is not the right fit for the wrong that [plaintiff] alleges, nor is it the right fix for the deficiencies [plaintiff] perceives in the existing system of remedies for wage nonpayment.” Plaintiff asserted “a right to money that did once exist, but which he believes was squandered. At least in such cases, [he] argues, the nonpayment of wages should be treated as a conversion of property, not as a failure to satisfy a ‘mere contractual right of payment.’”
The Court refused to endorse this logic, because it “would require us to indulge a similar fiction: namely, that once [plaintiff] provided the promised services, certain identifiable monies in his employers’ accounts became [his] personal property, and by failing to turn them over at the agreed-upon time, his employers converted [his] property to their own use.” Distinguishing a previous decision that suggested a common law claim such as conversion might lie “under appropriate circumstances” for an employer’s misappropriation of gratuities left for employees, the Court stated “an employer’s misappropriation of gratuities is not the same as an employer’s withholding of promised wages. When a patron leaves a gratuity for an employee (or employees), it arguably qualifies as a specific sum of money, belonging to the employee, that is capable of identification and separate from the employer’s own funds; indeed, the employee (or employees) for whom it was left has ownership of the gratuity by statute. … Unpaid wages are different in each of these respects.” A claim for unpaid wages “simply seeks the satisfaction of a monetary claim against the employer, without regard to the provenance of the monies at issue. In this way, a claim for unpaid wages resembles other actions for a particular amount of money owed in exchange for contractual performance—a type of claim that has long been understood to sound in contract, rather than as the tort of conversion.”
Am. Lecithin Co. v. Rebmann, No. 12-CV-929 (VSB), 2020 WL 4260989 (S.D.N.Y. July 24, 2020). Although domain names are intangible property, New York allows conversion claims for interference with one’s right to “possession” of the name.
Plaintiffs’ company brought suit in connection with defendant’s registration of certain domain names, and his retention of those domain names after plaintiffs terminated his employment. Plaintiffs alleged that while defendant was one of plaintiffs’ officers, he “registered under his own name, or transferred to his own name” the eight domain names identical in substance to a trademark that had been previously registered by plaintiffs. After terminating defendant’s employment, plaintiffs directed him to turn over all company property, but defendant did not transfer the domain names despite multiple demands.
Plaintiffs alleged conversion based on defendant’s transferring the domain names to his own name and continuing to retain them. Defendant argued that the domain names were intangible property incapable of conversion under New York law. Recognizing New York’s long-standing hesitancy to allow conversion claims for intangible property, the court nonetheless traced an ongoing trend away from such rigidity, as the law seeks to adapt to an increasingly electronic, computerized information economy.
The court highlighted C.D.S., Inc. v. Zetler, 298 F. Supp. 3d 727, 759 (S.D.N.Y. 2018) (finding, after bench trial, that when defendant changed the registration of various domain names belonging to plaintiff to his own LLC, he “interfered with [plaintiff’s] possessory interest” in the property, and was liable for conversion), and Triboro Quilt Mfg. Corp. v. Luve LLC, No. 10 Civ. 3604, 2014 WL 1508606, at *9 (S.D.N.Y. Mar. 18, 2014) (“New York courts recognize exceptions [to the normal rule that only physical property can be converted] when the rightful owner of intangible property is prevented from creating or enjoying a ‘legally recognizable and protectable property interest in his idea’ such as by being prevented from registering the domain name for a website or being denied access to a database he created.”). Because “domain names also have inherent value, particularly where they implement an intellectual property right like a trademark,” the court, “motivated by the need for the common law to respond … to the demands of commonsense justice in an evolving society,” the Court concluded that New York law permits a plaintiff to sue for conversion based on interference with a domain name. (quoting Thyroff v. Nationwide Mut. Ins. Co., 8 N.Y.3d 283, 289 (2007).
[1] “Section 7(a) of the Small Business Act … permits extension of financial assistance to small businesses when funds are ‘not otherwise available on reasonable terms from non-Federal sources.’” United States v. Kimbell Foods, Inc., 440 U.S. 715, 719 n.3, 99 S.Ct. 1448, 59 L.Ed.2d 711 (1979).
[2] Blockchain is a specific type of database that stores data in a particular way—as new data comes in, it is entered into a fresh block; once the block is filled with data, it is chained onto the previous block, which makes the data chained together in chronological order. Blockchain databases are most commonly used as a ledger for transactions. In Bitcoin’s case, blockchain is used in a decentralized way so that no single person or group has control—rather, all users collectively retain control. Decentralized blockchains are immutable, which means that the data entered is irreversible. For Bitcoin, this means that transactions are permanently recorded and viewable to anyone. Seehttps://www.investopedia.com/terms/b/blockchain.asp (last visited Jan. 12, 2021).
[3] An earlier order from the same case reviews the facts that gave rise to the dispute. See Ox Labs, Inc. v. Bitpay, Inc., No. CV 18-5934-MWF (KSX), 2019 WL 6729667, at *4 (C.D. Cal. Sept. 27, 2019).
Snell & Wilmer L.L.P., 1200 17th Street, Suite 1900, Denver, CO 80202, 303.635.2085, [email protected]
Byeongsook Seo is a member of the Snell & Wilmer L.L.P.’s commercial litigation practice. He represents clients in handling complex and, often, heated disputes related to failed business ventures and disputes among business partners, executives, owners, and directors. Byeongsook is a member and Vice-Chair of the Business Divorce Subcommittee of the ABA Business Law Section Committee on Business and Corporate Litigation. His honors include Colorado Super Lawyers and The Best Lawyers in America. Byeongsook graduated from the United States Air Force Academy and obtained his law degree from the University of Denver, Sturm College of Law.
Contributors
Melissa Donimirski
Heyman Enerio Gattuso & Hirzel LLP, 300 Delaware Avenue, Suite 200, Wilmington, DE 19801, 302.472.7314, [email protected]
Melissa N. Donimirski is an attorney with Heyman Enerio Gattuso & Hirzel LLP in Wilmington, Delaware. She concentrates her practice in the area of corporate and commercial litigation in the Delaware Court of Chancery and has been involved with many of the leading business divorce cases in that Court. Melissa is Co-Chair of the Business Divorce Subcommittee of the ABA Business Law Section, Business and Corporate Litigation Committee. She received her undergraduate degree from Bryn Mawr College and her law degree from the Delaware Law School of Widener University. Melissa has also co-edited and co-authored a treatise on business divorce, which is published by Bloomberg BNA.
Janel M. Dressen
Anthony Ostlund Baer & Louwagie P.A., 90 South 7th Street, 3600 Wells Fargo Center, Minneapolis, MN 55402, 612.492.8245, [email protected]
Janel Dressen is a lawyer and shareholder with the litigation boutique firm Anthony Ostlund Baer & Louwagie P.A., located in Minneapolis, Minnesota. Janel has 19 years of experience as a trial lawyer and problem solver. She assists her clients to avoid and prepare for business and employment-related disputes in and outside of the courtroom. Janel spends a significant amount of her time resolving family-owned and privately held business disputes for owners that are in need of a business divorce. In 2019, Janel was selected by her peers to the Top 50 Women Minnesota Super Lawyers list by Super Lawyers. In 2017, Janel was honored as one of Minnesota’s Attorneys of the Year.
Thomas Kanyock
Schwartz & Kanyock, LLC, 33 North Dearborn Street, Ste. 2330, Chicago, IL 60602, 312.441.1040, [email protected]
Thomas Kanyock is a principal with Schwartz & Kanyock, LLC, in Chicago, where he regularly litigates and resolves commercial disputes involving injunctions, trials and appeals in state and federal courts. Tom concentrates in representing oppressed equity interest holders frozen into and out of closely held business entities.
John Levitske
Ankura, One North Wacker Dr., Suite 1950, Chicago, IL 60606, 312.252.9533, [email protected]
John Levitske, CPA/ABV/CFF/CGMA, ASA, CFA, CFLC, CIRA, MBA, JD, is a Senior Managing Director in the disputes and economics practice of Ankura, a global business advisory and expert services firm. He serves as a business valuation, forensic accounting and damages expert witness, arbitrator, and advisor. John is frequently consulted regarding business disputes, shareholder disputes and post-acquisition transaction disputes. In addition, he is the current Chair of the Dispute Resolution Committee of the Business Law Section and a Member at Large of the Standing Committee on Audit of the American Bar Association.
John C. Sciaccotta
Aronberg Goldgehn, 330 N. Wabash Ave., Suite 1700, Chicago, IL 60611, 312.755.3180, [email protected]
John C. Sciaccotta is a Member at Aronberg Goldgehn. He focuses his practice on litigation, arbitration and business counseling matters with a special emphasis on complex civil trial and appellate cases brought in federal and state courts throughout the United States. John has also been appointed by the American Arbitration Association as an Arbitrator and Lawyer Neutral to adjudicate various claims and disputes in arbitration. For many years he has advised public and privately held businesses, lenders, employers and individuals in business transactions and disputes. He is experienced in dealing with numerous industries and business activities and has a specialty focus on representing entities in business divorce and complex ownership dispute resolution. John is highly active in professional associations and within his community. Among his activities, he is Co-Founder and current Chair of the Chicago Bar Association’s Business Divorce and Complex Ownership Disputes Committee. He served on the CBA’s Board of Managers from 2017 to 2019.
Ben T. Welch
Snell & Wilmer L.L.P., 15 West South Temple, Suite 1200, Salt Lake City, UT 84101, 801.257.1814, [email protected]
Ben T. Welch is a commercial litigator and trial attorney at Snell & Wilmer LLP. Ben litigates all types of complex business disputes, including shareholder disputes, contract disputes, and disputes regarding corporate dissolution, non-compete agreements, and trade secrets.
§ 1.1 Introduction
This chapter provides summaries of developments related to business divorce matters that arose from October 1, 2019 to September 30, 2020 from mostly eight states. Each contributor used his or her best judgment in selecting cases to summarize. We then organized the summaries, first, by subject matter, then, by jurisdiction. This chapter, however, is not meant to be comprehensive. The reader should be mindful of how any case in this chapter is cited. Some jurisdictions have rules that prohibit courts and parties from citing or relying on opinions not certified for publication or ordered published. To the extent unpublished cases are summarized, the reader should always consult local rules and authority to ensure relevant and permissible precedent is found for any particular matter. We hope this chapter assists the reader in understanding recent developments in business divorces.
§ 1.2 Access to Books and Records
§ 1.2.1 Massachusetts
Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished). Plaintiff held dual status as a corporation’s chief technology officer and 30% shareholder. Plaintiff left the company and his position as CTO, while maintaining his 30% shareholder status. More than a year later, plaintiff used his knowledge of the company’s computer systems to gain control of its website and to cut off the CEO’s email access for several days. Plaintiff filed suit claiming statutory rights, per G.L.C. 156D, §16.02, to inspect books and records. The trial court dismissed the claim. However, the issue arose again in the defendant company’s counterclaim brought under three federal statutes, each of which provide protections against unauthorized impairments or invasions of computer systems. The company obtained a preliminary injunction requiring plaintiff to return systems controls. However, despite the preliminary injunction, plaintiff downloaded and kept select company records and communications. Plaintiff claimed that his continuing status as a 30% shareholder authorized him to access records and communications. The trial court entered judgment for counterclaimant and plaintiff appealed.
Plaintiff argued on appeal that he was authorized to take the actions at issue, acting in good faith out of a desire to help the corporation. Plaintiff asserted his 30%ownership of the close corporation, citing Donahue v. Rodd Electrotype Co., 367 Mass. 578 (1975), claiming a right to participate in management. As such, reasoned plaintiff, he had an unfettered right to access the computer system to force the controlling member to negotiate.
The Appellate Court, in an unpublished order, rejected plaintiff’s core argument for three main reasons, including:
[T]he trial judge made several factual findings that establish that Bernstein was not “authorized” to take the actions at issue. The judge found that Bernstein left the company’s employ in September of 2011, that the company termed that a “resignation,” and that Bernstein did not contest that designation at that time. Thereafter Bernstein may have been involved in some oversight functions, but he was no longer “at the company.” Bernstein’s successor as CTO changed the company passwords, and did not share them with Bernstein. The judge found that “within a few months of leaving, [Bernstein] was no longer allowed access to company emails.” To the extent Bernstein contests these findings, they are not clearly erroneous. Accordingly, even if we were to accept Bernstein’s contention that his employment with MyJoVE continued past September 30, 2011, the judge was still more than justified in concluding that when Bernstein accessed the company’s computer system over one year later, he knew he was not employed by MyJoVE, and knew he did not have the requisite authorization.
§ 1.2.2 New York
Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019). A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC. The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty. The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.
§ 1.3 Business Judgment Rule
§ 1.3.1 California
Coley v. Eskaton, 51 Cal.App.5th 943 (2020). In an action involving homeowner claims against directors of an HOA, the court addressed whether the business judgment rule was properly ignored to impose liability against the board members for breach of fiduciary duty among other claims for relief. In doing so, the court analyzed both statutory and common law versions of the business judgment rule.
California recognizes two types of business judgment rules: one based on statute and another on the common law. Corporations Code section 7231 supplies the relevant statutory rule for nonprofit mutual benefit corporations like the Association. Under that statute, a director is not liable for “failure to discharge the person’s obligations as a director” if the director acted “in good faith, in a manner such director believes to be in the best interests of the corporation and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar circumstances.” The common law business judgment rule is similar but broader in scope. It is similar in that it immunizes directors for their corporate decisions that are made in good faith to further the purposes of the corporation, are consistent with the corporation’s governing documents, and comply with public policy. And it is broader in that it also insulates from court intervention those management decisions that meet the rule’s requirements. A director, however, cannot obtain the benefit of the business judgment rule when acting under a material conflict of interest.
Corporations Code section 7233 provides, among other things, that an interested director who casts a deciding vote on a transaction must show the “transaction was just and reasonable as to the corporation at the time it was authorized, approved or ratified.” Section 7233, however, only applies to transactions “between a corporation and one or more of its directors, or between a corporation and any domestic or foreign corporation, firm or association in which one or more of its directors has a material financial interest.” The common law rule, as before, is similar but broader in scope. It is similar in that it requires interested directors to prove that the arrangement was fair and reasonable—a rigorous standard that requires them not only to prove the good faith of the transaction but also to show its inherent fairness from the viewpoint of the corporation and those interested therein. And it is broader in that it is not concerned only with transactions between a corporation and either its directors or a business in which its directors have a material financial interest. Courts have found directors must also satisfy the common law requirements when they approve other transactions in which they have a material financial interest distinct from the corporation’s own interest.
Here the directors were employees of the development company that developed the residential community. The directors were compensated in a way that encouraged them to pass assessments that benefit the development company and not the owners. Plaintiff initiated the action in his individual capacity and derivatively on behalf of the HOA. During litigation, the defendant directors participated in privileged communications between the HOA and its counsel, then shared privileged information with their employer, who was also a defendant in the action. Given these facts, the court determined the directors had a material conflict of interest, which precluded the application of the business judgment rule.
§ 1.3.2 Massachusetts
Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *12-13 (Mass. Super. 2020). In a case mixing Massachusetts and Delaware oppression issues, plaintiff brought a claim against the company’s controlling shareholder for failure to issue distributions. Plaintiff alleged that defendant siphoned assets by, among other things, overcompensating himself and family members, thus leaving no funds available for distribution. Defendant moved to dismiss asserting that the company charter granted him “sole discretion” whether to pay dividends. The Court denied the motion reasoning that defendant may have frustrated plaintiff’s reasonable expectations:
A minority owner of a closely-held corporation may sue under a freeze-out theory by alleging that a corporate fiduciary kept corporate benefits for themself while denying them to the minority plaintiff. See Clemmer v. Cullinane, 62 Mass. App. Ct. 904, 905-06 (2004) (rescript) (applying Delaware law). “Freeze-outs can occur … ‘[w]hen the reasonable expectations of a [minority] shareholder are frustrated.’” Selmark Assocs., Inc. v. Ehrlich, 467 Mass. 525, 536 (2014).
Where those in control of a closely-held corporation with lots of free cash do not pay any dividends, but use other mechanisms to pay or distribute substantial sums to themselves, they may be liable to the minority shareholders for engaging in shareholder oppression; this is “a classic squeeze out situation.” Litle, 1992 WL 25758, at *8; accord Crowley v. Communications for Hosp., Inc., 30 Mass. App. Ct. 751, 762-63 (1991) (majority froze out minority stockholder by, among other things, paying themselves excessive compensation while refusing to declare dividends).
§ 1.3.3 New York
Beckerman v. Lattingtown Harbor Property Owners Association, Inc., 183 A.D.3d 821, 124 N.Y.S.3d 651 (N.Y. App. Div. 2020). A homeowner brought an action against the homeowners’association seeking to annul a license agreement between the board and another member of the association regarding use of the community dock. In reviewing the action under the business judgment rule, which inquired whether the action was taken in good faith and in furtherance of the legitimate interest of the association, the Court concluded that it should defer to the homeowners’association as long as the board “acts for the purposes of the [homeowners’ association], within the scope of its authority and in good faith.” Id. at 654. Here, however, the trial court found that the homeowners’association was acting outside its authority and therefore annulled the license. The appellate court affirmed.
Witty v. Wallace, 176 A.D.3d 906, 107 N.Y.S.3d 871 (N.Y. App. Div. 2019). This case involved a dispute between 50% co-owners of a limited liability company that owns a commercial building that leases to a bank under a triple-net lease. When the lease was renewed in 2010, the tenant was granted a rent reduction, whereupon one of the co-owners brought an action for corporate waste. In reviewing the application, the Court concluded that pursuant to the business judgment rule, absent evidence of bad faith, fraud, self-dealing, or other misconduct, courts would respect business judgments. Here, the evidence for overcoming the business judgment rule was not present; rather, the evidence suggested that the lease extension was made in good faith and in furtherance of the corporation’s legitimate business interest. Thus the trial court’s decision to dismiss the plaintiff’s complaint was proper.
§ 1.4 Dissolution
§ 1.4.1 Delaware
SolarReserve CSP Holdings, LLC v. Tonopah Solar Energy, LLC, 2020 WL 1291638 (Del. Ch. Mar. 18, 2020). The Court held that equitable dissolution was not available where the petitioning party failed to demonstrate that the Court should “invoke equitable principles to override the plain language” of the Delaware LLC Act and the relevant LLC agreement. Originally, plaintiff SolarReserve held a direct ownership interest in the subject company, Tonopah Solar Energy, LLC, which would have permitted plaintiff to seek judicial dissolution of that entity. However, that interest was reduced to an “indirect equity interest” through several intermediary entities, which the Court held were “calculated choices to reshape Tonopah’s complicated ownership structure in order to secure additional funding.” Because the intended relationship of plaintiff to the subject Company was intended to be remote, the Court held that plaintiff did not meet the standard set forth in In re Carlisle Etcetera LLC, 114 A.3d 592 (Del. Ch. 2015) to warrant finding that plaintiff had equitable standing to seek dissolution.
§ 1.4.2 New York
PFT Technology, LLC, v. Wieser, 181 A.D.3d 836, 122 N.Y.S.3d 313 (N.Y. App. Div. 2020). A limited liability company and its majority members filed suit against a minority member seeking to dissolve the company and reconstitute without the minority member. The minority member, in turn, counterclaimed for breach of the operating agreement. The minority member eventually agreed that the majority could buy out his membership interest, and the court held a valuation proceeding in which the minority member’s interest was valued at $1.250M. The minority member was also awarded attorney fees and prejudgment interest but not any damages based on his counterclaim. Both sides appealed.
On appeal the appellate court noted that although limited liability law did not expressly authorize a buyout in a dissolution proceeding, that remedy was appropriate as an equitable remedy. The appellate court found that the trial court’s decision to allow the buyout was a “provident” exercise of its discretion. However, the trial court erred in applying certain adjustments to the company’s value, which should have been $1.489M. The trial court also erred in the amount of attorney fees it awarded. The trial court did not err in deciding not to award damages on the counterclaim or in the amount of prejudgment interest.
§ 1.4.3 Utah
HITORG, LLC v. TC Veterinary Serv. Inc., 2020 UT App 123, 472 P.3d 1177. A veterinarian brought suit against other veterinarians for breach of contract, breach of good faith and fair dealing, and dissolution of a limited liability company based on her expulsion. The other veterinarians moved to compel arbitration pursuant to the operating agreement. The plaintiff-veterinarian opposed the motion and filed a motion to stay arbitration claiming that she sought dissolution and other causes of action arising from duties and obligations outside the operating agreement (such as statutory dissolution on the basis of oppressive conduct or fraud). The trial court granted the motion to compel and denied the motion to stay, concluding that the operating agreement contained a provision for judicial dissolution and therefore the issue of dissolution was within the power of the arbitrator to decide along with other claims. The court of appeals affirmed.
§ 1.5 Jurisdiction, Venue, and Standing
§ 1.5.1 California
Clark v. S&J Advertising, Inc., 611 B.R. 669 (E.D. Cal. 2019). This case involves the interplay between a bankruptcy court’s jurisdiction and California’s involuntary dissolution/valuation/share buyback statute (Cal. Corp. § 2000) and related proceedings. A married couple filed a Chapter 13 bankruptcy petition. The wife later filed a certificate of election to wind up and dissolve a company with the California Secretary of State pursuant to Cal. Corp. Code § 1900. She owned 50% interest in the company. The company filed a petition to stay dissolution proceedings and ascertain value of the wife’s shares under § 2000 in state court. The state court stayed dissolution until appraisers could arrive at a fair valuation. The bankruptcy court granted the company relief from stay so the valuation could proceed in state court. The court approved the § 2000 valuation and the transfer of the wife’s shares to the corporation for the valuation price.
The couple appealed the bankruptcy court’s decision to adopt the § 2000 valuation under the Rooker-Feldman doctrine, which precludes a federal court from overturning a state court’s judgment. Since the bankruptcy court did not overturn the state court’s decision, but effectively affirmed the state court’s decision to proceed with § 2000 proceedings, Rooker-Feldman did not apply.
The couple also argued that the bankruptcy court could not exercise subject matter jurisdiction over the § 2000 proceeding absent removal from state court pursuant to 28 U.S.C. § 1452(a), which sets forth a formal removal process that was not followed in this case. But the bankruptcy court had not exercised jurisdiction over the § 2000 state proceedings. It just adopted and applied the § 2000 valuation to the bankruptcy proceedings, so removal was neither necessary nor relevant to the bankruptcy court’s jurisdiction analysis. The bankruptcy court had proper jurisdiction over the couple and the wife’s shares in the company.
§ 1.5.2 Illinois
Tabirta v. Cummings, 2020 IL 124798. The Illinois Supreme Court held that an employee’s home office within a county did not qualify as an office of the employer for the purposes of venue. The court found that there was no evidence that the employer hired the employee because of the location of his residence and home office or that his employment would be affected if he moved to another county and therefore the employer did not purposely select a fixed location as necessary to avail itself to venue in that county.
§ 1.5.3 Massachusetts
In re Bos. Grand Prix, LLC, 2020 WL 6140391, at *16 (Bankr. D. Mass. 2020). The Court rejected a Chapter 7 trustee’s argument that he had standing to ask the Court to hold an LLC member personally liable for all debtor LLC’s debts as the LLC’s alter ego. The trustee brought a series of fiduciary breach claims against the sole member, manager, and operating officer of an insolvent LLC purporting to promote auto races in Boston. The Court had little difficulty entering judgment against the LLC member based on an apparently indefensible series of egregious self-dealings acting as a fraud on creditors, resulting in the Court awarding significant damages and unwinding fraudulent transfers. However, the Court held that the trustee went too far asking to hold the LLC member personally liable for all LLC debts as its alter ego. The Court held that, under the Bankruptcy Code, only actual creditors, and not the trustee, have standing to pierce the debtor’s veil.
Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *12-13 (Mass. Super. 2020). In a case mixing Massachusetts and Delaware oppression issues, plaintiff brought direct and derivative claims against the company’s controlling shareholder for failure to issue distributions. Plaintiff alleged that defendant siphoned assets by, among other things, overcompensating himself and family members, thus leaving no funds available for distribution. The company had layers of subsidiaries. The company was a Delaware corporation, but one of its subsidiaries was a Massachusetts corporation. Plaintiff sued derivatively on behalf of the Massachusetts entity.
Defendant moved to dismiss arguing that plaintiff lacked standing because he never made a pre-suit derivative demand. Delaware and Massachusetts statutory law differ in that Delaware law still applies the futility exception, while Massachusetts changed its BCA, G.LC. 156D, § 7.42, to always require a prerequisite derivative demand on behalf of a corporation. The Court denied the motion, noting that plaintiff brought a pass-through “double-derivative” claim and therefore was suing primarily in the interests of the Delaware corporation, thus applying Delaware’s futility exception.
JT IP Holding, LLC v. Florence, 2020 WL 5217118, at *3–4 (D. Mass. 2020). Unlike corporations, Massachusetts’s LLC Act has no universal pre-suit derivative demand requirement. Defendant moved to dismiss a derivative claim for failure to make a pre-suit demand, regardless of futility, per § 156 C, § 56, arguing that the LLC operating agreement did not authorize suit without a demand. The Court denied the motion, holding that a provision in the operating agreement prohibiting action on behalf of the entity without approval of all members was too generic, without more specific language, to require a pre-suit derivative demand.
§ 1.6 Claims and Issues in Business Divorce Cases
§ 1.6.1 Accounting
§ 1.6.1.1 New York
Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019). A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC. The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty. The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.
§ 1.6.2 Alternative Entities
§ 1.6.2.1 Delaware
Franco v. Avalon Freight Services, LLC, 2020 WL 7230804 (Del. Ch. Dec. 8, 2020). Where an LLC Agreement provides that the co-equal members must agree on the identity of a tie-breaking director, but is silent on the topic of how to remove a director, removal is governed by the Delaware LLC Act. Such provision does not mean that, if one faction becomes dissatisfied with the service of the tie-breaking director, such director must be removed. Avalon Freight Services, LLC, is a co-equally owned LLC, owned between two members. The Company is governed by a board of directors, on which sits the two members, two additional directors, one appointed by each member, plus a tie-breaking director, whose appointment must be agreed upon by the two members. When one member became dissatisfied with the tie-breaking director, that member brought this action seeking a declaration that his dissatisfaction with the tie-breaking director means that “position must be vacated and [the members] must mutually agree on a new person to fill the position.” The Court held that the provision in question related only to the appointment of the tie-breaking director, and not to such director’s removal. Because the LLC Agreement did not specify how to remove a director, the terms of the Delaware LLC Act were considered incorporated to fill the gap.
§ 1.6.3 Breach of Fiduciary Duty
§ 1.6.3.1 Delaware
Wright v. Phillips, 2020 WL 2770617 (Del. Ch. May 28, 2020). In a business divorce between co-equal owners who were formerly husband and wife, the Court found that Phillips failed to demonstrate that Wright’s actions rose to the level of a breach of her duty of care or loyalty. Phillips claimed that Wright breached her fiduciary duties by (1) using company funds to pay personal credit card bills; (2) “raiding” the offices to take files and equipment; (3) engaging in accounting practices that caused cash crunches; (4) failing to follow the Receiver’s instructions; and (5) removing money to bank accounts that she independently controlled. The Court held that Wright credibly explained why personal credit card charges appeared on the company accounts and found that there was insufficient evidence to find that this activity was wrongful or that it breached Wright’s fiduciary duties. The Court additionally held that the allegations of “raiding” the company offices to take files and equipment were without scienter, and were actually “careless actions … directed at the disintegrated personal relationship between the parties.” With respect to the “cash crunches,” the Court found that both parties were equally at fault in this regard, and, again, that Wright’s actions lacked scienter. With respect to failing to follow the Receiver’s instructions, which included designating office hours for Wright, the Court held that “a failure to obey guidelines set by a Receiver is not a per se violation of fiduciary duties.” The Court additionally credited Wright’s trial testimony that she had logical reasons for her choices regarding work hours and location that included her safety and her long history of working from home. Finally, the Court held that Wright’s actions in removing company money to her personal bank accounts were not actionable because she had “cognizable reasons to move the funds,” and because the Receiver’s instruction to transfer them back was contingent on Phillips reinstating her salary, which he did not do.
§ 1.6.3.2 Illinois
Flynn v. Maschmeyer, 2020 IL App (1st) 190784. The appellate court held that a member of an Illinois limited liability company who was held to have breached his fiduciary duties to his co-members and the LLC was nonetheless entitled to a judgment on his counterclaim for the fair value of his interest in the LLC. The court held that the member did not forfeit his right to recover his interest in the LLC by failing to respond to a purported capital call that was sent only to him to recover the amount of funds he had misappropriated from the LLC.
§ 1.6.3.3 Massachusetts
Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished). (See description in § 7.1). The Court rejected plaintiff/counter-defendant’s argument that, after he resigned his position as Chief Technology Officer, he remained a 30% shareholder entitled to access records and communications because defendant/counter-plaintiff breached fiduciary obligations owed to him:
Bernstein did not at any time have an unfettered right to participate in management, and he surely did not once he resigned as CTO. More importantly, Bernstein’s status as a shareholder of a close corporation did not give him a right to engage in unauthorized acts. “Allowing a party who has [allegedly] suffered harm within a close corporation to seek retribution by disregarding its own duties has no basis in our laws and would undermine fundamental and long-standing fiduciary principles that are essential to corporate governance …. ‘Rather, if unable to resolve matters amicably, aggrieved parties should take their claims to court and seek judicial resolution.’” Selmark Assocs., Inc. v. Ehrlich, 467 Mass. 525, 552-553 (2014), quoting Rexford Rand Corp. v. Ancel, 58 F.3d 1215, 1221 (7th Cir. 1995). See Donahue, 367 Mass. at 593 n.17 (recognizing that, “[i]n the close corporation, the minority may do equal damage through unscrupulous and improper ‘sharp dealings’”). To the extent Bernstein felt aggrieved by any mistreatment he may have received by MyJoVE or Pritsker (including Pritsker’s refusal to meet with him), his recourse was not through unauthorized access to the company’s computer system.
Dolan as Tr. of Charles B. Dolan Revocable Tr. v. DiMare, 2020 WL 4347607, at *13 (Mass. Super. 2020). Plaintiff shareholder brought, among other things, aiding and abetting breach of fiduciary duty claims against the company’s lawyer for failure to inform plaintiff that the company’s controlling shareholder improperly siphoned assets by overcompensating family members, thus leaving no funds available for distribution. The Court dismissed the claim, holding that allegations that the lawyer had familiarity with the company’s financial condition did not rise to the level of actual knowledge of wrongdoing.
Mahoney v. Bernat, 2019 WL 6497601, at *3 (Mass. Super. 2019). Plaintiff minority shareholder, Mahoney, brought an aiding and abetting claim against the company’s lawyers, the Sabella Defendants, alleging that they breached a duty owed to him by assisting with preparing a buy-out of another shareholder that plaintiff claimed harmed him. The Court granted the lawyers’ motion to dismiss:
Massachusetts law imposes a fiduciary obligation on corporate counsel to protect the interests of individual members or shareholders only in rare circumstances. See Baker v. Wilmer Cutler Pickering Hale & Dorr, LLP, 91 Mass. App. Ct. 835, 837 (2017) (recognizing fiduciary duty on part of corporate counsel to individual members of limited liability company where the LLC was “governed by an operating agreement providing significant minority protections,” and it was alleged that counsel “secretly worked to eliminate those protections …”). Those rare circumstances are not present here. The Shareholders’ Agreement does not afford Mr. Mahoney “significant minority protections,” and there is no allegation that the Sabella Defendants engaged in any clandestine effort to undermine Mr. Mahoney’s position vis-a-vis the Company.
§ 1.6.3.4 Minnesota
Blum v. Thompson, No. A19-0938, 2020 WL 1983218 (Minn. Ct. App. Apr. 27, 2020), review denied (July 23, 2020). Richard Ward and Rosemary Ward raised seven children. Three of their children, Kathryn, Charles and Thomas (plaintiffs), sued three of their siblings and their father relating to the operations of their family-owned business, Ward Family, Inc. (“WFI”). The dispute involved a long-term lease that WFI executed that gave one of the defendants’ corporation, El Rancho Manana, Inc., greater authority over a large plot of land known by the parties as “the Ranch.” Following a jury trial on plaintiffs’ common-law breach-of-fiduciary duty claim against defendants and a court trial on plaintiffs’ statutory shareholder-oppression claim, both the jury and district court found in favor of defendants. The Minnesota Court of Appeals affirmed, reasoning that the shareholders knew about the plan to formalize the lease arrangement, and that WFI allowed shareholders to propose terms of the lease. The Court of Appeals, like the district court, rejected a claim that consensus was needed among the shareholders as to the terms of the lease. While the parties had reached a consensus on some issues in the past, “it was not reasonable for [plaintiffs] to expect that WFI would be governed in a manner inconsistent with its bylaws.” WFI’s bylaws stated that actions were approved by simple majority. “It is not clear error to conclude that it is unreasonable for minority shareholders to expect that they have veto power over an action permitted by the company’s bylaws just because the majority shareholders had tried to achieve consensus with them in previous disputes.”
40 Ventures LLC v. Minnesquam, L.L.C., No. A19-2082, 2020 WL 5507887 (Minn. Ct. App. Sept. 14, 2020). Members of Aspire Beverage Company LLC (“Aspire”) entered into a Membership Control Agreement (MCA) that established a six-person board of governors for Aspire. Plaintiff, a member of Aspire, alleged breach of contract, breach of fiduciary duty, and tortious interference with contract, and sought an order compelling Aspire to disclose company records. When the Aspire board voted to dissolve Aspire, plaintiff alleged that the board did not have the authority to do so (breaching supermajority requirements set forth in the MCA). The district court dismissed all of the claims on a Rule 12 motion for failure to state a claim. The Court of Appeals affirmed, reasoning that the MCA supermajority requirements in the MCA provision applied to the board, not the members. The Court held that plaintiff could sustain a breach-of-fiduciary-duties claim against the members just because the members appointed governors to the board. The plaintiff alleged that its allegations in the Complaint related to “actions taken by the members, not the governors, in violation of the member-control agreement”; the only alleged violations of the member-control agreement are the alleged violations of the supermajority requirements in section 3.3 of the member-control agreement, which is an alleged violation by the Aspire board, not by the members themselves.
§ 1.6.3.5 New York
Atlantis Management Group II LLC v. Nabe, 177 A.D.3d 542, 113 N.Y.S.3d 79 (N.Y. App. Div. 2019). A non-managing member of a limited liability company sought an equitable accounting from the managing members of the LLC. The trial court granted summary judgment in favor of the equitable accounting and the appellate court affirmed, finding that the managing members owed the non-managing member a fiduciary duty. The appellate court noted that while an equitable accounting is distinct from a right of accounting, the latter was appropriate here because the managing members had repeatedly refused to respond to demands for access to books and records.
§ 1.6.4 Breach of Contract and Breach of Covenant of Good Faith and Fair Dealing
§ 1.6.4.1 Massachusetts
Bernstein v. MyJoVE Corp., 97 Mass. App. 1127, 150 N.E.3d 1144 (2020), review denied, 486 Mass. 1101 (unpublished). The Appellate Court rejected plaintiff/counter-defendant’s argument that, after he resigned his position as CTO, he remained a 30% shareholder and therefore entitled to access records and communications because defendant/counter-plaintiff breached the obligation to treat him fairly and in good faith:
[W]e are aware of no authority that would allow Bernstein, as a minority shareholder of a close corporation, to surreptitiously access the company’s computers in retaliation for the alleged breach of such a duty. Put differently, whether Bernstein was treated with the “utmost good faith and loyalty,” in connection with his resignation or termination in 2011 is simply not before us. Rather, the issue before us is whether Bernstein was authorized, in November of 2012, to access MyJoVE’s computer system and to interfere with the company’s operations.
Crashfund, LLC v. FaZe Clan, Inc., 2020 WL 4347254 (Mass. Super. 2020). Plaintiffs invested in Wanderset LLC, which then merged into defendant Wanderset, Inc. In exchange for plaintiffs’ cash investments, Wanderset granted plaintiffs the conditional right to obtain specified shares of capital stock if Wanderset changed ownership. Plaintiffs contended that occurred when Wanderset functionally, but not formally, merged Wanderset into FaZe Clan, Inc. Plaintiffs sued both Wanderset and FaZe, asserting two alternative breach of contract theories, tortious interference, and unjust enrichment.
The Court granted defendant FaZe’s motion to dismiss the first alternative breach of contract claim seeking shares of its stock. Plaintiff’s express contractual right to convert stock was limited to legal mergers, did not extend to de facto successor liability, and thus plaintiff had no right to stock of the succeeding entity. However, the Court denied the motion as to plaintiff’s second alternative contract claim alleging successor liability for consequential damages equal to the value of the stock if plaintiffs had been permitted to participate if defendants had acted in good faith. The Court held that plaintiffs may be entitled to recover against all defendants for breach of contract, at least insofar as plaintiff seeks consequential damages, unjust enrichment, and tortious interference.
Ramey v. Beta Bionics, Inc., 2020 WL 4931636, at *5–6 (Mass. Super. 2020). Plaintiff alleged that a defendant promoter orally promised him a salary and 5% equity stake in a new company to be established developing medical devices. Plaintiff began working for nothing, and then for his salary, as the defendant established the company. However, defendant then refused to assign plaintiff his 5% equity, instead engaging in a series of negotiations trying to convince plaintiff to accept a fraction of that stake. The Court rejected defendant’s argument that the alleged agreement’s terms were too vague to enforce:
While “[i]t is not required that all terms of the agreement be precisely specified, and the presence of undefined or unspecified terms will not necessarily preclude” a contract’s formation, “[t]he parties must, however, have progressed beyond the stage of ‘imperfect negotiation.’” Id., (citations omitted).… It may be that, after discovery, Ramey will not be able to prove that his negotiations with Damiano in 2013 progressed beyond the stage of “imperfect negotiations” to an oral agreement on material terms that is sufficiently definite to be enforceable .… However, given the specificity of Ramey’s allegations that in the fall of 2014, Damiano offered, and he accepted, a 5% interest in the corporation to be formed in exchange for his continued work on the Project, I cannot conclude at this stage that Count I fails to state any claim for breach of contract.
§ 1.6.5 Fraud
§ 1.6.5.1 Massachusetts
In re Blast Fitness Grp., LLC, at *9 (Bk. D. Mass. 2020). Creditors alleged that a general partner fraudulently induced them to participate in a real estate transaction. The Bankruptcy Court noted extensive allegations of aiding and abetting the fraud on the part of other entities. However, the Court stopped short of allowing an aiding and abetting claim against the partnership itself, noting that the complaint contained no such allegations against the partnership – thus drawing a distinction between a general partner acting on behalf of the partnership, which the Court allowed, and whether the partnership itself aided and abetted the fraud, which the Court disallowed.
Sapir v. Dispatch Techs., Inc., 2019 WL 7707794, at *3 (Mass. Super. 2019). Plaintiff alleged that two director shareholders fraudulently induced him to sell his shares in a closely held corporation by withholding information about the status of software development and fundraising efforts. Plaintiff also claimed negligent misrepresentation and breach of fiduciary duty. Defendants moved to dismiss proffering the sale agreement containing the usual integration and waiver clauses.
The Court denied the motion as to the fraudulent inducement claim, holding that, generally, Massachusetts law recognizes that neither integration clauses nor releases bar fraudulent inducement claims, citing Shawmut-Canton, LLC v. Great Spring Waters of America, Inc., 62 Mass. App. 330, 335 (2004). An exception exists where the alleged inducement contradicts clear statements in the writing – a situation not usually present unless the waiver contains contextual references.
The Court granted the motion as to the negligent misrepresentation claim. Unlike a claim for fraudulent inducement, a claim for negligent misrepresentation ordinarily can be released or waived; thus, the seller release barred plaintiff’s claim for simple negligence.
The Court also granted the motion as to the fiduciary breach claim. The Court held that, as a Delaware corporation, Delaware law controlled that issue and that, unlike other jurisdictions, Delaware does not impose a heightened duty of good faith and loyalty on shareholders or directors in a close corporation and does not impose a fiduciary duty on the part of a close corporation for the benefit of individual shareholders.
§ 1.6.6 Interference
§ 1.6.6.1 California
Siry Investment, L.P. v. Farkhondehpour, 45 Cal.App.5th 1098 (2020). Penal Code section 496 is entitled “Receiving or concealing stolen property.” Subdivision (a) makes it a crime to (1) “buy[ ] or receive[ ] any property that has been stolen or that has been obtained in any manner constituting theft or extortion, knowing the property to be so stolen or obtained,” or (2) “conceal[ ], sell[ ], [or] withhold[ ] any property from the owner, knowing the property to be so stolen or obtained.” Subdivision (c) empowers “[a]ny person who has been injured by a violation of subdivision (a)” to “bring an action for three times the amount of actual damages [he has] … sustain[ed]” as well as for “costs of suit[ ] and reasonable attorney’s fees.” This case presents the question: Does Penal Code section 496, subdivision (c) authorize treble damages and attorney fees where the underlying criminal conduct did not involve trafficking in stolen property, but rather the improper diversion of a limited partnership’s cash distributions through fraud, misrepresentation, and breach of fiduciary duty? The court ruled that treble damages and attorney fees are not available under Penal Code section 496, subdivision (c) in cases where the plaintiff merely alleges and proves conduct involving fraud, misrepresentation, conversion, or some other type of theft that does not involve “stolen” property for two reasons. First, treble damages under Penal Code section 496, if held applicable to torts of fraud, misrepresentation, conversion or breach of fiduciary duty, would all but eclipse traditional tort damages remedies. Second, reading Penal Code section 496 to apply in theft-related tort cases would effectively repeal the punitive damages statutes. The legislature never declared that it wanted to effect significant changes to tort remedies but only wanted to “dry up the market for stolen goods.”
§ 1.6.6.2 Massachusetts
Viken Detection Corp. v. Videray Techs. Inc., 2020 WL 68244, at *6–7 (D. Mass. 2020). Defendant allegedly stole confidential information and trade secrets and formed a new entity. Plaintiff’s claims included one against defendant’s new entity for tortious interference with plaintiff’s customer relationships. The individual and entity defendants moved to dismiss contending that plaintiff failed to state a claim because the individual defendant, as owner and principal of the entity, was synonymous with his company. In other words, the individual was so “closely identified” with the entity that he should not be considered a third party for purposes of a claim of tortious contractual interference. The Court denied the motion, at least at the pleading stage, holding that whether an individual is synonymous with a corporation of which he is owner and principal is a fact-intensive question “ill-suited” for resolution at the motion-to-dismiss stage.
§ 1.6.7 Equitable/Statutory Relief
§ 1.6.7.1 Massachusetts
Automile Holdings, LLC v. McGovern, 483 Mass. 797, 813–14, 136 N.E.3d 1207, 1221–22 (2020). Defendant was a minority equity owner and executive of plaintiff but left to work for a competitor. He violated a restrictive covenant in his repurchase agreement by poaching three employees. Among other claims, plaintiff sued the individual’s new employer for tortious interference and sought a preliminary injunction barring defendant from employing the former officer.
Defendants argued that absent “more expansive interests,” Wells v. Wells, 9 Mass. App. Ct. 321, 326, 400 N.E.2d 1317, 1321 (1980), no legitimate interest exists in stifling competition. The Court, however, found that more expansive interests indeed existed. The Court noted the individual’s status as both an owner and officer of plaintiff, reasoning that the contract was more akin to a business interest than an employment restriction.
The Court emphasized that the individual sold his minority interest at a premium because he agreed to the restrictive covenant. His repurchase agreement, aimed at shoring up the protections in the original operating agreement, thus served plaintiff’s legitimate business interest in ensuring that defendant did not “derogate from the value of the business interest he sold to the other owners” when he left, quoting Boulanger v. Dunkin’ Donuts Inc., 442 Mass. 635, 639, 815 N.E.2d 572 (2004), and Alexander & Alexander, Inc., 21 Mass. App. Ct. at 496, 488 N.E.2d 22 (“Where the sale of the business includes good will, as this sale did, a broad noncompetition agreement may be necessary to assure that the buyer receives that which he purchased”).
§ 1.6.8 Privilege
§ 1.6.8.1 Delaware
Pearl City Elevator, Inc. v. Gieseke, 2020 WL 5640268, at *1 (Del. Ch. Sept. 21, 2020). The Court ordered the production of documents withheld as privileged on behalf of the subject company regarding matters as to which the subject company and the plaintiff were not adverse. Plaintiff, Pearl City Elevator, Inc., sought a declaration under 6 Del. C. § 18-110 that it may appoint a seventh and controlling member to the board of directors of nominal defendant, Adkins Energy, LLC. The Board currently consists of six directors, three designated by Pearl City, as an Adkins member, and three designated by Adkins’ General Members (the “General Directors”). After plaintiff’s dispute with the General Members emerged, counsel to Adkins Energy began to give legal advice to the General Members and General Directors, to the exclusion of Pearl City and its directors on the question of whether Pearl City’s unit acquisitions were bona fide, and whether Pearl City’s effort to place a seventh member on the Board were effective. Citing Moore Business Forms, Inc. v. Cordant Holdings Corp., 1996 WL 307444, at *1 (Del. Ch. June 4, 1996), the Court held that Pearl City was just as much the “client” of counsel to Adkins as the General Directors were, and accordingly counsel to Adkins was required to produce to plaintiff privileged documents respecting its analysis of the bona fides of Pearl City’s unit acquisitions and, relatedly, the effectiveness of Pearl City’s effort to place a seventh member on the Board.
§ 1.6.9 Trade Secret
§ 1.6.9.1 Delaware
iBio, Inc. v. Fraunhofer USA, Inc., 2020 WL 5745541, at *14 (Del. Ch. Sept. 25, 2020). The Court held that the Delaware Uniform Trade Secrets Act (“DUTSA”) preempts common law claims based upon alleged misappropriation of confidential information that does not otherwise qualify as a trade secret under the statute. iBio, Inc. and Fraunhofer USA, Inc., enjoyed a commercial relationship for several years pursuant to which Fraunhofer developed plant-based biopharmaceutical technology for iBio. iBio later discovered that Fraunhofer had entered into an agreement to perform the same services for an iBio competitor. iBio brought suit alleging that, among other things, Fraunhofer misappropriated iBio’s technology in the performance of its duties for the competitor. iBio brought claims under both DUTSA, as well as for conversion and misappropriation of confidential information that does not qualify as a trade secret under DUTSA. The Court held that DUTSA preempted the common law claims for conversion and misappropriation, even though the confidential information alleged to have been converted did not qualify as a trade secret under DUTSA.
§ 1.7 Valuation and Damages
§ 1.7.1 Alabama
Porter v. Williamson, 2020 Ala. Lexis 98; 2020 WL 3478540 (Ala. Supr. Ct., Jun. 26, 2020). In this appeal regarding an action for specific performance of a shareholders agreement, the Court addressed the valuation of the interests in five companies owned by a pair of brothers. Ultimately, the Court determined that the valuation process at trial was error because it was inconsistent with the evaluation process set forth in the shareholders agreement and beyond the action in the claim and remanded the case to the trial court.
The two brothers owned interests in four corporations and one limited liability company. The Court stated that the claim before the trial court was only for specific performance of part of the agreement and an injunction, and that the shareholders agreement provided a clear, specific, two-step process to determine values including the parties’ expression that the companies’ accountant would provide the evaluation methods.
Regarding the claim presented, the Court noted that the defendants “argue only that the trial court awarded relief beyond the scope of a request for specific performance of the agreement.” In addition, the Court stated regarding its review of a trial court’s decision, “The trial court’s findings of fact, insofar as they are based on evidence presented during the hearing, are presumed correct and will not be overturned unless they are shown to be plainly or palpably wrong … However, a presumption of correctness does not attach to the trial court’s legal conclusions, which are reviewed de novo.” In addition, “Regardless of whether [the] paragraph … of the agreement may allow for legal and equitable remedies beyond specific performance of the agreement and an injunction, [plaintiff] is bound by the claims he actually brought against the … defendants.”
Regarding the process in the agreement, the Court stated, “We cannot agree that the method of determining share value in the agreement was so unclear or indefinite that it could not be specifically enforced … there is no indication that any of the parties believed that the part of the agreement requiring an evaluator to be selected by [the companies’ accountant] … that was acceptable to the shareholders was indefinite or otherwise unenforceable. Yet, the trial court ignored that clear and specific part of the agreement when it accepted the valuation provided by an evaluator independently selected by [one employee-owner]. As to the second step, we must conclude, as a matter of law, that the agreement clearly expressed the parties’ agreement that [the companies’ accountant] … would provide the evaluation methods that would be used by the independent evaluator acceptable to the shareholders to determine share value… given his knowledge and familiarity with the … companies, we see no reason why the parties could not have agreed to allow [the companies’ accountant] to provide the evaluation methods to be used by an independent evaluator for purposes of determining share value.”
Considering the terms of the agreement in combination with the nature of the claim, the Court concluded that the trial court was not at liberty to depart from and ignore the process in the agreement nor to provide relief in “any other legal or equitable remedy” under the agreement. Therefore, the Court determined it was an error for the trial court to ignore a clear and specific part of the agreement when it accepted the valuation provided by an evaluator selected by the plaintiff.
§ 1.7.2 Connecticut
R.D. Clark & Sons, Inc. v. Clark, 222 A. 3d 515, 194 Conn. App. 690 (Dec. 10, 2019). In a buyout dispute involving the value of the departing shareholder’s interest in a family business organized as an “S” Corporation, the Appeals Court considered the trial court’s decision to not tax affect the company’s earnings in determining value even though both sides’ experts had applied tax affects. The Court affirmed the trial court’s decision to not tax affect.
On appeal, the company asserted that not tax affecting “artificially inflated” the value. The Court reviewed relevant court decisions in various jurisdictions. The Court noted that some courts “have chosen to reject an S corporation cash flows based on taxes” such as the US Tax Court in Gross v. Comm’r v. IRS, 272 F.3d 333, 335 (6th Cir. 2001) and called it “the only reported decision on tax affecting by a United States Court of Appeals.” It also noted that some cases such as one Delaware and one Massachusetts state trial court cases had approved tax affecting. Furthermore, the Court stated that “the issue of tax affecting continues to be an open debate among experts in the field.”
The Court found it important and influential in this case that before it was a “fair value” proceeding rather than a “fair market value” proceeding. In this current context of fair value, the Court considered the fact of the company’s policy of covering the shareholders’ tax liabilities. Ultimately, the Court found that considering that policy, “The present case seems particularly ill-suited to tax affecting earnings … based on the facts of this case … and … We discern no bright line rule in this area.”
§ 1.7.3 Delaware
Kruse v. Synapse Wireless, Inc., 2020 Del. Ch. Lexis 238 (July 14, 2020). In a statutory appraisal fair value buyout action, the Court addressed issues of whether there was meaningful market-based evidence of fair value in prior purchases of the company’s stock, and whether there were flaws in the experts’ comparable transactions and discounted cash flow valuation analyses. Based upon the evidence, the Court found that there was no “wholly reliable indicator of value” in the case and decided to adopt the discounted cash flow valuation analysis by the company’s expert but adjust it.
The Court noted that both experts used the same three valuation methods and “the experts reached monumentally different valuations.” In its analysis of the evidence regarding prior purchases of the company’s stock, the Court found that the two prior transactions did not take place in a competitive market, and that the earlier of the two transactions was “stale” and at a time when the company faced different prospects. Regarding the experts’ comparable transactions analyses, the Court found that approach “a dicey valuation method in the best of circumstances,” one in which both experts made “well-considered, convincing objections to the other side’s model,” and, therefore, not reliable in this case.
Regarding the experts’ discounted cash flow analyses, the Court noted that the discounted cash flow method of valuation is “widely considered the best tool for valuing companies when there is no credible market information and no market check.” Furthermore, the Court considered that both experts looked largely to the company’s management projections for the forecast for the first five years, but the experts differed widely regarding the forecast for years six through ten, long-term growth rate and weighted-average cost of capital discount rate.
The Court determined that none of the valuations by the experts was “wholly reliable,” and that a fact-finder might find that neither party has met their burden of proof, but that the Court “in the unique world of statutory appraisal litigation” was forced to make a fair value decision. In this regard, the Court viewed the forecasts, long-term growth rate and discount rate used by the company’s expert as more reliable, and the figure for debt of the company as of the transaction date used by the plaintiff’s expert as more reliable. The Court commented that the company’s expert “credibly made the best of less than perfect data to reach a proportionately reliable conclusion.” As a result, the Court adopted the company’s expert’s discounted cash analysis but adjusted it by adopting the figure for debt of the company as of the transaction date used by the plaintiff’s expert.
Riker v. Teucrium Trading, LLC, 2020 Del. Ch. Lexis 178; 2020 WL 2393340 (C.A. No. 2019-0314-AGB, May 12, 2020). In this Demand action to inspect books and records of a limited liability company (“LLC”) for appraisal purposes, the Court concluded that some books and records sought were not necessary, while it deemed others, such as plans and projections, important to valuation. In its analysis, the Court considered the purpose for seeking the specific books and records, whether the requested information was necessary and essential to valuation, whether the request was reasonably targeted, and whether there was wrongdoing in errors in filed documents. Consequently, the Court granted in part and denied in part the member’s demand for books and records under the Delaware LLC Act, Section 18-305.
Regarding document requests, the Court considered that “the company [had] produced some documents to [plaintiff] … within weeks of receiving his inspection demand, produced a substantial number of additional documents to him after engaging in a mediation, and produced certain other documents after trial.” As a result, six document requests from the Demand were still in dispute.
The Court stated that, under the Delaware LLC Act, valuing one’s own interest is a proper purpose to seek books and records. Furthermore, the Court considered that plaintiff “testified credibly that he was looking to value his interest … to determine whether to sell or hold his shares in light of the Company’s ‘deteriorating financial performance’ and what he perceives to be ‘erratic decision-making at the Company’”; and plaintiff “more specifically identified at trial … types of information … he needs to prepare a DCF analysis.”
In its review of the scope of the requests in dispute, the Court deemed the request for: (1) the Excel workbook detailing the company’s expense allocation model not necessary for the plaintiff’s stated purpose, far exceeds the types of information in the Demand, and that necessary expense information could be found in the company’s audited financial statements which were produced or in the process of being produced; (2) memoranda regarding contingent assets and liabilities not necessary, because they are not significant and information is in the financial statements produced; and (3) documents to investigate potential mismanagement, appointment or removal of officers, not necessary, because no credible evidence of wrongdoing was presented and the errors in the document filings were honest mistakes and corrected. Nevertheless, the Court deemed the request for cash projections, including the full current year’s budget and business plan, not just portions, important to valuation under the facts in this case and granted this request, because “an investor cannot hope to do is [to] replicate management’s inside view of the company’s prospects.” In this regard, the Court directed that “to the extent that other parts of the Company’s 2020 budget address expanding the outstanding shares of the Funds, increasing the Company’s assets under management, or restoring the Company to profitability, the Company must produce those parts of the 2020 budget.”
Consequently, the Court concluded that the plaintiff “has failed to establish an entitlement to receive any further documents in response to his broadly worded demand except for a few specific items enumerated herein relevant to valuing his interest in [the company]….”
Zachman v. Real Time Cloud Servs., LLC, 2020 Del. Ch. Lexis 115 (C.A. No. 9729-VCG, Mar. 31, 2020). At trial regarding a valuation dispute involving a member’s interest in an LLC related to an alleged breach of fiduciary duty, each side offered a valuation expert to opine on the fair value of plaintiff’s fifty-percent economic interest in the company. In its determination, the Court selected the most representative analysis and then made what it deemed appropriate adjustments to arrive at a valuation.
In evaluating the two sides’ valuation reports, the Court deemed the expert’s report more reliable, which valued the plaintiff’s interest at the date of the subject merger transaction and relied upon financial information from the company’s accounting system, in comparison to the other report which valued the interest as of five months preceding the transaction with financial information from an accounting firm engaged to re-create the company’s financial statements based upon source documents provided by plaintiff.
According to the Court, the plaintiff “had no credible basis for the financial figures supplied to” his valuation expert, “simply guessed” at some of the expenses, and “inflated [the company’s]… income figures.” Instead, the Court used the figures in the defendants’ expert report as the basis for determining the value of plaintiff’s interest at the time of the merger.
Nevertheless, the Court made adjustments because it found that the defendant’s expert report valuation was based on unduly conservative future growth estimates for the business. Consequently, the court adjusted the growth estimates upwards “to account for the Company’s early-years hyper-growth” in determining the value of plaintiff’s interest.
§ 1.7.4 Kentucky
§ 1.7.4.1 Henley Mining v. Parton, U.S. Dist. Ct., ED Ky., S. Div., No. 6:17-cv-00092-GFVT-HAI (Aug. 3, 2020)
In a dissenting shareholder action, both sides offered expert testimony and their estimates of fair value varied widely. The Court found that summary judgment was not the appropriate means to resolve the valuation dispute; because both sides presented thorough expert valuations, the Court’s role is not simply to pick one valuation over the other, and that the Court “may combine or choose among [estimates] as it believes appropriate given the evidence” and “make whatever use of the experts’ appraisals it deems reasonable.” Consequently, the Court concluded that the fair value standard does not automatically preclude all use of a net asset approach to meet the legal definition of fair value “of the company as a whole and as a going concern.”
The Court noted established precedent that the “value of dissenting shareholders is to be calculated ‘In accord with generally accepted valuation concepts and techniques and without shareholder level discounts for lack of control or lack of marketability.’” Furthermore, the Court deemed that “one such valuation concept is the net asset value …. [in which] ‘one of the things the appraiser seeks to do is to establish the market value, as opposed to the book value of the company’s assets.’” It also noted precedent that “the company’s going concern value … is almost certain to be, estimated by reference to market values of one sort or another” but “what is being sought is the company’s going concern value, not the mere liquidation value of its tangible assets,” (p. 5) therefore, “to the extent that the asset approach cannot yield a going concern value … it should be given no weight.”
After reviewing the experts’ reports, the Court determined that the challenged expert valuation is not “inherently, legally flawed because [it] … appraised [the company’s]… equipment as he would equipment for sale.” Furthermore, the Court considered that the expert “conducted additional analysis” which “also considered the health of the economy, the … industry and a financial analysis of [the company].” In this context, the Court noted that “business appraisal, of course, is ‘as much an art as it is a science,’” and “should the Court later reject [the challenged] valuation, the Court is not then bound to accept Plaintiff’s valuation whole-cloth.” Therefore, the Court rejected the motion of summary judgment.
§ 1.7.5 Missouri
Robinson v. Langenbach, 599 S.W.3d 167; 2020 Mo. Lexis 192; 2020 WL 2392488 (Supr. Ct. Mo., No. SC97940, May 12, 2020). This family business valuation dispute regarding a determination of fair value arises from claims of breach of fiduciary duty and shareholder oppression. On appeal, the Court evaluated whether the trial court’s use of a valuation which applied discounts for lack of marketability and lack of control was appropriate. The Court considered the context and particular facts, determined that a separate prior trial on the breach of fiduciary claim had already awarded damages to plaintiff for the increase in the company’s value before plaintiff’s removal, that in this case the shareholder oppression claim does overlap and that the trial court had determined that valuation discounts are needed to avoid double recovery. As a result, the Court concluded that the trial court’s decision was within the trial court’s broad equitable discretion, and, therefore, upheld the trial court’s decision.
In its analysis, the Court noted that the “parties here agree that fair value is a broader, equitable concept” than fair market value, and that both sides’ experts relied on valuation treatises which indicated that “there is no hard and fast rule regarding the use of discounts to determine fair value… the case law is literally all over the place.” Although the Court agreed that “the rationale for applying a minority and marketability discount usually would have limited application in the case of a court-ordered sale to a majority stockholder,” it stated that there is “no fixed set of factors a court must review to determine ‘fair value,’” “context is crucial in a ‘fair value’ analysis,” and a trial court has broad discretion “to shape and fashion relief to fit the particular facts and circumstances and equities of the case before it.” Therefore, considering the particular facts, the Court determined it was not an error for the trial court to agree with the defendant’s expert that a discount was proper in this one case and noted that the trial court “did not purport to determine any broad principle of law as to application of these discounts.”
§ 1.7.6 Nebraska
Anderson v. A&R Spraying & Trucking, Inc., 306 Neb. 484; 946 N.W. 2d 435, 2020 Neb. Lexis 116 (Supr. Ct. Neb., July 17, 2020). On appeal, in a shareholder buyout dispute regarding fair value, the Court upheld the trial court’s valuation of the shares in which it adjusted the earnings-based valuations of both parties’ experts and averaged the results. The Court deemed that trial court’s approach not to be an error, because it was reasonable and had an acceptable basis in fact and principle for use of the experts’ income approach valuation analyses but adjusts for inconsistencies.
The Court noted that neither party asserted on appeal that the trial court used an incorrect valuation method, and instead, “the sole issue presented is whether the… court’s valuation ‘is unreasonably high,’ considering expert’s reports and supporting testimony regarding the income approach.” In addition, the Court commented that “the determination of the weight that should be given expert testimony is uniquely the province of the fact finder. The trial court is not required to accept any one method of stock valuation as more accurate than another accounting procedure. A trial court’s valuation of a closely held corporation is reasonable if it has an acceptable basis in fact and principle.”
On appeal, in a shareholder buyout dispute regarding fair value, the Court upheld the trial court’s valuation of the shares in which it adjusted the earnings-based valuations of both parties’ experts and averaged the results. The Court deemed that trial court’s approach not to be an error, because it was reasonable and had an acceptable basis in fact and principle for use of the experts’ income approach valuation analyses but adjusts for inconsistencies.
In its analysis, the Court found that the trial court carefully reviewed the expert opinions, identified certain variables that were inconsistent with the income approach, adjusted each opinion accordingly, and used the resulting average of the two adjusted valuation conclusions. Furthermore, a fair value determination assumes that the business is valued as a going concern, which can be achieved through an income approach. Therefore, it found that the trial court was not speculative when it made an adjustment because it viewed one expert’s “subtracting 100% of the debt from the valuation estimate of the business [because it] does not comport with the overall theory of the Income Approach because a business, as a going concern, is not required to pay back all of its debt on a lump sum basis.” In this regard, the Court also considered that the business continued to operate, “there have been no effort to liquidate,” both experts agreed that the company generated significant cash flows, and its banker testified that the company paid its loans on time.
§ 1.7.7 New York
Magarik v. Kraus USA, Inc., No. 606128-15, Nassau County, Supreme Court of New York (April 10, 2020). In a claim alleging shareholder oppression and a petition for judicial dissolution, the Court considered each of the parties’ experts’ valuations, which came to conclusions that “were vastly disparate from each other.” The Court selected the valuation which item deemed to “reflect a more accurate value,” and rejected the valuation by plaintiff’s expert that it deemed was “based on income projections that were unrealistic and optimistic and not based on comparable businesses.”
In this case, the company prepared projections for purposes of applying for a bank loan, but not in the ordinary course of running the business. The plaintiff’s expert relied on those projections. But, based upon the facts in this case, the Court deemed those projections to be “ambitious and, in fact, overstated.”
In evaluating the projections, although the Court noted the early rapid sales growth of the company, it viewed that “not as great as petitioner contended (especially considering … negative cash flow) nor was it accurately predictive of future success.” Rather, it deemed the projections used “did not sufficiently account for the competitive nature of the … business … lack of cash flow,” and lack of ownership of the brand name. Furthermore, regarding the statements and forecasts that the company’s owners made to the bank in obtaining the loan, the Court noted “the representations were not accurate.” Consequently, according to the Court, the plaintiff’s expert’s income approach “was based on unrealistic projections, proven to be unrealized and wrong.”
In addition, the Court considered that both parties’ experts also applied a market valuation approach. It deemed that the market approach used by the plaintiff’s expert to be “based on incorrect comparables … public companies, not reasonably related to [the subject company] in terms of size, ownership or marketability.” Nevertheless, the Court viewed the market approach using the “merged and acquired company method” when weighted with the income approach to be “sound” in this case.
In this situation, the plaintiff owned 24 percent of the company’s shares, the other two owners held 25 percent and 51 percent, respectively. Finally, the Court also accepted “application of a discount for lack of marketability [of 5 percent], recognizing that the shares of [the subject company] cannot be readily sold on a public market.”
PFT Technology, LLC, v. Wieser, 181 A.D.3d 836, 122 N.Y.S.3d 313 (N.Y. App. Div. 2020). A limited liability company and its majority members filed suit against a minority member seeking to dissolve the company and reconstitute without the minority member. The minority member, in turn, counterclaimed for breach of the operating agreement. The minority member eventually agreed that the majority could buy out his membership interest, and the court held a valuation proceeding in which the minority member’s interest was valued at $1.250M. The minority member was also awarded attorney fees and prejudgment interest but not any damages based on his counterclaim. Both sides appealed.
On appeal, the appellate court noted that although limited liability law did not expressly authorize a buyout in a dissolution proceeding, that remedy was appropriate as an equitable remedy. The appellate court found that the trial court’s decision to allow the buyout was a “provident” exercise of its discretion. However, the trial court erred in applying certain adjustments to the company’s value, which should have been $1.489M. The trial court also erred in the amount of attorney fees it awarded. The trial court did not err in deciding not to award damages on the counterclaim or in the amount of prejudgment interest.
§ 1.7.8 Tennessee
Boesch v. Holeman, 2020 Tenn. App. Lexis 410; 2020 U.S.P.Q.2D (BNA) 11062; 2020 WL 5537005 (Ct. App. Tenn., Knox., No. E2019-02288-COA-R3-CV, Sep. 14, 2020). This case concerns valuation of a disassociated partner’s interest in a business, and the issue of whether a discount should have been applied to the value of the disassociated partner’s one-third minority interest. On appeal, the Court determined that a discount for lack of marketability as to the entire partnership business and not as to the minority partnership interest may be appropriate, but a discount for lack of control by the minority partnership interest is inappropriate because [Tennessee Code Annotated, Section 61-1-701 (b)] calls for determining value based on the sale of the entire partnership as a going concern. Consequently, the Court deemed the trial court’s application of a minority discount improper and remanded the case back to the trial court.
In this situation, the plaintiff is one of three partners. The Court considered that the expert’s report, which the trial court accepted, applied both a discount for lack of control (aka discount for minority position) and a discount for lack of control. The Court referenced the Uniform Law comment to Tennessee Code Annotated, which states, “The notion of a minority discount in determining the buyout price is negated by valuing the business as a going concern. Other discounts, such as for a lack of marketability or the loss of a key partner, may be appropriate, however.” Furthermore, the Court stated that “the statute calls for determining value based on a sale of the entire partnership business as a going concern.” As a result, the Court concluded that since that expert’s report did not comply with the Tennessee Code, remand to the trial court was necessary.
Raley v. Brinkman, et al., 2020 Tenn. App. Lexis 342 (M2018-02022-COA-R3-CV, Jul. 30, 2020). In a buyout dispute involving one of the two 50% owners of a limited liability company (“LLC”) organized as an “S” corporation for income tax purposes, the issue on appeal was whether tax affecting is “relevant” to the determination of fair value buyout. The trial court declined to tax affect. On appeal, the Court determined that tax affecting assisted “in determining the going concern value of the S corporation to the shareholder or member.”
The Court noted that the defendant’s expert explained “in considerable detail” why tax affecting and applying an income tax rate “was entirely appropriate and comports with generally accepted valuation standards and methods.” The expert’s rationale included that “all of the components of the Capitalization Rate are based on after-tax values or after-tax income data, the income stream to which the Capitalization Rate is applied in the Income Approach must also be an after-tax amount in order to be comparing apples to apples.”
The Court considered that its role on appeal is not to determine value but only to determine “whether tax-affecting constitutes relevant evidence of fair value.” Furthermore, the Court stated that relevant evidence under Tennessee law includes “evidence having any tendency to make the existence of any fact that is of consequence to the determination of the action more probable or less probable than it would be without the evidence.”
The Court stated that the trial court erred in rejecting tax affecting because the trial court incorrectly “applied the fair market value standard, as the Gross court[1] [in a tax case, not a buyout case] did” and incorrectly relied on an Internal Revenue Service (“IRS”) job aid.[2] The Court noted that although there is no Tennessee case law on the precise issue of how to define fair value under the LLC Act, there is a Tennessee decision, Athlon Sports, under the dissenter’s rights statute that is instructive. In Athlon, the Tennessee Supreme Court said that fair value is the required standard, fair value is not fair market value, and that the selling fair value owner is “not in the same position as a willing seller on the open market – he is an unwilling seller with little or no bargaining power.”
Instead of Gross and the IRS job aid which the trial court referenced, the Court deemed that the better guidance was Delaware Open MRI,[3] in which the Delaware Court of Chancery determined the going concern fair value of interests in an S corporation and deemed tax affecting relevant to determine “what the investor ultimately can keep in his pocket.” Therefore, the Court concluded that tax affecting is relevant evidence.
§ 1.7.9 Virginia
Biton v. Kreinis and New Tomorrow, Inc., 2020 Va. Cir. Lexis 94 (Cir. Ct. Norf. Va., No. CL19-7991, Jul. 10, 2020). In this buyout litigation dispute, the fair value of the departing owner’s shares in a corporation was at issue. Both parties’ experts used an income approach-capitalization of earnings valuation method, but they reached very different conclusions. Based upon the evidence, the Court resolved disputed issues regarding valuation date and key valuation inputs of: estimating representative annual revenue to calculate annual cash flow to use in the income approach to value, whether a revenue discount is appropriate due to the implied loss of the sales expertise of the departing owner, estimating representative net income margin percentage to calculate annual cash flow, and estimating capitalization rate.
Regarding valuation date, the Court determined that since this is an action for dissolution of corporate stock in lieu of dissolution, “The statutory valuation date is the day before the date on which the dissolution petition was filed unless the court deems another valuation date appropriate under the circumstances. [Plaintiff] … filed her dissolution action on August 2, 2019, so the presumptive valuation date is August 1, 2019.”
In estimating representative annual revenue to calculate annual cash flow to use in the income approach to value, the Court addressed the lack of projections, little revenue history, and problems with the quality of some historical financial information. In this regard, the Court commented that “although using the twelve months of revenue immediately prior to the valuation date arguably would have yielded a more accurate representative annual revenue for valuation purposes, that would have required using the monthly [internal accounting] figures, which … are not reliable,” and noted several problems, including “the [internal accounting] data are suspect, as evidenced by the fact that the 2018 revenue is more than twelve percent higher than the 2018 tax-reported revenue, a fact that neither expert could explain. Further, … two [internal accounting] profit-and-loss statements produced in discovery … for the same time period … are markedly different.”
In addition, the Court rejected the defendant’s expert’s use of full calendar year 2019 internal accounting information, because it includes five months of information subsequent to the valuation date of August 1, 2019. The Court stated, “Using data after the valuation date is discouraged by the Statement on Standards for Valuation Services,[4] which states that ‘[g]enerally, the valuation analyst should consider only circumstances existing at the valuation date and events occurring up to the valuation date,’ and [defendant’s] expert acknowledged as much in his expert report, and he admitted during his testimony that using post-valuation date revenue was highly irregular.”
Based upon the evidence, “For valuation purposes, the Court finds it appropriate to use the 2018 revenue as calculated by [the plaintiff’s] expert … as … representative annual revenue, … subject to discounting to account for [plaintiff’s] unique contributions.” The Court considered that “[plaintiff’s]… expert chose to use the 2018 tax reported annual revenue because it was the last available year an accountant had filed a corporate tax return, the last full year before the valuation date, and the last year before the events that led to [plaintiff] filing for dissolution. He also claimed that there was no reason to believe … operations would not continue as in 2018. He filled in the missing months of … [the additional location’s] operations revenue — January through April 2018 — by calculating an average 2018 monthly income per location and applying a seasonal adjustment.” The Court also noted that “the … 2018 revenue information that [plaintiff’s] expert used, on the other hand, appears reliable. The 2018 corporate tax return is available.”
Regarding whether the revenue discount is appropriate, “The Court finds, based on evidence presented at trial, that [plaintiff’s] sales expertise is not easily replaceable and that the corporate revenue for purposes of valuation therefore should be discounted based on her loss,” and “finds it appropriate to discount the representative annual revenue by ten percent to represent [the company’s] future cash flows without the benefit of [plaintiff’s] sales expertise.”
In estimating the representative net income margin percentage to calculate annual cash flow, the Court made adjustments for non-recurring items such as one-time store opening expenses, discretionary charitable contributions, and manager and officer salary costs.
In analyzing the capitalization rate, the Court considered the totality of the evidence and the company’s current circumstances. According to the court, “The experts agree to a large extent on the discount rate to be used to calculate the capitalization rate applicable to the ongoing cash flows … [however] the experts disagree regarding … longterm sustainable growth rate.” Regarding growth rate, the Court considered testimony regarding historical and forecast increases in economic gross domestic product, projected inflation rates, and inflation and future prospects for retail sales.
§ 1.7.10 Washington
McClelland v. Patton, 2019 Wash. App. Lexis 2960, 11 Wn. App. 2d 181 (No. 35401-6-III, Nov. 21, 2019). In this dissolution case regarding interests in a professional limited liability company (PLLC), the Appellate Court addressed a dispute over whether a PLLC can have entity goodwill value separate from the goodwill of the professionals. The Court considered the evidence, reviewed goodwill principles, and affirmed the trial court’s finding of entity goodwill.
As a basic premise, the Court noted that “goodwill blossoms from a business’ brand name, trade name, customer relationships, locations, memes, logos, patents, and proprietary technology.” In addition, it noted that previously regarding goodwill, the Washington Court of Appeals said that goodwill is the “expectation of continued public patronage,” and that helpful insight from the Texas Court of Appeals said, “Goodwill is generally understood to mean the advantages that accrue to a business on account of its name, location, reputation, and success.”
The Court considered the proffered testimony by both parties’ valuation experts on the issue, and that the courts in numerous states recognize that a professional business may possess goodwill separate from that of the individual practitioners, but a few states recognize that professional goodwill attaches to the individual professional rather than the entity. Among various facts, the Court considered that at the time of trial, referrals were still occurring to the PLLC, not to the professionals, professionals continued to practice at all three of the offices, patients received a bill from the PLLC, not the individual professional, and that when the plaintiff bought into the practice several years earlier, he paid a specified amount then for goodwill value.
The Court rejected the assertion by defendant’s expert as a “false alternative” that either the individual practitioner or the entity but not both could have goodwill. Rather, the Court concluded that “no reason exists to preclude the practitioner and the entity that employs the practitioner from both enjoying goodwill,” and it adopts “the rule that a professional business entity may enjoy goodwill as the rule that best follows the phenomenon that some customers or clients chose to conduct business with the professional organization not only because of the individual skill of one professional inside the entity.” Furthermore, the Court concluded that dissolution of the PLLC does not mean it is a going concern, and based upon the fact, the value of the entity as a going concern was preserved. Finally, the Court listed the five goodwill valuation methods, which the Washington Supreme Court has recognized, and stated that the trial court “could have accepted [plaintiff’s expert’s] valuation of goodwill based on a market value on a going concern basis.”
[1]Gross v. Comm’r v. IRS, 272 F.3d 333, 335 (6th Cir. 2001).
[2] “Valuation of Non-Controlling Interests in Business Entities Electing to be Treated as S Corporations for Federal Tax Purposes,” prepared by representatives of the Large Business and International Division NRC Industry, Engineering Program and the Small Business/Self-Employed Division Estate and Gift Tax Program, dated October 29, 2014.
[3]Delaware Open MRI Radiology Associates, P.A. v. Kessler, 898 A.2d 290 (Del. Ch. 2006).
[4] “Statement on Standards for Valuation Services,” American Institute of Certified Public Accountants.
Artificial intelligence has allowed us to enter the age of Big Data, where extremely large collections of digitized data can be analyzed computationally through the application of complex algorithms to reveal patterns, trends, and associations relating to human behavior and interactions. If you believe that history merely repeats itself, Big Data can be enormously profitable to the extent that it allows users to better predict economic outcomes.
The gap in this seamless evolution of technology is the government. If banks are now technology companies, the government should regulate them as such. That means that government regulators must also understand and use technology. But federal and state banking agencies still ground many decisions on the results of manually collected historical data and physical on-site examinations. There is still an important role for an examiner’s ability to look into the eyes of bank executives and discuss and debate the operations and safety and soundness of a bank during an on-site examination. It is also a critical way to identify and evaluate potential fraud and other misdeeds. But it can no longer be the main tool in a real-time environment.
The Panic of 2008 has pointed regulators in the direction of evaluating future risks. For example, regulators now oversee the creation of elaborate bank resolution plans called living wills, sophisticated capital, and stress testing under alternative financial scenarios as a part of its Comprehensive Capital Analysis and Review (CCAR), and measurements of liquidity and risk management plans under similar duress. But the supervisory function should move to the next level and become fully focused on the comprehensive, real-time collection of data that can be analyzed by artificial intelligence algorithms to assess present and predict future economic and financial behavior.
Predicting the next financial crisis is comparable to forecasting the next hurricane. There are endless human, operational, and financial variables that may impact the outcome and timing. Artificial intelligence can be the bridge between the historically based microeconomic analysis that financial regulation supervisors focus on, and predictive macroprudential regulation that can use Big Data to build a safer and sounder financial services network. The risks embedded in the financial statements of a bank are only a part of the challenge that it must confront. The risks inherent in the overall economy and financial networks will often have as much if not more of an impact on the quality of the credit that it has extended and its performance than its own financial predicament.
Our current system of financial regulation is not only seriously challenged when it comes to averting or mitigating financial crises, it can often exacerbate them. Technology provides a solution because the supervision of financial institutions relies on “the evaluation of a vast quantity of objective and factual data against an equally vast body of well-defined rules with explicit objectives.”
Consider how artificial intelligence and Big Data could have impacted the Panic of 2008. Assume that a huge amount of macroeconomic and financial industry data going back to 1965 had been compiled and was being analyzed by sophisticated computer algorithms beginning in 2000. That data input would have covered the inception of interest and usury rate controls, the most volatile interest rate environment the country had ever experienced, the failure of a massive number of S&Ls and banks, the collapse of oil prices, risky lending in Latin America, several real estate development recessions, the junk bond boom and bust, the stock market collapse of 1987, dramatic changes in demography, the rise of mutual and money market funds, the emergence of asset management businesses, and the internet and social media explosion.
An integrated approach to the evaluation of financial data could also have included information related to the financial incentives and behavior, rational and irrational, that were built into the system. Socialized risk and short-term compensation incentives could have been factored into the mix, perhaps leading to a quicker grasp of how, for example, the securitization of assets ranging from home mortgages to credit cards had skewed the risk/reward formula. With better data sets and analysis, the government and industry executives would have had more reliable indications of developing crises years before they arrived.
What would have occurred if years before the Panic of 2008, regulators and executives accessed these new databases and ran simulations that began to show red flags emerging? They would have seen, as early as 2000, disturbing data about the impact of increases in the amounts of outstanding credit, leverage, second and third mortgages, default rates, and the potential impact of several generations of variable-rate mortgages in rising rate and decreasing home value scenarios. Intelligent machines could have analyzed data that the government had in ways that it was not capable of doing. Red flags would have been seen earlier and more clearly about the interrelated impact of reductions in credit quality, increases in credit availability and the proliferation and interaction of shiny new financial products such as MBS, collateralized debt obligations, and credit default swaps. The creation of excessive risk created by parties with no skin in the game and few downside concerns would have been noticed and hopefully financial incentives could have been adjusted. Intelligent computers would have produced alternative economic scenarios that regulators could have evaluated. If regulators could have spent less time micro-supervising less important matters, they would have had the time to war game how these events might have intersected and made appropriate course corrections.
Congress, bank and investment banking executives, the SEC, and the Federal Reserve might have had the chance to realize that under the developing circumstances, the capitalization and leverage ratios of firms like Bear Sterns and Lehman Brothers were dangerously low and were creating a massive systemic threat. Similarly, regulators and executives might have seen much earlier that AIG could not have sustained a credit default swaps exposure that was effectively insuring all of Wall Street. Better data and predictive analysis could have led to more fulsome public securities disclosures by Bear Sterns, Lehman Brothers, AIG, and Merrill Lynch about possible risk factors that the companies were facing. That would have given shareholders the opportunity to speak through their platforms and, perhaps, alter the course of future events.
Technology, and particularly artificial intelligence, bring with it significant challenges. Artificial intelligence is a tool that relies on the integrity of the program, the programmer, and the data being used. It can be wrong, biased, corrupted, hijacked, stale, or simply based on bad data. Trusting artificial intelligence is an exercise in caution and discretion. Whether factual or not, the parable about the US Navy’s testing of artificial intelligence is instructive. As it goes, when the navy’s artificial intelligence applications sensed that a simulated convoy was moving too slowly, it simply sank the slowest two ships in its convoy to speed up the convoy’s overall progress. That is hardly a solution that would work in the field of financial regulation.
The issues of “explainability” and “accountability” are extraordinarily important in the financial world. How does a financial institution explain why the predictive conclusions of a machine were followed or rejected, particularly after the outcome goes wrong? How can a decision made by an intelligent machine be challenged? How is the use of artificial intelligence impacted by privacy laws and the ability or inability to identify an accountable party? Can machines explain what their algorithms did or how they did it to satisfy the kinds of legal obligations that are imposed by the Fair Credit Reporting Act, the Equal Credit Opportunity Act, the Fair Housing Act, and the European General Data Protection Regulation to provide the borrower or customer with an explanation about why credit was denied?
Big Data, superintelligent and quantum computers, the cloud, complex algorithms, and artificial intelligence will increasingly provide governments with tools that will dramatically increase their ability to predict and avert future economic disasters. While those systems will never be foolproof, they will increase the opportunity for the government and businesses to make course corrections based on a wider and clearer field of vision. They will potentially give regulators better intelligence and more time to improve and adapt financial regulation, monetary and interest rate controls, and economic responses to impending downturns. Imagine being able to avoid the next financial crisis or, more realistically, lessening its impact because of the decisions made based on information produced by algorithms feverishly analyzing sets of Big Data years before. The advantages of having substantially more data that can be analyzed quickly by intelligent machines can alter the course of financial history and create a smarter and more effective system of financial supervision. Every day that passes without this technological tool in the government’s pocket is another day the economy potentially creeps closer to the next financial Armageddon without any clear warning.
200 Years of American Financial Panics: Crashes, Recessions, Depressions And The Technology That Will Change It All is available from Prometheus Books and all online book outlets. Learn more about the author.
Although the use of ‘blank check’ vehicles dates back to the 1980s, there has been a proliferation of Special Purpose Acquisition Companies (SPACs) as a means of raising capital over the last 18-24 months (mid-2019 to present). The rise of SPACs has – despite a recent slowdown – been unprecedented, both in terms of the number of new SPAC listings taking place and the amount of capital raised.
Of the 248 SPACs which listed in the US in 2020,[1] 94 were incorporated in either the British Virgin Islands (BVI)[2] or, predominantly, the Cayman Islands.[3] This highlights the significance of these international finance centers to the re-emergence of SPACs as a dominant force in the US capital markets.
By June 2021, the number of new SPAC IPOs had begun to fall away from its peak in Q1 2021: whereas the first three months of 2021 saw more capital raised by SPACs than in the whole of 2020,[4] the number of new SPAC listings fell sharply from April 2021.[5]
This drop-off has been attributed to a combination of possible factors. The Securities and Exchange Commission’s statement in April 2021 (the SEC’s Statement)[6] concerning the treatment of warrants in a typical SPAC structure as liabilities on a SPAC’s balance sheet rather than as equity undoubtedly led to a pause amongst SPAC sponsors and service providers while the ramifications of the SEC’s Statement were digested and some financials had to be restated. Further, large numbers of investment opportunities caused institutional investors who typically participate in the Private Investment in Public Equity (PIPE) financing element of SPAC transactions to become more discerning, and merger valuations were impacted by significant competition amongst large numbers of SPACs simultaneously hunting for a target.
As the SPAC IPO market begins to cool slightly in the US, the attention of many M&A practitioners is turning to the substantial levels of capital sitting within SPACs seeking a merger target – recently estimated by Goldman Sachs to be around $129 billion.[7] Given that SPACs are required to spend money within a certain period or return it to shareholders via redemptions, this seems certain to have a meaningful impact on the domestic and cross-border M&A markets at least through the first half of 2023 as these vehicles begin to effect ‘de-SPAC’, or business combination, transactions.
Since a substantial proportion of SPACs’ dry powder is contained within Cayman Islands or BVI incorporated entities,[8] it is pertinent to analyse the range of options available pursuant to the laws of those jurisdictions to effect a de-SPAC transaction once the SPAC’s management team has identified a merger target.
Initial choice of Cayman Islands or BVI as jurisdiction for SPAC incorporation
The selection of a jurisdiction for the incorporation of a SPAC (i.e., whether it should be formed in the US or offshore) is typically driven in large part by complex US tax considerations which are both beyond the scope of this article and outside the scope of offshore counsel’s involvement in the structuring process.
However, generally speaking, where the SPAC’s management team has ascertained that it is more likely than not that the acquisition of a non-US based company – rather than a domestic US company – will be targeted by the SPAC, a non-US jurisdiction is often selected as the jurisdiction of incorporation of the SPAC.
The Cayman Islands or the BVI are commonly selected as the jurisdiction of a non-US SPAC’s incorporation for a number of reasons:
the entity may be a ‘foreign private issuer’ from an SEC perspective if correctly structured;[9]
both the Cayman Islands and the BVI are tax neutral, with no withholding taxes, capital gains or stamp duty levied;[10]
the company law frameworks in each jurisdiction are flexible but sophisticated, with a simple solvency test for distributions, no corporate benefit requirements, and bespoke governance requirements capable of being included in tailored constitutional documents; and
there is considerable market familiarity (amongst sponsors, institutional investors, bankers and US counsel) with the use of vehicles incorporated in these jurisdictions.
Just as the corporate flexibility of Cayman Islands and BVI vehicles is attractive at the IPO stage of the SPAC lifecycle, the range of options provided by Cayman Islands and BVI company laws to achieve a desirable structuring outcome in the de-SPAC transaction is notable.
Availability of de-SPAC structuring alternatives under Cayman Islands and BVI company law
At the business combination stage of the SPAC lifecycle, it is not always the case that a target company which is taken public by an offshore-incorporated SPAC (Offshore SPAC) will continue to be structured as a Cayman Islands or BVI-incorporated holding company after the reverse merger is effected.
If the Offshore SPAC acquires a non-US target company (Foreign Target), the post-merger listed entity is often incorporated in the same jurisdiction as the Foreign Target, with the transaction commonly accomplished by way of a cross-border merger. A possible series of transactions in this scenario (assuming that the Offshore SPAC is incorporated in the Cayman Islands) would be:
Foreign Target forms a wholly-owned Cayman Islands subsidiary (Merger Sub);
Merger Sub merges with and into the Offshore SPAC with the Offshore SPAC continuing as the surviving company after the merger; and
the Offshore SPAC becomes a direct, wholly-owned subsidiary of Foreign Target.
This form of transaction structure was used, for example, in the acquisition of Taboola, the Israeli targeted marketing platform, by ION Acquisition Corp. 1 Ltd., a Cayman Islands-incorporated SPAC[11] at an implied valuation of $2.6 billion, per SEC filings in connection with the transaction.[12]
The statutory merger provisions in Cayman Islands company law allow this form of transaction to be accomplished with ease: typically, a special resolution of the shareholders of the Cayman entity is required to approve the merger, which is generally capable of being passed by 2/3 of voting shareholders at a duly convened and quorate shareholder meeting, along with such other authorization, if any, as may be set out in the Cayman entity’s constitutional documents. The law also requires the consent of certain security interest holders, although it is rare for a SPAC to have granted security over its assets.[13]
If the Offshore SPAC acquires a domestic US target company, it may be the case that the Offshore SPAC will effect a domestication to a US jurisdiction such as Delaware as part of the business combination transaction, with a domestic US entity as the resulting public company. For example, per SEC filings,[14] this deal structure was employed in the acquisition of San Francisco-headquartered property technology company Opendoor by the Cayman Islands-incorporated SPAC Social Capital Hedosophia Holdings Corp. II, in a transaction which valued Opendoor at an enterprise value of $4.8 billion.[15]
As with the Cayman Islands statutory merger provisions, the procedure for effecting a re-domiciliation out of the Cayman Islands (known as a ‘de-registration’) is straightforward. A number of procedural steps need to be taken in the Cayman Islands, including the filing of a declaration by a director of the Cayman Islands entity confirming that, amongst other things:
it is solvent and able to pay its debts as they fall due;
the application for de-registration is not intended to defraud its creditors;
any contractual consent to the transfer has been obtained, waived or released;
the transfer is permitted by and has been approved in accordance with the company’s constitutional documents; and
the laws of the jurisdiction where the Cayman Islands entity is transferring have been or will be complied with.[16]
Alternatively, where the parties to the merger can receive their consideration in the form of shares in another entity formed for that purpose, that entity will then list with both the SPAC and the original target vehicle sitting beneath it.
The corporate flexibility and political stability afforded by both the Cayman Islands and the BVI has ensured that both jurisdictions have been vital in the structuring of cross-border mergers, acquisitions, IPOs and investment fund formations for decades. Even if the SPAC IPO boom witnessed throughout 2020 and Q1 2021 continues to taper off somewhat, the Cayman Islands and the BVI will continue to remain absolutely central to the domestic and global M&A markets as the billions of dollars of undeployed capital sitting within SPACs incorporated in these jurisdictions continues to seek out suitable merger targets.
[5] SPAC Research, reported in CNBC article ‘SPAC transactions come to a halt amid SEC crackdown, cooling retail investor interest’, Yun Li, 21 April 2021.
[6] SEC Staff Statement on Accounting and Reporting Considerations for Warrants Issued by Special Purpose Acquisition Companies (“SPACs”), 12 April 2021.
[7] Goldman Sachs analyst note (led by David Kostin) dated 21 April 2021, reported by businessinsider.com, ‘SPACs could drive $900 billion of dealmaking over the next 2 years despite the boom slowing, Goldman says’, Harry Robertson, 22 April 2021.
[9] SEC Division of Corporation Finance, ‘Accessing the U.S. Capital Markets – A Brief Overview for Foreign Private Issuers’ (Part II: Foreign Private Issuer Status).
[10] See, for example, section 242 of the BVI Business Companies Act 2004 (as amended).
Two recent reports suggest that a federal crackdown on cryptocurrency tax avoidance in the United States is in process. In March 2021, Damon Rowe, Director of the IRS Office of Fraud Enforcement, and Carolyn Schenck, National Fraud Counsel & Assistant Division Counsel (International) in the IRS Office of Chief Counsel, announced a partnership between the IRS’s civil office of fraud enforcement and criminal investigation unit targeting cryptocurrency tax evasion.[1] Dubbed “Operation Hidden Treasure,” the effort is “all about finding, tracing, and attributing crypto to U.S. Taxpayers.”[2] Reports indicate that IRS employees are working with European law enforcement agencies as a part of the effort.[3]
Likewise, at an April 13, 2021, hearing of the Senate Finance Committee, Sen. Rob Portman (R-OH) and IRS Commissioner Charles Rettig discussed issues relating to the reporting of cryptocurrency transactions. Commissioner Rettig specifically highlighted new cryptocurrency disclosure obligations on the Form 1040 tax return. Sen. Portman announced a forthcoming bipartisan bill specifically aimed at tax reporting of cryptocurrency-related transactions.[4]
The increased targeting of cryptocurrency transactions means users of cryptocurrency—and their counsel—should be aware of possible tax reporting and fraud issues.
Cryptocurrency Regulatory Confusion
One of the major problems with cryptocurrency regulation in the United States is an inconsistent regulatory conceptualization. Federal banking regulators disagree as to whether cryptocurrency firms are engaged in the business of banking. According to the Securities and Exchange Commission, some, but not all, cryptocurrencies are securities. The Federal Elections Commission considers cryptocurrency as currency, yet cryptocurrency campaign contributions are considered “in-kind” contributions.[5]
The IRS position is also inconsistent, recognizing cryptocurrency as a medium of exchange but refusing to treat it as currency. Instead, the IRS treats of cryptocurrency as a capital asset.[6] Essentially, when a person acquires a cryptocurrency, the cost associated with its acquisition is the asset’s basis. For an owner who holds the cryptocurrency for appreciation in value (as one might with publicly traded securities), the sale or disposition of the cryptocurrency results in either a gain or loss, with appropriate tax treatment.
But cryptocurrency is not acquired just for capital appreciation; it is used as a medium of exchange in ordinary commercial transactions. When normal currency is used in a commercial transaction, typically only the vendor must recognize taxable income. But because the IRS treats cryptocurrency as property with basis, when it is used for the purchase goods or services, the purchaser also must recognize taxable gain or loss on the disposition of the asset.[7]
It is unclear whether cryptocurrency users are aware of these tax consequences. One source estimates that 18 to 21 million taxpayers will need to consider cryptocurrency transactions for 2021 income.[8] And in reporting income, taxpayers need to be careful to properly track the basis of the cryptocurrency to correctly calculate taxable gain or loss.[9]
Form 1040 Disclosures
The 2020 Form 1040 tax return requires taxpayers—as the very first question on the return—to answer, “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”[10] According to the Form 1040 Instructions, virtual currency includes digital currency or cryptocurrency, and virtual currency transactions include, but are not limited to:
The receipt or transfer of virtual currency for free (without providing any consideration), including from an airdrop or hard fork;
An exchange of virtual currency for goods or services;
A sale of virtual currency;
An exchange of virtual currency for other property, including for another virtual currency; and
A disposition of a financial interest in virtual currency.[11]
Taxpayers seeking to avoid IRS attention to their cryptocurrency transactions may be tempted to answer “no” to the question, hoping that the supposed anonymity offered by cryptocurrency will protect them. This is the specific type of activity that the IRS seeks to target with Operation Hidden Treasure:
The IRS, through its trained agents working together with specialist vendors, is “analyzing blockchain and de-anonymizing [crypto] transactions” to be “able to track, find, and work to seize crypto in “both a civil and a criminal setting.”
Schenck had a message for crypto traders who are would-be tax evaders: “We see you.”[12]
Civil and Criminal Tax Fraud
Failing to properly disclose cryptocurrency transactions can trigger both civil and criminal tax fraud. If—or perhaps when—the IRS eventually traces cryptocurrency transactions back to the taxpayer, the Internal Revenue Code allows a 75% civil penalty for any underpayment of taxes attributable to fraud.[13] While the IRS bears the burden of proving by clear and convincing evidence that the underpayment is due to fraud, the burden is met by showing that an underpayment of tax exists, and that the taxpayer intended to evade taxes known to be owed intentionally concealing, misleading, or otherwise preventing the collection of taxes.[14]
Criminal tax fraud is also a possibility if the taxpayer fails to truthfully answer the cryptocurrency question on the tax return.[15] However, the federal criminal tax fraud statutes include the heightened mens rea element of willfulness, which is not found in the civil tax fraud statutes. Courts have construed “willfulness” in the context of tax fraud to require the government to show that the law imposed a duty on the taxpayer, that the taxpayer knew of the duty, and that the taxpayer voluntarily and intentionally violated the duty.[16] Given the incongruence between the common use of cryptocurrency in transactions and the tax treatment thereof by the IRS, many taxpayers may be saved by the willfulness element.
Tax Amnesty
Some observers have noted the similarities in the IRS’s early approach to foreign account disclosures and the tactics currently employed with regard to cryptocurrency.[17] Under the Offshore Voluntary Disclosure Program (“OVDP”), first instituted in 2009, taxpayers with undisclosed foreign financial accounts could avoid criminal prosecution and heightened civil penalties by fully disclosing accounts and paying a lesser amount.[18] This “carrot”—contrasted with the “stick” of criminal prosecutions—netted the IRS $11.1 billion of voluntary payments.[19]
Some have called for an IRS voluntary disclosure and amnesty program for cryptocurrency users, similar to the OVDP. At least one observer has described the IRS’s game plan thusly: use Joe Doe summonses directed to cryptocurrency exchanges to obtain user information, push Congress to pass legislation addressing third-party reporting of cryptocurrency transactions, and then offer amnesty for violators that voluntarily disclose.[20] Thus far, the IRS has rebuffed calls for cryptocurrency tax amnesty,[21] but Sen. Portman’s proposed legislation may be a vehicle to advance the outlined strategy.
Foreign Cryptocurrency Accounts
Subsequent to the initial OVDP amnesty, Congress passed the Foreign Account Tax Compliance Act (“FATCA”) in 2010.[22] Like OVDP, FATCA is tool to reduce tax avoidance via foreign financial accounts. Under the statute, foreign financial institutions are obligated to identify and report information about U.S. account holders to the IRS. Institutions that fail to comply with the requirements face a 30% withholding tax on certain types of U.S.-sourced income.[23]
At least one observer has called on regulators to include cryptocurrency within the FATCA regime, noting the similarity between cryptocurrency virtual wallets and financial accounts.[24] Indeed, regulators announced in 2020 that the current foreign reporting regulations would be updated to address cryptocurrency.[25]
But FATCA relies on cooperation between the IRS, foreign governments, and foreign financial institutions in order to complete reporting of foreign accounts. It is unclear whether a FATCA-style reporting system is workable with cryptocurrency—virtual wallet providers beyond the scope of the IRS’s jurisdiction may not voluntarily report their users’ activity, especially when supposed anonymity is one of the selling points of cryptocurrency usage.
Tax Whistleblower Statute
Cryptocurrency users should also be aware of the federal tax whistleblower statute. In a commercial transaction, the vendor and buyer necessarily have identifying information about the other, so that the vendor can ensure that payment is received, and the buyer can ensure that goods or services are delivered according to the contractual specifications. This is true even in commercial transactions with cryptocurrency serving as the medium of exchange—the vendor must be able to match the cryptocurrency to the transaction as a bookkeeping function.
Thus, if a vendor accepting cryptocurrency learns that the buyer is using cryptocurrency to avoid taxes, the vendor may be able to take advantage of the whistleblower program. Under the statute, a whistleblower is eligible to receive up to 30% of the proceeds collected by the IRS in an enforcement action, with lesser amounts available depending on the extent of the whistleblower’s assistance.[26]
The tax whistleblower statute is in contrast with the federal False Claims Act, which permits qui tam actions by individuals to encourage whistleblowing.[27] In a qui tam action, a private person may file a suit under seal on behalf of the government against the defrauding party. The government may take over the case, in which case the relator is entitled to 15% to 25% of the amount recovered; alternatively, the government may decline the case, in which case the relator may continue the action and receive 25% to 30% of the recovery. A successful relator is also entitled to recover attorney fees and other expenses.
Because commercial counterparties will have greater access to information about cryptocurrency usage than the IRS., the qui tam scheme may be especially helpful in eliminating tax fraud. However, the federal False Claims Act specifically excludes tax cases,[28] so qui tam actions are not available to private persons who may know of a tax avoidance scheme. Some have argued for an expansion of the False Claims Act to include federal tax fraud, in an effort to encourage private participation in eliminating tax fraud.[29]
Speculating on Forthcoming Cryptocurrency Taxation and Regulation
Thus far, Sen. Portman has been coy about the specifics of his forthcoming bill. His comments raise two general areas of concern: defining cryptocurrency for tax purposes, and improving information reporting.[30] With regard to the first concern, a more consistent overall federal regulatory approach treating cryptocurrency as a true medium of exchange would be welcome for commercial parties.
With regard to the second, foreign cryptocurrency account reporting certainly seems to be on the regulatory radar, as discussed above. Vendors accepting cryptocurrency as payment may also see additional information reporting requirements—such as Form 1099s specifically for cryptocurrency transactions. This could potentially open the door for private enforcement mechanisms such as qui tam actions, but there is no indication that policymakers are considering that tactic.
Portman’s comments also specifically highlighted a $1 Trillion “tax gap” between amounts owed by taxpayers and collected by the IRS, with taxes owed on cryptocurrency transactions constituting part of that gap. Treasury Secretary Janet Yellen has also criticized the use of cryptocurrencies in certain commercial transactions as “extremely inefficient.”[31]
One may speculate as to whether enhanced information reporting requirements will be sufficient to close the gap, or whether stronger disincentives towards cryptocurrency use may be on the regulatory horizon. Users of cryptocurrency should consider what a cryptocurrency-specific taxation scheme could look like. A financial transfer tax, such as the “Tobin tax”[32] or “Section 31 Fees”[33] could serve as a model for a federal excise tax on cryptocurrency transactions.
[5]See, Ralph E. McKinney Jr., Casey W. Baker, Lawrence P. Shao & Jeff Y. L. Forrest, Cryptocurrency: Utility Determines Conceptual Classification Despite Regulatory Uncertainty, 25 Int. Prop. & Tech. L.J. 1, 3-4 (2021).
[16]Cheek v. United States, 498 U.S. 192, 201; 111 S. Ct. 604, 610 (1990).
[17]See, Caroline T. Parnass, Pay Toll with Coins: Looking Back on FBAR Penalties and Prosecutions to Inform the Future of Cryptocurrency Taxation, 55 Ga. L. Rev. 359 (2020); Nathan J. Hochman, Policing the Wild West of Cryptocurrency: Part Two: The Ability of Federal and State Regulators to Work Together Will Determine Whether the Wild West of Cryptocurrency Enforcement Will Be Won, 41 Los Angeles Lawyer 14 (2018); Arvind Sabu, Reframing Bitcoin and Tax Compliance, 64 St. Louis L.J. 181 (2020).
[18] Jay R. Nanavati & Justin A. Thornton, DOJ and IRS Use “Carrot ‘N Stick” to Enforce Global Tax Laws, 29 Crim. Just. 4 (2014).
[29] Franziska Hertel, Qui Tam For Tax?: Lessons From The States, 113 Colum. L. Rev. Sidebar 1897 (2013). But see, Sung Woo “Matt” Hu, Fine-Tuning the Tax Whistleblower Statute: Why Qui-tam is not a Solution, 99 Minn. L. Rev. 783 (2014).
When a company files Chapter 7 bankruptcy, the U.S. Bankruptcy Code provides for the appointment of a trustee that, essentially, displaces the company’s existing management. The Bankruptcy Code tasks the trustee with administering the company’s assets and making distributions to creditors. This process often includes reviewing transactions that occurred prior to the filing of the bankruptcy petition and determining whether causes of action may exist against third parties, including the company’s former officers and directors.
When former directors and officers become the target of a trustee investigation and subsequent litigation, one of the first items that both the bankruptcy trustee and the former directors and officers will address is whether the company purchased an executive risk insurance policy (a “D&O Policy”) prior to the bankruptcy filing. D&O Policies frequently play outsized roles in determining the course and outcome of trustee investigations and litigation against former directors and officers because trustees view these policies as easily accessible sources of recovery for creditors. At the same time, former directors and officers typically rely on D&O Policies as the source of payment of defense costs—most notably attorney’s fees—in defending against trustee litigation since the Chapter 7 debtor is no longer permitted to indemnify the former directors and officers for their defense costs.
Bankruptcy courts often must resolve the competing interests in the D&O Policies. One common dispute involves the interplay between the automatic stay and the beneficiaries’ desire to access the D&O Policy proceeds to pay the defense costs. Trustees may seek to block the former directors and officers from accessing policy proceeds to pay defense costs to preserve the policy proceeds for the trustee’s potential claims. It is important for attorneys retained to handle such disputes to make the right arguments in support of accessing D&O Policy proceeds, and those arguments require counsel to understand the various coverages under a D&O Policy and who has the right to benefit from those coverages.
Side A Coverage
Most D&O Policies provide coverage for losses incurred directly by directors and officers for their alleged wrongful acts to the extent those losses are not reimbursed by the company. This coverage is known as “Side A” coverage. Defense costs incurred by directors and officers to defend against a lawsuit filed by a bankruptcy trustee alleging breaches of fiduciary duties is a common example of a loss covered by Side A. In a Chapter 7 bankruptcy, even if the debtor had the resources, the trustee would not agree to, nor the would the bankruptcy court permit, reimbursement of the directors’ and officers’ defense costs out of bankruptcy estate assets for defending litigation brought by the trustee. Thus, Side A coverage benefits the directors and officers exclusively, and the bankruptcy trustee, standing in the shoes of the company, should not have any claim to D&O Policy proceeds under the Side A coverage.
Side B Coverage
Another type of coverage commonly found in D&O Policies, “Side B” coverage, is for losses incurred by the company in indemnifying directors and officers for losses the executives incurred for their wrongful acts in accordance with the company’s governance provisions. The company, and thus the bankruptcy trustee, may benefit from policy proceeds of this coverage to reimburse the company for its indemnification obligations. An example of a claim for such coverage in the bankruptcy context would be the efforts of a bankruptcy trustee to recover monies for which the debtor reimbursed its former directors and officers in defending claims against them, such as shareholder litigation, and for which the insurer had not paid the company under the policy at the time of its Chapter 7 bankruptcy filing. In this instance, the trustee may seek to preserve policy proceeds on account of the company’s claim against the insurer under the D&O Policy’s Side B coverage rather than agreeing to allow the Side A beneficiaries to drain the policy proceeds in which Side B claims may share. It would be much more difficult for the trustee to argue that policy proceeds should be preserved for Side B coverage claims if the company had not incurred any eligible losses as of the bankruptcy petition date. This is because there are few, if any, circumstances in which a Chapter 7 trustee would reimburse the debtor company’s former directors and officers out of estate assets for losses related to their pre-petition wrongful acts.
Side C Coverage
A third type of coverage that D&O Policies may contain, known as “Side C” coverage, is “entity coverage” for situations in which a corporation is sued along with its directors and officers. Insurers typically offer this type of coverage to public corporations to cover claims of securities laws violations, while broader coverage may be available for private companies. Bankruptcy trustees may cite existing or potential claims covered by Side C as reasons to preserve policy proceeds and limit directors and officers from accessing coverage to pay defense costs. However, many D&O Policies subordinate Side C coverage to other D&O policy coverages, such as Side A. Directors and officers, and their counsel, should review the D&O Policy’s payment priority provisions carefully to understand how these provisions may affect access to policy proceeds if the company files bankruptcy.
A Recent Bankruptcy Court Decision Addressing These Issues
In In re National Fish & Seafood, Inc., No. 19-11824, 2021 WL 771652 (Bankr. D. Mass. Feb. 26, 2021), the U.S. Bankruptcy Court for the District of Massachusetts recently issued an opinion addressing a bankruptcy trustee’s challenge to attempts by directors and officers to access D&O Policy proceeds.
In May 2019, National Fish and Seafood, Inc. (the “Debtor”) filed for Chapter 7 bankruptcy and a trustee (the “Trustee”) was appointed to administer the Debtor’s estate. In April 2020, the Trustee filed a complaint against three of the Debtor’s former directors and officers (collectively, the “D&Os”), alleging that the D&Os breached their fiduciary duties by authorizing a series of transactions that removed $31 million in assets from the Debtor (the “D&O Litigation”). In early-2021, the D&Os filed a motion seeking relief from the automatic stay imposed by Section 362 of Title 11 of the U.S. Code (the “Bankruptcy Code”), to allow the D&Os to receive payment and/or the advancement of defense costs from the Debtor’s D&O Policy, which was purchased prior to the bankruptcy filing, for fees and expenses incurred in connection with defending the D&O Litigation. The Trustee opposed the D&Os’ request to access the D&O Policy proceeds.
The D&O Policy provided for up to $3 million of primary insurance coverage, along with an additional $500,000 in executive coverage applicable to the D&Os. The D&O Policy further provided for the advancement of defense costs incurred in connection with a covered claim. The D&O Policy included all three types of coverages discussed above: Side A, Side B, and Side C.
Additionally, the D&O Policy provided that any loss covered by the Side A coverage would be paid first, the Side B coverage would be paid second, and the Side C coverage would be paid last. The D&Os and the Trustee agreed that the claims asserted in the D&O Litigation constituted Side A covered claims, and that no Side B or Side C claims either had been or were expected to be asserted under the D&O Policy (although the D&Os may ultimately have a Side B indemnification claim against the Debtor, but such claim would be unlikely based on the direct Side A coverage).
The D&Os demanded payment of their defense costs in the D&O Litigation as covered Side A claims. The insurer agreed to cover defense costs upon entry of an order authorizing such advances and a finding that making the advances was not a violation of the automatic stay. First, the Court addressed whether the proceeds of the D&O Policy constituted property of the Debtor’s estate. While the D&Os and the Trustee agreed that the D&O Policy itself was property of the estate pursuant to Section 541 of the Bankruptcy Code, the parties disagreed with respect to the proceeds of the policy. The Trustee argued that the policy proceeds were property of the estate, and therefore any distribution of such proceeds would violate Section 362(a)(3) of the Bankruptcy Code, which prohibits acts to obtain possession of and exercise control over property of the estate.
While courts universally hold that pre-petition insurance policies issued to the debtor are property of the estate, they are divided concerning whether the proceeds of such policies also constitute estate property. Such determination commonly depends on the language of the insurance policy, as well as the other specific facts and circumstances of the case and the jurisdiction. “Where the policy covers claims against the directors and officers (Side A Coverage) as well as claims against the corporation (Side B or Side C Coverage), courts have almost uniformly found the proceeds to be assets of the estate. . . . These cases focus on the proposition that the bankruptcy estate is worth more with the D&O policy that includes entity coverage than without it.” In re Nat’l Fish & Seafood, Inc., 2021 WL 771652, at *3.
While the Court in National Fish agreed that the proceeds of the D&O Policy constituted estate property subject to the automatic stay, “cause” existed for relief from the automatic stay pursuant to Section 362(d)(1) of the Bankruptcy Code. The D&Os cited a number of facts supporting cause for relief from stay, including:
the D&O Policy provides for payment of defense costs;
the D&Os relied on that coverage in serving as directors and officers;
the D&Os had a real need for the coverage and would be unable to retain counsel to defend themselves in D&O Litigation if they were denied access to the policy proceeds;
the Side B and Side C coverage that the Trustee sought to protect was, at best, highly speculative and remote; and
the Trustee’s real concern was to preserve Side A coverage to fund the Trustee’s anticipated judgment in the D&O Litigation, which is not an appropriate basis for opposition because the Side A coverage belongs entirely to the D&Os and is not subject to any right of control by the Debtor (or the Trustee standing in the place of the Debtor).
Ultimately, the Court agreed with the D&Os, finding that the Trustee’s request to continue the automatic stay to determine whether any Side B or Side C claims might arise was not supported by the terms of the D&O Policy. “The property of the estate that requires protection here is limited to the Debtor’s rights under the policy, such as they are. In the policy, they coexist with and are limited by the right of officers and directors to A-side coverage.” Id. at *4. Additionally, the priority of payments provision in the D&O Policy clearly stated that Side A claims are to be paid in full first, and therefore always take priority over any Side B or Side C coverage rights the Trustee may someday accrue (if ever). Thus, continuation of the stay would not protect the estate and only delay the inevitable distribution to Side A covered claims. Finally, the Trustee’s “real reason for his opposition” – preserving the amount of Side A coverage to pay any judgment in the D&O Litigation – was not a valid basis to deny relief from the automatic stay. Thus, the Court permitted the insurer to distribute funds to the D&Os for attorney’s fees.[1]
Takeaways
When a company files Chapter 7 bankruptcy, the appointed bankruptcy trustee has a duty to investigate potential causes of action, including against the company’s directors and officers. While it is imperative that directors and officers ensure that adequate insurance coverage is in place, Chapter 7 trustees may target the D&O Policy as a potential source of recovery for creditors. This creates a potential conflict between the directors and officers who are insureds under the D&O Policy and the trustee who steps into the shoes of the corporation as the owner of the policy.
Notwithstanding the ruling in National Fish, and the fact that the matter was contested, the first step for any directors and officers facing this situation is to attempt to negotiate an agreed order with the Chapter 7 trustee (or other estate representative) and the insurer to allow access to the D&O Policy proceeds. A Chapter 7 trustee may request a cap on payments to the directors and officers for defense costs. Frequently, the parties agree to a soft cap, which allows the executives to seek additional payments if the cap is reached and circumstances justify further payments. To assist the parties in ascertaining whether to seek further relief from the court, an agreed order may include a reporting provision that requires the insurer to periodically report any amounts it pays under the D&O Policy.
[1] The insurer already had advanced $100,000 in defense costs to the D&Os before the Court rendered its opinion. The Court, however, refused to make its ruling retroactive to encompass such payments, finding that the D&Os had not offered a compelling reason to justify retroactivity.If the parties are unable to reach agreement on an order permitting access to D&O Policy proceeds, directors and officers may have no choice but to file a contested motion to access the policy to pay defense costs. In that situation, National Fish and other cases in which courts address this issue provide a good road map for the arguments to make. More specifically, counsel should carefully review the D&O Policy to understand what coverages it contains and how they relate to each other, particularly with respect to any priorities of payment provisions that may favor the directors and officers.
In early December 2020, a federal judge for the Southern District of New York rendered a 100-page decision determining the outcome of the so-called “Black Swan” event that made headlines – Citibank’s $900 million mistake.[2]
The Judge allowed Citibank’s mistake to go unfixed on the basis of a 30-year-old precedent relating to the principle of “discharge for value.”
1. Facts
In 2016, the cosmetic giant Revlon closed a 7-year $1.8 billion syndicated loan, with a maturity date of September 2023. Citibank served as the administrative agent for the loan.
In August 2020, Citibank intended to wire $7.8 million in interest payments to Revlon’s lenders and instead, following an erroneous “check” in the wrong box, wired nearly $900 million – which corresponded to the exact amount of principal and interest that Revlon owed to its lenders. While some lenders returned the money after being notified of the mistake, others opted to keep it as a prepayment of their loan.
The Hon. Judge Furman was left to decide whether Citibank was entitled to claim the money back or whether the lenders were permitted to keep it.
2. Decision
The Court held that Citibank was not entitled to claim the money back and the lenders could keep it based on the common law “discharge for value” principle.
As a general rule, if a party does not return money that was sent to it by mistake, it will inevitably be required to return that money to the sender based on the common law concepts of unjust enrichment or conversion.
However, the leading 1991 New York Court of Appeals[3] decision cited in support of Judge Furman’s findings presents an exception, known as discharge for value:
“When a beneficiary (1) receives money to which it is entitled and (2) has no knowledge that the money was erroneously wired, the beneficiary should not have to wonder whether it may retain the funds; rather, such a beneficiary should be able to consider the transfer of funds as a final and complete transaction, not subject to revocation.”[4]
Ultimately, the use of this defense in the Citibank case was contingent on whether the lenders had constructive notice of Citibank’s mistake when they received the wire transfer. The lenders argued that the applicable form of constructive notice was that “reasonably should have known… that the funds had been sent by mistake.”[5] On the other hand, Citibank asserted that it was the “inquiry” notice standard that applied, which would have required the lenders to conduct further inquiry, thus revealing the error made. However, the Court did not rule on which formulation of the constructive notice standard applied and concluded that “when the August 11th wire transfers were received, Defendants did not have constructive notice of Citibank’s mistake under either standard.”[6]
B. Further analysis
Let’s delve a little further into the concepts, as discussed in Citibank.
(1) Receiving money to which a party is entitled: Citibank tried to argue that since the money was not “due” until 2023, the lenders were not “entitled to the funds at the time of the transfer.”[7] However, so long as the recipient is a bona fide creditor, it is “entitled” to the funds regardless of the payment schedule.[8]
(2) Having constructive notice that payment was made by mistake: the discharge for value defense can be defeated if the recipient has constructive notice that the payment was made by mistake. The Court concluded that the lenders had not received notice, as the evidence demonstrated that they believed in good faith that the payments received were an intentional early paydown by Revlon – and, according to Judge Furman, that belief was reasonable as:
(i) the payments matched to the penny the outstanding amount; and
(ii) Citibank is one of the most sophisticated financial institutions in the world and no bank had ever made a similar mistake of such nature or magnitude.[9]
What about the notice of prepayment requirement that is systematically placed in loan agreements? Citibank tried to argue that the lack of such notice effectively should have placed the lenders on constructive notice of the mistake – but the Court found a way to circumvent this boilerplate provision.
Judge Furman found that, putting contractual obligations aside, it is not uncommon practice for lenders to receive separate prepayment notices, to receive them after payment, or not to receive them at all.[10] Furthermore, the loan agreement required Citibank to “promptly” notify each lender of prepayments and, since that term was not explicitly defined in the agreement, it was deemed ambiguous.
Citibank appealed the Court’s ruling[11] and oral arguments in the appeal are expected in August or September 2021. Will the appellate court agree to review the Court’s ruling?[12] The suspense remains…
To mitigate the risks raised by the decision, administrative agents have begun inserting what are now being called “Revlon clawback” provisions into their credit agreements to ensure that lenders repay any amount mistakenly transferred and waive any defense that can be set up against the claim.[13] From an operational standpoint, financial institutions may also consider reviewing their internal procedures for issuing payments and executing wire transfers to avoid errors in the process.
C. What principles would apply in Canada?
1. Common Law
While Canadian courts have not dealt with a case based on facts similar to those of Citibank, they have dealt with the notion of mistaken payments.
In 2009, the Supreme Court of Canada in B.M.P. Global Distribution Inc. v. Bank of Nova Scotia,[14] adopted the United Kingdom’s Simms[15] test for recovering money paid under a mistake of fact. The test lays out that a claim for money paid under a mistake of fact is prima facie recoverable. However, this recovery may fail if the payment is made for good consideration. This defense of good consideration can be invoked if the money transferred is paid to discharge, and does discharge, a debt owed to the payee (or a principal who is authorised to receive the payment on the payee’s behalf) from the payor (or by a third party authorized by the payor to discharge the debt).[16]
The B.M.P. Supreme Court decision involved mistakenly paid funds on the basis of fraudulent cheques. Therefore, the Court did not analyze the defense of good consideration because value was not given for the money mistakenly transferred. In her reasoning, Justice Deschamps differentiated the case from “a case where a party pays a debt it owes or where other similar circumstances preclude the payor from denying that it intended the payee to keep the funds.” [17] This distinction seems to suggest that the outcome may have been different if this were a case where a debt was owed to the recipient of the mistakenly transferred funds.
Subsequent Canadian case law has analyzed the notion of mistaken payments in relation to fraudulent cheques, payment over a countermand request,[18] and belief of sufficient funds,[19] but never regarding an honest mistake to a recipient that would have been entitled to receive the sums at one point in time or another. In the UK case Lloyds Bank PLC v. Independent Insurance Co Ltd,[20] the Court of Queen’s Bench confirmed that the Simms test adopted by Canadian courts applies to electronic bank payments as well. This case also highlights that determining who the drawee bank can turn to in order to recover funds mistakenly transferred (that discharge a debt owed to the payee) will depend on whether the bank acted with or without a mandate from its client.
The prevailing principle at common law[21] is that if the bank acts on its client’s instructions when making a mistaken payment that discharges a debt (ex: a cheque is paid by the bank while the client has insufficient funds), the bank will not be able to seek recovery from the payee who has a defense of good consideration, but will have to seek recovery from its client. However, if the bank is not within its mandate when making the mistaken payment (ex: payment over client’s countermand request), then on the basis of its contractual obligations towards its client, the bank will credit the funds back to its client and, in turn, seek recovery from the payee. However, as the Simms test established, if the recipient of a mistaken payment can prove that good consideration was given and that it had a debt that was discharged by the payment, the claim for recovery by the bank against the payee will fail. Evidently this creates a dilemma, as the bank’s client is unjustly enriched by having its debt extinguished, while simultaneously getting credited the funds mistakenly transferred. However, Canadian courts have yet to clarify this unsettled area of law.[22]
2. Quebec Civil Law
Quebec is a civil law jurisdiction and we would therefore turn to the concept of “réception de l’indu” or “receipt of a payment not due” set out in article 1491 of the Civil Code of Quebec (“1491 CCQ”). This concept can form the basis for restitution in a case similar to Citibank. It requires (1) the existence of a payment, (2) the absence of a debt, and (3) a payment made in error.[23]
The first condition is straightforward and rarely raises issues. The debate often revolves around the absence of a debt which is extrinsically linked to the existence or not of an obligation and the error on the part of the payor.
The fulfillment of the second condition, i.e. the absence of a debt, is paramount. The onus is placed on the payor to prove that the debt does not exist. Then, the burden is shifted to the payee to prove that the payment was not made in error, but that, in fact, was made with liberal intent, which intent is not presumed.[24] Quebec courts have recognized the existence of a debt as barring a claim under 1491 CCQ. In 1989, a bank who acted against a countermand request from its client was unable to seek recovery from the payee as it failed to prove that the payment was made for a debt not due.[25] In Quebec law, there is a presumption that any payment implies an obligation (1554 CCQ) and the bank was unable to prove the contrary in order to benefit from the “réception de l’indu”.
However, courts have upheld an action for recovery for a payment not due in cases where the payor has paid more than was provided for in the contract.[26] This conclusion seems to recognize the recovery of an overpayment, leaving us to question whether a Quebec court would qualify a Citibank-type mistaken transfer as either an overpayment of the scheduled interest payment due at the time of the transfer or a prepayment for a debt later due. In the former scenario, the claim for a payment not due could be made in order to recover the funds mistakenly transferred to the creditors. If, however, the transfer was considered a prepayment of a debt due, could a Quebec court potentially arrive to the same conclusion as in Citibank?
As for the third condition, being that the payment must have been made in error, in 2019, the Quebec Court of Appeal settled a long-standing debate as to whether errors deemed “inexcusable” would bar a claim for a payment not due.[27] The Court confirmed that irrespective of the gravity of the error, this recourse is available to the payor.
On balance, it is unlikely that a Quebec court would come to the same conclusion as in Citibank.
D. Concluding Thoughts
If a Citibank-type mistake were to occur in Canada, it would be interesting to see what a Canadian court (or a Quebec court) would in fact decide… One thing is for sure: lenders cannot disregard the outcome of the Citibank decision. To mitigate the risks highlighted in Citibank, lenders should ensure that their loan documentation includes provisions allowing for the “clawback” of sums paid in error and that the proper operational checks and balances are in place to avoid having payment errors occur, which can be costly and lead to high stakes litigation.
[1] Ashley is legal counsel and Kiriakoula is Senior Manager, legal counsel, in the Retail, Commercial and International Sector of the Legal Affairs Department of National Bank of Canada. The opinions and comments expressed in this article are solely their own and do not represent the opinions or views of the National Bank of Canada. Ashley and Kiriakoula wish to gratefully thank Michel Deschamps, Counsel in the Business Law Group at McCarthy Tétrault for his insight.
[13] The Loan Syndications and Trading Association (LSTA) recently published a standardized “Erroneous Payment Provision” clause to be inserted into credit agreements (https://www.lsta.org/content/erroneous-payment-provision/); for a summary of the key provisions of the clause, see David W, Morse, “Revlon Decision Leads to New “Erroneous Payment” Provisions for Credit Agreements: The Backstory and the Consequences” at
[15]Barclays Bank Ltd. v. W. J. Simms Son & Cooke (Southern) Ltd., [1979] 3 All E.R. 522.
[16] This is one of three defenses that can be set up against a claimant. The claim for recovery can also fail if (1) the payor intends that the payee shall have the money at all events or is deemed in law so to intend; or (2) the payee has changed his position in good faith or is deemed in law to have done so. B.M.P., para 22.
Lawyers and legal professionals are intimately familiar with the importance of institutions. Law itself is an institution, one that can be used for good or ill. Law and other legal institutions have justified great harms but can also be the venue for transformative change. The difference between the two comes down not only to individual commitment to principles but also the institutional milieu and the cultural norms people surround themselves with. To shift those norms, and to allow the law to more equitably serve all people by confronting racial inequities, we must change our institutions.
Luckily, each of us has the power to create change in the institutions we belong to. Indeed, doing this work is crucial to creating an anti-racist and just society. Toni Morrison says that the “function of freedom is to free someone else.” In other words, there is a duty to promote the agency of those who lack it, a duty to empower those who are marginalized. In the context of racial equity, that means those of us with relative safety and the ability to speak out and create change must do so. As advocates, lawyers and legal professionals have a special responsibility because they are in fact well placed to make a difference.
Organizing for change within institutions is no easy task because their very function is to maintain continuity over time. They are designed to resist change and possess an intrinsic immune system that fights transformation, regardless of whether the shift imagined is good or bad. Overcoming that resistance is easiest when institutional leadership supports the change and is prepared to commit to concrete modifications to better embody inclusive values. However, even those without formal authority can participate in efforts to change the organization for the better. To aid in those efforts, With a Lever is a DIY guide that identifies six steps on the path toward creating institutional change for racial equity.
Step One: Evaluate Starting Conditions
Changing an institution, shifting it on racial equity, requires understanding the institution: its pressure points, its values, how people have tried to change it in the past. Anyone who belongs to an institution already has the primary tool needed to understand all this: connection to other people within it. Institutional knowledge resides within the individuals who make up an institution, and understanding its past and missteps is an important part of preparing to shift it toward greater equity and inclusion.
Step Two: Set Expectations
Pushing for institutional change can be exhausting. It is key to be prepared to face resistance from the institution, and to expect both tedium and conflict. Even when the leaders of an institution are eager to embrace change and understand the value of promoting racial equity, the structures and cultural norms that reinforce existing inequalities are not easy to address.
Step Three: Build a Coalition and Get Buy-in on Goals
Institutions are made up of people and so a diverse team is necessary to make collective action and inclusive decision-making possible. Gather a coalition of people interested in creating change by starting discussions with as many people as possible about how the institution can improve racial equity issues. These discussions are not easy, and are sometimes uncomfortable, but that is a sign that they are necessary.
Step Four: Make a Plan and Stay Organized
Once a coalition comes together, it should agree on a plan and establish basic logistics. This means having a rough timeline for action, setting up structure, and running effective meetings. These are all important for accountability and for focusing energy on concrete actions to address inequities.
Step Five: Avoid Common Pitfalls
Understanding why efforts to change institutions and improve representation as well as inclusiveness stalled in the past is important because it can help the coalition to avoid the same mistakes. With a Lever offers some common challenges to watch out for.
Step Six: Maintain Momentum
The last step is simply to keep spirits up by acknowledging the need to settle in for the long haul while also celebrating small victories. This is true precisely because promoting institutional change is not easy.
The DIY guide, available both as a PDF and as a series of articles, delves into each of these steps and expands upon them with concrete tips for doing the critical work of transforming our institutions to entrench and normalize racial equity. Of course, each institution is different and so its path toward racial equity must be individually tailored but the information contained within the DIY guide is meant to provide practical advice. With a Lever aims to guide anyone who wishes to engage with equity and inclusion work at their institutions because transformative societal change is only possible when all of us work together.
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