In recent years, the United States Supreme Court has twice addressed the meaning of the five-year statute of limitations for government enforcement actions for civil penalties.* On both occasions, in 2013 and 2017, the Court unanimously ruled against the government’s interpretations of 28 U.S.C. Section 2462 and its efforts to stretch or avoid the five-year rule. Section 2462 provides as follows:
Except as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued, if within the same period, the offender or the property is found within the United States in order that proper service may be made thereon.
In 2013, the Supreme Court ruled in Gabelli that for all enforcement actions, including fraud, the statute begins to run when the claim or fraud “first accrued” and not when the fraud was discovered by the government.[1] Four and a half years later, in 2017, the Supreme Court ruled in Kokesh that the government’s pursuit of a “disgorgement” claim was a “penalty” action under Section 2462 and the government was required to bring the disgorgement claim within five years.[2]
While Gabelli and Kokesh resolved two issues, other issues under Section 2462 have not yet been ruled upon by the Supreme Court and remain unsettled. These unsettled issues include important questions concerning the proper interpretation of the statute:
(1) Whether government actions for obey-the-law injunctions are actions covered by the penalty language of Section 2462. One Federal District Court held on December 13, 2017 that the “obey-the-law” injunction sought by the SEC was punitive and penal in nature and covered by the five year rule of Section 2462.[3] On appeal, the Third Circuit ruled that the SEC injunction statute does not permit the issuance of punitive injunctions and therefore “punitive’ or “penalty” injunctions are not covered by Section 2462 because they cannot be brought at any time–even within five years.[4]
(2) Whether the five-year clock is tolled until the defendant is present in the United States. One Federal District Court has ruled, at the government’s urging, that the five-year clock does not begin to run until the defendant is present in the United States.[5]
In Gabelli and Kokesh, the Supreme Court set out basic and long-standing principles it has applied to statute of limitations issues since 1805. These principles include the importance of the certainty created by a fixed time frame to bring an action, the undesirability of allowing cases to be brought at any distant time, the need to avoid stale claims, lost evidence, or faded memories, and the importance to the welfare of society by promoting timely justice and stability in human affairs.
In 1805, the Supreme Court addressed whether an action for debt to recover a penalty is covered by a two-year statute of limitations in Adams v. Woods.[6] Chief Justice Marshall provided the following insight in ruling for the defendant:
In expounding this law, it deserves some consideration, that if it does not limit actions of debt for penalties, those actions might, in many cases, be brought at any distance of time. This would be utterly repugnant to the genius of our laws. In a country where not even treason can be prosecuted after a lapse of three years, it could scarcely be supposed that an individual would remain forever liable to a pecuniary forfeiture.[7]
This has been an important principle for most Congressional lawmaking on statutes of limitations, as well as precedent for the Supreme Court rulings in Gabelli and Kokesh.
I. Background of 28 U.S.C. Section 2464.
The general five-year statute of limitations in the U.S. Code for government enforcement actions for civil penalties is set forth in 28 U.S.C. Section 2462. Essentially the same statute was first enacted by Congress in 1839 as part of “[a]n act in amendment of the acts respecting the Judicial Systems of the United States.”[8] The 1839 Act itself was focused in part on defendants receiving service of process before a lawsuit could go forward against the defendant and be adjudicated. Although there is no legislative history on the statute of limitations provision in the 1839 Act, it was adopted against the backdrop of Chief Justice Marshall’s opinion in Adams v. Woods.
II. Gabelli—Whether the statute of limitations clock starts ticking when the claim first accrued or when discovered by the government
In Gabelli v. SEC, Chief Justice Roberts wrote the unanimous opinion of the Court. The question presented was as follows:
The Investment Advisers Act makes it illegal for investment advisers to defraud their clients, and authorizes the Securities and Exchange Commission to seek civil penalties from advisers who do so. Under the general statute of limitations for civil penalty actions, the SEC has five years to seek such penalties. The question is whether the five year clock begins to tick when the fraud is complete or when the fraud is discovered.[9]
The SEC brought its enforcement action for civil penalties more than 5 ½ years after the alleged fraud had occurred. The defendants in the District Court action invoked the five-year statute of limitations of Section 2462. The District Court ruled that it applied and dismissed the SEC’s civil penalty claim as barred by Section 2462.
The SEC appealed to the U.S. Court of Appeals for the Second Circuit on the grounds that they had brought the civil penalty action within five years of discovering the fraud and that the “discovery rule” should be applied to Section 2462. The Second Circuit agreed with the SEC. It grafted onto Section 2462’s language of “five years from the date when the claim first accrued” the “discovery rule” for fraud matters – that the fraud claim accrues when it is discovered or could have been discovered with due diligence.[10] In sum, the Second Circuit concluded that “for claims that sound in fraud a discovery rule is read into the relevant statutes of limitations.”[11]
The Supreme Court reversed the Second Circuit’s ruling. The Court unanimously concluded that “[g]iven the lack of textual, historical, or equitable reasons to graft a discovery rule onto the statute of limitations of §2462, we decline to do so.”[12]
The Court recognized that the “discovery rule” for fraud claims was designed to protect victims of fraud who did not learn that they had been defrauded for some time. It distinguished fraud victims for whom the discovery rule was created from government enforcement agencies whose responsibility it was to investigate fraud.
Chief Justice Roberts emphasized that in 1805 “Chief Justice Marshall used particularly forceful language in emphasizing the importance of time limits on penalty actions, stating that it ‘would be utterly repugnant to the genius of our laws’ if actions for penalties could ‘be brought at any distance of time.’ Adams v. Woods, 2 Cranch 336, 342, 2 L.Ed. 297 (1805).”[13] Chief Justice Roberts recognized that adopting the discovery rule for Section 2462 would leave defendants exposed for not only the five years but for an additional uncertain period, concluding that “[r]epose would hinge on speculation about what the Government knew, when it knew it, and when it should have known it.”[14]
Chief Justice Roberts made abundantly clear that the catchall statute of limitations, 28 U.S.C. Section 2462, serves an important purpose: a party should not be able to hold a threat of litigation over another party indefinitely. This fear seems particularly potent when the party threatening litigation is the United States government.
III. Kokesh—Whether a claim for disgorgement is a penalty claim under Section 2462
In Kokesh v. SEC, the issue presented under Section 2462 was whether claims for disgorgement as a sanction for federal securities law violations were subject to its five-year limitations period.[15] Rejecting the Government’s contention that Section 2462 did not apply to claims for disgorgement, the Court echoed the language from Gabelli that “[s]tatutes of limitations ‘se[t] a fixed date when exposure to the specified Government enforcement efforts en[d].’ . . . Such limits are ‘vital to the welfare of society’ and rest on the principle that ‘even wrongdoers are entitled to assume that their sins may be forgotten.’”[16]
Justice Sotomayor, writing for a unanimous court, set out the allegations against Kokesh:
Charles Kokesh owned two investment-adviser firms that provided investment advice to business-development companies. In late 2009, the Commission commenced an enforcement action in Federal District Court alleging that between 1995 and 2009, Kokesh, through his firms, misappropriated $34.9 million from four of those development companies. The Commission further alleged that, in order to conceal the misappropriation, Kokesh caused the filing of false and misleading SEC reports and proxy statements. The Commission sought civil monetary penalties, disgorgement, and an injunction barring Kokesh from violating securities laws in the future.[17]
The issues surrounding sanctions had arisen after the case went to trial and a jury found that Kokesh had violated a number of securities laws. The SEC sought both monetary penalties and disgorgement monies as a result of the jury’s findings. The District Court considered both sanctions in the light of the Section 2462 statute of limitations.
First, the District Court found that Section 2462’s five-year limitations period prevented the award of penalties for conduct more than five years before the SEC’s complaint was filed. Therefore, the District Court ordered a civil penalty of $2,354,593, the amount Kokesh received during the five-year period.
Second, the District Court considered whether Section 2462’s five-year limitations period applied to disgorgement claims. The SEC sought $34.9 million for disgorgement, of which $29.9 million would relate to conduct more than five years prior to the complaint. The SEC argued that disgorgement was not a “penalty” under Section 2462. The District Court agreed and awarded a disgorgement amount of $34.9 million plus $18.1 million in prejudgment interest.
Kokesh appealed and the Tenth Circuit affirmed, ruling that Section 2462 does not apply to SEC disgorgement claims. The Supreme Court agreed to hear the case to resolve the disagreement among the Circuits.[18]
The Supreme Court held that “[d]isgorgement, as it is applied in SEC enforcement proceedings, operates as a penalty under §2462. Accordingly, any claim for disgorgement in an SEC enforcement action must be commenced within five years of the date the claim accrued.”[19]
The Kokesh Court looked at a ‘penalty’ as a “punishment, whether corporal or pecuniary, imposed and enforced by the state, for a crime or offen[s]e against laws.’ Huntington v. Attrill, 146 U.S. 657, 667 (1892).”[20] The Court then gave three reasons why disgorgement in an SEC enforcement context is a penalty. First, disgorgement is imposed for violating public laws. Second, disgorgement is imposed for punitive purposes. Third, disgorgement is not compensatory and frequently the funds go to the United States Treasury as a deterrent.
The Supreme Court made it clear in a footnote that “nothing in this opinion should be interpreted as an opinion on whether courts possess authority to order disgorgement in SEC disgorgement proceedings or on whether courts have properly applied disgorgement principles in this context.”[21] Three years later, in June 2020, the Court in Liu v. SEC answered these question in an 8-1 decision, holding that “a disgorgement award that does not exceed a wrongdoer’s net profits and is awarded for victims is equitable relief permissible under” securities laws.[22] The Court also found that lower courts had gone beyond equitable principles in awarding disgorgement by: (1) “ordering the proceeds of fraud to be deposited in Treasury funds instead of distributing them to victims;” (2) “imposing joint-and-several disgorgement liability;” and (3) “declining to deduct even legitimate expenses from the receipts of fraud.”[23]
IV. Gentile—Whether obey-the-law injunctions fall within Section 2462
The SEC frequently brings an action for an obey-the-law injunction alongside its enforcement action for civil penalties and disgorgement. If the SEC establishes that a defendant has violated the securities laws, they have routinely asked courts to impose an obey-the-law injunction, which enjoins the defendant from violating the securities laws in the future. Since everyone is required to obey the law in the first place, the question arises whether the purpose of these type of injunctions are to penalize and stigmatize the defendant. This issue has arisen in the context of Section 2462 and whether the claim for an obey-the-law injunction is really another type of penalty under Section 2462, which would require the claim for injunction to be brought within five years.
Six months after the Supreme Court decision in Kokesh on June 5, 2017, one district court addressed the issue of whether an obey-the-law injunction is a penalty and must be sought within five years under Section 2462.[24] There, the SEC had filed suit against defendant Gentile in March 2016 for securities violations relating to two schemes manipulating penny stocks that allegedly occurred some eight to nine years earlier, between April 2007 and June 2008. The SEC sought two remedies: an obey-the-law injunction and a bar to engaging in any penny stock offerings in the future—arguing that these remedies were ‘equitable’ and therefore outside the scope of legal remedies specified in Section 2462.
Chief Judge Linares of the District Court of New Jersey determined that the issue of whether the claims for relief were time-barred under the five-year statute of limitations in Section 2462 turned on whether the relief sought was a “penalty . . . pecuniary or otherwise” within the meaning of Section 2462. He concluded that the injunctions sought were “punitive in nature” and a penalty under Section 2462:
The Court disagrees with [Plaintiff SEC’s] arguments. First, and most importantly, both injunctions sought by Plaintiff are punitive in nature. Indeed, the “obey-the-law” injunction would simply require Defendant to obey the already established federal laws and regulations relating to securities. Should the Court enter such an order, Defendant would not be required to do anything more than obey the law; a basic understanding of all citizens and those involved with securities. However, such an order would also stigmatize Defendant in the eyes of the public.[25]
It is instructive to compare Chief Judge Linares’ post-Kokesh views on whether obey-the-law injunctions are penalties under Section 2462 with the pre-Kokesh views of the U.S. Court of Appeals for the Eleventh Circuit in SEC v. Graham.[26]
The Eleventh Circuit reviewed the District Court decision of Judge James Lawrence King who had ruled that Section 2462 barred the untimely relief sought by the SEC for disgorgement and an obey-the-law injunction.[27] As to disgorgement, the District Court held that disgorgement was essentially an action for ‘forfeiture’ under Section 2462 and therefore barred by the five-year rule. As to the obey-the-law injunction, the District Court rejected the SEC’s argument that no statute of limitations applies to injunctions since the word ‘injunction’ is not found in Section 2462. Instead, the District Court looked to Gabelli and the concern expressed by the Supreme Court for “leav[ing] defendants exposed to government enforcement action not only for five years after their misdeeds, but for an additional uncertain period in the future. [Gabelli] at 1223.”[28] The District Court concluded that “the injunctive relief sought by the SEC in this case forever barring defendants from future violations of federal securities laws can be regarded as nothing short of a penalty ‘intended to punish.’”[29]
The Eleventh Circuit agreed with the District Court that disgorgement was a ‘forfeiture’ subject to Section 2462. Kokesh later held that ‘disgorgement’ was a ‘penalty’ under Section 2462 rather than a “forfeiture, but still subject to Section 2462.”
However, as to obey-the-law injunctions, the Eleventh Circuit reversed the District Court’s ruling and stated that “[b]ecause injunctions are equitable, forward-looking remedies and not penalties within the meaning of §2462, we conclude that the five year statute of limitations is inapplicable to injunctions such as the one the SEC sought in this case.2”[30] Footnote 2 in the Graham case condemned obey-the-law injunctions as follows:
We note that the injunction the SEC requested in the operative complaint sought to prevent the defendants from violating federal securities laws, otherwise known as an “obey-the-law” injunction. Repeatedly we have said that, in the context of SEC enforcement actions and otherwise, “obey-the-law” injunctions are unenforceable. See SEC v. Smyth, 420 F.3d 1225, 1233 n. 14 (11th Cir. 2005); Fla. Ass’n of Rehab Facilities v. Fla. Dep’t of Health & Rehab, Servs., 225 F.3d 1208, 1222-23 (11th Cir. 2000) (citing cases holding that obey-the-law injunctions are unenforceable). In particular, “an injunction which merely tracks the language of the securities statutes and regulations,” as the injunction in this case presently is described, “will not clearly and specifically describe permissible and impermissible conduct” as required by Federal Rule of Civil Procedure 65(d). SEC v. Goble, 682 F.3d 934 952 (11th Cir. 2012). We “condemn these injunctions because they lack specificity and deprive defendants of the procedural protections that would ordinarily accompany a future charge of a violation of the securities laws.” Id. at 949. . . .[31]
In reaching its conclusion that obey-the-law injunctions are not penalties under Section 2462, the Eleventh Circuit did not have the benefit of the Supreme Court’s discussion of what the word ‘penalty’ means under Section 2462 in its 2017 opinion in Kokesh. The Eleventh Circuit also relied on its own precedent that Section 2462 only applied to claims for legal relief and not equitable remedies. To support this, it cited to cases involving ongoing violations like discharging materials into wetlands in violation of law. These cases are distinguishable since the government must be able to enjoin and stop ongoing violations, and statutes of limitations seem irrelevant to ongoing violations.
The SEC filed a notice of appeal in the Gentile case on February 7, 2018 in the U.S. Court of Appeals for the Third Circuit. The appeal was argued on November 6, 2018 and decided on September 26, 2019. The Third Circuit framed the issue and its holding as follows:
At issue in this appeal are two different remedies sought by the SEC: an injunction against further violations of certain securities laws and an injunction barring participation in the penny stock industry. The District Court held that those remedies—like the disgorgement remedy at issue in Kokesh—were penalties. We see these questions of first impression differently and hold that because 15 U.S.C. § 78u(d) does not permit the issuance of punitive injunctions, the injunctions at issue do not fall within the reach of § 2462.[32]
In other words, obey-the-law injunctions are not permitted at all if they are ‘punitive’ or a ‘penalty;’ and therefore, any statute of limitations is irrelevant. Section 78u(d)(1) states:
Whenever it shall appear to the Commission that any person is engaged or is about to engage in acts or practices constituting a violation of any provision of this chapter, [or] the rules or regulations thereunder . . . it may in its discretion bring an action in [district court] to enjoin such acts or practices, and upon a proper showing a permanent or temporary injunction or restraining order shall be granted without bond.[33]
The Third Circuit concluded that under this provision “injunctions may properly issue only to prevent harm” when “there is a reasonable likelihood of future violations,” but “not to punish the defendant.”[34]
The Court remanded the case to the District Court to determine whether the obey-the-law injunction sought against Gentile was ‘preventive’ or ‘punitive.’ In so doing, it provided the District Court with the following guidance:
We stress that the District Court, on remand, should not rubber-stamp the Commission’s request for an obey-the-law injunction simply because it has been historically permitted to do so by various courts. . . If the District Court, after weighing the facts and circumstances of this case as alleged or otherwise, concludes that the obey-the-law injunction sought here serves no preventive purpose, or is not carefully tailored to enjoin only that conduct necessary to prevent a future harm, then it should, and must, reject the Commission’s request. We note that the District Court has already addressed some of the relevant concerns involved in its opinion. We are also troubled by the fact that the Commission appears to seek two injunctions that attempt to achieve the same result.[35]
Of course, Chief Judge Linares already found that the obey-the-law injunction sought by the government against Gentile was “punitive in nature.” How all this plays out going forward in other future cases remains to be seen. If Gentile remains good law, it does not seem likely that the government will be able to obtain obey-the-law injunctions as a matter of course going forward, especially in cases where the wrongful conduct occurred and concluded years earlier.
Chief Judge Linares retired from the bench several months before the Third Circuit’s ruling and opinion in Gentile. On remand, the case was reassigned to District Judge Brian R. Martinotti who was then called upon to consider Gentile’s motion to dismiss. On September 29, 2020, Judge Martinotti issued a 31-page opinion granting the motion to dismiss on the ground that “the allegations of the Amended Complaint are insufficient to state a plausible claim for [injunctive] relief.”[36] The court then added that it would, “however, []permit the SEC one final opportunity to amend their complaint.”[37] The SEC declined to do so and the case was closed.
V. Straub—Whether a defendant’s presence in the United States is required for Section 2462 to start to run
Notwithstanding that Section 2462 does not provide for tolling when the defendant is outside the United States, one district court judge, at the government’s urging, ruled that Section 2462 does not take effect unless the defendant is present in the United States.[38]
On December 29, 2011, the SEC filed an enforcement action in federal district court in the Southern District of New York against defendants Elek Straub, Andras Balogh and Tomas Morvai, three former senior executives of the Hungarian telephone company Magyar Telekom, Plc. (“Magyar”). All three defendants were Hungarian citizens who worked and resided in Hungary. The complaint alleged that more than five years earlier, in 2005 and 2006, the defendants engaged in a scheme to bribe Macedonian government officials in order to receive favorable treatment for Magyar’s Macedonian cellphone subsidiary, which was jointly owned by Magyar and the Macedonian government. The action was brought under the civil anti-bribery and accurate books and records provisions of the Foreign Corrupt Practices Act, 15 U.S.C. Sections 78dd-1, et seq. The suit sought civil penalties, disgorgement and an obey-the-law injunction. The action was filed more than five years after the claims first accrued.
The defendants moved to dismiss the SEC’s claims on the grounds that they were time barred under Section 2462. On February 8, 2013, the District Court issued an opinion in which it adopted the government’s position that the claims were not time barred.
It is undisputed that more than five years have elapsed since the SEC’s claims first accrued. (See Opp’n 23-24; Reply 10.) The parties nevertheless disagree as to the plain meaning of §2462 and, given that Defendants were not physically located within the United States during the limitations period, whether the statute limitations has run on the SEC’s claims. The SEC argues that the statute of limitations has not run because the statute applies only “’if, within the same period, the offender . . . is found within the United States.’” (Opp’n 23-224 (quoting 28 U.S.C. §2462).) Thus, according to the SEC, because the Defendants were not “found” in this country at any point during the limitations period in question, the Court’s inquiry should end. (Id. at 24.) The Court agrees.
* * *
Here, the operative language in Section 2462 requires, by its plain terms, that an offender must be physically present in the United States for the statute of limitations to run.[39]
A close reading of Section 2462 shows that the District Court got it backwards. Instead of concluding that because the defendants could not be found in the United States for service of process within the five year limitations period, the case could not be brought, the Court ruled just the opposite – that the case could be brought at any time in the future after the five year period had elapsed. This leaves open the possibility that the SEC can bring suit 20 years, 30 years, or even more after the claim first accrued.
The language of Section 2462 is drafted in a way that makes reasonably clear that “an action, suit or proceeding for the enforcement of any civil fine, penalty or forfeiture, pecuniary or otherwise, shall not be entertained unless” certain things occur. The two things that must occur to allow the lawsuit to be entertained are (1) the suit must be “commenced within five years from the date when the claim first accrued” and (2) “if within the same [five-year] period, the offender or the property is found within the United States in order that proper service may be made thereon.” Unless these two things take place, the statute dictates that the lawsuit “shall not be entertained.” Yet the District Court neither acknowledged nor applied this clear structure.
The Court also disregarded the fact that under the Hague Convention the SEC could have served the defendants anytime it wanted within the five-year limitations period. In fact, it was under the Hague Convention that the SEC made its service some six plus years after the claim ‘first accrued.’
On February 27, 2013, approximately three weeks after the District Court issued its opinion on Section 2462 in the Straub case, the Supreme Court issued its opinion in Gabelli. Of particular relevance to the Straub issue was the statement in the opinion by Chief Justice Roberts that the ‘discovery rule’ “would leave defendants exposed to Government enforcement action not only for five years after their misdeeds, but for an additional uncertain period into the future.”[40]
In light of Gabelli, the Straub defendants requested the District Court to certify an interlocutory appeal under 28 U.S.C. Section 1292(b) to the Second Circuit regarding the statute of limitations ruling. The District Court did not disagree that the legal issue in dispute was “a controlling question of law as to which there is substantial ground for difference of opinion” under Section 1292(b).[41] However, the Court denied the Straub defendants’ motion to certify an interlocutory appeal because an immediate appeal would not “materially advance the ultimate termination of the litigation” under Section 1292(b).[42] The Court stated that “even if reversal would eliminate the SEC’s claim for civil penalties, the claims for disgorgement and injunctive relief would still survive . . . Further, in seeking these equitable remedies, the SEC will still need to establish Defendants’ liability.”[43]
Of course, had this litigation and request for interlocutory appeal occurred in 2018 or 2019, the Kokesh decision on disgorgement, the Gentile case, and the discussions in the Graham decisions on obey-the-law injunctions may have gotten the issue to the Second Circuit and possibly the Supreme Court. The Straub case went forward with several years of discovery and then motions for summary judgment. A critical issue in the motions for summary judgment was the five-year statute of limitations of Section 2462 and whether the District Court erred when it ruled that “the operative language in §2462 requires, by its plain terms, that an offender must be physically present in the United States for the statute of limitations to run.”[44]
The issue for the District Court became much more complicated because discovery had shown that two of the three defendants had been in the U.S. for a short period of time during the five-year period, as the Court acknowledged:
Discovery has since revealed, however, that, despite the SEC’s allegations at the pleading stage, two of the defendants – Straub and Morvai – were physically present in the United States in 2005. Specifically, Straub traveled to New York and Boston during the week of September 6, 2005 (Def. 56.1 ¶ 1), and Morvai traveled to San Francisco on June 23, 2005 and, on a separate trip, to New York on October 21, 2005 on his way to Connecticut (id. ¶ 2). These undisputed facts require the Court to now consider what effect, if any, these visits have on the running of Section 2462’s statute of limitations.[45]
In deciding how Section 2462 should be applied in these circumstances, the District Court wrote a complicated ten-page analysis. It was a far cry from the straightforward and “set[ting] a fixed date” opinion of Chief Justice Roberts in Gabelli. The District Court began its analysis by concluding “that Section 2462 does not apply to the SEC’s claims to the extent those claims seek injunctive relief or disgorgement − it applies only to the SEC’s claim for penalties.”[46] As we now know from Kokesh, the District Court in the Straub case got disgorgement wrong, and as the Third Circuit ruled in Gentile, obey-the-law injunctions sought by the SEC that are ‘punitive’ and a ‘penalty’ are not permitted to be issued by federal courts at any time.
The District Court then addressed the fact that two of the defendants (Straub and Morvai) were in the United States for a few days each during the five-year period while one of the defendants (Balogh) was not. The Court found that:
actions covered by Section 2462 are subject to a five year statute of limitations that applies if the defendant is present in the United States at any time during that five year period, which begins to run on the date the subject claim accrues and does not toll while the defendant is absent from the United States. The Court also finds that the limitations period does not apply at all if the defendant is not present in the United States at any point during the five year period. . .[47]
This rather bizarre result − that a foreign defendant who is in the U.S. for a few days or a “fleeting” moment gets the benefit of Section 2462 while a foreign defendant who is not in the U.S. at all does not get its benefit − cannot be justified by the language Congress enacted.
The District Court erred when it “ruled that ‘found in the United States’ means ‘physically present’ within the United States.”[48] The phrase in Section 2462 that states “if within the same period, the offender or the property is found within the United States in order that proper service may be made thereon” means something quite different than ‘physically present.’ It means the government must ‘find’ the defendant in order to serve him, and the defendant likewise must be ‘found’ by the government in the United States in order to be served. Merely being ‘physically present’ in the U.S. does not mean the government has ‘found’ the defendant to effect service; and absent finding the defendant and properly serving him, the enforcement action cannot truly commence.
As discussed earlier, Section 2462 does not allow an enforcement action to be entertained unless it is commenced in five years and if – within the same period – the government can find the defendant to effect proper service. In the 1839 statute, Congress gave the government five years to find the offender in the United States in order to make proper personal service on him. Congress did not provide the government with a limitless time frame.
The SEC argued that Section 2462 means that the statute of limitations “tolls whenever the defendant is absent from the United States.”[49] The District Court rejected this argument because
the statute contains none of the language typically associated with tolling provisions, such as references to a period being “tolled,” “suspended,” “excluded,” “extended,” or “enlarged.” (See Def. Mem. at 21-23 (collecting tolling provisions from Defendants’ impressive survey of 135 federal statutes of limitations)).
* * *
Moreover, the Court’s own research has revealed virtually no cases even suggesting, much less holding, that Section 2462’s limitations period tolls while a defendant is absent from the United States. . .[50]
Yet the District Court ruled that the five-year period of Section 2462 did not run while one defendant was outside the United States. This generates the confusion of there being no apparent difference between ‘being tolled’ and ‘not starting to run.’ The District Court then held that even though two of the defendants were in the U.S. during the five-year period, albeit briefly, Section 2462 only applied to claims that first accrued in the five-year period before defendants’ presence in the United States. For those claims that accrued after the defendants’ presence in the U.S., the five-year limitations period of Section 2462 did not apply.
Three summary points about all these contortions: First, several years earlier, a unanimous Supreme Court in Gabelli espoused a simple and straightforward approach to analyzing Section 2462 and being able to “set[ ] a fixed date when exposure to the specified government enforcement efforts ends” and thereby avoid leaving the government’s options open “for an additional uncertain period into the future.”[51]
Second, the District Court in Straub appears not to have considered Section 2462 in the context of the 1839 Act. Section 1 of the 1839 Act provided jurisdiction for the courts to proceed to decide lawsuits even if all parties had not been properly served, so long as the court proceeded only with respect to “the parties who may be properly before it” and did not issue any judgment that would “prejudice other parties” not before the court—such as those who were “not regularly served with process” because they were “not inhabitants of nor found within the district.”[52] Congress was focused on not having cases proceed and adjudicated against defendants unless they had been found and properly served.
Third, as set forth earlier, Chief Justice Roberts and a unanimous Supreme Court stressed the importance of Chief Justice Marshall’s views on this issue:
Chief Justice Marshall used particularly forceful language in emphasizing the importance of time limits on penalty actions, stating that it “would be utterly repugnant to the genius of our laws” if actions for penalties could “be brought at any distance of time.” Adams v. Woods, 2 Cranch 336, 342, 2 L.Ed. 297 (1805).[53]
The District Court in Straub, however, found defendants’ reliance on this language to be ‘absurd’ since Congress had enacted indefinite tolling provisions in other and more recent specific statutes dealing with Customs and IRS violations.[54] The Straub Court’s point actually proves just the opposite. If Section 2462 did not run while defendants were out of the country, there would be no reason for Congress to have provided for specific Customs and IRS claims a tolling provision for persons outside the United States. The fact that Congress enacted tolling provisions in a few specific instances where defendants are out of the country does not impact on the importance of the general rule in Section 2462 of having a fixed period of time, without the possibility of bringing the action at any indefinite period of time in the future.
Ultimately, Straub was settled before trial and therefore the District Court’s decision was not appealed. Thus, the issue of tolling the limitations period when defendants are not in the United States remains unsettled.
VI. Conclusions
We are now 180 years after the predecessor statute to Section 2462 was first enacted by Congress. The Supreme Court has addressed the meaning of the statute twice in recent years. District Courts and Circuit Courts are still addressing the open issues as to its meaning and scope. Issues remain unsettled and the Supreme Court may well have to step in again to provide clarity. Hopefully, the five-year rule will remain intact as originally intended. As the Supreme Court has opined regarding statutes of limitations: “They provide ‘security and stability to human affairs.’ . . . We have deemed them ‘vital to the welfare of society,’ . . . and concluded that ‘even wrongdoers are entitled to assume that their sins may be forgotten.’”[55]
On January 1, 2021, the 1,480 page, $740 billion National Defense Authorization Act for Fiscal Year 2021 (“NDAA”) became law after the House (on December 28, 2020) and Senate (on January 1, 2021) overwhelmingly voted to override President Trump’s veto of the law. Section 6501 of the NDAA, which was buried deep in a miscellaneous part of the bill dealing with other matters, contained amendments to the Securities Exchange Act of 1934 sought by the SEC to attempt to modify and alter rulings by the Supreme Court and other federal courts in cases like Kokesh, Liu and Gentile. These amendments, essentially hidden in a defense bill in the middle of a pandemic, raise questions about respect for the rulings of the federal courts and Supreme Court.
Of particular note for this article, none of the amendments made to the law by the NDAA changed the text of 28 U.S.C. Section 2462. What the amendments did, among other things, was to create special statute of limitations rules for SEC disgorgement and equitable relief actions, including a 10-year statute of limitations for the SEC to bring scienter-based disgorgement claims and equitable relief claims, and added a provision that tolls the statute of limitations for disgorgement and equitable claims while the alleged wrongdoer is outside the United States (“shall not count towards the accrual of that period”).
This means the SEC has made the statute of limitations for disgorgement and equitable claims a separate rule outside of Section 2462 and covered by its clause “except as otherwise provided by Act of Congress.” Of course, we are left wondering why the SEC – and the few in Congress willing to do its bidding – paid so little attention to the wisdom of Chief Justices Marshall and Roberts, some 200 years apart, as to the vital role that statutes of limitations play in our laws and history.
* Mr. Rauh is a former U.S. Attorney for the District of Columbia, a former senior partner at Skadden Arps, and presently the principal in the Rauh Law Offices. Mr. Rauh was counsel to Elek Straub in one of the cases discussed in this article. Ms. Rauh is an associate at the Buckley, LLP law firm.
[18] Compare SEC v. Graham, 823 F.3d 1357, 1363 (11th Cir. 2016) (Section 2462 applies to disgorgement) with Riordan v. SEC, 627 F.3d 1230, 1234 (D.C. Cir. 2010) (Section 2462 does not apply to disgorgement).
Troutman Pepper Hamilton Sanders LLP 3000 Two Logan Square Philadelphia, PA 19103-2799 215.981.4783 [email protected]
§ 1.1 Introduction
Antitrust litigation in 2020 included a number of cases addressing the National Collegiate Athletic Association’s amateurism rules, the analysis that should apply to trade restraints imposed by large or arguably dominant companies and some of the more esoteric antitrust subjects, including the filed rate doctrine, the Foreign Antitrust Trade, merger analysis and application of antitrust to digital platforms. Each of these and other significant antitrust decisions is discussed in this Chapter.[1]
§ 1.2 The Sherman Act Developments, Section 1
Overview
The Sherman Act, under Section 1, prohibits “every contract, combination, in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce.”[2] The main purpose of the section is to prevent conduct that unreasonably restrains competition.[3] Accordingly, the principal issues often are whether an agreement exists or has been pled adequately, whether a restraint should be examined under the rule of reason or the per se rule, and, if subject to the rule of reason, whether the restraints there are reasonable.
§ 1.2.1 Standing – Sonterra Capital Master Fund Ltd. v. UBS AG, 954 F.3d 529 (2d Cir. 2020)
In Sonterra Capital Master Fund Ltd. v. UBS AG,[4] the Second Circuit examined whether a group of investment funds had standing to bring Section 1 claims based on defendants’ alleged manipulation of the benchmark interest rates used to price financial derivatives in the Yen currency market. There, the court concluded that the plaintiffs had antitrust standing and reversed the district court’s dismissal in favor of the defendants.[5]
The plaintiffs in Sonterra Capital traded in three different types of Yen-based financial derivatives that were priced based on the Yen LIBOR and Euroyen LIBOR interest rates (“LIBOR rates”). These LIBOR rates are daily rates intended to reflect the interest rates at which banks offer to lend unsecured funds in the denomination of Japanese Yen. Plaintiffs alleged that defendant banks rigged the LIBOR rates in favor of their derivatives trading positions, which, in turn, negatively impacted plaintiffs. The complaint listed specific transactions where plaintiffs traded derivatives at unfavorable rates on dates when defendants purportedly manipulated LIBOR rates.[6]
The three types of Yen-based derivatives at issues were Yen FX forwards, interest rate swaps, and interest rate swaptions. According to the complaint, the LIBOR rates affect the value of the Yen FX forwards because it is used to take the cost of Yen for immediate delivery, and adjust it to account for the amount of interest paid or received on Yen deposits over the duration of the agreement. Interest rate swaps allow a party to exchange a fixed stream of interest rate payments for one based on a floating reference rate, such as the LIBOR rates. A Swaption gives the buyer the right to enter into an interest rate swap in the future. Plaintiffs allege that the LIBOR rates affect the value of a swaption because it determines the value of the interest rate swap underlying that swaption.[7]
The only issue on appeal was whether the plaintiffs sufficiently pled that they suffered harm as a result of defendants’ alleged manipulation of LIBOR rates, satisfying the injury in fact requirement of Article III standing.
To satisfy Article III standing, a plaintiff “must have (1) suffered an injury in fact, (2) that is fairly traceable to the challenged conduct of the defendant, and (3) that is likely to be redressed by a favorable judicial decision.” Spokeo, Inc. v. Robins, 136 S.Ct. 1540, 1547 (2016). … To plead injury, in fact, a plaintiff must allege ‘that he or she suffered an invasion of a legally protected interest that is concrete and particularized and actual or imminent, not conjectural or hypothetical.’ … ‘Any monetary loss suffered by the plaintiff satisfies’ this requirement.”[8]
To maintain a federal antitrust claim, the plaintiffs must have suffered antitrust injury. Antitrust injury is an “injury of the type the antitrust laws were intended to prevent and that flows from that which makes the defendant’s acts unlawful.”[9] The second aspect of antitrust injury – plaintiffs’ injury must have been proximately caused by the defendants’ antitrust violation overlaps with Article III constitutional standing.
The Second Circuit pointed to the numerous instances whether the plaintiffs entered into derivatives transactions at prices that they alleged were artificial because of defendants’ alleged price fixing. The court found the allegations related to the Yen FX forwards, where plaintiffs alleged specific trades in which they had to pay higher prices because of defendants’ market manipulation. Although the court appeared more skeptical of the swap and swaption allegations because they were not as direct, the court determined that, at the motion to dismiss stage, they were adequate.[10]
The Second Circuit held that plaintiffs plausibly pled that they suffered monetary loss from the Yen FX forwards, swap and swaption transactions as a result of defendants’ alleged manipulation of LIBOR rates and that this was sufficient to plead standing under Article III.[11]
§ 1.2.2 Agreement – Freedom Watch, Inc. v. Google, Inc., 816 Fed. Appx. 497 (D.C. Cir. 2020)
Although the D.C. Circuit declined to publish its opinion in Freedom Watch, Inc. v. Google, Inc.,[12] given the more recent spate of antitrust cases against U.S. technology companies and asserting untraditional forms of harm it is included here.
Plaintiffs are known as a conservative public interest group and congressional candidate. Plaintiffs filed a putative class action lawsuit in the U.S. District Court of the District of Columbia in 2019. The complaint named Google, Facebook, Twitter, and Apple as defendants and alleged that the platforms conspired to suppress conservative political opinions in violation of the First Amendment, the Sherman Act, and the District of Columbia Human Rights Act.[13] The district court dismissed the complaint as failing to state colorable legal claims.
The D.C. Circuit first addressed Freedom Watch’s standing to bring the instant case and held that it had standing based on its allegation that the platforms conspired to suppress its audience and revenues. Next, the court affirmed dismissal of Freedom Watch’s First Amendment claim because the platforms were not the “government” or otherwise a state actor.[14]
Although a less than conventional antitrust claim, the D.C. Circuit addressed an issue frequently at the core of Section 1 motions to dismiss—whether plaintiffs alleged a plausible agreement or conspiracy among the defendants. Plaintiffs argued that the court should infer an agreement principally from the platforms’ parallel behavior. Specifically, plaintiffs asserted that each of the defendants refused to provide certain services. Citing to Bell Atlantic Corp. v. Twombly, the D.C. Circuit noted that, without more, parallel conduct is not a sufficient basis to allege an agreement. The Supreme Court addressed pleading standards in antitrust cases in Twombly.[15] The Court held that stating an antitrust claim required a complaint with “enough factual matter” to demonstrate “plausible grounds to infer an agreement” was reached. The Court further held that “parallel conduct does not suggest conspiracy, and a conclusory allegation of agreement at some unidentified point does not supply facts adequate to show illegality.”[16]
Freedom Watch contended that it alleged more than parallel conduct. Specifically, plaintiffs argued that the platforms are motivated by political objectives and that they are pursuing a “revenue-losing strategy.”[17] The D.C. Circuit, however, found that those alleged facts alone did not make it more likely that the platforms’ actions were the result of an agreement among them than merely the independent conduct of each of the platforms.[18]
Next, the court addressed plaintiffs’ Section 2 monopolization claim. The court noted that a required element of a monopolization claim is that the defendant acquired or sought to maintain their monopoly power through anticompetitive conduct. The D.C. Circuit, however, found that the only anticompetitive conduct alleged by plaintiffs was that the platforms conspired to suppress conservative content, but nowhere alleged that they conspired to achieve or maintain a collective monopoly or explained how the purported agreement to suppress conservative content enhanced their market power.[19]
§ 1.2.3 Class Certification Predominance Element – In re: Lamictal Direct Purchaser Antitrust Litigation, 957 F.3d 184 (3d Cir. 2020).
In In re: Lamictal Direct Purchaser Antitrust Litigation,[20] the Third Circuit examined the district court’s analysis of the putative class’s poof of antitrust injury and determined that it had impermissibly relied on average prices to demonstrate the common proof of antitrust injury necessary for satisfying the predominance requirement of class certification. The Third Circuit also puts lower courts to task—a rigorous assessment of the facts and data must be undertaken when the use of averages are in dispute.
A putative class of direct purchasers of an anti-epilepsy drug sued GlaxoSmithKline (“GSK”) and Teva Pharmaceuticals (“Teva”), alleging that the pharmaceutical manufacturers entered an impermissible reverse-payment settlement in violation of antitrust law. According to the plaintiffs, this agreement delayed the launch of multiple generic versions of the drug and resulted in purchasers paying more for the drug than they would have absent the GSK-Teva arrangement.[21] Plaintiffs moved to certify a class of direct purchasers of the branded and generic version of the drug, and the district court granted the motion. The defendants appealed the inclusion of the generic purchasers in the class, and the Third Circuit vacated the class certification decision and remanded the case back to the lower court. The appellate court concluded that the district court had not performed the rigorous analysis required in assessing whether issues common to the putative class predominate over individualized ones.[22]
GSK is the patent holder for Lamictal, an anti-epilepsy drug, and it has been selling the drug since 1984. GSK’s Lamictal patent was set to expire in 2009. In April 2002, Teva filed for authorization with the FDA to begin selling a generic version of Lamictal, called Iamotrigine. In response, GSK sued Teva for patent infringement. After Teva won a bench trial for one of the claims in 2005, the pharmaceutical companies settled. Under the settlement, Teva would begin selling Iamotrigine in mid-2008, which was six months prior to when Teva could sell the generic had GSK won the infringement suit. GSK, in exchange, agreed not to sell an authorized generic version (“AG”) of Lamictal.[23] Plaintiffs alleged that, without the agreement, Teva would have launched Iamotrigine and GSK would have responded by selling an AG. With two generics in the market, the price would have decreased. Thus, plaintiffs contended that they were harmed by paying more for the generic Iamotrigine than they otherwise would have absent the settlement.[24]
To counter this theory, defendants argued that GSK competed with Teva on price despite not launching an AG. Because doctors appeared reluctant to switch their patients’ epilepsy drugs, GSK had long been worried that selling an AG would be ineffective since doctors would not move patients from Lamictal to the lower-priced generic. Moreover, to take advantage of this particularity of the anti-epilepsy drug market, GSK developed a strategy to compete aggressively with Teva on price by offering significant discounts and rebates to targeted pharmacies if the pharmacies sold Lamictal instead of Iamotrigine (the “Contracting Strategy”). According to defendants, Teva found out about GSK’s Contracting Strategy, and in response, lowered its prices on Iamotrigine. Direct purchasers thus did not pay more for Iamotrigine than they would have without the settlement.[25]
Under Federal Rule of Civil Procedure 23(b), common questions of law or fact of class members must predominate over ones affecting individual members.[26] For this predominance requirement to be met, courts must perform a “rigorous analysis” of the evidence and arguments proffered to determine whether the plaintiffs’ claims are capable of common proof at trial by a preponderance of the evidence.[27] In opposing class certification, defendants argued that plaintiffs could not show that injury to the proposed class of generic purchasers is capable of common proof at trial because plaintiffs’ evidence impermissibly relied on averages. These averages were inappropriate because up to one-third of the proposed class members likely paid no more, or even less, than they would have absent the settlement as a result of the discounting strategies employed by defendants. On appeal, defendants contended that the district court erred by accepting these averages without performing a rigorous analysis of the parties’ competing expert reports and resolving factual disputes on which the expert testimony was predicated.[28]
The Third Circuit agreed, vacating class certification and remanding the case. First, the Third Circuit explained that the lower court failed to perform the requisite “rigorous analysis” and resolve factual disputes that underlie the competing expert reports. The determination of whether the use of average prices was acceptable depended on several disputed facts, including “1) whether the market is characterized by individual negotiations; 2) whether Teva preemptively lowered its pricing in response to the Contracting Strategy; and 3) whether and to what extent GSK, absent the settlement agreement, would or could have pursued both the Contracting Strategy and an AG.”[29] Moreover, the district court failed to evaluate the sources of the competing experts’ pricing and discount data to decide what evidence was credible and could be used to support the expert reports. Assessing this “micro-level analysis” was required to decide whether plaintiffs could establish that common issues predominate by a preponderance of the evidence at trial, despite competing evidence and expert testimony.[30] While the Third Circuit acknowledged that the use of averages may be acceptable when they do not hide individualized injury, that determination could not be made here given the lack of rigorous analysis.[31]
Second, the Third Circuit further explained that the lower court confused the dispute regarding the use of averages as one involving damages, not injury.[32] However, the Third Circuit distinguishes between the questions of whether an injury actually occurred and what the value of damages for that injury should be, and it applies a more permissive predominance standard in class certification for damages than for injury. “While every plaintiff must be able to show antitrust injury through evidence that is common to the class, damages need not be susceptible of measurement across the entire class for purposes of Rule 23(b)(3).”[33] Because the district court applied the more lenient damages standard, remand was appropriate.[34]
Although the Third Circuit acknowledged that injury may be shown using averages, the opinion questions whether averages are appropriate to show common issues predominate.
§ 1.2.4 Class Certification Predominance Element – In re Suboxone (Buprenorphine Hydrochlorine & Naloxone) Antitrust Litigation, 967 F.3d 264 (3d Cir. 2020)
The Third Circuit again addressed class certification in another pharmaceutical case In re Suboxone (Buprenorphine Hydrochlorine & Naloxone) Antitrust Litigation.[35] Here, the Third Circuit focused its analysis on the totality of the conduct, as opposed to “considering each aspect” in isolation. The decision could make it more challenging for defendants to prevail and encourages plaintiffs to make as many allegations as they can substantiate to paint the full picture of the alleged misconduct.[36] Similarly, the ability to delay the eventual need for individualized damages past the class certification phase reduces plaintiff barriers to successfully certifying a class action.
Direct purchasers of Suboxone (“Purchasers”) sued Indivior, formerly Reckitt Benckiser Pharmaceutical, Inc. (“Reckitt”), for allegedly engaging in anticompetitive conduct that impeded the entry of generic versions of Suboxone into the market,[37] violating Section 2 of the Sherman Act.[38] The district court granted class certification for the plaintiffs, holding that common evidence of injury and damages demonstrated that 1) “[p]urchasers paid more for brand . . . name than they would have for generic tablets due to Reckitt’s actions to . . . suppress market entry” and 2) “[i]ssues regarding allocation of individual damages [were] insufficient to defeat class certification.”[39] On appeal, the Third Circuit affirmed the decision.[40]
The FDA granted Reckitt a seven-year exclusivity period for the drug Suboxone, which treats opioid addiction.[41] At the end of that period, Reckitt developed an under-the-tongue film version of the drug that also would have its own exclusivity period. Additionally, unlike the anticipated generic Suboxone tablets, the film version would not be AB-rated—meaning, pharmacists would not have to substitute a generic if a patient were prescribed Suboxone film under state substitution laws.[42] This transition to Suboxone film was allegedly coupled with efforts to eliminate demand for tablets, coercing providers to prescribe Suboxone film over the tablet form.[43] These actions resulted in the Purchasers bringing a class action against Reckitt for anticompetitive practices, “alleging that its efforts to suppress generic competition amounted to unlawful maintenance of monopoly power.”[44]
The Third Circuit agreed with the district court on class certification, holding that class members satisfied both the predominance and adequacy requirements.[45]
Regarding the question of predominance, Reckitt made two arguments. First, it contended that Purchasers had not provided common evidence of injury or damages as required by Comcast Corp. v. Behrend,[46] because Reckitt could “lawfully raise the prices on Suboxone tablets and change its rebate program.”[47] However, the Third Circuit wrote that the plaintiffs’ case was not just about the pricing of the brand tablets, but rather the totality of Reckitt’s actions, which also included “withdrawing tablets from the market, providing rebates only for film, disparaging the safety of tablets, and delaying the generics’ entry by filing a citizen petition and not cooperating in the REMS process.”[48] The court concluded that common evidence would be used to prove that these actions together suppressed competition, examining the evidence in its totality.[49] Second, Reckitt argued that since the plaintiff’s damages model only calculates aggregate damages, predominance was not satisfied.[50] But the court also rejected this argument, noting that prior Third Circuit cases allow for models that estimate “the damages attributable to the antitrust injury, even if more individualized determinations are needed later.”[51] Therefore, the court rejected both arguments, finding that the plaintiffs satisfied predominance under Rule 23(b).
Finally, Reckitt also challenged the adequacy of the class representative, arguing that the class representative has a risk of conflict with class counsel and lacks control over the litigation to class counsel.[52] The Third Circuit wrote that the risk of conflict was “hypothetical” which “cannot defeat adequacy.”[53] In addition, the Third Circuit rejected the argument that class certification should be denied because of the class representative’s lack of control. The court said that Reckitt cited no Third Circuit precedent that requires the class representative to control the litigation and reiterated that any suggestion that class counsel does not direct and manage class actions is “sheer sophistry.”[54]
§ 1.2.5 Collaborations – In re National Collegiate Athletic Association Athletic Grant-In-Aid Cap Antitrust Litigation (9th Cir. 2020)
Over 35 years ago, the Supreme Court, in NCAA v. Board of Regents of the University of Oklahoma,[55] suggested that rules regarding eligibility standards for college athletes would be subject to a different, less stringent standard than most trade restraints. But in May 2020, the Court of Appeals for the Ninth Circuit ruled, in a case brought by Division 1 football and basketball players, that the National Collegiate Athletic Association’s (NCAA) limits on (1)cash education related benefits below $5600 in academic or graduation awards and incentives and (2) non-cash education related benefits—such as computers, science equipment, post-graduate scholarships and internships—violated federal antitrust laws. In December, the Supreme Court granted certiorari and agreed to review that decision in National Collegiate Athletic Association v. Alston[56] and American Athletic Conference v. Alston.[57]
The Sherman Act prohibits agreements in restraint of interstate trade or commerce. The Ninth Circuit explained that, when examining agreements among entities involved in league sports, such as here, the court must determine whether the restriction is unreasonable under the rule of reason. The appellate court further explained the rule of reason’s “three-step framework:”
(1) Student-Athletes “bear[ ] the initial burden of showing that the restraint produces significant anticompetitive effects within a relevant market”; (2) if they carry that burden, the NCAA “must come forward with evidence of the restraint’s procompetitive effects”; and (3) Student-Athletes “must then show that any legitimate objectives can be achieved in a substantially less restrictive manner.” Throughout this analysis, we remain mindful that, although “the NCAA is not above the antitrust laws,” courts are not “free to micromanage organizational rules or to strike down largely beneficial market restraints,” Accordingly, a court must invalidate a restraint and replace it with an LRA only if the restraint is “patently and inexplicably stricter than is necessary to accomplish all of its procompetitive objectives.”[58]
Founded in 1905, the NCAA establishes rules governing college athletics. Its mission statement is to “maintain intercollegiate athletics as an integral part of the educational program and the athlete as an integral part of the student body and, by so doing, retain a clear line of demarcation between intercollegiate athletics and professional sports.” For many years, among other things, NCAA rules have provided that student athletes may not be paid to play. Specifically, at issue in the instant case was the NCAA regulations that govern the payments student-athletes may receive in exchange for and incidental to their athletic participation as well as in connection with their academic pursuits.
The NCAA categorizes its member schools into three competitive divisions: Division 1 schools—350 of the NCAA’s approximately 1,100 member schools—sponsor the largest athletic programs and offer the most financial aid. Division 1 football has two subdivisions, one of which is the Football Bowl Subdivision (FBS). In 2014, the NCAA amended its Division 1 bylaws (the “Bylaws”) to provide the “Power Five” conferences autonomy to adopt collectively legislation in certain areas, including limits on athletic scholarships known as “grants-in-aid.” In early 2015, the Power Five increased the grant-in-aid limit to the cost of attendance (“COA”), and, since August 2015, the Bylaws have provided that a “full grant-in-aid” encompasses “tuition and fees, room and board, books and other expenses related to attendance at the institution up to the [COA],” as calculated by each institution’s financial aid office under federal law. The Bylaws also contain an “Amateurism Rule,” which strips student-athletes of eligibility for intercollegiate competition if they “[u]se[ ] [their] athletics skill (directly or indirectly) for pay in any form in [their] sport.” “[P]ay” is defined as the “receipt of funds, awards or benefits not permitted by governing legislation.”[59]
In O’Bannon v. NCAA,[60] a class of student athletes challenged the NCAA’s rules that prohibited payment for use of their names, images and likenesses. There, the court deemed several of the NCAA’s rules unlawful under the rule of reason’s balancing test, finding that less restrictive alternatives to the challenged rules existed. Specifically, the court found that the NCAA’s rule that capped athletic scholarships at tuition and fees and meant student-athletes were not being compensated for the full COA violated the Sherman Act and required the NCAA to allow colleges to pay athletes $5,000 above the COA and unrelated to any educational expenses.[61]
On appeal, the Ninth Circuit held that the “rule of reason” analytical framework applies to all the NCAA rules and rejected the NCAA’s arguments that the Supreme Court’s Board of Regents decision perpetually shielded from antitrust claims the NCAA’s amateurism rules, including those barring athlete compensation. The Ninth Circuit affirmed the district court’s ruling in O’Bannon, except for the $5,000 payments, which the court said would “vitiate” athletes’ amateur status. The Ninth Circuit acknowledged the existence of “a concrete procompetitive effect in the NCAA’s commitment to amateurism: Namely the amateur nature of collegiate sports increases their appeal to consumers.”[62]
Another set of student athletes brought a new proposed class action against the NCAA challenging its amateurism rules and seeking to bar altogether the NCAA’s prohibition of unlimited cash payments to athletes. In 2017, the NCAA entered into a $208.7 million settlement covering part of the suit and resulting in payments to approximately 40,000 football and basketball players. The litigation, however, continued over possible injunctive relief.
The district court accepted plaintiffs’ theory narrowing the relevant market to one where students sell their “labor in the form of athletic services” to schools in exchange for athletic scholarships and other payments permitted by the NCAA. The court also found significant anticompetitive effects in the relevant market. Although the NCAA granted the Power Five autonomy to establish new forms of compensation and to expand previously available compensation and benefits, the district court observed that these conferences remain constrained by “overarching NCAA limits” that cap compensation at an artificially low level.
Although the district court accepted the NCAA’s “amateurism” justification, which drives consumer interest in college sports because consumers value amateurism with respect to the NCAA’s limits on cash compensation untethered to education, it did not accept it as to the limits on non-cash education-related benefits. In fact, the court found no proof that the rules directly foster consumer demand and observed that the NCAA’s proffered connection between amateurism and its pay-for-play prohibition is riddled with exceptions. The court then reached two conclusions: (i) the challenged rules do not follow any “coherent definition” of “amateurism” or “pay” and (ii) payments (many of which post-dated O’Bannon) have not reduced the demand for college sports.
Next, the district court examined three potential alternatives to the challenged restraints and whether they were less restrictive but virtually as effective in preventing “demand-reducing unlimited compensation indistinguishable from that observed in professional sports.” The district court rejected two proposed LRAs, both of which would have permitted individual conferences to limit above-COA compensation, but would have otherwise invalidated either (i) all NCAA compensation limits or (ii) NCAA limits on education-related compensation and existing caps on benefits incidental to athletics participation, such as healthcare, pre-season expenses, and athletic participation awards. The district court rejected these alternatives on the basis that they could result in professional-style cash payments and undermine the distinction between amateur and professional sports.
The district court then identified a viable LRA:
(1) allow the NCAA to continue to limit grants-in-aid at not less than the [COA]; (2) allow the [NCAA] to continue to limit compensation and benefits unrelated to education; (3) enjoin NCAA limits on most compensation and benefits that are related to education, but allow it to limit education-related academic or graduation awards and incentives, as long as the limits are not lower than its limits on athletic performance awards now or in the future.[63]
The court also identified a number of specific education-related benefits that, if the above, LRA applied, could not be barred by the NCAA: computers, science equipment, musical instruments and other items not currently included in the [COA] but nonetheless related to the pursuit of various academic studies; post-eligibility scholarships for undergraduate, graduate, and vocational programs at any school; tutoring; study-abroad expenses; and paid post-eligibility internships.
On appeal to the Ninth Circuit, the NCAA challenged the district court’s analysis at the rule of reason’s second step, where the NCAA bears a “heavy burden” to “competitively justify” its restraints. The NCAA advances a single procompetitive justification: The challenged rules preserve “amateurism,” which, in turn, “widen[s] consumer choice” by maintaining a distinction between college and professional sports.
The Ninth Circuit affirmed the district court’s finding that only some of the challenged NCAA rules serve that procompetitive purpose: limits on above-COA payments unrelated to education, the COA cap on athletic scholarships, and certain restrictions on cash academic or graduation awards and incentives. The Ninth Circuit also concluded that the record supported the district court’s finding that the remaining rules—those restricting “non-cash education-related benefits”—do not foster or preserve demand because the value of such benefits, like a scholarship for post-eligibility graduate school tuition, is inherently limited to its actual value, and could not be confused with a professional athlete’s salary.
The Ninth Circuit rejected the notion that prior precedent immortalized the definition of “amateurism” as excluding payment for athletic performance. The NCAA proffered a survey of 1,100 college sports fans, reflecting that 31.7 percent watch college sports because, among other things, they “like the fact that college players are amateurs and/or are not paid.” But, reliance on the survey disregards the district court’s finding that the survey results do not capture the effects, if any, that the tested compensation scenarios would have on consumer behavior. The NCAA’s continued reliance on the survey further ignores the district court’s finding that its use of the phrase “amateurs and/or not paid” made its responses unreliably ambiguous: respondents who selected “amateurs and/or not paid” may have very well equated amateurism with student status, irrespective of whether those students receive compensation for athletics.
The Ninth Circuit found reasonable the district court’s conclusion that consumer demand for college athletics is not necessarily dependent upon the NCAA’s capped education-related benefits because such benefits are easily distinguishable from professional salaries; “their value is inherently limited to their actual costs”; and “they can be provided in kind, not in cash.”[64] The appellate court also found record support for the district court’s less restrictive alternative provision of education-related benefits. The NCAA failed to explain why the cumulative evidence, which included demand analyses regarding the growth of NCAA revenue while payments to athletes were simultaneously expanding in the form of the NCAA’s Student Assistance Fund and Academic Enhancement Fund for a variety of purposes, such as academic achievement or graduation awards, school supplies, tutoring, study-abroad expenses, post-eligibility financial aid, health and safety expenses, clothing, travel, “personal or family expenses,” loss-of-value insurance policies, car repair, personal legal services, parking tickets, and magazine subscriptions. The district court also reasonably concluded that permitting student-athletes to receive up to $5,600 in aggregate athletic participation awards amount in academic or graduation awards and incentives will not erode consumer demand.
The Supreme Court granted certiorari to determine whether the Ninth Circuit erroneously held that the NCAA’s eligibility rules regarding student-athlete compensation violate federal antitrust law. The context of the case, however, increased focus on large buyers of labor and concerns that they have historically been permitted to inhibit increased compensation through unnecessary restraints.
§ 1.3 The Sherman Act Developments, Section 2
Overview
The statutory language of Section 2 makes unlawful “monopolization,” “attempts to monopolize,” or “conspiracies to monopolize.” The statute itself, however, does not define any of these offenses or explain the importance of key issues such as “relevant market,” “market power,” or “anticompetitive conduct.” Consequently, Section 2 has in recent years been the subject of a number of high-profile antitrust cases.
Even though the Supreme Court moved the line of scrimmage for Section 2 claims, particularly in the area of certain unilateral pricing conduct, fertile ground remains for Section 2 litigation. While Congress and various state legislatures are exploring reducing the standard for proof of harm from a single firm’s conduct, the courts continue to search for the right balance.
§ 1.3.1 Multi-Sided Platforms — Federal Trade Commission v. Surescripts, LLC, 424 F. Supp.3d 92 (D.D.C. 2020)
In 2018, the United States Supreme Court ruled that American Express’s contractual “anti-steering provisions” did not violate Section 1 of the Sherman Act’s prohibition on agreements that unreasonably restrain trade.[65] Both consumers and merchants depend on credit card networks to intermediate between them for transactions to work—they extend the cardholder credit to make a purchase and they provide merchants quick, guaranteed payment. As such, the credit card market is considered a “two-sided platform.”[66] Moreover, the Supreme Court characterized this particular structure as a “transaction platform,” because a sale to one side of the platform can only occur with a simultaneous sale to the other side.
In a five-to-four decision split along ideological lines, the conservative justices in the majority determined that plaintiffs did not carry their burden of showing that American Express’s anti-steering provisions result in anticompetitive effects in a properly defined product market.[67] In so doing, the Supreme Court announced that a multi-sided market cannot appropriately be analyzed without considering the effects of the restraint on both or all sides of a platform where transactions take place simultaneously.
As part of the enforcement agencies’ continuing efforts to reign in purportedly harmful restrictions in technology and healthcare markets, in 2019 the Federal Trade Commission (FTC) filed a complaint alleging that Surescripts, LLC (“Surescripts”) used anticompetitive vertical and horizontal contract restraints to monopolize two important e-prescribing markets.[68] The FTC claims that Surescripts used loyalty pricing, exclusivity, non-competition commitments, and threats in order to block its competitors from sufficient volume to achieve the critical mass necessary to be a viable competitor in the electronic prescription routing and eligibility markets in violation of Section 2 of the Sherman Act and Section 5 of the FTC Act.[69] In so doing, Surescripts prevented any meaningful competitors from entering either market, which caused higher prices, reduced innovation, and lowered output.[70]
The FTC’s challenge to Surescripts’ strategies will require the federal court to apply the antitrust laws to two-sided high tech, data driven markets where network effects are prevalent. The FTC’s complaint is the latest in a series of challenges to predominantly vertical contract provisions.[71]
Routing is the electronic transmission of prescription information from a healthcare provider to a pharmacy through a provider’s electronic health record (EHR) system. Providing routing requires building a two-sided network (or platform) linking EHRs to pharmacies.[72] Eligibility is the electronic transmission of a patient’s formulary and insurance coverage information from a payer (typically a patient’s pharmacy benefit manager (PBM)) to the prescribing provider’s EHR. Providing eligibility requires building a two-sided network (or platform) linking EHRs to PBMs.[73] Surescripts provides connections between EHRs and pharmacies for routing transactions and between EHRs and PBMs for eligibility transactions, both the routing and eligibility markets are considered “two-sided.”[74]
As two-sided platforms, the value to participants on one side of the platform increases when there are more participants on the other side. Therefore, neither side will join the platform unless they believe the other side will also join—what the FTC describes as the “chicken-and-egg-problem.”[75] In other words, for example, EHRs would be unlikely to join a routing network unless those EHRs believe a large number of pharmacies use the network, and pharmacies will only join the network if they believe they have access to a substantial number of EHRs.[76] This chicken-and-egg-problem increases the barriers for any new entrant.[77]
The FTC alleged that, in reaction to the threat of new competition, Surescripts maintained its near monopoly of the routing and eligibility markets by imposing anticompetitive contract provisions and threats.[78]
First, Surescripts imposed exclusivity in its pharmacy and PBM contracts through loyalty discounts. Those pharmacies that used Surescripts for all or nearly all routing transactions received a loyalty discount. Surescripts used the same tactics in the PBM eligibility contracts.[79] In addition, Surescripts enacted clawback obligations, which required a pharmacy or a PBM that switched from exclusive to non-exclusive to pay back the loyalty discount for past transaction volume over the term of the contract.[80] Under Surescripts’ EHR loyalty program, if an EHR agrees to be exclusive only in routing, Surescripts pays the EHR an incentive fee equal to a portion of each routing transaction or, if an EHR agrees to be exclusive only in eligibility, for a portion of each eligibility transaction. If the EHR agrees to be exclusive in both routing and eligibility, Surescripts pays the EHR a higher incentive fee on both transactions, leading nearly all EHRs participating in the loyalty program to agree to exclusivity for both transactions.[81]
Second, Surescripts included exclusivity and non-compete requirements with one of its largest customers and a potential rival, a health information technology company that resells Surescript’s routing transaction services to pharmacies. Surescript’s agreement with this customer provided for a discount if its customer exclusively used the Surescript network and a non-competition requirement.[82]
Third, Surescripts used contract provisions and threats to secure a large EHR customer. To ensure that its competitor did not gain a foothold in the market through this large EHR customer, Surescripts used its purportedly “must-have” EHR platform to require the customer to end its routing connection to the competitor’s network. Surescripts also threatened to cut the customer off from important information, such as a pharmacy directory and medication history, unless it agreed to exclusivity.[83]
According to the FTC, through these contractual provisions and a series of threats Surescripts was able to maintain at least a 95 percent share in each of the relevant e-prescribing markets.[84] Surescripts loyalty programs covered 79 percent of pharmacy routing transaction volume and at least 78 percent of PBM eligibility transaction volume, making it substantially more expensive for any firms that wanted to make use of a platform in addition to the Surescripts platforms.[85] By controlling, directly or indirectly, such a large portion of the transaction volume a challenger could not overcome the chicken-and-egg-problem.[86] It would not be able to convince one side of its platform that there are a substantial number of participants on the other side as too many participants were exclusive to Surescripts. With this monopoly power, Surescripts has imposed high prices and stalled innovation, and there were no procompetitive justifications for Surescripts’s conduct that outweighed these competitive harms.[87]
Surescripts moved to dismiss the complaint, arguing that the case was both procedurally and substantively defective. First, Surescripts argued that the court lacks subject matter jurisdiction over the FTC’s request for a permanent injunction under Section 13(b) of the FTC Act.[88] Second, Surescripts argued that the Section 2 monopolization claim fails because the FTC does not allege that the prices offered by Surescripts were predatory or that Surescripts’s market practices violated the rule of reason.[89]
With respect to Section 13(b), Surescripts argued the court lacks subject matter jurisdiction because is not a “proper case” under the statute to adjudicate the FTC’s request for permanent injunctive relief. Specifically, Surescripts contended that only straight forward, routine cases are proper candidates for relief under Section 13(b). This case, however, according to Surescripts, does not qualify as routine or straightforward because it involves complex and novel issues of antitrust law, such as how to understand the two-sided e-prescription markets of routing and eligibility in light of the Supreme Court’s recent decision in Ohio v. American Express Co. The FTC argued in response that the language of Section 13(b) does not clearly speak to courts’ power to adjudicate such claims. In addition, the FTC contended that this case is “proper” because that term just means any case in which a permanent injunction would be “appropriate.” The FTC posits that any case where a law enforced by the FTC has been violated and equitable remedies are needed to make harmed consumers whole is an appropriate case.[90] The district court found the FTC’s position more persuasive, denying Surescripts’s motion to dismiss on the basis that the court lacked subject matter jurisdiction under Section 13(b).
The court noted that the relevant provision provides that “in proper cases the [FTC] may seek, and after proper proof, the court may issue, a permanent injunction.”[91] The court found important that neither this specific provision nor Section 13(b)’s broader framework regarding equitable relief even include the word “jurisdiction,” let alone a clear statement that any of the statutory requirements are jurisdictional.[92] Surescripts’s argument that “proper cases” is a jurisdictional requirement relied, in part, on the label of Section 13(a)—“Power of Commission; jurisdiction of courts” and that Section 13(a) is “identical” to Section 13(b) in structure. The court, however, relied on the Supreme Court’s decision in Arbaugh v. Y&H Corp.,[93] defining the proper inquiry as whether Congress “clearly states that a threshold limitation on a statute’s scope” is jurisdictional, and Surescripts’s structural argument from Section 13(a)’s label falls short of this high bar.[94] Moreover, the court examined the title of Section 13(b) itself and its separate and distinct label (“Temporary restraining orders; preliminary injunctions”) that does not include any reference to jurisdiction.
Although the court agreed with Surescripts that “proper cases” is not synonymous with “all cases,” it noted that its task was not to define the term “proper cases” for all scenarios, but to determine whether the instant case is proper for a permanent injunction, if won by the FTC. The court took comfort in the FTC’s assurance that the primary authority governing the case was the D.C. Circuit’s precedent, United States v. Microsoft Corp.,[95] and that the court would not need to “go much beyond Microsoft.” Based on those assurances, the court concluded that the complaint adequately alleges a “proper case” under Section 13(b).[96]
Surescripts next argued that the FTC’s monopolization claim should be dismissed for two primary reasons. Specifically, Surescripts claimed that because its loyalty program was “optional,” it could not serve as the basis for a monopolization claim unless the prices under the loyalty program were “predatory” but the FTC did not plead the necessary elements for a predatory pricing claim. Additionally, Surescripts argued that the complaint should be dismissed even if, as the FTC claimed, its loyalty programs were analyzed as exclusive dealing arrangements because the FTC did not adequately allege that Surescripts’s loyalty programs created any anticompetitive effects. Specifically, Surescripts suggests that, because the FTC concedes that both routing and eligibility are two-sided markets, “the FTC must plausibly plead foreclosure of a substantial share of each of those markets as a whole.”
The court found that Surescripts’s loyalty programs or alleged practice of charging loyal pharmacies and PBMs less, and paying loyal EHRs greater incentives, do not need to constitute predatory pricing for Surescripts’s exclusionary practice to constitute illegal maintenance of a monopoly under Section 2.[97] The court pointed out that exclusivity provisions covering approximately 40–50 percent of the relevant market have been found to foreclose competition illegally, while Surescripts’s loyalty program allegedly locks 70–80 percent of the routing and the eligibility markets into effectively exclusive contracts. Thus, Surescripts’s criticism that the FTC failed to allege sufficient anticompetitive effects or foreclosure in each of the two-sided markets was incorrect. The court further determined that, Amex did not change the central question—whether the FTC alleged that Surescripts engaged in exclusionary conduct that “harmed competition, not just a competitor,” by blocking entrants into the market.[98]
The FTC’s monopolization case continues, despite Surescripts’s arguments that its optional loyalty programs would have to meet quite specific and rigorous standards for pleading, including predatory pricing and anticompetitive effects in each platform. Instead, the court focused on the broader concern of foreclosure in each market and its effect on the ability of firms to enter the market.
§ 1.3.2 Exclusivity and Refusal to Deal — Federal Trade Commission v. Qualcomm, Inc., 969 F.3d 974, rehearing en banc denied, (9th Oct. 28, 2020)
The Ninth Circuit Court of Appeals reversed a high profile decision which found that Qualcomm’s patent licensing practice violated Section One and Section Two of the Sherman Act. The court aptly described the case as drawing “the line between anticompetitive behavior, which is illegal under federal antitrust law, and hypercompetitive behavior, which is not.”[99] This distinction between aggressive competition and unlawful competition is often the subject of monopolization.
Qualcomm’s practices have been the subject of much antitrust scrutiny. In 2017, on the heels of investigations by government agencies in Japan, Korea, Taiwan, China, and the European Union, the FTC sued Qualcomm for its alleged use of anticompetitive tactics to maintain its monopoly power in the wireless cellphone chip market.[100] Much of the FTC’s complaint centered on Qualcomm’s ownership of certain standard essential patents (SEPs), including some related to code division multiple access (CDMA) and premium long-term evolution (LTE) cellular modem chips and that are key to the development and production of compatible devices able to communicate with each other.[101] Because an SEP is critical to other industry participants, SEP holders must commit to licensing their SEPs on fair, reasonable, and nondiscriminatory (FRAND) terms.[102] The FTC claimed that Qualcomm’s refusal to license its SEPs to other chip suppliers violated its FRAND commitment and the antitrust laws, that Qualcomm instead used its monopoly over chip supply and threats to withhold supply to coerce device manufacturers into unfair license arrangements, and that Qualcomm tied up such a large portion of the available business through exclusive dealing arrangements that its rival chip suppliers were unable to enter or thrive in the market.
After a ten-day bench trial, the U.S. Federal Trade Commission (FTC) convinced a California federal district court that Qualcomm’s longstanding intellectual property licensing practices and volume-based discounts violated the antitrust laws. As an initial matter, the court determined that Qualcomm had market power in two relevant global product markets—CDMA modem chips and premium LTE modem chips—based primarily on ordinary course documents reflecting high market shares and higher royalty rates.[103] Further, the court held that the FTC need not prove that the alleged anticompetitive acts caused harm to competition. Instead, the district court stated that in a government agency’s case for injunctive relief, the court need only infer causation where a defendant has market power and the defendant’s conduct “reasonably appears capable” of maintaining that power.[104]
The trial court also granted the FTC’s far-reaching requested injunctive relief—including the renegotiation of existing patent licenses and a seven-year compliance monitoring period. In fashioning its remedy, the court was not deterred by Qualcomm’s non-dominant position in the nascent 5G chip market or the Department of Justice, Antitrust Division’s last-minute attempt to intervene in the remedies phase.[105]
Before an examination of each of Qualcomm’s allegedly anticompetitive practices, the Ninth Circuit reset the analytical framework. The Ninth Circuit affirmed that the relevant product markets were the market for CDMA modem chips and the market for premium LTE modem chips,[106] but criticized the district court’s focus on the impact of Qualcomm’s conduct on the much broader market of cellular services generally. Accordingly, the Ninth Circuit reframed the issues to focus on the impact of Qualcomm’s practices in only the area of effective competition—the markets for CDMA and premium LTE modem chips.[107]
Refusal to Deal with Rivals. In advance of the trial, the district court granted the FTC’s partial summary judgment motion, holding that Qualcomm’s commitments to two standard setting organizations (SSO) required it to license its SEPs to other chip suppliers on FRAND terms and leaving the court to determine only whether Qualcomm’s failure to do so gave rise to antitrust liability. Qualcomm would only enter into licensing agreements with rivals if they agreed to sell only to cellphone manufacturers who also had separate licensing deals with Qualcomm, and to disclose customer names and sales volumes to Qualcomm. Based on the evidence at trial, the district court concluded that Qualcomm’s licensing practice constituted a refusal to license fairly and directly to its rival chip makers, and, accordingly was anticompetitive conduct without any procompetitive justification.
Additionally, the district court controversially held that Qualcomm has an antitrust duty to deal with its rivals, relying on the Supreme Court’s decision in Aspen Skiing Co. v. Aspen Highland Skiing Corp.[108] and the Ninth Circuit’s decision in Metro-Net Services Corp. v. Qwest Corp.[109] Specifically, the court concluded that such a duty exists when three conditions are met: (1) the defendant unilaterally terminated a voluntary and profitable course of dealing; (2) the defendant refused to deal even if compensated at market rates, which the court interpreted as proof of “anticompetitive malice”; and (3) the withheld product was already sold to other customers. Accordingly, the court found Qualcomm’s previous voluntary and profitable licensing deals with competitors particularly problematic and concluded that Qualcomm’s real justification for not licensing rivals was to prevent them from effectively competing. Finally, although Qualcomm complained that it would be difficult to engage in the multi-level licensing scheme the FTC posited, such arrangements were routine in the industry before Qualcomm began licensing only to cellphone manufacturers, and a market for chip-based licenses (as opposed to device-based licenses) undoubtedly existed.
The Ninth Circuit began its analysis of this issue by emphasizing the fundamental principle that a firm does not have a duty to deal with its competitors.[110] Next, the Ninth Circuit rejected application of the Aspen Skiing exception to this principle. Specifically, the court found that the district court’s reliance on Aspen Skiing to impose a duty on Qualcomm to grant exhaustive SEP licenses to its rival chip suppliers was misplaced because it ignored “critical differences between Qualcomm’s business practices and the conduct at issue in Aspen Skiing.[111] First, the Ninth Circuit determined that Qualcomm had not terminated a voluntary and profitable course of dealing in connection with licensing at the chip-manufacturer level because Qualcomm never granted exhaustive licenses to rival chip makers. Although Qualcomm previously entered into non-exhaustive, royalty agreements with chipmakers that explicitly did not grant rights to the chip supplier’s customers, it ceased this practice in response to developments in patent law’s exhaustion doctrine.[112] Second, Qualcomm’s reason for switching to OEM-level licenses was not to sacrifice short-term benefits in order to obtain higher profits in the long run by exclusion of competition but instead was to address patent exhaustion issues and maximize its profits in the short and the long term.[113] Third, there was no evidence that Qualcomm targeted any single chip maker for anticompetitive treatment in connection with its SEP licensing, while in Aspen Skiing the defendant sold the same lift tickets to any willing buyer with the exception of the plaintiff for the purpose of driving the plaintiff out of business.[114]
The Ninth Circuit also rejected the FTC’s proposed alternative basis for imposition of a duty to deal with its competitors on Qualcomm. Specifically, the FTC claimed that Qualcomm’s alleged breach of its contractual commitment to deal with its rivals as part of the SSO process constituted prohibited anticompetitive conduct in violation of section 2. The FTC was required to prove harm to competition, not merely Qualcomm’s competitors, but the Ninth Circuit found that the FTC failed to identify the requisite harm. Accordingly, the FTC failed to demonstrate that Qualcomm had a duty to deal with its chip-maker rivals or that the Ninth Circuit should apply the Aspen Skiing exception or recognize a new exception based on any SEP contractual obligations.
“Taxing” Competitors’ Sales Through a “No License-No Chips” Policy. The district court held that Qualcomm engaged in anticompetitive behavior by refusing to sell chips to cellphone manufacturers who would not sign a separate license agreement that covered not only the patents in Qualcomm chips, but also Qualcomm’s SEPs in other manufacturers’ chips. Because of its strong position in the chip market, Qualcomm increased its licensing leverage by threatening to withhold (or actually withholding) chips that cellphone manufacturers needed.
The district court concluded that, through this coercive tactic, Qualcomm was able to charge royalties that exceeded the value of its IP in several ways, including by allowing it to charge a royalty on the price of the entire device, no matter the incremental value the chip added to the device, and by permitting Qualcomm to maintain a 5 percent royalty despite the fact that its role in standard setting declined over time. This no license-no chips policy gave Qualcomm an edge over competitors on whose chips Qualcomm was collecting an identical royalty, harmed consumers by driving up the price of competing chips, and, with further threats to cut off chip supply, prevented litigation that would have tested the royalty rates—all of which perpetuated Qualcomm’s chip monopoly and allowed its anticompetitive licensing techniques to continue.
The Ninth Circuit, however, rejected the district court’s anticompetitive surcharge as failing to present a cogent theory of anticompetitive harm and found that it was based on a misunderstanding of the law related to calculation of patent damages.[115] First, the Ninth Circuit determined that the district court erroneously labeled Qualcomm’s royalty rate as unreasonable solely because the rate was based on the handset price instead of the chip price.[116] The Ninth Circuit also rejected the district court’s conclusion that any royalty rate exceeding patent law were automatically anticompetitive. Regardless of the extent or nature of the effect of any excess royalty rate, the Ninth Circuit noted that any putative harms would have been to the OEMs, and, therefore, outside the areas of effective competition—the CDMA and premium LTE modem chips markets. Similarly, the alleged negative effects of the “no license, no chip” policy effect were not in the areas of effective competition.[117]
De Facto Exclusive Dealing Arrangements. The district court began its analysis of Qualcomm’s agreements with Apple by defining de facto exclusivity to include the offering of contractual incentives and penalties that, in effect, coerce purchasers into buying a substantial portion of their needs from the supplier. The court then found that incentives Qualcomm provided to cellphone manufacturers amounted to this de facto exclusive dealing. Because of Apple’s substantial purchase volume and significance in the industry, the court focused on Qualcomm’s agreements with Apple. The court found that Apple received hundreds of millions in rebates if it purchased exclusively from Qualcomm—rebates that Qualcomm could clawback if Apple purchased any chips from a Qualcomm rival during the deal periods.
The court’s analysis of Apple-Qualcomm agreements concentrated on Apple’s stature and sales volume, the duration of the deal, and the presence of additional competition reducing or enhancing provisions. For example, the court noted that Qualcomm’s agreement with Apple blocked Qualcomm rivals from field testing and engineering collaboration opportunities with Apple and from the reputational boost that flows from an Apple partnership. In addition, the court took issue with the five-year duration of the rebate agreements, which, when paired with the rebate clawback provision, in effect, blocked Qualcomm’s rivals from supplying chips to Apple for the full five-year terms of the agreements.
The court also found that several Qualcomm near-exclusive deals with other cellphone manufacturers allowed Qualcomm to coerce cellphone manufacturers into favorable licensing deals by threatening to withhold the chips on which its near-exclusive dealing partners depended.
The Ninth Circuit examined the same Qualcomm agreements with Apple and the context surrounding those agreements and reversed the district court’s related rulings.[118] On appeal, Qualcomm argued, as it had below, that its agreements with Apple were volume discount contracts, not exclusive dealing contracts. The FTC urged the Ninth Circuit that the “practical effect” of Qualcomm’s agreements was to impose exclusive dealing on Apple, making the arrangements de facto exclusive.[119]
Despite recognizing that there is “some merit in the district court’s conclusion that the Apple agreements were structured more like exclusive dealing contracts than volume discount contracts,” the Ninth Circuit determined that those agreements did not substantially foreclose competition in the CDMA modem chip market. The basis of the Ninth Circuit decision was twofold: (1) within one year of entering into a new supply agreement with Qualcomm, Apple switch suppliers and entered into an agreement with Intel and (2) there was no evidence in the record to support Intel as a viable competitor until 2014, the same year that Apple switched from Qualcomm to Intel.[120]
The Ninth Circuit reversed the district court’s judgment on the FTC’s exclusive dealing claims as well as all the FTC’s challenges to Qualcomm’s other practices.
§ 1.4 Robinson-Patman Act Developments
Overview
The Robinson-Patman Act was enacted in 1936 to address the perceived inadequacies of the Clayton Act, the first federal price discrimination statute. Congress’s goal in creating the statute was to ensure that equivalent businesses stood on equal competitive ground.[121] In essence, the Robinson-Patman Act was designed to protect small, independent retailers and their independent suppliers from unfair competition from vertically integrated, multi-location chain stores.[122]
The Robinson-Patman Act established several key provisions. Section 2(a) of the Act requires sellers to sell to everyone at the same price.[123] Under Section 2(b), inter alia, an affirmative defense is allowed if the discrimination arises from “meeting competition.”[124] Section 2(c) prohibits parties from granting or receiving certain commissions or brokerage fees except for services rendered.[125] Sections 2(d) and 2(e) prohibit sellers from providing or paying for promotion or advertising in connection with a product’s resale, unless equivalent benefits are offered to all competing buyers.[126] Section 2(f) prohibits buyers from knowingly inducing or receiving a discriminatory price.[127] For liability to exist under the Robinson-Patman Act, plaintiffs must demonstrate several things:
Two or more consummated sales by the same seller;
Reasonably close in point of time;
Of commodities of like grade and quality;
With a difference in price;
To two or more different purchasers;
For consumption, or resale within the United States or any territory thereof; and
By persons engaged “in commerce” requirement.[128]
There are two types of possible injury, primary line and secondary line. Primary line injury is actual injury to competition between the seller granting the discriminatory pricing and other sellers. Secondary line injury is actual or threatened injury to competition between the favored customer of the seller and the seller’s disfavored customers.
Despite the continual narrowing of the Robinson-Patman Act, some plaintiffs still try to pursue price discrimination claims. Below is a discussion of the most interesting such case decided in 2020.
The plaintiff, H & C Animal Health, LLC, is a distributor of pet products to brick-and-mortar stores and through the Internet. The defendant Ceva Animal Health, LLC. (Ceva) develops and manufactures animal pharmaceuticals and provides related services and equipment. The plaintiff distributes defendant’s products, and according to the complaint, comprise 75 to 90 percent of the domestic market for pheromone-based pet-behavior products. The complaint identifies several different lines of products that have been developed by defendant for dogs and cats. Many of these products have been patented by defendant. The defendant’s products are sold to consumers through several channels, including brick-and-mortar stores, online platforms, and veterinarians.[129]
The parties had entered into a distribution and supply agreement under which the plaintiff held exclusive distribution rights for pet stores and their online platforms, which is referred to as the “Pet Specialty Channel” and “Independent Retail Channel.” The complaint refers to these channels as the “Pet Store Channel.” The plaintiff’s territory under the agreement specifically excluded sales through veterinarians or veterinary distributors. With respect to online platforms, which the complaint refers to as the “Ecommerce Channel,” the agreement granted the plaintiff non-exclusive authority to sell and advertise there.[130]
The plaintiff claimed that Ceva violated the Robinson-Patman Act by engaging in two different types of discriminatory pricing. First, Ceva allegedly engaged in price discrimination by offering rebates tor products sold through the Pet Store Channel that were not available for products sold through the Ecommerce Channel. Second, the plaintiff alleged that Ceva engaged in price discrimination by selling its products directly or indirectly to its own Ecommerce Channel customers for a lower price than it charged the plaintiff for distribution to the plaintiff’s Ecommerce Channel customers.[131]
Ceva argued that the price difference for products sold to the plaintiff for resale through the two different channels could not state a claim under the Robinson-Patman Act because the plaintiff did not allege that there were two purchasers. Instead, the allegations involved only a single purchaser—the plaintiff. The plaintiff argued, in response, that it stated an indirect price discrimination claim. The court explained that to state an indirect price discrimination claim, the seller must “`control the terms upon which a buyer once removed may purchase the seller’s product from the seller’s immediate buyer.’”[132] Under the indirect purchaser theory, a plaintiff which purchased through a middleman is considered to be a purchaser for Robinson–Patman purposes if the supplier sets or controls the resale prices paid by the plaintiff. The court rejected plaintiff’s claim of price discrimination based on two different prices from the rebates in the Pet Store Channel because there are not two different purchasers.
Next, the court examined the plaintiff’s claim that Ceva violated the Robinson-Patman Act by charging a different price to its own customers in the Ecommerce Channel than it charged to the plaintiff. Ceva argued that this second theory failed because the Robinson-Patman Act requires that discriminatory pricing be charged to buyers in the same market and there is not an injury to competition if the purchasers are not at the same functional level. The plaintiff responded that its Ecommerce Channel customers compete on the same level as Amazon.com, Ceva’s Ecommerce Channel customer, and that the price discrimination harms competition between its customers and Amazon.com.
The court sought existing case law that addressed the same facts, but apparently was unable to locate precedent addressing the current realities of the online marketplace or the treatment of direct sales by suppliers to Amazon.com. The court analogized the facts presented to when a manufacturer sells to both a distributor and a retailer.[133] The type of injury alleged here and addressed by the Robinson-Patman Act is often referred to as “secondary line injury,” because the actual or threatened injury is to competition between the favored customer of the seller and the seller’s disfavored customers. Although actual injury to competition must be established in order to establish primary line liability under Section 2(a) of the Robinson-Patman Act, the third clause of Section 2(a) expressly prohibits price discrimination where “the effect of the discrimination may be substantially” to “injure, destroy, or prevent competition with any person who grants or knowingly receives the benefit of the discrimination, or with the customers of either of them. . . .”
Therefore, the court concluded that “a price discriminator cannot ‘avoid the sanctions of the Act by the simple expedient of adding an additional link to the distribution chain.’”[134] In the instant case, the plaintiff alleged that Ceva sold its product to its Ecommerce Channel customers for less than it sold the same product to the plaintiff and that there was an injury to competition because it harms the plaintiff’s customers which compete with Ceva’s customers. Based on the alleged injury to competition, the court determined that these allegations were sufficient to plausibly state a claim under the Robinson-Patman Act.
§ 1.5 Miscellaneous
§ 1.5.1 Filed-Rate Doctrine – PNE Energy Supply LLC v. Eversource Energy (1st Cir. 2020)
One of the narrow exceptions to antitrust liability is the filed-rate doctrine. The filed-rate doctrine provides that there can be no antitrust damages action for rate levels that were set with the consent of a federal or state regulatory agency.[135] Although the Supreme Court has expressed the view that the reasoning behind the creation of the filed-rate doctrine is suspect, the Court has declined to overrule it because Congress has taken no action in over sixty years to eliminate the doctrine: “If there is to be an overruling of the [filed-rate doctrine], it must come from Congress, rather than from this Court.”[136] In 2020, the First Circuit again examined the filed-rate doctrine and when it might bar an antitrust claim.
PNE Energy Supply LLC v. Eversource Energy[137] was filed on the heels of the publication of a 2017 report examining “vertical market power” in the natural gas and electricity business. Plaintiff, a wholesale energy purchaser, was prompted to file the instant case shortly after the defendants challenged an earlier suit, triggered by the same 2017 report, on the basis that electricity consumers did not have standing to sue under the antitrust laws for manipulation in gas transmission markets.[138] The electricity consumer case was Breiding, v. Eversource Energy.[139] The District of Massachusetts dismissed Breiding, holding that the filed-rate doctrine barred the retail consumers’ claims, and in the alternative, that plaintiffs failed to plead antitrust injury or a plausible claim of monopolization.[140] On appeal, the First Circuit affirmed that dismissal, concluding that the filed-rate doctrine precluded plaintiffs’ Sherman Act and related state claims.[141]
Here, the wholesale electricity purchaser plaintiffs, thinking that they were better positioned to assert standing, also claimed that the defendants, by restricting the available natural gas capacity, increased electricity prices by approximately 20 percent on average and totaling billions of dollars in overcharges.[142] The court explained the regulatory background of natural gas transmission and sales. The Federal Energy Regulatory Commission (FERC) is the agency tasked with regulating natural gas sales and transmission.[143] This regulatory authority includes determining just and reasonable rates for the transportation of natural gas for resale, requiring no-notice contracts between pipelines and gas distribution companies for the purchase of gas capacity, and delegating the management of auctions for wholesale electricity to non-profit organizations that ensure just and reasonable rates.[144]
The First Circuit then outlined the filed-rate doctrine, explaining that it could be “understood as a form of deference and preemption which precludes interference with the rate setting authority of an administrative authority, like FERC.”[145] “`The filed-rate doctrine is “a set of rules that . . . revolve[s] around the notion that . . . utility filings with the regulatory agency prevail over . . . other claims seeking different rates or terms than those reflected in the filings with the agency.”’”[146] The court noted that upstream anticompetitive conduct that indirectly affects a downstream FERC-approved tariff is not always protected under the filed-rate doctrine, which applies to the downstream activity.[147] According to the court, FERC had exclusive authority to regulate natural gas transmission and required that companies file rate schedules for the transportation of natural gas and that pipelines offer no-notice contracts to energy distribution companies to ensure that unexpected demand is met.[148] Pursuant to these requirements, the FERC-approved Algonquin Pipeline tariff includes a statement of rates and addresses no-notice contracts. It also allows energy distribution companies to resell excess pipeline capacity, but it does not require that these companies do so.[149]
Although, in Breiding, the First Circuit concluded that the defendants had not engaged in any conduct other than that allowed by Algonquin’s detailed and reasonably comprehensive FERC-approved tariff, that FERC declined to require that energy companies sell their excess capacity, and that Congress granted FERC the ability to police anticompetitive conduct in the gas transmission industry, PNE Energy Supply persisted in its appeal. Specifically, PNE Energy Supply argued that the court should not be focused on the defendants’ use of no-notice contracts, but instead should focus on the fact that defendants not only failed to release excess transport capacity to the primary capacity market, but also refused to sell their extra capacity in the short-term secondary capacity market.[150]
The First Circuit determined that PNE Energy Supply’s characterization of the defendants’ conduct as “refusing to sell” was of no moment. The court noted that the “pivotal challenged conduct” in both Breiding and here was the alleged “over-reserving of and then failure to release gas transportation rights exercised under the defendants’ contracts with the Algonquin pipeline.”[151] The court examined the scope of FERC’s involvement in the secondary market on which PNE Energy Supply focused and found that the release of capacity into the secondary market is expressly regulated by FERC. Although a FERC order left to the market the determination of rates for short-term capacity releases, the court rejected PNE Energy Supply’s argument that this order is proof that how and under what terms a shipper should release any capacity falls outside FERC’s purview.[152] Instead, the court pointed to FERC statements that it has continued oversight of capacity releases and that it will entertain complaints and respond to specific allegations of market power. The First Circuit determined that defendants’ challenged activities related to reselling capacity on the pipeline and refusal or failure to sell stored natural gas and that these activities are within FERC’s scope of authority.
Accordingly, the filed-rate doctrine barred PNE Energy Supply’s claims.[153]
§ 1.5.2 Acquisitions — Federal Trade Commission v. Thomas Jefferson University, CV 20-01113, 2020 WL 7227250 (E.D. Pa. Dec. 8, 2020)
Although the U.S. antitrust enforcement agencies have an extraordinary record of success in litigation, in 2020, two district courts in the Third Circuit rejected a federal antitrust agency’s challenge to two different acquisitions between private parties.
The FTC and the Pennsylvania Attorney General sought to enjoin a merger between Thomas Jefferson University (Jefferson) and the Albert Einstein Healthcare Network (Einstein) until there was an administrative determination on whether the merger would violate Section 7 of the Clayton Act.[154] The Eastern District of Pennsylvania rejected this motion because the government failed to properly identify the geographic market at risk of anticompetitive effects should the merger proceed.[155]
Jefferson and Einstein are two of 13 provider systems providing general acute care (GAC) services that operate in southeastern Pennsylvania.[156] “GAC services include a broad cluster of medical, surgical, and diagnostic services that require an overnight hospital stay.”[157] According to economic analyses, healthcare providers face two stages of competition: (1) selection as an in-network provider by an insurer; and (2) selection by the members of an insurer’s plan for care.[158] The health insurance market in this region is “far more consolidated” with only four major health insurance companies, and thus, insurers have stronger bargaining power.[159] According to testimony, the largest of the four insurance companies in the region, Independence Blue Cross (IBC), has such a strong position that neither company can afford being out of IBC’s network.[160]
As the court explained, to succeed on an injunction, the government must show that a “substantial lessening of competition’ is ‘sufficiently probable and imminent.”[161] The government does not have to show that the proposed merger would violate Section 7, but rather that the proposed merger is likely to violate Section 7.[162] To make a prima facie case of a Section 7 violation, the government must propose the proper relevant market and show the anticompetitive effect from the proposed acquisition.[163] Defendants have the opportunity to rebut and then, if successfully rebutted, the burden of proof returns to the government.[164]
While the parties agreed that GAC services were a relevant product market, the court rejected the government’s identification of various geographic regions.[165] Properly selected markets must “correspond to the commercial realities of the industry” and must use the most relevant buyers to identify the parameters of that industry.[166] In this case, the court explained, the insurers, not the hospital patients, are the most relevant buyers, given that patients themselves are not the direct purchasers of healthcare.[167] In selecting this geographic area, the government must be able to show that the area is where an insurer “may rationally look for goods or services [it] seeks,” and then the government must show that a hypothetical monopolist in that area could impose a “small but significant non-transitory increase in price (SSNIP).”[168]
The government focused on patients instead of insurers to define the geographic market, relying predominantly on diversion ratios.[169] Although the government contended that the commercial realities and insurer’s involvement was “baked into the diversion numbers,” the court noted that diversion ratios “only capture insurer preferences . . . where . . . insurer decisions about which hospitals to include in their networks are aligned with patient decisions about where to seek care.”[170] Additionally, the court was unable to find a correlation between patient and insurer behavior to justify using diversion ratios because the insurers’ testimony on the potential correlation was not unanimous or unequivocal and was undercut by other evidence.[171]
In evaluating the testimony regarding whether there could be a post-transaction price increase on insurers, the court compared the evidence in this case to the evidence in Federal Trade Commission v. Penn State Hershey Medical Center (Penn State Hershey).[172] In Penn State Hershey, the Third Circuit reversed the district court’s denial of a preliminary injunction, even though the government had mainly presented statistical evidence based on patient behavior, because the government also had presented “extensive evidence showing that the insurers would have no choice but to accept a price increase.”[173] The extensive evidence included: (1) credible testimony from insurers that post-merger they could not market to employers without the merged hospital system; (2) evidence showing that at least one insurer was no longer viable when it excluded both of the merging hospitals; (3) testimony supporting the proposed geographic market area as distinct; and (4) testimony that other hospitals in the area were not suitable alternatives.[174]
However, here, the government’s evidence failed to reach the high bar set out in Penn State Hershey. First, there are more hospitals in a far smaller radius in Philadelphia when compared to the area in question and number of hospitals in Penn State Hershey.[175] Second, two of the four insurers failed to testify that the absence of both Jefferson and Einstein in their network pools would result in a price increase.[176] Third, the largest insurer for the area was not credible because its witness was motivated, not by antitrust concerns, but by concerns that the merger would make the joined hospital groups a “competitive threat in the insurance market.”[177] Fourth, while one of the insurance company witnesses indicated that they would pay higher rates, the court discounted his testimony because the record had already established that the company does not rely currently on these hospitals.[178]
Finally, the court also rejected an additional product market proposed by the FTC—inpatient acute rehabilitation services. However, because these services play only a “minor role in health systems’ operations and contracts,” the court rejected the FTC’s argument that an insurer could not offer a marketable health plan without Jefferson or Einstein.[179]
This case gives more insight into developing a prima facie case under Section 7 of the Clayton Act, with a focus on how to identify a relevant market. For healthcare-related mergers, it highlights the importance of selecting the correct relevant buyer (insurers not patients) in statistical analysis. But it also provides insights into how the proper market could still be identified through testimonial and other evidence, by comparing the record of Penn State Hershey with the record in this current case. Notably, the court, in viewing the record, considered the credibility of various third-party insurer witnesses, given the possibility of other motives underlying their testimony.[180]
§ 1.5.3 Acquisitions — United States v. Sabre Corp., 452 F. Supp. 3d 97 (D. Del.), vacated on mootness grounds, No. 20-1767, 2020 WL 4915824 (3d Cir. July 20, 2020)
The United States Department of Justice (DOJ) filed an expedited antitrust action against Sabre Corporation and Sabre GLBL (collectively, Sabre) and related defendants to enjoin their acquisition of Farelogix, Inc. (Fairlogix),[181] alleging that the transaction would violate Section 7 of the Clayton Act.[182] According to the DOJ, the acquisition would harm competition because Farelogix is an “innovative disruptor in the market for booking services,” which historically had been dominated by three players (including Sabre) that had tried to “stifle innovation.”[183] After an eight-day bench trial, the District Court of Delaware rejected the government’s arguments and refused to enjoin Sabre from acquiring Farelogix.[184]
Sabre is a large player in the airline travel industry boasting the largest U.S. global distribution system (GDS).[185] The GDS accounts for most of Sabre’s revenue through airline customer booking fees.[186] Additionally, Sabre offers information technology products for airlines including a passenger service system.[187] Farelogix, on the other hand, is a smaller company that offers information technology to airlines and other products relating to “distributing and merchandising airline content.”[188]
The district court concluded that the DOJ failed to establish a prima facie case under Section 7 of the Clayton Act and did not prove a reasonable probability of anticompetitive harm.[189] The court explained that the DOJ failed to establish a prima facie case because (1) Farelogix and Sabre did not compete as only Sabre was a two-sided platform and (2) the DOJ did not properly define relevant product or geographic markets. Moreover, it also failed to show a reasonable probability that the transaction would lessen competition.[190]
To establish a prima facie case, the government must define a relevant product and geographic market and demonstrate that the effects of the merger are likely to lessen competition.[191] Relying on a recent Second Circuit interpretation of the Supreme Court’s decision in Ohio v. American Express Co. (Amex), the District Court of Delaware determined that Sabre is not a competitor of Farelogix because Sabre is a two-sided platform that facilitates transactions between airlines and travel agencies whereas Farelogix only interacts with airlines and therefore is one-sided.[192] The district court rejected the DOJ’s attempts to distinguish Amex by suggesting that the Supreme Court precedent only applied to the credit card industry.[193] Similarly, the court was unpersuaded by the DOJ’s argument that limiting potential Section 7 violations to when two-sided companies acquire two-sided companies would give two-sided companies “carte blanche to buy any one-sided company.”[194] Rather, the court explained that the Amex rule would allow challenges to acquisition of one-sided companies, so long as the government could show that the transaction will harm competition “on both sides of the two-sided market.”[195] Here, however, the DOJ expert only looked at one side of the Sabre GDS, and the DOJ failed to produce evidence that any anticompetitive impact of the merger on the airline side of the Sabre platform would be so significant as to result in the two-sided platform becoming less competitive overall.[196]
In addition, the DOJ also failed to identify proper relevant product and geographic markets. The DOJ argued that “booking services” was the proper product market.[197] The court rejected this definition, opining that the DOJ improperly excluded other services that Sabre provided through its GDS. The government did not show that “booking services” generated separate demand from Sabre’s other services such that they to be their own relevant product market.[198] The court similarly did not accept the DOJ’s proposed geographic area of “U.S. point of sale.”[199] It explained that the relevant geographic area must be “where customers look to buy a seller’s products or services.” Farelogix’s customers are airlines located outside the United States, and it competes with foreign competitors to win bids. Sabre markets a direct connect product to airlines outside of the United States. The proposed geographic market, thus, was “at odds with commercial realities.”[200] By not defining proper geographic and product markets, DOJ failed to establish a prima facie case.[201]
Even if the government had properly defined markets, it failed to present evidence of a reasonable probability of anticompetitive harm.[202] The Third Circuit has previously held that a high market concentration can establish a prima facie case or a presumption of anticompetitive harm.[203] As such, the DOJ used the Herfindahl-Hirschman Index (HHI) market concentration measurements to support its theory of harm.[204] However, the DOJ expert’s calculations were flawed because he excluded airline.com, despite its competitive pressure on Sabre, and he misattributed sales by Sabre to Farelogix.[205] Once these errors were corrected, the numbers did not show a high post-acquisition market concentration, and so, the DOJ was not entitled to a presumption of anticompetitive harm.[206]
Without that presumption, the DOJ failed to prove that anticompetitive harm was likely. The DOJ also argued that there were barriers to entry that prevent adequate competition to Sabre post-acquisition and that the acquisition will harm competition or innovation.[207] The barriers to entry argument was quickly dismissed by the court, which pointed to “Farelogix’s vigorous competition with rival[s].”[208] Additionally, the court found that the merger was not designed to eliminate Farelogix and its platforms from the market or to stifle innovation, but rather to “integrate” Farelogix’s capabilities into Sabre’s own platform and that there was enough competition still to constrain Sabre’s ability to raise prices.[209] Therefore, the acquisition was not likely to harm competition or innovation.
Despite this win at the district court, Sabre and Farelogix ended up abandoning their deal after the U.K.’s Competition and Markets Authority challenged the acquisition.
In its decision, the district court carefully analyzed what constitutes a prima facie case under Section 7 of the Clayton Act. The case was particularly notable because the court found Sabre’s story—that Sabre did not view the new distribution capability (a capacity that Farelogix pioneered) as a threat, even when used for bypassing their global distribution system—as not credible.[210] Nevertheless, the court held that the DOJ was unable to meet their burden of proof to make a prima facie case because they failed to show competition between two “two-sided” platforms, they did not properly define the relevant markets, and they presented flawed market concentration calculations.[211]
§ 1.5.4 The Foreign Antitrust Trade Improvements Act
The Foreign Trade Antitrust Improvements Act (FTAIA),[212] enacted to provide greater clarity on the extraterritorial reach of the Sherman Act, instead continues to generate confusion. In 2004, antitrust practitioners looked to the Supreme Court’s decision in F. Hoffman—LaRoche Ltd. v. Empagran, S.A. (Empagran I) to address the complex and confusing statutory language of the FTAIA.[213] In pertinent part, the FTAIA provides:
[The Sherman Act] shall not apply to conduct involving trade or commerce (other than import trade or import commerce) with foreign nations unless:
(1) such conduct has a direct, substantial, and reasonably foreseeable effect;
(A) on trade or commerce which is not trade or commerce with foreign nations, or on import trade or import commerce with foreign nations; or
(B) on export trade or export commerce with foreign nations, of a person engaged in such trade or commerce in the United States; and
(2) such effect gives rise to a claim under the provisions of [the Sherman Act] …
The FTAIA establishes a general rule placing all (non-import) activity involving foreign commerce outside the Sherman Act’s reach. It then brings such conduct back within the Sherman Act’s reach provided that the conduct (1) sufficiently affects U.S. commerce (known as the “direct effect test”) and (2) gives rise to plaintiffs’ antitrust claim.
Jurisdictional or Substantive Element?
Until recently, the FTAIA was treated as a jurisdictional statute, which needs to be satisfied for an antitrust claim to be actionable under U.S. law. This was important because it allowed litigants the opportunity to challenge plaintiffs’ ability to satisfy the FTAIA standards earlier in a case than if the FTAIA requirements were deemed an element of the substantive antitrust claim.
After the Supreme Court decision in Arbaugh v. Y&H Corp., however, the trend has shifted. The question presented in Arbaugh was whether Title VII’s definition of employer to include only those having firms with fifteen or more employees was a requirement for the exercise of subject matter jurisdiction or was simply an element of plaintiff’s case.[214] The Court noted that courts had been imprecise in their use of the term jurisdiction and have been using it to describe a variety of doctrines that operate to bar a plaintiff’s suit.[215] The Court further explained that “[s]ubject matter jurisdiction in federal-question cases is sometimes erroneously conflated with a plaintiff’s need and ability to prove defendant bound by the federal law asserted as the predicate for relief—a merits-related determination.”[216] The Court held that the number of employees was not a jurisdictional requirement for a Title VII claim and expressed its desire to avoid “drive-by jurisdictional rulings” that have “no precedential effect” on the jurisdictional question.[217]
The Court established a test for deciding whether something is jurisdictional: “If the Legislature clearly states that a threshold limitation on a statute’s scope shall count as jurisdictional, then courts and litigants will be duly instructed and will not be left to wrestle with the issue. But when Congress does not rank a statutory limitation on coverage as jurisdictional, courts should treat the restriction as nonjurisdictional in character.”[218] Following Arbaugh, a number of courts, including the Second, Third, Seventh, and Ninth Circuits, have considered the question of whether the FTAIA is a substantive element of a Sherman Act claim or jurisdictional and each has determined that it is substantive.[219]
Extraterritorial Reach
With respect to the extraterritorial reach of the Sherman Act, in Empagran I, the Supreme Court determined that the “domestic injury exception” of the FTAIA did not provide a right to sue under the Sherman Act, to foreign plaintiffs in circumstances where the anticompetitive conduct “significantly and adversely affects both customers outside the United States and customers within the United States, but the adverse foreign effect is independent of any adverse domestic effect.”[220] Following that decision, the D.C. Circuit’s Empagran v. F. Hoffman-LaRoche Ltd. (Empagran II)[221] clarified that the domestic injury exception to the FTAIA requires is not triggered by “but for” causation. Rather, in order to sue under the domestic injury exception, the foreign plaintiff must prove that it is the domestic effects of a defendant’s anticompetitive conduct rather than the anticompetitive conduct itself, which gives rise to the plaintiff’s foreign injuries.
Since the Supreme Court’s ruling and the subsequent clarification by the D.C. Circuit, there have been a number of cases dealing with the FTAIA and its “domestic injury exception.” There was a string of cases that followed the Empagran II direct cause requirement and, thereby significantly restricted the ability of a foreign plaintiff to seek redress in the United States for anticompetitive conduct where the impact is felt only abroad.
Although 2020 was a relatively quiet year with respect to the FTAIA, below is a discussion of a case that tackled the question of whether U.S. courts have jurisdiction over antitrust claims based on a global patent licensing program under the FTAIA.
Continental Automotive Systems, Inc. v. Avanci, LLC, — F.Supp.3d —-2020 WL 5627224 (N.D. Tex. Sept. 10, 2020)
The U.S. District Court of the Northern District of Texas considered its jurisdiction over certain antitrust claims under the Foreign Trade Antitrust Improvement Act (the FTAIA). Plaintiff Continental Automotive Systems, Inc., manufactures telematics control units (TCUs) for motor vehicles. The motor vehicle manufacturers use the TCUs, including a baseboard processor in a network access device to provide their cars various functionalities, including cellular connectivity. To connect to cellular networks, the TCUs. To access second generation (2G), third generation (3G), and fourth generation (4G) cellular networks, the baseboard processors, network access devices, and TCUs must comply with standards set by standard setting organizations (SSOs). Plaintiff also alleged that Defendants Nokia Corporation, Nokia of America Corporation, Nokia Solutions and Networks US LLC, Nokia Solutions and Networks Oy, Nokia Technologies Oy (collectively, Nokia Defendants), Conversant Wireless Licensing SARL (Conversant), Optis UP Holdings, LLC, Optis Cellular Technology, LLC, Optis Wireless Technology, LLC (collectively, Optis Defendants), and Sharp Corporation (Sharp) (collectively, the Licensor Defendants) all own Standard Essential Patents (SEPs) for 2G, 3G, and 4G connectivity required in order to comply with SSOs’ established standards, and that as a result, the Licensor Defendants were obligated to license the relevant SEPs to the plaintiff on fair reasonable and non-discriminatory (FRAND) terms and conditions. Plaintiff further asserted that these FRAND terms should reflect the ex-ante value of the SEP, excluding its value obtained solely from its inclusion in the standard.[222]
The Licensor Defendants also pooled their SEPs and used the same licensing agent, offering their patents in a pooled arrangement. Through this pooling arrangement, the plaintiff alleged, the Licensor Defendants implemented an unlawful agreement to grant OEMs license to the SEPs only on non-FRAND terms. The OEMs, in turn, could or would seek indemnification from the plaintiff.[223] In addition to alleged harm suffered as a result of such indemnification, the plaintiff claimed that it was injured by its inability to obtain the SEP licenses needed for its TCUs from the Licensor Defendants on FRAND terms.[224]
The court held that the FTAIA limits subject matter jurisdiction over antitrust claims involving trade or commerce with foreign nations, unless it pertains to imports or the conduct has a direct, substantial, and reasonably foreseeable effect on U.S. domestic, import, or export trade or commerce, where that effect gives rise to the antitrust claims. Because the plaintiff used the SEPs to manufacture its TCUs in the United States, the court concluded that plaintiff’s allegations related to the import of SEP licenses for foreign patents, and the FTAIA’s limitations on subject matter jurisdiction would not bar Plaintiff’s claims.[225]
Separately, the court looked more broadly at the defendants’ SEP licensing program and found that even if it did not involve import trade, it would still satisfy the FTAIA’s jurisdictional requirements. The plaintiff alleged that the defendants had obligations to US SSOs and owed FRAND obligations to US entities seeking to license SEPs. Because these obligations are related to global licensing and product markets, which necessarily included US markets, the plaintiff alleges direct, substantial, and reasonably foreseeable effects in the U.S. that gave rise to the plaintiff’s antitrust claims. Therefore, the court denied the defendants’ motion to dismiss plaintiff’s claims on the basis of lack of subject matter jurisdiction.[226]
§ 1.5.5 Remedies – Federal Trade Commission v. AbbVie Inc., 976 F.3d 327 (3d Cir. 2020)
The Supreme Court granted certiorari on July 9, 2020, to decide the most significant challenge to the FTC’s authority in decades.[227] The Supreme Court must decide whether to affirm or reverse AMG Capital Management, LLC, et al. v. Federal Trade Commission,[228] where the Ninth Circuit held that that the FTC has the authority to seek restitution under Section 13(b) of the Federal Trade Commission Act (“FTC Act”).[229]
The AMG Capital Management case involved a series of companies controlled by Scott Tucker that offered high-interest, short term loans. In 2012, the FTC filed suit against Tucker alleging that he violated Section 5 of the FTC Act’s prohibition against “unfair or deceptive acts or practices” because his loan notes did not disclose the terms that Tucker actually enforced. The FTC asked the court to “permanently enjoin Tucker from engaging in consumer lending and to order him to disgorge ill-gotten-monies.” The district court ultimately determined that Tucker was required to pay $1.27 billion. Tucker appealed to the Ninth Circuit and argued that the district court “did not have the power to order equitable monetary relief under §13(b).” The Ninth Circuit acknowledged that “Tucker’s argument has some force,” but found that prior precedent supported the FTC’s position.
Although most circuits that have examined the issue, including the Ninth Circuit, held that the FTC has the authority to seek monetary relief under Section 13(b), in 2019 the Third and Seventh Circuits ruled against the FTC, creating a split among the circuits. The circuit decisions Federal Trade Commission v. Shire Viropharma, Inc.[230] and Federal Trade Commission v. Credit Bureau Center, LLC[231] specifically limited the FTC’s enforcement toolkit, leading the trend toward narrowing the implied statutory remedies available to federal agencies. Although the FTC may pursue administrative remedies that have traditionally required expending more resources and yielded smaller rewards, its preferred enforcement route—via FTC Act section 13(b)—allows the agency to bypass the administrative process. If the FTC believes anyone is violating, or is about to violate an FTC-enforced law, the FTC may immediately seek a temporary restraining order or temporary or permanent injunction in the courts.[232] A temporary restraining order or injunction will dissolve if the FTC does not file an administrative complaint within 20 days. However, “in proper cases[,] the [FTC] may seek, and . . . the court may issue, a permanent injunction.”[233]
Section 13(b) has been a significant tool and a mainstay of the FTC’s consumer protection program. However, until the 1980s, it was only used to bolster administrative proceedings. Since, however, the FTC has argued, and circuit courts have agreed, that by invoking the district court’s equitable jurisdiction under section 13(b), the district court has access to, and may use, a full suite of equitable remedies, including restitution. An implied restitution remedy allowed the FTC to collect over $17.5 billion through section 13(b) proceedings from 2016, 2017, and 2018 alone—far outpacing the funds obtained through administrative civil penalties.
In Shire Viropharma, issued in early 2019, the Third Circuit concluded that section 13(b) only permits the FTC to halt ongoing or imminent harms, and does not allow the FTC to sue for past conduct, even if it believes that conduct has “a reasonable likelihood” of recurring. The Third Circuit side-stepped the remedies question tackled by the Seventh Circuit in Credit Bureau Center, but its decision strongly suggested that section 13(b) permits the FTC to obtain only injunctive relief (and nothing more) to address ongoing or imminent conduct.
The Seventh Circuit’s decision in Credit Bureau Center more clearly undermines the FTC’s section 13(b) authority. In 2017, the FTC brought a suit against Credit Bureau Center and its sole operator and owner, for duping customers who believed they were receiving “free” credit-related information into subscribing to a $29.94 monthly membership. Defendants also enlisted the help of an agent who funneled unwitting consumers to defendants’ website by advertising fake rental properties and directing applicants to obtain a “free” credit report from defendants. The district court entered a permanent injunction and ordered defendants to pay more than $5 million in restitution.
On appeal, defendants conceded liability but argued section 13(b)’s reference to preliminary and permanent injunctions—and no other remedy—meant the FTC was prohibited from seeking any more relief than the statute explicitly authorized. In other words, because section 13(b) does not say a district court can require restitution, the FTC cannot seek it under section 13(b). The Seventh Circuit agreed, reversing decades of precedent and creating tension with eight sister circuits, most of whom had tacitly agreed that the FTC’s section 13(b) remedies include restitution. The Seventh Circuit explained that restitution is an inherently retrospective remedy because it orders the return of unlawful, past gains. Injunctions, on the other hand, halt ongoing or prevent imminent harms. The appellate court reasoned that if section 13(b), which only provides for injunctive relief, could be used to recoup restitution for past harms, then restitution would be conditioned on proof of ongoing or imminent conduct. According to the Seventh Circuit, such a reading was illogical.
Moreover, the court continued, Congress provided the FTC with avenues to seek equitable and civil penalties in actions pursuant to section 5 of the FTC Act. Both backward-looking enforcement provisions in section 5 explicitly authorize “the refund of money,” and when a person violates a final order, a district court can “grant mandatory injunctions and such other and further equitable relief as they deem appropriate.” If the FTC could use section 13(b) to obtain restitution without navigating section 5’s administrative process, then, the Seventh Circuit reasoned, it would have been unnecessary for Congress to enact section 5. By reading section 13(b) prospectively, the court afforded independent significance to each of the FTC’s enforcement tools.[234]
In 2020, the Third Circuit directly addressed whether the FTC had a right to seek disgorgement under section 13(b) in Federal Trade Commission v. AbbVie Inc.[235] The case began in 2014 when the FTC sued AbbVie Inc. and other pharmaceutical manufacturers, alleging that the patent owners[236] for the testosterone replacement therapy AndroGel impermissibly maintained their AndroGel monopoly using sham litigations and anticompetitive reverse-payment agreements. Specifically, the FTC contended that AbbVie and Besins brought sham patent infringement lawsuits against competitors Teva Pharmaceuticals USA, Inc. (Teva) and Perrigo Company (Perrigo) that had filed FDA applications for generic testosterone gels. AbbVie settled the litigations by agreeing to license a generic version of AndroGel to Teva and Perrigo in three years (which was still six years prior to the expiration of the patent). In addition, with the Teva settlement, AbbVie also agreed to grant Teva a license to the generic version of cholesterol drug TriCor.[237]
Pursuant to section 13(b), the FTC asked the district court to enjoin defendants from engaging in such conduct in the future and requested other equitable relief, including restitution and disgorgement.[238] Through numerous rulings and a bench trial, the district court dismissed the FTC’s reverse-payment claim, but it ruled in favor of the FTC on the sham litigation theory. Although the district court denied the request for an injunction, it awarded the FTC $484 million in disgorgement of ill-gotten gains. Both the FTC and defendants appealed.[239] The Third Circuit affirmed in part and reversed in part. It determined that that the district court erred in dismissing the reverse-payment theory and in concluding the litigation against Teva was a sham. It also erred in awarding disgorgement. However, the Third Circuit affirmed the conclusion that the Perrigo litigation was a sham, that defendants had monopoly power, and that injunctive relief should be denied.[240]
Reverse-payment settlements, also known as “pay-for-delay” agreements, occur when a patent holder sues an alleged infringer and then pays the alleged infringer to end the litigation. These settlement agreements can be anticompetitive if they permit a brand name pharmaceutical company to split monopoly profits with a generic drug supplier in exchange for the generic delaying market entry.[241] On this issue, the Third Circuit overruled the district court’s dismissal of the pay-for-delay theory and concluded that the FTC plausibly alleged an anticompetitive reverse-payment agreement.[242]
First, the FTC plausibly alleged that AbbVie and Besins brought sham patent litigations against Perrigo and Teva, which triggered a 30-month stay to the FDA’s approval process for the generic versions of AndroGel. The FTC then alleged that both AbbVie and Teva believed that Teva would win the lawsuit, so AbbVie approached Teva to enter a settlement. Teva agreed not to sell a generic AndroGel for three years in exchange for AbbVie authorizing Teva to sell a generic version of TriCor for four years with AbbVie supplying this drug to Teva at a percentage above production cost and a royalty.[243]
Second, the FTC alleged that the payment was “plausibly large.” Teva was struggling to get FDA approval for its generic version of TriCor, so with the authorization for and supply of the product from AbbVie, Teva could capitalize on the exclusivity window given to the first generic in the market. Teva estimated its net sales for TriCor would be $175 million over the four year window. TriCor’s estimated net sales far exceeded likely litigation costs for the patent infringement suit and the money Teva would have made marketing AndroGel.[244] Third, the FTC plausibly alleged that the payment was “unjustified” because the TriCor deal cannot be explained as an independent business arrangement from AbbVie’s perspective. Indeed, the deal increased competition for TriCor, and the royalty terms for TriCor in the Teva deal were worse for AbbVie than royalties received through other supply agreements. According to the FTC, AbbVie expected to lose $100 million in TriCor revenue, and this loss would not be offset by the royalties from Teva.[245] Finally, the FTC plausibly alleged that anticompetitive effects would outweigh any procompetitive results of the TriCor deal because the $100 million AbbVie would lose in TriCor sales was a small fraction of the billions of dollars in AndroGel revenues AbbVie protected by delaying generic competition for the drug for three years.[246]
As to the sham litigation claims, the Third Circuit upheld the district court’s ruling that the Perrigo litigation was a sham, but the appellate court reversed the lower court’s decision that the Teva lawsuit was so. Pursuant to the Noerr-Pennington doctrine, “those who petition the government for redress are generally immune from antitrust liability,” including those that bring federal lawsuits.[247] However, the immunity is not absolute, and those that bring sham lawsuits to interfere with the business relationships of competitors are not protected. For this sham exception to apply, the lawsuit first must be objectively baseless, meaning no reasonable litigant could expect success on the merits. If objectively baseless, then a court examines the litigant’s subjective motivation to determine whether the lawsuit conceals an attempt by the litigant to use the government process to interfere with a competitor.[248]
With respect to the Teva litigation, the Third Circuit determined that the infringement suit was not objectiveless baseless as prosecution history estoppel did not apply.[249] The defendants were not estopped from bringing the patent prosecution claim because, although the defendants’ October 2001 amendment to the AndroGel patent did not include the penetration agent in Teva’s generic formulation, the defendants drafted the amendment in response to a different penetration agent and would not have been expected to draft an amendment encompassing the agent used by Teva.[250]
Conversely, the Third Circuit concluded that the district did not err in ruling that the Perrigo lawsuit was a sham. First, the litigation was objectively baseless because the patent’s prosecution history estopped the defendants from claiming infringement. A December 2001 amendment to the patent narrowed the list of penetration agents, removing the agent used by Perrigo. Second, the subjective motivation prong also was met. The defendants had experienced patent counsel that knew the patent litigation would not succeed, while they also knew that they would benefit financially if Perrigo’s generic application was delayed. Therefore, the district court’s conclusion that defendants’ motivation was to delay generic entry, as opposed to asserting a patent in good faith, was not in error.[251]
The Third Circuit also concluded that the district court did not err in ruling that defendants had monopoly power for transdermal testosterone replacement therapies (“TTRT”). For the FTC to succeed on its monopolization claim, it had to show that defendants had monopoly power in a relevant market. “Monopoly power is the ability to control prices and exclude competition in a given market.”[252] The appellate tribunal first concluded that the lower court did not err in excluding injectable therapies from the relevant product market definition because evidence showed that AndroGel was priced much higher than injectables, that defendants did not price AndroGel against injectables, and that defendants did not consider injectable products to compete with AndorGel. The district court also did not err in finding that AndroGel had a dominant share of TTRT and that there were significant barriers to entry to this market because it considered market share data, the durability of AndroGel’s share, consumer demand, the size and strength of AndroGel’s competitors, and AndroGel’s pricing trends and practices. The evidence of monopoly power included AndroGel being the most widely prescribed TTRT, AndroGel’s share being above 60 percent prior to Perrigo’s generic entering the market, AndroGel’s profit margin being 65 percent, AndroGel’s prices increasing from 2011-2014, and the three brand-name TTRT products that entered the market from 2011-2014 having a very low share.[253]
As to remedies, the Third Circuit upheld the lower court’s ruling denying an injunction. To obtain an injunction, the FTC needed to show “a cognizable danger of recurrent violation, something more than the mere possibility which serves to keep the case alive.”[254] The district court did not abuse its discretion in determining that defendants reengaging in sham litigation was only a mere possibility. The FTC did not establish that defendants had a pattern or practice of filing sham litigations and did not present any evidence that any other patent infringement litigations as to the AndroGel patent since 2011were shams. In addition, generics had been on the market for three years. Finally, with the proposed injunction, the FTC sought to limit defendants’ ability to file infringement suits with respect to any patent, and the lower court concluded this was too broad.[255]
Notably, the Third Circuit reversed the district court’s $448 million disgorgement award, concluding that court’s lack the power to order disgorgement for claims brought under Section 13(b) of the FTC Act.[256] First, the text of section 13(b) authorizes courts to enjoin violators, but it is silent on disgorgement, which is a form of restitution not injunctive relief. Second, the statute’s language states that to bring a suit the FTC must believe that an entity or individual is “violating, or is about to violate,” an antitrust law. Given this language, the Third Circuit reasoned that providing for injunctive relief made sense, given that injunctions restrict future action. On the other hand, disgorgement dispossesses a violator of past gains—not for profits from ongoing or impending conduct. Third, other sections of the FTC Act specifically list out the forms of relief that can be granted; other forms of equitable remedies are not assumed to be a part of injunctive relief.
[1] The chapter was prepared with the invaluable and excellent assistance of Megan Morley, Associate at Troutman Pepper Hamilton Sanders LLP.
[26]Id. at 190. Other requirements of class certification under Federal Rule of Civil Procedure 23(a) and (b) include: “(1) the class must be so numerous that joinder of all members is impracticable (numerosity); (2) there must be questions of law or fact common to the class (commonality); (3) the claims or defenses of the representative parties must be typical of the claims or defenses of the class (typicality); [] (4) the named plaintiffs must fairly and adequately protect the interests of the class (adequacy of representation, or simply adequacy)…and (ii) the class action is the superior method for adjudication (superiority).” Id.
[27]Id. at 190-91 (citing In re Hydrogen Peroxide Antitrust Litig., 552 F.3d 305, 309 (3d Cir. 2009)).
[43]Id. (According to the plaintiffs, Reckitt allegedly: “(1) engaged in a widespread campaign falsely disparaging Suboxone tablets as more dangerous to children and more prone to abuse; (2) publicly announced that it would withdraw Suboxone tablets from the market due to these safety concerns; (3) ended its Suboxone tablet rebate contracts with managed care organizations in favor of Suboxone film rebate contracts; (4) increased tablet prices above film prices; (5) withdrew brand Suboxone tablets from the market; and (6) impeded and delayed the market entry of generic Suboxone tablets by manipulating the FDA’s Risk Evaluation and Mitigation Strategy (“REMS”) process and filing a baseless citizen petition.”).
[54]Id. (citing In re Cmty. Bank of N. Va., 622 F.3d 275, 292 (3d Cir. 2010) (quoting Greenfield v. Villager Indus., Inc., 483 F.2d 824, 832 n.9 (3d Cir. 1973))).
[128]International Tel. & Tel. Corp., 104 F.T.C. at 417 (quoting E. Kitner, A Robinson-Patman Primer 35 (2d ed. 1979)); accord. L. Sullivan, Handbook of the Law of Antitrust 679-90 (1977).
[129] 2020 WL 6384303, at *1 (D. Kan Oct. 30, 2020).
[159]Id. at *5 (According to a witness, insurance providers “especially the big ones, United, Aetna, IBC, of course, and Cigna, they could just say fine, we won’t [keep a provider in-network]’ and not suffer negative repercussions.”)
[171]Id. at *14-15. (comparing this situation to Fed. Trade Comm’n v. Advocate Health Care, No. 15-11473, 2017 WL 1022015, at *4 (N.D. Ill. Mar. 16, 2017), where the Northern Illinois District Court similarly rejected the notion that the patients (instead of the insurers) were the most relevant buyers; nevertheless the court ultimately found a prima facie case because of unequivocal testimony from insurance executives that they “had to include at least one of the merging hospitals to offer a product marketable to employers”).
[192]Id. at 135-37 (citing Ohio v. Am. Express Co., 138 S. Ct. 2274, 2287 (2018)) (discussing In US Airways v. Sabre Holdings Corp., 938 F.3d 43, 48-49 (2d Cir. 2019)).
[204] “The HHI is calculated by summing the squares of the individual firms’ market shares. In determining whether the HHI demonstrates a high market concentration, we consider both the post-merger HHI number and the increase in the HHI resulting from the merger. A post-merger market with a HHI above 2,500 is classified as “highly concentrated,” and a merger that increases the HHI by more than 200 points is presumed to be likely to enhance market power.” Id. (quoting FTC v. Penn State Hershey Med. Ctr., 838 F.3d 327, 346-47 (3d Cir. 2016).
[218] Arbaugh, 546 U.S. at 515-16. The Supreme Court also applied the clear statement rule and determined that statutory requirements were substantive instead of jurisdictional. Morrison v. Nat’l Austl. Bank, Ltd., 561 U.S. 247, 254 (2010) (extraterritorial reach of § 10(b) of the Securities and Exchange Act of 1934); Reed Elsevier, Inc. v. Muchnick, 599 U.S. 154, 160-66 (2010) (requirement under Copyright Act).
[219]U.S. v. Hsiung, 758 F.3d 10,74 (9th Cir. 2014) (substantive); Lotes Co. v. Hon Hai Precision Industry Co., 753 F.3d 395 (2nd Cir. 2014) (substantive); Animal Sci. Prods., Inc. v. China Minmetals (3d Cir. 2011) (substantive); Minn-Chem v. Agrium, Inc., 683 F.3d 845 (7th Cir. 2012) (en banc) (substantive).
[224] Although the court held that the alleged harm flowing from the indemnification was too speculative to serve as a basis for the plaintiff’s antitrust claim, it concluded that the harm from the alleged refusal by four of the five defendants to license SEPs on FRAND terms was sufficiently direct harm to satisfy standing requirements. Id. at *726-27.
[227]AMG Capital Management, LLC, et al. v. Federal Trade Commission, No. 19-508, Petition for Writ of Certiorari filed by AMG Capital Management, LLC; Black Creek Capital Corporation; Broadmoor Capital Partners, LLC; Level 5 Motorsports, LLC; Scott A. Tucker, Park 269 LLC; and Kim C. Tucker (Oct. 18, 2019), available at https://www.supremecourt.gov/DocketPDF/19/19‑508/119538/20191018161100345_Tucker%20Cert%20Petition%20PDFA.pdf.
[234] The Seventh Circuit’s logic was not limited to FTC-specific principles. It also relied on the Supreme Court’s refusal to find implied statutory remedies where Congress did not provide them. In Meghrig v. KFC Western, Inc., the Supreme Court held that an environmental statute in which Congress permitted private plaintiffs to obtain injunctions against toxic-waste handlers did not provide an implied restitution remedy. Similarly, the Seventh Circuit reasoned that because Congress did not list restitution among the section 13(b) remedies, the FTC was foreclosed from seeking it.
[236] Defendants AbbVie Inc. (“AbbVie”) and Besins Healthcare, Inc. (“Besins”) own the patent relating to AndroGel. Initially, defendant Unimed Pharmaceuticals LLC (“Unimed”) and Besins jointly filed for the AndroGel patent. In 1999, Solvay acquired Unimed, and then defendant Abbot Laboratories (“Abbott”) purchased Solvay in 2010. In 2013, Abbott split into Abbott and AbbVie, with AbbVie taking the pharmaceutical business (including AndroGel). For ease of discussion, Unimed, Abbott, and AbbVie are referred to as “AbbVie.” Id. at 341.
[249]Id. at 364-66. “[P]rosecution history estoppel…applies when the patentee originally claimed the subject matter alleged to infringe but then narrowed the claim in response to a rejection…The patentee may not argue that the surrendered territory comprised unforeseen subject matter that should be deemed equivalent to the literal claims of the issued patent.” Id. at 362 (citing Festo Corp. v. Shoketsu Kinzoku Kogyo Kabushiki Co., 535 U.S. 722, 733-34 (2002)).
Most limited liability company operating agreements contain provisions that address transfers of interests by the LLC members.[1] In the absence of specific provisions in an operating agreement, statutory defaults will apply. In privately held companies, transfers are often severely restricted by governing law, and sometimes prohibited altogether. LLC statutes commonly permit transfers of economic interests (i.e., the right to receive allocations and distributions), but not governance rights (e.g., voting, access to information). The bifurcation of LLC interests between economic rights and governance rights can, over time, tend to concentrate management authority in the person(s) who still possess governance rights, even though the person(s) represent only a minority of the economic interests in the LLC at present.
To address this tension, operating agreements often contain so-called “buy-sell” provisions to facilitate orderly transfers of economic interests and ensure a reasonable level of congruity between ownership of economic interests in the LLC and its governance. Sometimes these provisions are designed to mimic an unrestricted market dynamic in which capital can be efficiently deployed and property rights easily alienated. More often than not, however, the provisions contain cumbersome processes and ambiguous legal terms which are far removed from the goal of facilitating transfers at a price “a willing buyer would pay a willing seller.”
There are five key topics that counsel should consider when drafting buy-sell provisions:
the events which trigger buy-sell rights (including deadlock),
valuation of the interest,
the form of transaction and payment terms,
the means for resolving disputes regarding value, process, or both, and
tax consequences.
Triggering Events. Triggering events vary greatly based upon the nature of the LLC’s business. For example, service partnerships in which all members agree to devote substantially all of their time and attention typically list buy-sell triggers that include death, disability, resignation, and retirement. On the other hand, an LLC organized solely as a passive real estate holding company under third party management is likely to have a very limited set of triggering events. Where management authority is divided (either generally or with respect to approval of material transactions) in a manner that could result in deadlock, the parties may choose to include buy-sell provisions as a method for breaking (or superseding) the deadlock.
Valuation of LLC Interests. The basis for valuing LLC interests generally falls into the following three categories: the Market-Based approach, the Income-Based approach, and the Asset-Based approach. Some agreements reference a (seemingly) objective standard such as “fair value,” “fair market value,” or “book value;” and some go the extra step of describing the person responsible for making the determination (e.g., the company’s accountant, a panel of appraisers, or a third-party independent valuation firm). Other agreements use a detailed formulaic approach based on some multiple of revenues, earnings, or both. Finally, some simply reference the value as determined by an outside expert. Among the issues often neglected in a buy-sell agreement are the impact of changed market conditions and company circumstances, extraordinary events (especially those that result in anomalous operating results), the applicability of valuation discounts (whether at the enterprise or equity owner level), or the relationship of the valuation to the amount of available insurance. For example, in today’s context, market conditions, company circumstances and extraordinary events arising from the COVID-19 pandemic and its aftermath may be relevant valuation factors. The parties also should consider the impact of value determinations made in the context of a buy-sell transaction on subsequent equity-based transactions, such as the grant of profits interest or options.
Transaction Structure and Terms. Buy-sell transactions can be structured as cross-purchase transactions between or among equity owners, entity purchase transactions, or a combination of the two. The structure of the transaction not only has important tax implications, but it can also significantly impact ownership ratios and the resulting governance of the LLC. In certain circumstances, transactions can be funded with insurance. In others, a long-term payout may be required to ensure the soundness of the entity. The agreement must consider release from debt obligations and other liabilities (especially those taken into account in the valuation of the enterprise); and any cash waterfalls or profits interests (with corresponding value hurdles). Finally, the parties may want to address the possibility of a clawback in favor of the selling equity holder in the context of a future sale or other change in control transaction consummated within a defined window following the buy-sell transaction.
Dispute Resolution. Buy-sell transactions often generate disagreement – on value, on terms, on structure, and any other issue that parties can contest. This is particularly true when the transaction has been precipitated by alleged oppressive or other improper conduct. The success of a buy-sell agreement is highly dependent on the parties’ (mutual) perception of fairness and willingness to share information which may be perceived to be relevant to value. To that end, engagement of a competent neutral under well-defined conditions can help ensure a speedy end to potentially intractable disputes – especially if the agreement specifies the requisite background and qualifications of the neutral. If parties agree to a good process up front, they can eliminate (or at least minimize) months- or years-long battles over selection of mediators, arbitrators, appraisers and other experts, access to information, and the allocation of costs of the process itself.[2]
During the COVID-19 pandemic, courts and counsel have increasingly relied on mediation in civil cases. In fact, a new ABA study comments that for civil cases many “judges, plaintiff attorneys and defense attorneys agree that mediation is the fairest way to resolve cases.”[3] In the context of business valuation disputes, mediation presents an opportunity to implement an innovative (and cost-effective) approach in which an independent valuation expert is jointly retained by the disputing parties to serve as a neutral expert advisor to the mediator.
Tax Implications. A buy-sell transaction is in essence a mini-acquisition, and like any other acquisition, the structure of the transaction will dictate its tax consequences for both the buyer and seller (e.g., whether the buy-out will be funded with pre-tax or post-tax dollars, whether the buyer will get a basis step-up in the entity assets or just its interest the acquired equity, etc.). Tax consequences depend on both the structure of the transaction and the tax classification of the entity itself. It is possible for the parties to agree up front to standard deal terms – or at least on a process to deviate from those terms so long as the after-tax position of the parties is largely preserved. For entities taxed as partnerships, the agreement must also consider so-called “hot assets”, the impact of release from debt, the availability of Section 754 elections, and the taxation of periodic payments (especially those that are based on the future performance of the company, tied to subsequent employment or service obligations, or are open-ended in amount). Lastly, the “new” partnership audit rules in effect for 2018 and subsequent years must be considered, as standard release language in buy-sell agreements may operate to shift pre-closing tax risks of the seller to the buyer.
Buy-sell agreements are a challenge – especially for clients who resist the reality that nothing ever stays the same. For the alert practitioner, they also present an opportunity to deliver real value, even if its impact may not be realized until well into the future.
[1] Daniel J. Sheridan, Esq., Partner, Potomac Law Group, PLLC; Elizabeth Fialkowski Stieff, Esq., Associate, Venable LLP; Mario A. Richards, Esq., Associate, Latham & Watkins, LLP; and John Levitske, Senior Managing Director, Disputes & Economics – Valuation & Accounting, Ankura Consulting Group, LLC. Ankura is not a law firm and cannot provide legal advice. This topic addressed in this article was the subject of a presentation by the authors at the 2020 LLC Institute sponsored by the ABA Business Law Section Committee on LLCs, Partnerships and Unincorporated Entities.
[2]SeeWho Decides Disputed Valuation Under LLC Agreement’s Buy-Out Provision: Arbitrator or Appraiser? in New York Business Divorce (Blog Post, February 15, 2021)
Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. One Financial Center, Boston, MA 02111 +1.617.239.8427 [email protected]
Steve Ganis
Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, P.C. One Financial Center, Boston, MA 02111 +1.617.348.1672 [email protected]
§ 1.1 Introduction
The volumes of final judicial and enforcement actions decreased somewhat in 2020 due to disruptions associated with the global coronavirus pandemic. As in previous years, a significant amount of financial institutions’ enforcement litigation that established important precedents was settled, due in part to the difficulties associated with disputing cases brought by one’s regulator. Still, there were some very important cases, including enforcement actions imposing record monetary penalties. Key themes of 2020’s financial institutions’ litigation include cases arising in alleged failures by all types of financial institutions to address suspicious activities by institutional and retail customers. We summarize instances in which a banking official, broker-dealers, a futures commission merchant, and a cryptocurrency money transmitter all allegedly failed to detect and report suspicious activity and agreed to significant fines. Another case holds an institutional broker-dealer responsible for providing direct market access to other broker-dealers that operated alternative trading systems and allegedly conducted a wide range of market manipulation schemes. We also discuss the continuation in 2020 of sales practice-related cases centering on special investor protection issues for more complex retail investment products like variable annuities and unit investment trusts. We hope you find this summary of key cases on financial institutions’ legal and regulatory requirements helpful and welcome any feedback.
§ 1.2 Banking Institutions
In the Matter of Michael LaFontaine, 2020-01, U.S. Department of the Treasury Financial Crimes Enforcement Network (Feb. 26, 2020)
Michael LaFontaine, the former Chief Operational Risk Officer at U.S. Bank National Association (“U.S. Bank”), accepted a fine from the Financial Crime Enforcement Network (“FinCEN”) in the amount of $450,000 in connection with his role in anti-money laundering (“AML”) violations committed by U.S. Bank. FinCEN found that, while Mr. LaFontaine was in charge of U.S. Bank’s AML compliance function, the bank improperly capped the number of alerts generated by its automated transaction monitoring system and failed to adequately staff the Bank Secrecy Act (“BSA”) compliance function. This matter is of interest because FinCEN placed weight on the fact that a separate institution, Wachovia Bank, had previously been fined by FinCEN for similar conduct, and Mr. LaFontaine “should have known based on his position the relevance of the Wachovia action to U.S. Bank’s practices or conducted further diligence to make an appropriate determination.” In essence, individuals responsible for AML compliance must be aware of regulatory actions generally in the industry. Further, the targeting of the individual executive starkly reminds the industry that AML suspicious activity monitoring parameters must be set based on actual AML risks, not arbitrary volume limits, and that suspicious transaction volumes, not desired resource expenditure levels, must dictate the amount of suspicious activity monitoring and investigation a financial institution conducts. Mr. LaFontaine admitted to all facts in consenting to the $450,000 penalty.
In the Matter of TD Bank, N.A. (“TD Bank”), CFPB Administrative Proceeding No. 2020-BCFP-0007 (August 20, 2020)
TD Bank consented to an order by the CFPB relating to the marketing and sale of its optional overdraft service, without admitting or denying the findings. According to the CFPB, TD Bank’s general practice was not to present new customers with a written overdraft notice until the end of the account-opening process, and without having provided written disclosures. The overdraft service forms were pre-filled by TD Bank, and CFPB viewed these practices as amounting to an “opt-out” procedure as opposed to the “opt-in” procedure for overdraft services as mandated by Regulation E, and were deceptive acts or practices. According to the CFPB, TD Bank’s practices also violated the Electronic Fund Transfer Act (“EFTA”) and Regulation E by charging consumers overdraft fees for ATM and one-time debit card transactions without obtaining their affirmative consent. TD Bank agreed to pay restitution in the amount of $97,000,000 and a civil monetary penalty in the amount of $25,000,000.
In the Matter of Citibank (“Citi”), National Association, OCC Case AA-EC-2020-65 (October 2, 2020)
Without admitting or denying the allegations, Citi settled an Office of the Comptroller of the Currency (“OCC”) enforcement action alleging that it failed to implement and maintain an enterprise-wide risk management and compliance risk management program, internal controls, or a data governance program commensurate with the Bank’s size, complexity, and risk profile. The OCC found Citi violated 12 C.F.R. Part 30, Appendix D, “OCC Guidelines Establishing Heightened Standards for Certain Large Insured National Banks, Insured Federal Savings Associations, and Insured Federal Branches,” and conducted unsafe or unsound practices with respect to the Bank’s enterprise-wide risk management and compliance risk management program. Deficiencies the OCC found included: (a) failure to establish effective front-line units and independent risk management; (b) failure to establish an effective risk governance framework; (c) failure of the Bank’s enterprise-wide risk management policies, standards, and frameworks to adequately identify, measure, monitor, and control risks; and (d) failure of compensation and performance management programs to incentivize effective risk management. The OCC further found Citi lacked clearly defined roles and responsibilities, resulting in noncompliance with multiple laws and regulations and unsafe or unsound practices with respect to the Bank’s data quality and data governance, including risk data aggregation and management and regulatory reporting. The OCC alleged that these enterprise risk management failures contributed to separate violations of: the Fair Housing Act, 42 U.S.C. § 3601—19, and its implementing regulation, 24 C.F.R. Part 100; the holding period for other real estate owned, 12 U.S.C. § 29 and 12 C.F.R. § 34.82; and the Flood Disaster Protection Act, as amended, 42 U.S.C. § 4012a(f), and its implementing regulations, specifically 12 C.F.R. § 22.7(a). The OCC noted Citi has begun taking corrective action and has committed to taking all necessary and appropriate steps to remedy the deficiencies identified by the OCC. Citi agreed to pay a civil monetary penalty of $400,000,000. The case is an important example of how federal banking regulators will aggregate various risk, control, and governance issues to impose large fines under the stricter enterprise risk management requirements specifically imposed on large institutions by the Dodd-Frank Wall Street Reform and Consumer Protection Act and related guidance issued by federal banking regulators.
§ 1.3 Securities Institutions
In the Matter of Department of Enforcement vs. Wilson-Davis & Co., Inc., James C. Snow, and Byron B. Barkley, FINRA Case No. 2012032731802 (Dec. 19, 2019)
The National Adjudicatory Council affirmed the Decision of a FINRA Hearing Panel finding that the Respondents (1) engaged in short selling in violation of Regulation SHO of the Securities Exchange Act of 1934 (“Reg SHO”), (2) failed to supervise registered representatives generally, including failure to supervise instant message communications, and (3) failed to establish and implement AML policies and procedures and conduct adequate AML training. These findings also triggered violations of NASD Rule 3010 and FINRA Rule 2010. Mr. Snow and Mr. Barkley were two of the three principals of Wilson-Davis. According to FINRA, the short sales were designed to carry out a speculative trading strategy, and not as “bona fide market making activities.” FINRA also found that the written supervisory procedures “did not provide procedures, processes, tests, or guidance that would permit an evaluation by supervisors at the firm of whether the particular facts of a short sale transaction established that a sale was made in connection with bona-fide market making activity … [and that] the firm did not even have procedures for locating or borrowing securities for its short sales because the firm considered all trading to be bona-fide market making.” Wilson-Davis was fined $350,000 and ordered to disgorge $51,624 plus prejudgment interest for the violations of Reg SHO. The firm was fined an additional $750,000 and directed to retain an independent consultant for its failures to supervise and implement adequate AML procedures. Mr. Snow was fined $77,000 and suspended for one year as a principal and supervisor (including three months in all capacities) for AML violations. Mr. Barkley was fined $52,000 and suspended for one year as a principal and supervisor (including three months in all capacities) for short sale violations.
Without admitting or denying the findings, Robinhood agreed to a settlement of an enforcement action alleging violations of FINRA Rule 5310 (“Best Execution”) relating to equity orders, and related supervisory failures. For a period of more than a year, Robinhood routed non-directed equity orders to four separate broker-dealers, each of whom paid back Robinhood for the order flow. Best Execution requires that firms use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions. This obligation can be satisfied by either reviewing order-by-order, or conducting what is known as “a regular and rigorous review.” According to FINRA, Robinhood failed to do either, and did not have written supervisory procedures for Best Execution outside of merely reciting the regulatory requirements. The result was hundreds of thousands of orders a month falling outside of a compliant review process. In addition to accepting a censure and retaining an independent consultant, the firm paid a fine in the amount of $1,250,000.
Without admitting or denying the findings, Credit Suisse agreed to a settlement of an enforcement action alleging violations of Exchange Act Rule 15c3-5 (the “Market Access Rule”). Over a four-year period, Credit Suisse offered clients direct market access (“DMA”) to a number of exchanges and alternative trading systems (“ATSs”), generating in excess of $300 million in revenue. In addition to accepting a censure and retaining an independent consultant, the firm paid a fine in the amount of $1,250,000. FINRA alleged that, despite this large revenue figure, Credit Suisse failed to implement reasonable supervisory procedures to detect manipulative activity by its DMA clients. This failure resulted in more than 50,000 alerts at FINRA and multiple exchanges for potential manipulation, including spoofing, layering, wash sales, and pre-arranged trading that Credit Suisse allegedly allowed to continue unabated. In addition to a censure, Credit Suisse agreed to update its supervisory policies and procedures with respect to DMA clients, and pay a fine of $6,500,000.
Without admitting or denying the findings, PIMS settled an enforcement action with FINRA relating to the allegedly inaccurate information it provided with respect to group variable annuities (“Group VAs”). According to FINRA, PIMS provided inaccurate expense ratio and historical performance information to employer sponsors and employee participants over a period of seven years, in violation of FINRA’s advertising content rules. Additionally, for a period of 15 years, PIMS allegedly provided performance data for money market funds available as investment options in retirement plans without providing the seven-day yield information required by SEC Rule 482. The result of this failure was that plan participants using the communications did not have up-to-date yield information when making investment decisions, as required by the Rule. In addition to a censure, PIMS agreed to retain an independent consultant and pay a fine of $1,000,000.
Without admitting or denying the findings, Virtu agreed to settle an enforcement action relating to its trading of over-the-counter (“OTC”) securities. According to FINRA, Virtu failed to immediately execute, route, or display 156 customer limit orders in OTC securities in violation of FINRA Rule 6460 and to timely report nearly 500 transactions in Trade Reporting and Compliance Engine (“TRACE”)-Eligible Securities in violation of FINRA Rule 6730. Virtu also allegedly violated FINRA Rule 6437 (the “Locked/Crossed Rule”) by failing to implement policies designed to avoid displaying locking or crossing quotations in any OTC Equity Security. Virtu agreed to a censure and a fine of $250,000. This fine included $100,000 for the Locked/Crossed Rule violations and $40,000 for TRACE-related violations.
In the Matter of the Application of Newport Coast Securities, Inc. (“Newport”), SEC Admin. Proc. File No. 3-185555 (April 3, 2020)
The SEC upheld a FINRA decision (1) expelling Newport from FINRA membership; (2) imposing a $403,000 fine; and (3) ordering payment of more than $900,000 in restitution and costs. FINRA imposed these sanctions upon a finding that Newport’s registered representatives engaged in a five-year pattern of excessive trading, churning, and qualitatively unsuitable recommendations. According to FINRA, Newport abdicated its responsibility to supervise those representatives. Newport did not contest liability or the fines assessed. Rather, Newport argued that the proceedings were constitutionally and procedurally defective and that the order of expulsion was excessive and oppressive. Specifically, Newport argued that the expulsion was punitive because the firm was no longer doing business, was an undue burden on competition, and was disproportionate to the claimed supervisory failures. The SEC disagreed, finding that “Newport abused its customers’ trust and confidence by excessively trading and churning their accounts and by making qualitatively unsuitable recommendations. These were not isolated incidents; rather, they were repeated, years-long securities law violations committed against more than twenty customers by multiple representatives and across multiple offices.” The SEC also found that there was no evidence of any procedural or constitutional abnormalities and that FINRA did not single out Newport unfairly. The SEC sustained FINRA’s findings of violations and imposition of sanctions in their entirety.
Without admitting or denying the findings, SagePoint agreed to settle a FINRA enforcement action alleging failure to supervise its registered representatives’ recommendations to customers for early rollovers of Unit Investment Trusts (“UIT”), an area where both the SEC and FINRA have had increasing focus over the past few years. A UIT is a type of registered investment company offering a fixed (unmanaged) portfolio of securities having a definite life. The common maturity date of a UIT is between 15 and 24 months from initial offering, and at maturity, the investor will usually receive the proceeds of the value of the investment, accept a rollover of the investment into a new UIT, or receive an in-kind transfer of the UIT’s underlying portfolio securities. According to regulators, UITs are generally not suitable for short-term holds because of their fee structure. The early liquidation of a UIT accompanied by the rollover of investor positions into another UIT is particularly problematic for regulators due to the attendant sales charges generated for the broker. FINRA found that SagePoint executed more than $895 million in UIT transactions during a four-year period that generated more than $17.2 million in sales charges. This included $203.7 million in proceeds for early rollovers and $65.8 million in proceeds for trades where the UIT is rolled over to purchase a subsequent series in the same UIT (known as “series-to-series rollovers”). SagePoint agreed to a censure, a fine of $300,000 and restitution in the amount of $1,315,373.01.
In the Matter of Department of Enforcement vs. Sandlapper Securities, LLC, (“Sandlapper”) Trevor Lee Gordon, and Jack Charles Bixler, FINRA Case No. 2012032731802 (June 23, 2020)
The National Adjudicatory Council affirmed the Decision of a FINRA Hearing Panel finding that (1) the respondents defrauded investors; (2) Mr. Gordon and Mr. Bixler caused Sandlapper to be an unregistered broker-dealer; and (3) Sandlapper and Mr. Gordon failed to reasonably supervise investment sales. These findings amounted to willful violations of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Exchange Act Rule 10b-5, and FINRA Rules 2010 and 2020. The underlying scheme involved the purchase of fractional interests in saltwater disposal wells from a well operator, and reselling those interests to investors. Over a three-year period, more than $12 million was raised from 170 investors to fund this endeavor. According to FINRA, the sales of the fractional interests were fraudulent, and investors were overcharged by $8 million through excessive markups. Additionally, despite the fact that Mr. Gordon and Mr. Bixler claimed the investments were not securities, FINRA found otherwise. Therefore the failure to register Sandlapper as a broker-dealer was another violation. The NAC upheld the sanctions in their entirety, including expulsion of Sandlapper, a permanent bar for Mr. Gordon and Mr. Bixler, and restitution totaling $7.1 million.
Frederick Scott Levine, AWC No. 2018057247201, FINRA (July 21, 2020)
Without admitting or denying the findings, Mr. Levine agreed to settle a FINRA enforcement action alleging “an unsuitable pattern of short-term trading of [UITs] in customer accounts.” This enforcement action continues FINRA’s apparent interest in early rollovers of UITs (see Sagepoint case summary above), and shows that FINRA is targeting individuals as well as firms. According to FINRA, Mr. Levine recommended early rollovers to customers on approximately 950 occasions, 600 of which were series-to-series rollovers. FINRA found that these recommendations “caused his customers to incur unnecessary sales charges and were unsuitable in view of the frequency and cost of the transaction.” Mr. Levine agreed to a three-month suspension and a $5,000 fine.
Morgan Stanley Smith Barney LLC (“MSSB”), AWC No. 2019063917801, FINRA (August 12, 2020)
Without admitting or denying the findings, MSSB agreed to a settlement of an enforcement action alleging failure to supervise a registered representative in recommending trades without a reasonable basis for doing so. During a period of five years, the registered representative engaged in a practice of recommending the purchase of corporate bonds or preferred securities, only to then recommend the sale of the same investments shortly thereafter. According to FINRA, this practice resulted in losses to the customers, while at the same time generating increased sales charges for the representative. MSSB’s automated system generated multiple alerts relating to this activity, and the compliance department conducted a review concluding that the representative’s recommendations were “generating high costs/commissions and the products/investment strategies were costing the clients more money than they are making the client.” Despite these facts, MSSB did not take action sufficient to address the representative’s practices, resulting in more than $900,000 in customer losses over the relevant period. MSSB consented to a censure, a fine of $175,000, and restitution in the amount of $774,574.08, plus interest. In a related action, the registered representative received a permanent bar from associating with any FINRA member firm. This matter reflects an ongoing trend of FINRA levying fines on firms for failure to supervise excessive short-term trading, not just in equities, but also as here in fixed income securities.
Jose A. Yniguez, AWC No. 2018060543701, FINRA (August 25, 2020)
Without admitting or denying the findings, Mr. Yniguez agreed to settle a FINRA enforcement action relating to failing to disclose an Outside Business Activity (“OBA”) and participating in a private securities transaction. The actual allegations here are not extensive relative to other enforcement actions: Mr. Yniguez only received $5,000 from his OBA, and the total investment of individuals he referred to the private securities transaction amounted to $99,000, while his undisclosed investment was $4,300 (Mr. Yniguez also received $1,600 in referral compensation). What is notable, however, is that while the fine and disgorgement totaled $14,000, the representative was suspended for 14 months – a considerable period of time in light of the allegations.
§ 1.4 Derivatives Institutions
United States Commodity Futures Trading Commission vs. Peter Szatmari, Civil Action No. 19-00544, United States District Court for the District of Hawaii (July 28, 2020)
The CFTC secured a default judgment against Peter Szatmari in the amount of $13,800,000 for fraudulently soliciting U.S. residents to open binary options trading accounts. Mr. Szatmari engaged in “affiliate marketing,” a form of performance-based marketing promoting third-party products or services, such as binary options trading. This activity is typically conducted by email or internet postings. According to the CFTC, Mr. Szatmari intentionally defrauded customers by sending marketing solicitations that “(1) misrepresented that trading binary options would generate guaranteed profits while minimizing or disclaiming any risks; (2) claimed trading software was tested and produced profits when software had not been tested; (3) used actors or fake personalities as real owners of the trading software; and (4) depicted fictitious trading results as real.” The Court found that Mr. Szatmari “intentionally committed fraud in connection with his binary options which qualify as a ‘swap’ under Section 1a(47)(A), 7 U.S.C. § 1a(47)(A).” The judgment includes $6,258,250 in restitution, $1,899,837 in disgorgement, and a civil monetary penalty of $5,700,000.
In the Matter of JPMorgan Chase & Co., JPMorgan Chase Bank, N.A., and J.P. Morgan Securities LLC (together, “JPMorgan”), CFTC Docket No. 20-69 (Sept. 29, 2020)
The CFTC settled charges against JPMorgan alleging manipulative and deceptive conduct and spoofing with respect to precious metals and U.S. Treasury futures over an eight-year period. This settlement is significant because JPMorgan agreed to a payment of $920,203,609, representing the largest amount of monetary relief ever imposed by the CFTC. According to the stipulated findings, “[JPMorgan] traders placed hundreds of thousands of orders to buy or sell futures contracts with the intent to cancel them before execution, intentionally sending false signals of supply or demand designed to deceive market participants into executing against other orders they wanted filled.” The CFTC noted JPMorgan’s cooperation in the early stages of the investigation was “unsatisfactory[,]” but that it was cooperative in the later stages of the investigation. According to the CFTC, JPMorgan benefitted from the scheme in the amount of $172,034,790, which was the total amount of disgorgement under the settlement. Restitution was in the amount of $311,737,008 and the civil monetary penalty was $436,431,811.
In the Matter of Interactive Brokers LLC (“Interactive Brokers”), SEC File No. 3-19907 (Aug. 10, 2020)
In the Matter of Interactive Brokers, CFTC Docket No. 20-25 (Aug. 10. 2020)
Interactive Brokers settled with three separate regulatory entities for a total of $38 million, without admitting or denying the findings. According to the SEC, Interactive Brokers failed to file at least 150 SARs in connection with the potential manipulation of microcap securities in its customers’ accounts, leading to $11,500,000 in fines. The same alleged activity constituted violations of AML rules resulting in $15,000,000 in fines payable to FINRA and $12,000,000 million to the CFTC. Some of the activity cited by the SEC that should have resulted in SARs filings included:
Interactive Brokers’ customers deposited large blocks of microcap securities followed by sales of those securities and the rapid withdrawals of the proceeds from the customers’ accounts.
Customer sales accounted for a significant portion of the daily trading volume in certain U.S. microcap securities issuers.
Interactive Brokers failed to review at least 14 deposits of U.S. microcap securities where the security at issue had been the subject of an SEC trading suspension.
With respect to the AML violations, FINRA and the CFTC determined that:
Interactive Brokers’ customers wired hundreds of millions of dollars, including to countries recognized as “high risk,” without being surveilled for money laundering concerns.
Interactive Brokers lacked sufficient personnel and a reasonably designed case management system to investigate suspicious activity, despite being warned of such deficiencies by a compliance manager.
Interactive Brokers failed to establish and implement policies, procedures, and internal controls reasonably designed to cause the reporting of suspicious transactions as required by the Bank Secrecy Act (“BSA”).
Even where Interactive Brokers maintained written policies, it did not commit adequate resources to monitor, detect, escalate, and report suspicious activity in practice, commensurate with the size and scope of its business.
The FINRA and CFTC settlements carried with them the additional penalty that Interactive Brokers must retain an independent compliance consultant and disgorge $700,000 in profits. These matters highlight that AML compliance was singled out as a 2020 examination priority of both the SEC and FINRA.
§ 1.5 Money Services Businesses
In the Matter of Larry Dean Harmon d/b/a Helix, 2020-2, U.S. Department of the Treasury Financial Crimes Enforcement Network (Oct. 19, 2020)
In its authority pursuant to the Bank Secrecy Act (“BSA”), FinCEN assessed a civil monetary penalty against Larry Dean Harmon as the primary operator of Helix and as CEO and primary operator of Coin Ninja LLC (“Coin Ninja”) in the amount of $60,000,000. During the relevant time period, Mr. Harmon and Coin Ninja were doing business as “money transmitters” as defined by 31 C.F.R. § 1010.100(ff)(5) in their capacity as exchangers of convertible virtual currencies, accepting and transmitting bitcoin. Over the course of a five-year period, Harmon (1) failed to register as a money services business on behalf of himself and Coin Ninja; (2) failed to implement an effective AML program; and (3) failed to report certain suspicious activity. With respect to the unreported suspicious activity, FinCEN identified at least 2,464 instances in which Mr. Harmon failed to file a SAR for transactions involving Helix. Helix was also involved in $39,074,476.47 in bitcoin transactions with darknet and other illicit marketplace-associated addresses. FinCEN determined that a maximum penalty would have been $209,144,554, but ultimately settled on the $60,000,000 fine. The reasons for the reduced fine are not expressly detailed in the Order, but FinCEN noted that Helix agreed to two statute of limitations tolling agreements.
The requirement of non-financial reporting. Financial market regulators and stock exchanges across the world have issued guidance and/or requirements on non-financial reporting for listed companies. An increasing number of jurisdictions, however, are changing non-financial reporting from a voluntary element of CSR to a legal requirement, often with extra-territorial reach. Non-financial reporting is a company’s formal disclosure of certain information not traditionally related to finances, including environmental, social and governance (ESG) factors. Such reporting elevates Corporate Social Responsibility (CSR) and sustainability to the next level. The resultant transparency is intended to help organizations, investors and other stakeholders identify and measure the biggest non-financial challenges facing business today: climate change, diversity, equity and inclusion, and human rights impacts.
Given the different regulatory regimes across the globe governing ESG disclosure[i] and discrepancy within industry norms, companies that previously enjoyed a degree of latitude in the context of non-financial reporting are under increasing pressure. Companies are now expected to gather accurate data to ensure that their disclosures in non-financial reports are comprehensive and reliable. Banks and investors alike are looking for company-specific information that identifies impacts, risks and opportunities within ESG categories. On January 19, 2021, together with the Principles for Responsible Investment (PRI), the European Leveraged Finance Association (ELFA) and the London-based Loan Market Association (LMA) jointly published a Guide for Company Advisers on ESG Disclosure in Leveraged Finance Transactions (Guide). The Guide addresses considerations for including ESG-specific contractual obligations in documentation such as credit agreements. Such provisions would require quarterly and/or annual reporting with respect to ESG factors, ESG-compliance certificates, and third party verification (optional). As ESG metrics become more prevalent, the Guide anticipates covenant protections may be elaborated to refer to pre-determined performance thresholds or metrics, akin to a financial covenant.[ii] And a series of recent announcements by the U.S. Securities and Exchange Commission (SEC) underscores the agency’s commitment – and allocation of resources – to a heightened focus on ESG disclosures and related litigation.[iii]
More importantly, ESG issues are increasingly recognized as yet another aspect of corporate risk management included in expected financial reporting. As more ESG issues are rightly included in regulatory and financial reporting requirements, companies will be expected to provide specific data rather than broad statements and assurances with respect to their policies.
How MCCs 2.0 can help. The ABA Business Law Section’s UCC Committee Working Group to Draft Model Contract Clauses to Protect Human Rights in International Supply Chains (Working Group) recently published its 2021 Report and Model Contract Clauses (MCCs) for International Supply Chains, Version 2.0 which can be found here. The Working Group’s 2021 Report and the MCCs Version 2.0 are the culmination of more than four years’ research and consultation with international companies, trade associations, NGOs and civil societies. The MCCs offer modular terms companies can use in contracting and operational practice, and can significantly assist companies with complex international supply chains in satisfying non-financial reporting obligations. The MCCs can help a company accurately “tell its ESG story.”[iv]
Section 1.1(b) of the MCCs Version 2.0 requires timely sharing throughout the supply chain of all relevant information relating to human rights threats in the supply chain by providing:
“[Buyer and Supplier each] [Supplier] shall and shall cause each of its [shareholders/partners, officers, directors, employees,] agents and all subcontractors, consultants and any other person providing staffing for Goods or services required by this Agreement (collectively, such party’s “Representatives”) to disclose information on all matters relevant to the human rights due diligence process in a timely and accurate fashion to [the other party] [Buyer].” (Emphasis added)
Section 1.4 requires the creation of a functioning grievance mechanism and self-reporting cooperation with regular reports as to OLGM use and success as follows:
“Operational-Level Grievance Mechanism. During the term of this Agreement, Supplier shall maintain an adequately funded and governed non-judicial Operational Level Grievance Mechanism (“OLGM”) in order to effectively address, prevent, and remedy any adverse human rights impacts that may occur in connection with this Agreement. Supplier shall ensure that the OLGM is legitimate, accessible, predictable, equitable, transparent, rights-compatible, a source of continuous learning, and based on engagement and dialogue with affected stakeholders, including workers. Supplier shall maintain open channels of communication with those individuals or groups of stakeholders that are likely to be adversely impacted by potential or actual human rights violations so that the occurrence or likelihood of adverse impacts may be reported without fear of retaliation. Supplier shall demonstrate that the OLGM is functioning by providing [monthly] [quarterly] [semi-annual] written reports to Buyer on the OLGM’s activities, describing, at a minimum, the number of grievances received and processed over the reporting period, documentary evidence of consultations with affected stakeholders, and all actions taken to address such grievances.” (Emphasis added)
Section 1.4 is immediately followed by Article 2, which addresses remediating adverse human rights impacts linked to contractual activity. Section 2.1(a) requires Supplier to prepare and provide a detailed summary of the human rights threat and how it was addressed stating:
“Within _____days of (i) Supplier having reason to believe there is any potential or actual violation of Schedule P (a “Schedule P Breach”), or (ii) receipt of any oral or written notice of any potential or actual Schedule P Breach, Supplier shall provide to Buyer a detailed summary of (1) the factual circumstances surrounding such violation; (2) the specific provisions of Schedule P implicated; (3) the investigation and remediation that has been conducted and/or that is planned as informed by implementation of the OLGM process set forth in Section 1.4; and (4) support for Supplier’s determination that the investigation and remediation has been or will be effective, adequate, and proportionate to the violation.” (Emphasis added)
To ensure the contractually required sharing of all relevant information relating to a discovered human rights abuse or likely abuse without vulnerability to the argument that there has been a waiver of the attorney-client privilege or other barrier to a defense in the event of a dispute, Section 2.2(b) addresses the parties’ respective concerns with the following text:
“Each party shall provide the other with a report on the results of any investigation carried out under this Section; provided that any such cooperation in the investigation does not require Buyer or Supplier to waive attorney-client privilege, nor does it limit the defenses Supplier or Buyer may raise.” (Emphasis added)
And, turning to the implementation of a specific remediation plan, Section 2.3(d) insists upon proof of execution and stakeholder satisfaction by noting:
“Supplier shall provide [reasonably satisfactory] evidence to Buyer of the implementation of the Remediation Plan and shall demonstrate that participating affected stakeholders and/or their representatives are being regularly consulted. Before the Remediation Plan can be deemed fully implemented, evidence shall be provided to show that affected stakeholders and/or their representatives have participated in determining that the Remediation Plan has met the standards developed under this Section.” (Emphasis added)
MCCs 2.0 are a practical, business-minded tool to meet legal and financial obligations and replace outmoded “check the box” routines. MCCs 2.0 are not another guide to nonfinancial ESG reporting.[v] They are instead a practical tool for gathering essential information at every tier of the supply chain. This information is crucial to any board committed to satisfying its active oversight and subsequent monitoring obligations under In re Caremark International, Inc. Derivative Litigation[vi] and its progeny.[vii] Data collected as a result of regular enforcement of the MCCs would also be sufficient to complete a questionnaire presented by a governmental unit, regulatory agency, stock exchange, fund manager, or lending source that is insisting on greater ESG transparency.
In the current risk landscape, contract provisions that continue to focus only on supplier representations and warranties with respect to the absence of human rights abuses such as forced labor, child labor and dangerous working conditions are simply insufficient to address human rights impacts in a company’s supply chain. It is important to operate with the assumption that the chain is vulnerable to human rights abuse compromises which make the representations and warranties ineffective if not meaningless the moment a supply contract including such empty promises is signed. It is essential that we change the focus of supply chain contract provisions to assess, clearly identify and address human rights abuses upon detection and add provisions that allow buyers and suppliers to acquire accurate data for required ESG disclosures. Take a look; the MCCs Version 2.0 can help.
[i] Recent examples of instruments include the Nasdaq Reporting Guide 2.0 (https://www.nasdaq.com/docs/2019-ESG-Reporting -Guide.pdf) (2019), the B3 State-Owned Enterprises Governance Program (http://www.b3.com.br/data/files/F3/B4/1E/4F/C1B2F510ACF0EOF5790D8AA8/State-Owned-Enterprises-Governance-Program11.05.17.pdf) (2017) and the Singapore Stock Exchange Listing Rules (http://rulebook.sgx.com/net_file_store/new_rulebooks/s/g/SGX_Mainboard_Practice_Note_7.6_July_20_2016.pdf (2016) which requires every listed issuer to prepare an annual sustainability report on a “comply or explain” basis. For example, EU Directive 2014/95/EU (https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32014L0095) set out rules on disclosure of non-financial and diversity information from large businesses with more than 500 employees. Covered companies must publish reports on the policies they implement in relation to environmental protection, social responsibility and treatment of employees, respect for human rights, anti-corruption and bribery, and diversity on company boards. In June 2017, the European Commission published its guidelines to help business with this information (https://ec.europa.eu/info/publications/170626-non-financial-reporting-guidelines_en) but, under Directive 2014/95/EU businesses are given significant flexibility to disclose relevant information in the way they consider most useful using international, European or national frameworks to produce their statements. They can reply on the UN Global Compact (https://unglobalcompact.org/), the UN Guiding Principles on Business and Human Rights (https://www.chchr.org/Documents/Publications/GuidlingPrinciplesBusinessHR_EN.pdf), or the OECD Guidelines for Multinational Enterprises (https://www.iso.org/iso/hone/standards/iso26000.htm). Draft Directive (EU) 2021/338 of the European Parliament and of the Council of 16 February 2021 (EU 2021) intends to amend Directive 2014/65/EU as regards information requirements, product governance and position limits, and also contemplates revisions to Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms. Another example is the French Duty of Vigilance Law (2017), applicable to certain large French businesses headquartered in and outside France, which requires the development, implementation and publication of annual vigilance plans detailing the steps taken or to be taken to detect human rights risks and prevent serious violation, the health and safety of persons and the environment resulting from the activities of the business, its subsidiaries, suppliers and subcontractors.
[ii]See OECD Guidance on Due Diligence for Responsible Corporate Lending and Securities Underwriting and the Dutch Banking Sector Agreement, both of which involve a multi-stakeholder approach including banks, CSOs and governments. In December 2019, GLS Bank and Pax-Bank called for a legal duty of care for human rights and the environment. In February 2020, the New York-based Loan Syndications and Trading Association (LSTA) published a template ESG Diligence Questionnaire applicable to borrowers across all industries to facilitate due diligence reviews of the ESG profile of borrowers. In April 2020, a statement, led by the Investor Alliance for Human Rights and signed by 105 international investors representing over US $5 trillion in assets under management called on governments to require companies to conduct human rights due diligence and, during the UN Forum in November 2020, BMO Asset Management explicitly supported mandatory human rights due diligence during a panel on the topic. See the BankTrack Human Rights Benchmark (https://www.banktrack.org/) which evaluates 50 of the largest private sector commercial banks globally against a set of 14 criteria based on the requirements of the UN Guiding Principles by looking at four aspects of banks’ implementation of the Guiding Principles: their policy commitment, human rights due diligence (HRDD) process, reporting on human rights and their approach to access to remedy. For investors, there are resources which attempt to quantify the social and environmental factors that can contribute to the value of the investment but are not included in its financial reports such as the ESG Index and the Israeli Maala Index. The Corporate Human Rights Benchmark (https://corporatebenchmark.org/) is an investor-backed initiative which assesses 101 of the largest publically traded companies in the world on 100 human rights indicators including transparency.
[iii] In the United States, the standard for disclosure in financial reports is “materiality” as defined by the United States Supreme Court and the SEC. This definition is based on what is deemed to be likely to significantly affect the total mix of information a reasonable investor considers in making an investment decision. While ESG considerations are not currently required to be part of US public companies’ financial statements, the SEC requires companies to include non-financial information and metrics in their regulatory filings, effective for the upcoming proxy season in 2021. Stepping up its focus on ESG reporting, the SEC announced on March 4, 2021 the creation of a Climate and ESG Task Force in the Division of Enforcement (https://www.sec.gov/news/press-release/2021-42) which will focus on identifying “material gaps or misstatements in issuers ‘disclosure of climate risks under existing rules,” examining “disclosure and compliance issues related to investment advisers’ and funds’ ESG strategies,” and evaluating whistleblower complaints related to ESG issues. The previous day, on March 3, 2021, the SEC’s Division of Examinations announced its 2021 examination priorities with enhanced “focus on climate and ESG-related risks by examining proxy voting policies and practices to ensure voting aligns with investors ‘best interest and expectations,’” noting that investment advisors are “increasingly offering investment strategies that focus on ESG factors” (https://www.sec.gov/news/press-release/2021-39).
[iv] Proper implementation of the MCCs would also assist a company responding to a Customs and Border Protection investigation which might otherwise result in a Withhold Release Order and provide for the regular collection of data as indicia of satisfaction of mandatory human rights due diligence very likely to be soon imposed by Germany and EU 2021.
[vi] 698 A.2d 959 (Del. Ch. 1996) finding that the directors violated their fiduciary duties when the corporation’s information and reporting system in concept and design is “adequate to assure the board that appropriate information will come to its attention in a timely manner as a matter of ordinary operations…” Id. at 970.
[vii]See, Stone v. Ritter, 911 A.2d 362 (Del. 2006) and Caremark at the Quarter-Century Watershed: Modern-Day Compliance Realities Frame Corporate Directors’ Duty of Good Faith Oversight, Providing New Dynamics for Respecting Chancellor Allen’s 1996 Caremark Landmark, E. Norman Veasey and Randy J. Holland, The Business Lawyer, Winter 2020-2021, Vol. 76, Issue 1, page 1.
As COVID-19 cases have raged across the United States, we have all realized that we must be better prepared for future pandemics. Moreover, businesses must be ready to adapt to future public health restrictions, including the possibility of future lockdowns. As such, businesses cannot stick to a status quo, and should anticipate long-term remote work. Public health experts have a far less optimistic outlook on a return to normalcy than the general public, and businesses should heed the expert position rather than public opinion. Therefore, businesses – especially law firms – must prepare for the possibility of continued pandemic-related public health restrictions until at least the end of 2021.
Dr. Anthony Fauci, the director of the National Institute of Allergy and Infectious Diseases, has warned that even with a vaccine, normalcy will not be established until the end of 2021 at the . This is because of multiple issues, including: the logistics of distributing the vaccine to the entire population, difficulty educating the public about the vaccine, and the struggle to ensure that the vaccine is able to reduce the number of new COVID-19 cases. The vast amount of viewpoints – from experts and non-experts alike – and mixed messaging from the media and government has also contributed to uncertainty about when the public will consider it to be safe to return to work in-person.
There is also the possibility of future returns to complete lockdowns. As we have seen abroad, returning entirely to normal is not feasible at present. In Israel, after almost defeating COVID-19 (with numbers lower by percentage than the most successful of US counties) a full lockdown was reinstated after the spread of COVID-19 again increased. In the US, even in states that may be starting to re-open or are already fully open, law firms should be prepared for the possibility of re-lockdown, and the effects of this on workflow.
This article will outline the specific problems related to privacy and security issues, and technological solutions to address them.
Problems: Privacy and Security Issues when Working from Home
Attorneys and law firm support staff face unique challenges in light of the COVID-19 pandemic. At the forefront of this new wave of difficulties is attempting to manage workplace productivity while still ensuring the integrity of client information. Law firms are especially vulnerable to cyberattacks and security breaches because of the high-volume of sensitive client data. The FBI recognized the increased likelihood of cyberattacks and security breaches in the COVID-19 pandemic, due to the sudden shift of businesses relying on technology for working from home. The legal field relies on protecting confidential communications between attorneys and their clients, which raises an important question amid the new work from home (WFH) norm: when attorney work product is created at home, client information is accessed outside the office, and non-attorney employees correspond about active legal matters?
The main data privacy issues for firms operating out of residential living spaces rather than offices include:
Maintaining confidentiality of client information when working from home, potentially in shared living spaces;
Preventing unauthorized access of physical documents in transit to non-office spaces and at home; and
Restricting unauthorized wireless access to firm systems.
These problems can be difficult to remedy without a dedicated IT professional monitoring employee access – may find it challenging to adapt to employees’ WFH habits. In the absence of dedicated IT staff, firms can also proactively establish proper access protocols with employees, including:
Restricting unauthorized use;
Ensuring client information is not divulged to unauthorized persons; and
Requiring encryption on emails and other firm documents.
These are all reasonable means to avoid data security issues, and do not necessarily require a tech professional to implement.
Other issues may arise depending on the size of the firm: the number of employees that have access to confidential or sensitive client information can multiply security issues. Firms that do not provide electronic devices on which employees can perform work – instead having employees use personal devices – may also require additional measures to prevent misuse or unauthorized access. Because professional and private spaces are being shared, firms should be especially wary of suspicious access patterns. Clients in the early stages of litigation may be particularly concerned about data privacy, since sensitive materials like medical records or financial documents may not yet be publicized in court documents.
Despite these issues, law firms can easily adapt to WFH through meaningful tech training, document-access protocols, and downloading modern communications protections to stay ahead of the COVID-19 curve.
Solution: Technological and Workplace Management Solutions
Technological Solutions
Any firm transitioning its employees to a WFH format should be equipped with a comprehensive plan that addresses as many of the above-mentioned challenges as applicable. Proactive measures should include purposeful research into secure communication technologies that allow safe and efficient collaboration between firm employees. Without the support of dedicated IT staff to upgrade existing infrastructure or remotely install new software on work devices, determining which software can adequately protect client data falls on the shoulders of firm management.
Like physicians, legal practitioners enjoy the privilege of being able to leverage a wide spectrum of profession-specific software. Many software companies employ former attorneys or have consulted with a large number of firms to tweak software settings to firm preferences. Most firms mandate that work devices also run software for encrypted, secure access. Remaining diligent in educating employees on safe communication practices can also prove useful in limiting unauthorized access to firm documents.
Before delving too extensively into available software to protect confidential information or purchasing such software, it is critical that decision-makers understand relevant terminology. The following analysis weighs several methods for securing communications software for legal staff.
1. Encryption of Messaging Software
Most attorneys have a general understanding of what encryption does and how this feature is typically used. However, firm management may not be aware of the degree and quality of encryption that messaging software companies offer. For instance, various methods of encryption serve different purposes for different organizations that may not need identical levels of protection. However, in the legal industry where client information is expected to remain confidential, advanced encryption methods – like AES 256 and Blowfish – may be necessary. As discussed below, these algorithms utilize longer strings of encryption to protect data.
How does encryption protect client data or a firm’s communications? Although some of the more secure encryption methods involve additional protective measures, most encryption algorithms in software operate under the same principle. Generally, when sending a message to a coworker or client, firm staff send an email with readable text in the body of the message. If the messaging software uses encryption technology, these plain-text messages (i.e. the text that is readable in your inbox) are converted to “cipher text,” making communications unreadable to unauthorized users. In a sense, encryption turns plain-text messages in emails or other messaging software into a coded language, which is then translated by the reciever’s cooperating encrypted device. Because the textual information is scrambled and then unscrambled by the receiving device, encryption technology facilitates secure communications between devices or servers that utilize the same encryption software.
Much like the secure transmittal of patient treatment information in a hospital setting, law firms can find solace in software. The good news is that most commonly used messaging software already implements some form of encryption. However, firms may need to upgrade their current software to remain fully protected. Most software providers, like Microsoft for its Outlook mail application, offer enterprise-level encryption for communications at no additional cost. The table below provides an overview of available software packages:
*Not HIPAA-compliant upon install, but can be configured to be HIPAA-compliant
2. Cloud-Based Storage of Electronic Communications
Additional scrutiny should apply when logs of client communications or client information are stored in cloud-based servers. The security of cloud-based technology can be difficult because client information stored in a cloud-based CRM system, for example, is at the mercy of the third-party’s security infrastructure. Firm management should become familiar with their preferred cloud-based storage technology company’s data management policies and analyze the firm’s liability for potential data breaches. Reliance on third-party software providers or data storage companies may result in increased liability for clients’ information. An attorney’s ethical duty to protect client data obliges firm management to assess several factors when using cloud-based software, such as the vendor’s security policies and the use of confidentiality agreements. Cloud-based systems offered by Google and Amazon make data storage simple and safe.
3. Network Security: VPNs
Unauthorized access through unprotected wireless networks can also prove difficult to manage, but installing and mandating use of a firm-wide virtual private network (VPN) can provide the security of a traditional firm network. are essentially secure ways to create a reliable internet connection, encrypting network access by rerouting it through a proxy server. Law firms operating with WFH models may wish to implement VPNs because residential Wi-Fi access typically lacks adequate protection from cybersecurity attacks.
While working outside the office, employees may be tempted to join public wireless networks at cafés or libraries for convenience. Firm management should discourage this in order to preserve data security. Because employees’ home internet services may pale in comparison to that provided at the office, partially funding employees’ wireless connection can facilitate the use of a secure wireless network, while also incentivizing work productivity. Reimbursing employees who upgrade their Internet service may also be beneficial, as the expense of these upgrades will be far less than the costs of a data breach. The following chart provides some VPN software that could be an ideal fit for a law firm moving to a WFH structure:
No logs of web access and communications, but features multi-layered security to provide ad- and malware-free private browsing sessions
$6.95/mo.
4. Antivirus and Antimalware Software
Similar to employee-caused data breaches, external cybersecurity threats to law firms can be prevented and mitigated with relative ease. By installing anti-malware software onto firm devices, employees may not have to be as diligent in identifying phishing emails. Consider the following , all of which allow for weeks-long trial periods to test functionality:
Real-time anti-malware protection, virus & ransomware detection, blocks compromised or dangerous websites, secures multiple devices in any location through the website, advanced real-time antivirus security, password data protection, anti-keylogger software, premium live chat support.
Vulnerability Scanner, Web Advisor (identifies potential ransomware/threats on internet sites), App Boost (optimizes computer processing power), Quick Clean (optimal metadata & document deletion), VPN and identity theft protection
$59.99/yr.*
*Free version available with fewer security features
In conclusion, the of sticking to the status quo for law firms that operate in their physical office is that the remote work circumstances continue beyond current expectations. The current model, where the law firm’s office Internet has encryption and security features, and firm-provided devices may have the security software but be used on an employees’ less robust home Internet connection, means that the corresponding increase and prevalence of cyberattacks and data breaches will become more serious threats to the industry. To minimize these risks, law firms must be able to switch to working remotely and have efficient ways of managing the subsequent effects of this switch.
Laws and regulations relating to cannabis and the cannabis industry continue to evolve at a rapid pace. In order to put current developments in context, it is important to understand the current state of the law regarding marijuana and hemp.
The starting point is the Controlled Substances Act, 21 U.S.C. § 801 et. seq. (“CSA”), passed in 1970 to regulate the manufacture, use, and distribution of certain controlled substances for medical, scientific and industrial purposes and to prevent these substances from being used for illegal purposes. The CSA classified various drugs and chemicals into five categories, or schedules. Marijuana, along with heroin, cocaine, LSD, and other substances, was placed on the most restrictive schedule, Schedule 1. The CSA prohibits the manufacture, distribution, sale possession, or use of marijuana. Also, the CSA operates to prohibit the transportation of marijuana across state lines, even between states that have passed laws legalizing marijuana, as well as international borders.
Despite the existence of the CSA, as of today, thirty six states plus the District of Columbia, Guam, Puerto Rico, and the U.S. Virgin Islands have laws legalizing marijuana for medical use, and fifteen of those states, plus D.C., and Guam a have legalized marijuana for recreational use, as well. Legislation to legalize marijuana is currently working its way through other state legislatures. Since the CSA is the law of the land, how states can “legalize” marijuana consistent with the preemption doctrine is complicated. _____.
The laws relating to marijuana and hemp became very complicated at the end of 2018, with the passage of the Agricultural Improvement Act of 2018, the Farm Bill. It is important to understand that both hemp and marijuana come from the same species of plant, Cannabis sativa L., and both were included in the definition of marijuana in the CSA. Both marijuana and hemp contain a number of chemical compounds, the two most known of which are THC (the psychoactive compound) and CBD. The legal difference is that hemp contains less than three percent THC. Part of the confusion revolves around the other chemical compound, CBD, which is extremely popular and ubiquitous in the market place. CBD comes from both hemp and marijuana. Further complicating the situation is that there is no standard for measuring THC content in a cannabis plant, so what might be classified as hemp by one state might be classified as marijuana by a different state.
While hemp is technically legal under federal law, the Food and Drug Administration maintains jurisdiction over hemp (and therefore CBD) to the extent it is marketed as a food or dietary supplement or as a drug. Also, the state statutory and regulatory framework for hemp and CBD derived from hemp remains very confusing and is rapidly evolving.
This section will focus on recent developments in cannabis law.
§ 1.2 Tax Issues for the Cannabis Industry
Richmond Patients Group v. Commissioner of Internal Revenue, T.C. Memo 2020-52
Date: May 4, 2020
Facts: Plaintiff operated a medical marijuana dispensary. It purchased for resale bulk marijuana and inspected, sent out for testing, trimmed, dried, packaged, and labeled the marijuana it purchased. It did not grow marijuana or sell live plants, clones, or seeds. Plaintiff took business expense deductions for compensation to officers, salaries and wages, repairs and maintenance, rents, taxes, and license fee. Plaintiff argued that it was a producer, not a reseller and therefore should be able to include in cost of goods sold (COGS) certain indirect inventory costs pursuant to regulations issued under Internal Revenue Code (Code) section 471.
Held: Plaintiff was a reseller, not a producer and therefore not able to deduct certain indirect inventory costs included in COGS and plaintiff was not able to deduct certain business expenses.
Reasoning: The plaintiff argued that it was a producer for purposes of sections 471 and 263A of the Code and should be entitled to deduct or include in COGS certain indirect inventory costs. The Court analyzed the definition of what it means to produce and found that constructing, building, installing, manufacturing, developing, improving, creating, raising, or growing were activities of production. Plaintiff did none of those things and was therefore a reseller, not a producer.
In denying a deduction by the Plaintiff for certain business expenses, the Court cited Code section 280E which denies a deduction of any business expenses related to a business consisting of trafficking in a controlled substance. A marijuana dispensary is such a business. The Court then analyzed whether such business expenses could be included in COGS. The Court noted that Section 263A includes in COGS only business expenses that are otherwise deductible and since 280E prohibits these expenses from being deductible they could not be included in COGS. This case is one of a long line of cases in which the Internal Revenue Service has successfully argued against taxpayers seeking to plan around section 280E.
Wakefield v. Department of Revenue, State of Oregon (unpublished) 2020 WL 905739 (Or. Tax Magistrate Div.)
Date: February 25, 2020
Facts: Plaintiff operated a medical marijuana business in Oregon. Plaintiff filed its 2014 and 2015 Oregon income tax returns reporting certain business expenses. The Oregon Department of Revenue disallowed Plaintiff’s business expenses citing Code section 280E. The issues was whether the Plaintiff could deduct its business expenses due to Code section 280E since Oregon income tax law generally follows federal tax law.
Held: Plaintiff was not eligible to deduct certain business expenses in 2014 but was able to do so in 2015 based on a state measure, Measure 91, that was approved in 2015 that made Code section 280E inapplicable to computation of state income taxes.
Reasoning: Plaintiff argued that Measure 91 which became effective on July 1, 2015 for tax years beginning on January 1, 2015, should be retroactively applied to the 2014 tax year. The version of the statute that implemented Measure 91 was modified and the earlier version of that statute was deleted and Plaintiff argued that this rendered the effective date ambiguous. The Oregon Tax Magistrate Division ruled that based on the Oregon constitution, statutes, and case law the effect of deleting a statute that was superceded by an amended version of the same statute did not have the effect of altering the effective date. Accordingly, the Plaintiff could not take business deductions prohibited under 280E prior to the date it was decoupled from Oregon law. This case illustrates the complexities of dealing with the impact of section 280E under federal and state tax law. A careful analysis of the impact of Code section 280E on a cannabis business is essential both for ongoing business planning as well as for an M&A transaction.
§ 1.3 Trademarks
Kiva Health Brands LLC v. Kiva Brands Inc., 439 F. Supp.3d 1185 (N.D. Cal. 2020)
Date: February 14, 2020
Facts: Plaintiff started using KIVA trademark in connection with natural foods starting in 2013 and obtained a registration in 2014. Defendant started using KIVA trademark in connection with cannabis infused chocolates starting in 2010. Plaintiff allegedly first learned of Defendant’s use of the same mark in June 2015. Plaintiff brought suit for trademark infringement in 2018. Among other things, Defendant asserted laches and prior use as affirmative defenses to infringement. Both parties moved for summary judgment on these defenses.
Held: Summary judgment against laches defense denied. Summary judgment against prior use defense granted.
Reasoning: Laches defense. The principle behind laches is that a court should not help a plaintiff who sleeps on its rights. To establish laches, a defendant needs to show unreasonable delay and prejudice. A plaintiff’s delay is the time between: (a) the date it knew, or in the exercise of reasonable diligence, should have known about its potential cause of action; and (b) the date it brings suit against the defendant. A delay cannot be reasonable if it is longer than the analogous statute of limitations, which in this case, the court held was four years. Here, Plaintiff brought suit in 2018, claiming to have first learned of Defendant’s use of the KIVA mark in 2015 (within the statute of limitations period). Defendant, however, showed evidence of its use online, including on its website and on Facebook as early as 2013 (outside the statute of limitations period). Thus, summary judgment was denied because there was a genuine dispute as to the period of Plaintiff’s delay and whether it was even capable of being deemed reasonable.
Prior use defense. In a prior decision on a motion for preliminary injunction, the court held that Defendant’s prior use defense was not likely to succeed under the Lanham Act, 15 U.S.C. § 1115(b)(5) because its use—in connection with cannabis infused chocolates—was illegal under federal law. The court restated its reasoning from that opinion in this one: “To hold that [Defendant’s] prior use of the KIVA mark on a product that is illegal under federal law is a legitimate defense to [Plaintiff’s] federal trademark would put the government in the anomalous position of extending the benefits of trademark protection to a seller based upon actions the seller took in violation of that government’s own laws.” (citation and internal quotation marks omitted). (Author’s view: The court’s reasoning is questionable for multiple reasons, including because it denied summary judgment on the laches defense. If the federal illegality of Defendant’s use would bar a prior use defense, there is no reason why it would not also bar a laches defense.)
Given the court’s earlier decision denying prior use as a defense under Section 1115(b)(5), Defendant this time relied on Section 1065 of the Lanham Act, which expressly provides for a prior use defense based on trademark rights established under state law. The court did not dispute Defendant’s interpretation of Section 1065’s language or suggest that Defendant’s prior use defense would not be available thereunder. But the court dismissed Defendant’s position as inapposite because Section 1065 concerns “incontestable” marks, which Plaintiff’s mark is not, and granted summary judgment to Plaintiff on Defendant’s prior use defense. (Author’s view: The court’s reasoning is questionable. Marks that have obtained incontestable status are afforded even greater protections under the Lanham Act than marks that have not. See 15 U.S.C. § 1115(b). By seemingly making prior use of cannabis marks a viable defense to incontestable marks but not contestable marks, the court gave greater protections to contestable marks. That does not square with the Lanham Act.)
BBK Tobacco & Foods LLP v. Skunk Inc., No. CV-18-02332-PHX-JAT, 2020 WL 1285837 (D. Ariz. March 18, 2020)
Date: March 18, 2020
Facts: Plaintiff brought suit against Defendant for infringing certain federally registered SKUNK-formative marks. Defendant counterclaimed seeking to cancel Plaintiff’s SKUNK registration for “herbs for smoking” on the grounds that SKUNK is generic for cannabis, which is an herb for smoking. Plaintiff moved to dismiss the counterclaim.
Held: Motion to dismiss counterclaim granted.
Reasoning: The court found that the USPTO’s policy is to refuse registration of marks used for unlawful goods, such as cannabis, and noted the USPTO’s refusal of several registrations for cannabis-based goods. The court therefore concluded that the “herbs for smoking” identified in Plaintiff’s SKUNK registration could not have been a reference to cannabis. The court also noted that “a trademark registration is not susceptible to a genericness challenge simply because it is the generic name for something; rather, it must be the generic name for the particular goods listed in the trademark registration.” Here, even if skunk is generic for cannabis, cannabis is not one of the goods listed in Plaintiff’s registration. Accordingly, Defendant’s counterclaim seeking dismissal of SKUNK on the basis that skunk is generic for cannabis failed to state a claim upon which relief could be granted.
Clint Eastwood v. Sera Labs, Inc., et al., Case No. 2:20-cv-06503-RGK-JDE, 2020 WL 5440564 (C.D. Cal. July 28, 2020)
Date: July 28, 2020
Facts: Advertising claimed that Defendant’s CBD product was put out by Clint Eastwood. Advertising included fabricated interviews with Mr. Eastwood. Eastwood sought a TRO and preliminary injunction based on false advertising, violation of common law right of publicity, false endorsement under the Lanham Act, and various other related claims.
Held: TRO granted.
Reasoning: Defendants had zero relationship with Clint Eastwood. All advertising was completely fabricated. Defendant Sera Labs submitted a declaration explaining that the advertising was created and disseminated by others without approval from Sera Labs. On that basis, the court agreed to exclude Sera Labs from the TRO, but acknowledged that such a finding would not preclude its potential liability.
§ 1.4 False Advertising
Snyder v. Green Roads of Florida LLC, 430 F. Supp.3d 1297 (S.D. Fla. January 3, 2020)
Date: January 3, 2020
Facts: Defendant sells various CBD products. Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content. Defendant moved to stay under the primary jurisdiction doctrine.
Held: Motion to stay granted.
Reasoning: Courts consider four factors when applying the primary jurisdiction doctrine: (1) the need to resolve an issue that (2) has been placed by Congress within the jurisdiction of an administrative body having regulatory authority (3) pursuant to a statute that subjects an industry activity to a comprehensive regulatory scheme that (4) requires expertise or uniformity in administration. Courts also consider and rely heavily on a fifth factor implicating FDA jurisdiction: whether the FDA has shown any interest in the issues presented by the litigants. Here, the court determined that the primary jurisdiction doctrine was applicable because there is a need for consistent guidance on CBD labeling standards, Congress has placed the authority with the FDA via the Farm Bill, and the FDA, which has expertise and will ensure uniformity in administration, is in the midst of working on the issue.
Potter v. Potenetwork Holdings, Civil Action No. 19-24017-Civ-Scola, 2020 WL 1516518 (S.D. Fla. March 30, 2020)
Date: March 30, 2020
Facts: Defendant sells various CBD products. Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content. Defendant moved to stay under the primary jurisdiction doctrine.
Held: Motion to stay denied.
Reasoning: The court determined that the primary jurisdiction doctrine was not applicable here because the FDA’s forthcoming guidance and regulations on the labeling of CBD products is unlikely to affect the outcome of a case concerning the truth or falsity of the content claim at issue.
Colette et al. v. CV Sciences, Inc., 2:19-cv-10227-VAP-JEM(x), 2020 WL 2739861 (C.D. Cal. May 22, 2020)
Date: May 22, 2020
Facts: Defendant sells various CBD products. Plaintiff sues for false advertising and related laws on the theory that she would not have purchased the products if she had known they were not legally sold in the U.S. Defendant moved to stay under the primary jurisdiction doctrine.
Held: Motion to stay granted.
Reasoning: The court determined that the primary jurisdiction doctrine was applicable in this case because the FDA is in the process of regulating the products at issue and there is uncertainty with respect to how the products will be classified, the types of labelling that will be required, etc. The court was also concerned that because there are multiple similar litigations pending, proceeding in any of them without the benefit of the FDA’s ultimate guidance likely would result in inconsistent rulings. The court also distinguished this case from others where FDA guidance would not affect the outcome, and there was no danger of inconsistent rulings.
Glass v. Global Widget, LLC d/b/a Hemp Bombs, No. 2:19-cv-01906-MCE-KJN, 2020 WL 3174688 (E.D. Cal. June 15, 2020)
Date: June 15, 2020
Facts: Defendant sells CBD-infused edibles, capsules, oils, and vape products. Defendant’s advertising represented that its products were legal and, according to Plaintiff, that they contain between seven and 82% more CBD than is actually present in the products. Plaintiff brought suit for false advertising and related claims. Defendant, among other things, moved to stay based on the primary jurisdiction doctrine.
Held: Motion to stay granted.
Reasoning: Piggybacking on Collette case, the court held that the FDA’s activities in clarifying its position on CBD warranted a stay.
Ahumada v. Global Widget, Case No. 19-cv-120005-ADB, 2020 WL 5669032 (D. Mass. August 11, 2020)
Date: August 11, 2020
Facts: Defendant sells various CBD products. Plaintiff sues for false advertising and related laws on the theory that labels overstate the CBD content and falsely convey legality. Defendant moved to stay under the primary jurisdiction doctrine.
Held: Motion to stay granted.
Reasoning: The court determined that the primary jurisdiction doctrine was applicable in this case because the FDA is in the process of regulating the products at issue and there is uncertainty with respect to how the products will be classified, the types of labelling that will be required, etc. The court was also concerned that because there are multiple similar litigations pending, proceeding in any of them without the benefit of the FDA’s ultimate guidance likely would result in inconsistent rulings.
Ballard v. Bhang Corp., Case No. EDCV 19-2329 JGB (KKx), 2020 WL 6018939 (C.D. Cal. Sept. 25, 2020)
Date: September 25, 2020
Facts: Defendant sells “medicinal chocolate,” which claims to have certain amounts of THC and CBD. Plaintiff’s independent lab testing revealed that Defendant’s chocolate did not contain the amount of CBD advertised. Plaintiff therefore filed a class action lawsuit for false advertising and related claims. Among other things, Defendant moved to stay based on the primary jurisdiction doctrine, and dismiss based on preemption.
Held: Motion to stay based on primary jurisdiction denied. Motion to dismiss based on preemption denied
Reasoning: Motion to stay. Defendant argued that FDA regulations concerning CBD safety, including how to measure and label cannabinoid content, was forthcoming, and that the court should therefore defer consideration of the CBD claim until after such guidance was issued under the primary jurisdiction doctrine. The court denied the motion because FDA guidance would not clarify the straightforward issue of whether the amount of advertised CBD was true or false. The court distinguished other cases that had granted stays pending FDA guidance on the theory that such guidance would clarify an issue, such as the legality of CBD, or the meaning of “hemp extract.” The court reasoned that no such clarity was needed here, as this was not a case that involved a “definitional agreement” or required “the FDA’s technical expertise.”
Motion to dismiss. Defendant’s motion to dismiss was based, in part, on its argument that the 2018 Farm Bill granting the FDA authority to regulate cannabinoids in food products preempted Plaintiff’s stated false advertising claims. The court denied the motion because nothing in the Farm Bill purports to preempt state tort laws, and state false advertising laws do not conflict with or impede the 2018 Farm Bill. The court, however, ultimately granted Defendant’s motion to dismiss, with leave to amend, because Plaintiff’s complaint failed to identify basic information, including the specific chocolates he bought, when he bought them, how they were advertised, and how they fell short of that advertisement.
§ 1.5 Bankruptcy
In re Malul, 614 B.R. 699 (Bankr. D. Colo. 2020)
Facts: Several years after the debtor’s Chapter 7 case was closed, the debtor filed a motion to reopen the case in order to disclose her interests in what was then a non-operational medical marijuana company and pending state court lawsuit against the company’s principal. The motion was granted and after entry of order reopening the case, the debtor filed an amended schedule of assets and a motion to compel abandonment of her interests in the company and the lawsuit. The Chapter 7 trustee filed a motion to settle the debtor’s claim in the state court action. The United States Trustee filed a motion to vacate the order conditionally reopening the case and to return the parties to the status quo ante.
Held: The Bankruptcy Court granted the motion to vacate, vacated the Order reopening the case, and then denied the Motion to Reopen. It also directed the parties to take all actions necessary to re-establish the status quo ante.
Reasoning: The Bankruptcy Court reasoned that under the Controlled Substances Act (CSA), which preempted state law in this instance, it was illegal to use, sell or cultivate marijuana. Any contract relating to the sale, use, or cultivation of marijuana was in contravention of public policy and therefore void and unenforceable. The Court pointed out that any such contract was also illegal and unenforceable under Colorado law.
The debtor argued that the company had no assets and operations and was therefore no longer a marijuana business. The Court found, however, that despite the fact that the company had no assets or operations, the debtor’s interest in the marijuana company was illegal ab initio and ownership of an interest in the company constituted an ongoing violation of the CSA. Furthermore, the Court found that the lawsuit involved a loss of profits from an illegal business. Following a long line of bankruptcy cases, the Court found that reopening the case would require the Court to deal with an illegal asset in violation of Federal laws. In rendering its decision the Court noted that “participants in the marijuana industry will continue to experience difficulty and uncertainty in predicting the outcome of any song marijuana-related bankruptcy case unless and until Congress provides a legislative solution to the divergent federal and state drug laws.” The Court may enjoy the opera, but anxiously awaits the fat lady’s song.
§ 1.6 Real Estate
§ 1.6.1 Zoning
SEVEN HILLS, LLC, et al., Appellants, v. CHELAN COUNTY, Respondent, Case No. 36439-9-III, Unpublished Opinion Filed April 23, 2020.
Facts: Washington State voters approved Initiative 501 in 2012 to decriminalize most marijuana production and use in the state. Chelan County passed a moratorium on the siting of marijuana facilities in September 2015, and in February 2016, banned marijuana production and processing permanently in Chelan County. Appellant received four citations in September 2016, for manufacturing marijuana in violation of the local Chelan County ban on cannabis production and for operating without proper permits. Chelan County, in March 2017, then ordered Appellant to cease marijuana production and processing, and to remove all plants, growing structures, and propane tanks from the premises. Appellant alleged that they had a vested right to produce marijuana because they began operating legally prior to the enacted moratorium. They challenged the citations and the order to the county hearing examiner, who affirmed, and to the Chelan Superior Court, which did the same. Seven Hills then appealed to the Court of Appeals of Washington, Division 3.
Held: The Court of Appeals affirmed the decisions of the county hearing examiner and the Chelan Superior Court, ruling that Appellant did not establish that it had a valid nonconforming use, as it was not legally operating its production business prior to the moratorium established in September 2015.
Reasoning: While the appeal to the Court of Appeals raised two primary areas of challenge, the Court found Appellant’s arguments regarding the burden of proof at the administrative hearing and deficiencies regarding the county hearing examiner’s lack of legal citations to be without merit. When addressing the issue concerning Appellant’s alleged nonconforming use of the property, the Court analyzed the timeline of Appellant’s activities. In order to establish a nonconforming use despite local zoning ordinances, the use must lawfully exist, and continuously be maintained, prior to enactment of the regulation restricting such use. Here, the Court found that Appellant’s actions prior to the passing of the moratorium in September 2015 were not sufficient to establish a legal nonconforming use. Appellant claimed that the applications filed and permits obtained from the Chelan County officials in advance of the moratorium were in pursuit of the development and construction of marijuana production and processing facilities. However, the Washington State Liquor and Cannabis Board (WSLCB) first issued a license to Seven Hills to produce and process marijuana on January 26, 2016, two weeks prior to the passing of the permanent ban, but nearly four months following the temporary moratorium. The Court found that marijuana production remains illegal in Washington State absent permission from WSLCB to produce it. Therefore, Appellants actions prior to the issuance of the WSLCB permit could not sufficiently establish a legal nonconforming use of the property once the moratorium was enacted.
§ 1.6.2 Geographical Restrictions
TOP CAT ENTERPRISES, LLC, Appellant, v. CITY OF ARLINGTON, et al., Respondents, Case No. 79224-5-I, Opinion Filed: January 6, 2020. 11 Wash.App.2d 754 (Court of Appeals of Washington, Division 1).
Facts: The Washington State Liquor and Cannabis Board (WSLCB) was the agency tasked with awarding the retail licenses in Washington State following the approval of Initiative 501 in 2012. Licenses were initially granted using a lottery system and were assigned to specific jurisdictions. In 2015, with the passing of the Cannabis Patient Protection Act (CPPA), the number of available licenses increased by 222, but were awarded to applicants using a priority rating system (based on skill, experience, and qualifications in the marijuana industry). The CPPA also allowed certain previously awarded lottery licenses with jurisdictional limitations to transfer to other jurisdictions, but only once their WSLCB licensing approval process was complete and if an open spot remained in their desired target jurisdiction. Top Cat was a lottery winner that was unable to open in its initial jurisdiction due to a local moratorium. On December 8, 2015, 172nd Street Cannabis received its initial CPPA designation and sought the last available retail license in Arlington for a retail location. They sought to operate at a leased property located at 5200 172nd St., in Arlington, which was identified as lot 500B on the larger Arlington Municipal Airport property. On January 29, 2016, Top Cat applied to move its license to Arlington, but WSLCB then subsequently approved and issued the only available license to 172nd Street, before completing a final inspection of Top Cat’s application. Top Cat requested an administrative hearing before an Administrative Law Judge (ALJ) alleging that the 172nd’s leased property violated the CPPA requirement prohibiting marijuana retail locations within 1,000 feet of “the perimeter of the grounds of” a school, since Weston High School leases lot 301 from the Airport as well. The ALJ concluded that the measurement of 1,000 feet was to be calculated from the edge of the leased premises, not the larger Airport parcel. The Snohomish County Superior Court then affirmed the order and Top Cat appealed to the Court of Appeals of Washington, Division 1.
Held: The Court of Appeals agreed with the conclusions of the ALJ and WSLCB, finding that the ordinary meaning of “property line” should apply, which in this case was interpreted to mean that the distance should be measured from the line separating a lot from other adjoining lots or streets, not the edge of the larger parcel containing the lot.
Reasoning: The Court of Appeals of Washington stated that they interpret agency regulations as if they were statutes, but reviews an agency’s legal determinations de novo (but with substantial weight to an agency’s interpretation of statutes and regulations within its area of expertise). Under I-502, the WSLCB is prohibited from issuing “a license for any premises within one thousand feet of the perimeter of the grounds of any elementary or secondary school.” In the WSLCB regulations, the language included additional text providing that “The distance shall be measured as the shortest straight line distance from the property line of the proposed building/business location to the property line of” the prohibiting entity. Top Cat argued that “property line” should be understood as a legal description from a deed setting forth the boundaries of real property for the lot overall, which, they alleged, put the 172nd Street Cannabis’s location only 120 feet from the school property (because the Airport property is immediately diagonal from the proposed retail store). However, the Court of Appeals of Washington, agreeing with the prior decisions, confirmed that the 1,000 foot separation requirement must follow the plain meaning and should use the leased lot lines when calculating the distance. They concluded that the WSLCB’s measurement finding a 1,600 foot separation between the retail location and the school was consistent with the statute, the legislative intent and the plain meaning, thereby affirming the approval of 172nd Street Cannabis’ license.
The Mendes Hershman Student Writing Contest is a highly regarded legal writing competition that encourages and rewards law students for their outstanding writing on business law topics. Papers are judged on research and analysis, choice of topic, writing style, originality, and contribution to the literature available on the topic. The distinguished and highly-regarded former Business Law Section Chair, Mendes Hershman (1974-1975) lends his name to this legacy. See the abstract of this year’s third place winner, Kristen Kelbon of the Villanova University Charles Widger School of Law, Class of 2021, below.
The effects of the novel coronavirus pandemic (“COVID-19”) altered operations, financial performance, and market predictions for a vast majority of companies and industries in virtually a matter of weeks. In January 2020, the Senate held a private briefing where senators learned of classified information pertaining to COVID-19. Four U.S. senators subsequently dumped their stocks—just days before the market plummeted. The senators faced intense disparagement and accusations of potential insider trading, thus, the overarching question was whether these senators actually violated insider trading laws.
Prior to 2012, the conventional insider trading laws arguably did not apply to Congress. However, in 2012, Congress passed the Stop Trading on Congressional Knowledge Act (“STOCK Act”) into law, expressly prohibiting members of Congress from trading on material, nonpublic information they gleaned on Capitol Hill. The STOCK Act attempted to clarify whether members of Congress are subject to prohibitions on insider trading. However, it remains unclear whether the Securities and Exchange Commission or Department of Justice can successfully pursue civil and criminal actions against members of Congress under the current securities laws. Indeed, the STOCK Act has some deficiencies making it difficult to successfully prosecute congressional insider trading, and the coronavirus controversy renewed concerns about its effectiveness as a deterrent.
The recent insider trading scandal illustrates that the STOCK Act and preexisting insider trading statutes are not sufficient to prevent corruption and financial conflicts of interest. As such, high- profile stock transactions during the country’s worst pandemic, and accompanying economic crisis, should provide a sufficient impetus for a new Congress to revisit the issue of congressional insider trading and take appropriate action.
On March 31, 2021, the Consumer Financial Protection Bureau (“Bureau” or “CFPB”) announced the rescissions of a range of policy statements issued under the leadership of former Director Kathleen L. Kraninger. These rescissions rolled back one policy statement regarding communications between institutions subject to CFPB supervision and their examiners, and seven policy statements issued in the early days of the COVID-19 pandemic to provide regulatory relief to affected institutions. Below, we describe the state of play prior to these rescissions, the effect of each rescission, and what these developments tell us about the CFPB under new leadership.
Discontinuation of Supervisory Recommendations
From September 2018 until the March 2021 announcement, CFPB Bulletin 2018-01 provided the rules of the road regarding the CFPB’s communication of its supervisory expectations. Under the Bulletin, the CFPB could include in examination reports and supervisory letters two distinct categories of findings to convey supervisory expectations:
First, the CFPB could issue Matters Requiring Attention (“MRAs”), which were tied to a violation of federal consumer financial law and would provide directions for correcting the violation, remediating affected consumers, and addressing relevant weaknesses in the institution’s compliance management system (“CMS”). Covered persons receiving an MRA would be required to provide periodic reporting to the Bureau regarding the status of corrective actions, as well as the timeframes for completing such corrective actions.
Second, the CFPB could provide Supervisory Recommendations (“SRs”), which would recommend action in light of supervisory concerns related to CMS. Unlike MRAs, SRs would arise from perceived weaknesses in CMS, rather than actual violations of federal consumer financial law.
On March 31, 2021, the Bureau rescinded CFPB Bulletin 2018-01 and replaced it with CFPB Bulletin 2021-01. The new Bulletin ends the use of SRs outright, instead instructing examiners to “continue to rely on [MRAs] to convey supervisory expectations” in examination reports and supervisory letters. Under the new CFPB Bulletin 2021-01, MRAs no longer must be tied to a violation of federal consumer financial law, but may also result from “risk of such violations or compliance management system (CMS) deficiencies.” In effect, the function of SRs under Bulletin 2018-01 has been merged into the function of MRAs under Bulletin 2021-01.
The rescission represents a sudden and significant alteration to the supervisory relationship between the CFPB and the industry. As a practical matter, the change limits examiners’ ability to give feedback to institutions in a constructive, non-adversarial manner. SRs provided examiners with a middle ground between informal feedback and MRAs that could convey concrete recommendations to institutions, without legal sanction, while inviting further dialogue on achieving compliance goals. The gravity accompanying MRAs raises the stakes for institutions subject to CFPB examinations, and institutions may lose the ability to pursue innovative compliance approaches because MRAs impose specific, prescriptive remedial actions. Further, the Bureau’s statement that it may now issue MRAs even without a finding that an institution has violated the law could foreshadow operational micromanagement by examiners, requiring changes in CMS even when an institution has not deviated from the requirements of applicable laws.
Reversing Industry-Focused Pandemic Relief
Following the onset of the COVID-19 pandemic in the United States in early 2020, the CFPB (under the leadership of former Director Kraninger) issued a number of policy statements to offer relief to the financial industry, which was grappling with the practical realities of the pandemic. These industry-relief measures included the suspension of certain filing deadlines, relaxing of timeframes for certain responses to consumers, and the consideration of pandemic-rooted staffing changes in supervisory and enforcement determinations. Last month’s action by the Bureau included the rescission of seven statements that provided such industry-relief measures:
Statement on Supervisory and Enforcement Practices Regarding the Fair Credit Reporting Act and Regulation V in Light of the CARES Act: Under this policy statement, the CFPB had described the responsibilities of furnishers under the CARES Act, stated that it would not take supervisory or enforcement action based on a consumer reporting agency or furnisher’s failure to timely resolve consumer reporting disputes so long as the institution “mak[es] good faith efforts to investigate disputes as quickly as possible,” and encouraged institutions to provide payment relief options to consumers. The Bureau’s rescission undoes much of the policy statement’s regulatory relief and flexibility for conduct after March 31, 2021, stating the CFPB’s “intent to exercise its supervisory and enforcement authority consistent with the Dodd-Frank Act and FCRA and with the full authority afforded by Congress consistent with the statutory purpose and objectives of the Bureau.” However, the rescission leaves intact provisions that encourage voluntary payment relief efforts and that provide that the CFPB will not take supervisory or enforcement action against an institution that furnishes information accurately reflecting such relief.
Statement on Supervisory and Enforcement Practices Regarding Regulation Z Billing Error Resolution Timeframes in Light of the COVID-19 Pandemic: This statement had provided that the CFPB would not take supervisory or enforcement action against a creditor that failed to timely resolve a billing error notice under Regulation Z, so long as the creditor complied with all other applicable requirements and made a good faith effort to obtain the necessary information and make a determination as quickly as possible. The Bureau’s rescission lifts this regulatory relief effective April 1, 2021, stating that the CFPB “intends to exercise its supervisory and enforcement authority consistent with the Dodd-Frank Act and with the full authority afforded by Congress consistent with the statutory purpose and objectives of the Bureau.”
These seven rescissions show a clear shift in focus from the pandemic response of the Bureau under Director Kraninger. The initial policy statements targeted the effects of the pandemic on the financial industry, such as the need to shift to remote work in light of stay-at-home orders. While the Bureau encouraged institutions to work with consumers facing hardship as a result of the pandemic, such encouragement was voluntary only.
In contrast, the rescissions pivot the CFPB’s efforts towards ameliorating the effects of the pandemic on consumers through robust supervision and enforcement. In doing so, the Bureau points to changed circumstances for the industry in the time since the policy statements were issued, such as the successful transition to remote work, the ability to resume in-person work in certain limited capacities, and the lifting of stay-at-home orders in some jurisdictions. The CFPB portrays different circumstances for consumers than those in effect at the time the statements were issued: Acting Director David Uejio, in announcing the rescissions, opined that “[t]he virus has affected industry as well as consumers, but individuals and families have been hardest-hit by the pandemic’s health and economic impacts.”
Lessons from the Rescissions
The rescissions of these policy statements illustrate a number of changes at the Bureau under the direction of Acting Director Uejio. The undoing of the pandemic-centered regulatory relief aligns with an increased focus on consumers experiencing financial distress as a result of the pandemic. Acting Director Uejio has described this as a top priority of the CFPB since his first days on the job, and the Bureau has demonstrated a focus on housing insecurity amid the pandemic through a proposed rulemaking, a joint statement, and a research report.
More generally, these rescissions mark a conscious change in direction—in supervision, enforcement, regulation, and general tone from the top—from that of the CFPB under Director Kraninger. Much like the Bureau’s March 11, 2021 rescission of a Kraninger-era policy statement setting parameters around the Dodd-Frank prohibition on abusive acts or practices, these shifts send the message that the CFPB is acting to dissolve Kraninger-era roadblocks on its discretion to interpret and enforce the law. Taken together, these actions suggest that the Bureau under Acting Director Uejio (and, if confirmed, Director Rohit Chopra) will move forward with a far-reaching approach to consumer protection, even at the cost of reduced clarity for the industry.
A human resources department now culls through resumes using an Artificial Intelligence (AI) tool. No human eyes see the candidates’ credentials until the pool of job seekers is culled down to a manageable number. Elsewhere, an online insurance company has a very quick turnaround and low cost of client acquisition when selling life insurance. Prospective clients provide minimal personal information into a web interface and thereafter the company’s AI application crunches the provided information with various relevant databases to automate underwriting and make a go, no-go decision within hours, not days or weeks. Somewhere, a financial organization uses chatbots to securely process banking transactions for customers. Another firm uses facial recognition to allow employees to enter the building and to gain access to the company’s technology systems and data. Healthcare professionals use AI to improve accuracy and efficiency in diagnostics, treatments, and predictions. And a widget manufacturer does quality control and visual inspection with the aid of Machine Learning so that human verification of its products is no longer necessary.
All of this makes business better, cheaper, and happen faster. But the changes that come with new processes require lawyers, business folks, and information and technology professionals (at a minimum) to play a new role in managing the informational output of the processes to deliver compliance with laws and regulations, and to manage risk and cost. This article explores how AI creates information that must be proactively managed and who is needed to get such management done right.
Will AI Be Coming to Your Company?
There are numerous predictions about the growth and impact of AI, Machine Learning (teaching a tool by using known parameters) and Deep Learning (neural networks that behave like a human brain), and it appears that these technologies will continue to be transformative. The corporate pressure to use AI makes it almost impossible to avoid if your corporation wants to stay competitive. According to the International Data Corporation (IDC), the AI hardware and software market is predicted to be $156 Billion in 2021. What this means in practical terms is that many businesses are committing to using these powerful tools to transform all kinds of business processes. But as AI changes the way businesses function, there is still a need for regulatory compliance, and to have evidence of business activities and operations.
AI isn’t just about “running faster,” as the implementation of AI tools creates unique, information issues (e.g. ownership, bias, privacy, retention), which must be addressed by the company using the AI. An example may help make this point clear.
Building a Better Widget: A Business Case
Company manufactures and sells widgets around the world. While they produce high quality widgets, ABC Company is always striving to better the process, predict errors, advance new innovations, and cut costs. The head of manufacturing entertains various proposals each year to help manufacture a better widget. So how can ABC Company automate more of the manufacturing process and make AI robots do the heavy lifting? How can the manufacturing process attain better product consistency and reduce variables in the manufacturing process across the globe, in the various plants?
Just about every proposal advanced in 2021 to better the manufacture of the widget involves the application of technology in various aspects of the manufacturing process (sometimes referred to as Digital Transformation[1] or applying new technologies to radically change processes, customer experience, and value). So, ABCCompany decides to begin producing widgets by using robots, and inspecting them with the aid of AI tools. ABC Company’s R&D team decide to make the widgets “smart,” such that the widgets now send information back to ABC Company.
Every time technology is brought to bear on the design and development of the widget, there is new information output that needs to be addressed. In other words, the company has to deal with issues like information access, ownership, control, lifecycle, etc. for each new process that bettered the manufacturing process of the widgets. And unless these issues are addressed up front from legal, information and records, technical and business perspectives, there will be many downstream legal issues that are more thorny to unwind.
So, for example, because ABC Company’s widget became “smart” and sends information back to the company, there are now privacy, liability, ownership and other previously unaccounted for challenges. And because ABC Company’s widget is now produced by robots and inspected with the aid of AI tools, there is information output which must be managed. The remainder of this article provides an approach to taking on these new information issues.
Let the Past Be Your Guide
As AI technology is introduced into your business processes, it may make sense to use the old rules that you developed in the past as a guide and morph them for today’s technology realities, rather than starting from scratch in your approach to managing the information that is generated because of AI. Let’s say your company is using AI tools to cull through engineers’ resumes, in order to find skilled resources to help build the new manufacturing lines; the engineers’ experience will be vital to reworking the manufacturing process. If your company previously kept the resumes for workers that you did not hire, then it may be worth keeping the resumes reviewed by the AI tool as well. Perhaps the resumes rejected by the AI tool will be useful if you wish to interview the candidates in the future, such as for a position different from the candidate’s original application. Or perhaps the resumes were kept in the past to address claims of discriminatory hiring – in this case, keeping not only the resumes reviewed but also the method the AI tool used to cull through the resumes seems logical. In any event, it is essential to consider what existing laws and regulations say about retaining the information in the relevant jurisdictions.
Does the Information Document a New Process or System?
When the implementation of AI technology to a business process creates a whole new way of doing things, you will need to consider how the technology functions; what information is used in or created by the process; how the process and AI technology is set up and what the output of the process is.
Setup
Let’s say ABC Company wants to do a better job of quality control on their widgets while also phasing out inspection operators on the assembly line. Instead of using humans to review the quality of the widgets during production, the new process will use AI tools. Images of the widget will be taken and compared to the images that were used to train the AI tool to determine which widgets conform to quality standards and which widgets don’t meet specifications. Machine Learning techniques (or something similar) will be required to get the system to assess which widgets pass the minimum quality standards without human intervention. If done correctly, the AI or Machine Learning application will be far faster and more consistent at reviewing the quality of the manufactured product.
To get this process right, the following questions regarding information retention should be considered:
Should information related to the development, sourcing and implementation of the AI software and any hardware to run the AI or Machine Learning process be retained, and for how long?
Should the company keep information related to the decision-making process during which it was determined where AI would be applied in the business or manufacturing process?
Should the company retain information related to the AI technology in use (both hardware and software), and if so, what information should be kept?
What decisions regarding implementation of the AI technology should be documented for future reference?
Should the company retain documentation related to the AI functionality?
What information regarding training and testing (Machine Learning) should be retained?
What does the law of the relevant jurisdictions say about retaining these various types of information?
Machine Learning and the Need to Understand Training Records
Back to the earlier example, if the company is seeking to replace human inspection with AI tools, a “learning” or “training” process will be needed to teach the system what good widgets look like, and what defective parts should be flagged or discarded. Many training examples will be needed to “educate” the AI system on what to look for and how to determine if a part is good or bad. Can an algorithmic equation be used effectively to unearth defective parts? Yes! And AI and Machine Learning are doing a whole lot more to increase efficiency in areas beyond manufacturing as well.
So, what should ABC Company do with the training examples after the AI system has been trained? To the extent that the system will need to be retrained in the future, the training examples should be kept. Also, if they are needed to keep the AI system running (if the system needs to refer to good and bad samples for comparisons, i.e.), the training examples should be retained as well.
If a regulator wants to review how the system functions, you will want to be able to show how the system was trained and why you know it is doing the job it was trained to do. In the HR context, if an AI tool is assisting in the resume culling process to find the right candidate, the way in which the system was trained could be the focus of a discrimination claim. The company will want both the training examples and evidence of the process used to demonstrate that the system doesn’t discriminate.[2]
What Happens when Information Volumes Grow?
The AI and Machine Learning processes sometimes create huge volumes of information as part of the process. But does all that information need to be retained? When you are determining what – if any – of the AI process’s informational output should be retained and for how long (two complicated questions), you need to assess the business utility of the content as well as any legal obligation to retain the information. This requires an upfront analysis of the business need for the information and what laws dictate that a record of the process is retained. In that regard, not all information output must be considered a “Record” for long term retention. In the case of the widgets, if multiple images are obtained to ensure the parts in production have passed, an analysis of business needs could become critical in weighing the cost of retaining every image obtained.
So, part of the informational output of the AI or Machine Learning process may be records while other output will not rise to the level of a record requiring retention. Usually, the company can decide what records of the business process they want to retain, but that too can be a complicated question. In any event, it is likely not necessary to retain all information as a record of the new business process. Getting a handle on this issue will require working through the various business and legal issues with the lawyers, business folks and IT professionals. Again, a team approach will get the company to the full-bodied right answer.
Consider Ownership
Whenever technology creates new information, the company should consider if there are any information ownership issues. Say for example, as part of the manufacturing line renovation project, ABC Company plans on installing smart monitoring tools to manage electricity utilization, and smart line vibration technology that will seek to maximize the stability of the manufacturing line so that the end-product remains consistently produced over time. Each of the monitoring devices are an Internet of Things (IoT), which means that they will be connected to the network and send data in real time to a centralized server. Many times, this IoT will be a cloud-based service. Assuming the server or service is owned by the maker of the monitoring equipment company, will ABC Company have access to the information (beyond its immediate use in adjusting equipment, etc.)? Perhaps more importantly, who owns the data that came from the manufacturing line monitoring tools? Who will get to use that information and how can they use it? Can the monitoring equipment company sell the data that came from ABC Company’s factory? Can they use it to improve the quality of the monitoring tools they might provide to other widget companies? You get the point. For every new stream of information, the company needs to understand who owns the information, what the access is, and the use your company will have of the information. Waiting until the process is up and running is too late to address ownership of information issues. Negotiate ownership, access, use and privacy issues up front in the contract for a more predictable and less painful result.
Consider Privacy and Information Security
Like all business processes that create or store information, consideration should be given to ensuring private information remains private, securing and locking down information as needed, and protecting company intellectual property and trade secrets. It is important to avoid unintended and unaccounted for data collection. For example, if a camera is capturing images of a manufacturing process, will it also capture images of a human operator? Are there additional data privacy considerations that need to be made? Also be aware that every time a new piece of technology or network connected device is added to a business process, that may be another way for your company systems to be hacked, exposed, exploited, and pilfered.
Conclusion
For every technology applied to a business process, there is information output that must be managed. And for all informational output that requires management, there are questions that need lawyers, business leaders, and technology and information professionals to weigh in. In that sense AI, Machine Learning, IoT and the application of any new technology is a team sport.
[2] Randolph A. Kahn, Niki Nolan, James Beckmann. “When Algorithms Inherited the Earth, How They Learned to Discriminate and What You Can Do About It.” April 17 2020. https://businesslawtoday.org/2020/04/algorithms-inherited-earth-learned-discriminate-can/
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