Definitions of the term “Material Adverse Effect” (“MAE”) in business combination agreements typically contain exceptions from the definition for events arising from certain systematic risks.[1] Common exceptions pertain to general changes in business or economic conditions, changes in financial or securities markets, and changes in the industries in which the target operates. Other common exceptions pertain to force majeure events or changes in law or generally accepted accounting principles (“GAAP”). Such exceptions have figured prominently in the MAE cases arising from the COVID-19 pandemic, such as AB Stable[2] and KCake[3] in Delaware and Fairstone[4] in Canada. Indeed, these cases have revealed a latent ambiguity in the typical MAE definition: sometimes the causal background of a material adverse effect on the target is complex, with an earlier event E1 (such as a pandemic) causing a later event E2 (such as governmental lockdown orders) and the later event E2(the lockdown orders) causing the material adverse effect on the target. If the MAE definition allocates the risk of both events to the same party, then clearly that party bears the risk of the material adverse effect, but what happens if the definition allocates the risk of one event to one party and the risk of the other event to the other party? If the target bore the risk of a pandemic but the acquirer bore the risk of lockdown orders (under an exception related to changes in law), has there been a Material Adverse Effect or not?
Albeit only in dicta, the courts in AB Stable[5] and KCake[6] both resolved this particular problem by saying that there would be no Material Adverse Effect. The court in Fairstone reached a similar conclusion.[7] Further complicating the problem, the court in KCake also considered the effect of language in the MAE definition introducing the exceptions and expanding their scope to include not only events falling into the exceptions but also events “arising from” or “related to” such events. The problems that these cases raise thus involve the meaning of the language in the exceptions, the relation of the exceptions to the main part of the MAE definition and to each other, and the effect of the language introducing the exceptions.
Starting with First Principles
In a new article on Pandemic Risk and the Interpretation of Exceptions in MAE Clauses[8] forthcoming in the Journal of Corporation Law, I argue that, to make sense of these issues, we should begin by taking a step back and reflect on the general structure of a typical MAE definition. In my view, there are two aspects of that definition that are critically important in this context. First, in MAE definitions, the (capitalized) term “Material Adverse Effect” is defined to mean any event that has or would reasonably be expected to have (the exact language varies) an (uncapitalized) material adverse effect on the target. The definition thus involves two separate things, an event and a material adverse effect that the event causes, which are related as cause to effect. It is counterintuitive but nevertheless apparent from the face of the definition that a (capitalized) Material Adverse Effect is not an (uncapitalized) material adverse effect. Rather, a Material Adverse Effect is an event that causes (i.e., “has or would reasonably be expected to have”) a material adverse effect.
Of course, good transactional lawyers know all this, but they nevertheless often speak imprecisely, running together Material Adverse Effects and material adverse effects, an infelicitous habit that is greatly facilitated by the fact that the three-letter abbreviation “MAE” is used indiscriminately for both concepts. Confusions of Material Adverse Effects with material adverse effects crop up in ordinary speech when someone says that a company “has suffered a Material Adverse Effect”; if anything, the company suffered a material adverse effect because some event occurred that was a Material Adverse Effect. Some confusions even appear in the text of merger agreements negotiated by expert counsel, as when a representation is required to be true except for “inaccuracies that would not have a Material Adverse Effect”; if anything, the inaccuracies just are a Material Adverse Effect because they are facts or events that would reasonably be expected to have a material adverse effect on the company. Because, as we shall see, such confusions are not always harmless, I shall distinguish in this article clearly and consistently between Material Adverse Effects and the material adverse effects that they cause.
The second feature of MAE definitions I want to emphasize concerns how they allocate risk between the parties. In particular, such definitions allocate risk on the basis of events causing material adverse effects, not on the basis of material adverse effects arising from such events. That is, the definition takes the universe of all possible events and divides these events into two classes—events the risk of which is allocated to the target, and events the risk of which is allocated to the acquirer. In particular, MAE definitions effect this division by saying all events causing a material adverse effect are Material Adverse Effects, except for events falling into one of the exceptions enumerated in the definition. Hence, the risk of an event causing a material adverse effect is allocated to the target, unless the event falls into an exception, in which case the risk of that event is allocated to the acquirer. Exceptions in the MAE definition apply to events, and whether the risk of an event is allocated to the acquirer or the target depends on whether the event falls into an exception or not.
What Is Included with an Allocated Risk
The fact that Material Adverse Effects are not material adverse effects but events causing material adverse effects, and the fact that MAE definitions allocate risks on the basis of events not effects are both evident from the plain language of the typical MAE definition. For this reason, I think both are well-nigh indisputable. There is another key point about the typical MAE definition, however, that is implicit in the definition and so not immediately evident from the text. This point concerns exactly which risks are allocated when an MAE definition allocates to one party or another the risk that a certain event will occur. To grasp this point, notice that MAE definitions allocate the risks that certain events may occur not because the parties care about those events in and of themselves; MAE definitions allocate the risks that certain events may occur because those events may have a material adverse effect on the target. That is why MAE definitions define Material Adverse Effects in terms of their effects—that is, they define an event to be a Material Adverse Effect in terms of the event’s having, or being reasonably expected to have, a material adverse effect on the target. Therefore, when an MAE definition allocates to one party or the other the risk that a certain event may occur, what is being allocated is the risk that the event occurs along with all of the event’s reasonably-expected consequences, up to and including any reasonably-expected material adverse effect on the target.
To see just what that means, reflect that events rarely have material adverse effects on a company immediately and directly. On the contrary, events typically result in material adverse effects, if at all, only through generally predictable causal pathways. Indeed, parties single out certain kinds of events and specifically allocate the risks of those events precisely because the parties know that such events tend to set in motion a sequence of events that often lead to a material adverse effect. For example, suppose the MAE definition allocates to one party or the other the risk of “a change in interest rates,” and after the agreement is signed the Federal Reserve’s Federal Open Market Committee (the “FOMC”) announces that it has decided to increase its target Federal Funds Rate. This decision is a “change in interest rates,” and the risk of any material adverse effect reasonably expected to follow from that change is allocated to the party that bears the risk of such change. But any adverse effect on the target resulting from this decision by the FOMC would come about only through a long and complicated, but nevertheless reasonably-expected, sequence of events. In particular, the FOMC’s decision to increase the target Federal Funds Rate will result in the Trading Desk at the New York Federal Reserve Bank making certain purchases of securities in the open market, and this, via the decisions of bond traders and commercial bankers, will likely result in a change in the effective Federal Funds Rate, which is an average of the rates depository institutions actually charge each other for overnight loans of banking reserves. That change, via the trading decisions of innumerable market participants, will filter through the credit markets, eventually increasing the yield on long-term Treasury bonds, which will (under accepted principles of corporate finance) increase the company’s cost of equity capital, thus reducing the present value of its future cashflows. When the parties allocate the risk of a change in interest rates, they do so precisely because they understand that changes in interest rates tend to have such consequences, up to and including a reduction in the value of the target when the present value of its future cashflows is reduced in the manner stated. It would subvert the intention of the parties were someone to later argue that, because the causal sequence from the decision by the FOMC to the reduction in the present value of the company’s future cashflows runs through a great many other events, the material adverse effect on the target should be attributed not the decision by the FOMC but to some intermediate event in the causal sequence, such as the decisions of bonders traders reacting to the FOMC’s decision. On the contrary, in allocating the risk of a change in interest rates, the parties are allocating the risks of all events that would reasonably be expected to follow from a change in interest rates, up to and including any reasonably-expected material adverse effect on the company. More generally, when an MAE definition allocates the risk of a certain event, it allocates the risk of all other events reasonably expected to follow from that event. Indeed, the whole point of allocating the risk of the event is to allocate the risk of the reasonably-expected consequences of the event, again, up to and including any material adverse effect on the company.[9]
How to Apply MAE Definitions in Causally Complex Cases
Such considerations show us how we should apply MAE definitions when the causal background of a material adverse effect runs through multiple events and the definition allocates the risks of different events to different parties. Thus, suppose that a first event E1 (say a pandemic) causes a second event E2 (such as governmental lockdown orders) and the second event E2 (the lockdown orders) causes a material adverse effect on the company (because the orders curtail its operations), and suppose further that the MAE definition allocates the risk of E1 (the pandemic) to the target and the risk of E2 (the lockdown orders, under an exception for changes in law) to the acquirer. In such cases, when event E1 (the pandemic) occurs, the relevant question under the MAE definition is whether that event would reasonably be expected to have a material adverse effect on the target. If so, since the target bore the risk that event E1 (the pandemic) would occur, E1 is a Material Adverse Effect. This is true even though the causal pathway from E1 (the pandemic) to the material adverse effect runs through another event E2 (the lockdown orders) that is of a kind that, generally speaking, falls into an exception, which would shift the risk of such an event to the acquirer. The reason is that, in allocating to the target the risk of a pandemic, the MAE definition allocated to the target everything that is reasonably expected to follow from a pandemic, and if a pandemic actually occurs and is such that it would reasonably be expected to result in certain lockdown orders, then the risk of such orders was included with the risk of the pandemic. As a matter of contract interpretation, the specific governs over the general, and even if the risk of changes in law was generally allocated to the acquirer, nevertheless in allocating the risk of a pandemic to the target, the MAE definition also allocated to the target the specific risk of lockdown orders reasonably-expected to follow from a pandemic. This is the reasonable way of giving effect to both allocations of risk made by the MAE definition.
Now, although in allocating the risk of a pandemic to the target the MAE definition also allocated the risk of all events reasonably expected to follow from a pandemic, including any reasonably-expected lockdown orders, nevertheless the acquirer could concede arguendo that the risk of lockdown orders resulting from a pandemic was allocated to it under the exception for changes in law and yet still succeed in showing that there had been a Material Adverse Effect. The reason is that, in situations like this, where the risk of the more remote event E1 (here the pandemic) is allocated to the target and the risk of the more proximate event E2 (here the lockdown orders) is allocated to the acquirer, there is an even stronger argument available to the acquirer, an argument that does not require the acquirer to rely on the fact that, in allocating a risk, an MAE definition allocates the risk of everything reasonably expected to follow from that risk. That is, the acquirer can argue that, if the more remote event E1(the pandemic) occurs and would reasonably be expected to have a material adverse effect on the target, then that event is a Material Adverse Effect under the express terms of the MAE definition. It may well be perfectly true, the acquirer may say, that some other eventE2(the lockdown orders) is not a Material Adverse Effect because the risk of such an event was allocated to the acquirer. But the fact that some other event is not a Material Adverse Effect in no way changes the fact that E1 (the pandemic), the risk of which was allocated to the target, is a Material Adverse Effect. The acquirer will say that, in arguing that the risk of a change in law was allocated to the acquirer and so cannot be a Material Adverse Effect, the target is like the defendant who, charged with the murder of Jones, proves he did not kill Smith.
Now, what is good for the goose is good for the gander, or, more accurately, MAE definitions treat all events in the same way, whether the risk of the event is allocated to the target or to the acquirer. Thus, suppose again that a first event E1 (a pandemic) causes a second event E2 (lockdown orders), with event E2 (the lockdown orders) causing a material adverse effect on the company, but this time suppose that that the MAE definition allocates the risk of event E1 (the pandemic) to the acquirer and the risk of event E2 (the lockdown orders) to the target (because there is no exception for changes in law). If a pandemic occurs and is such that it would reasonably be expected to have a material adverse effect on the target, then that risk has been allocated to the acquirer, and so the pandemic is not Material Adverse Effect. If the acquirer says that it bore the risk of a pandemic but not the risk of changes in law, and the material adverse effect on the target resulted from governmental lockdown orders (albeit ones that themselves resulted from the pandemic), the answer is that in allocating the risk of a pandemic to the acquirer, the MAE definition also allocated to the acquirer the risk of all events reasonably expected to follow from the pandemic up to and including any material adverse effect on the target. Hence, if the pandemic results in lockdown orders of a kind reasonably expected to follow from the pandemic, and those orders have a material adverse effect on the target, the risk of such orders was allocated to the acquirer along with the risk of the pandemic itself. It does not matter that, in general, the MAE definition allocated the risks of changes in law to the target. In this specific case (and the specific governs over the general), the risk of these changes in law (the lockdown orders reasonably to be expected to follow from the pandemic) were specifically allocated to the acquirer when the acquirer agreed to bear the risk of a pandemic and, by implication, everything reasonably to be expected to follow from any pandemic that actually occurs.
It is important to understand, however, that the target cannot concede arguendo that the risk of the change in law was allocated to it and still claim it is entitled to prevail in the way the acquirer could when the roles were reversed and the target bore the risk of the more remote event E1 (the pandemic) and the acquirer bore the risk of the more proximate event E2(the lockdown orders). The acquirer could make this concession and still prevail because it could argue that the more remote event, E1 (the pandemic), the risk of which was allocated to the target, was still a Material Adverse Effect even if some other event, such as E2 (the lockdown orders), was not a Material Adverse Effect because that other event fell into an exception. The target cannot make an analogous argument because such an argument would amount to saying that, since the more remote event E1 (the pandemic) is not a Material Adverse Effect (because the risk of such an event was allocated to the acquirer), it does not matter that the more proximate event E2 (the lockdown orders), the risk of which was allocated to the target, is a Material Adverse Effect. Clearly, such an argument does nothing to help the target, for it most certainly would matter that there was another event that was a Material Adverse Effect. Indeed, such a point would be decisive. This form of the argument (as long as one event is a Material Adverse Effect, it does not matter that some other event is not) is available to the acquirer while the analogous form of argument (as long as one event is not a Material Adverse Effect, it does not matter than some other event is) is not available to the target because of the fundamental asymmetry between acquirers and targets in relation to MAE clauses. That is, for the acquirer to prevail, there need be only one event that is a Material Adverse Effect, and so the acquirer can shrug off the existence of events that are not Material Adverse Effects; but for the target to prevail, there need be no events that are Material Adverse Effects, and so the target cannot shrug off events that are Material Adverse Effects.
This asymmetry puts the target at a disadvantage in cases where the risk of the more remote event E1 is allocated to the acquirer and the risk of the more proximate event E2 at least appears to be allocated to the target in the sense that it is not expressly covered by an exception from the MAE definition. As explained above, under the correct interpretation of the MAE definition, the allocation of the risk of event E1 includes the allocation of the risk of all events reasonably expected to follow from event E1, including event E2 (assuming E2 really would reasonably be expected to follow from E1). The target is at a disadvantage, however, because, unlike the acquirer, it cannot make the kind of argument explained above but would have to argue that, in allocating the risk of the more remote event E1 (the pandemic) to the acquirer, the MAE definition also allocated the risk of all events reasonably expected to follow from E1, which would include event E2 (the lockdown orders). This argument is perfectly sound, but the target would still have to make it, which puts the target at a disadvantage relative to the acquirer in the analogous situation. There is, however, a simple drafting solution to this problem: the MAE definition can make explicit what is already implied by expressly providing that, when the risk of a certain event is allocated to the acquirer under an MAE exception, allocated along with that risk are the risks of all events reasonably to be expected to follow from that event. And, in fact, the language introducing the exceptions in the MAE definition typically does exactly this by expressly stating that excepted from the definition are not only events falling into the exceptions but also all events “arising from” events falling into the exceptions. This language thus restores a certain parity between the target and the acquirer by ensuring that the risks of events allocated to them are treated in the same way.
Why the Courts Have Misread the Exceptions in MAE Definitions
If all this correct, then the courts that have thus far confronted these issues have been misreading the exceptions in the MAE definitions before them in rather serious ways. Take AB Stable, by far the best-reasoned of these cases. Albeit only in dicta,[10] the court in that case suggested that, even if the target had borne the risk of a pandemic, exceptions in the MAE definition for changes in business conditions, changes in industry conditions, and changes in law would each have applied, with the result that there was no Material Adverse Effect.[11] Now, the court’s argument for that conclusion has three main steps. In the first, the court stated that the various exceptions to the MAE definition are to be read independently of each other in the sense that whether an event falls into an exception depends on the language in that exception and is independent of whether the event would fall also into some other exception.[12] That proposition, I think, is entirely correct.
In the second step, however, the court said that whether an event falls into an exception is also independent of whether any event causing that event falls into an exception, and thus, for example, governmental lockdown orders would fall into an exception related to changes in law even if the orders resulted from a pandemic and the pandemic was not excepted.[13] Although I myself once argued for exactly that proposition[14] (and the court cited one of my working papers in reaching that conclusion),[15] for the reasons given above I now think that this is mistaken. The better view is that, when the MAE definition allocates the risk of an event, it allocates along with that risk the risk of all the reasonably-expected consequences of the event. Hence, if a pandemic is such that it would reasonably be expected to result in lockdown orders, then the risk of those orders is allocated along with the risk of the pandemic. It was a mistake for the court to treat events reasonably expected to follow from the pandemic as being separate events under the MAE definition.
But even making this mistake, the AB Stable court could still have reached the right result, for it was still open to the acquirer to argue that, although the lockdown orders were not a Material Adverse Effect (because they fall into the exception for changes in law), nevertheless the pandemic, a quite different event, was a Material Adverse Effect, for it did not fall into any exception and would reasonably be expected to have a material adverse effect on the target. As explained above, this reasoning is perfectly sound, and although it is not clear whether the acquirer made this argument, it is clear that the court would have rejected it because of an additional and even more serious mistake in the third and final step of the court’s argument. That step is left mostly implicit, but from what the court says explicitly elsewhere in the opinion, we know that the court thinks that if “the cause of the [material adverse] effect fell within an exception to the MAE Definition,” then “the effect could not constitute a Material Adverse Effect.”[16]
This innocuous-sounding sentence conflates material adverse effects and Material Adverse Effects and leads to a near reversal of the internal logic of the MAE definition. That is, in the situation that the court is considering, an event causing a material adverse effect falls within an exception. What follows from this is that this event is not a Material Adverse Effect. What the court thinks follows from this is that the material adverse effect caused by the event is not a Material Adverse Effect. But this latter conclusion is nonsense, for it is events causing material adverse effects that are Material Adverse Effects (if the event is not excepted) or not Material Adverse Effects (if the event is excepted); material adverse effects themselves cannot be Material Adverse Effects. Thinking they could be is a category mistake. Moreover, confusing material adverse effects with Material Adverse Effects in this context leads the court to the erroneous view that exceptions in the MAE definitionapply to material adverse effects in the sense that, if an excepted event causes a material adverse effect, then not only is that event itself excepted but the material adverse effect it causes is excepted too, and so any other event causing that material adverse effect is treated as if it were excepted as well, even if it is plainly not excepted. That is why, in the court’s view, if the lockdown orders (an excepted event) cause a material adverse effect, the pandemic that caused the same material adverse effect (via the lockdown orders) is not a Material Adverse Effect: on the court’s view, the pandemic is not a Material Adverse Effect because the material adverse effect it causes has been “excepted” since it was also caused by an excepted event (the lockdown orders). This is all quite wrong, of course, because the exceptions in an MAE definition plainly apply to events causing material adverse effects and not to material adverse effects themselves, and the fact that one event is not a Material Adverse Effect does not generally imply that some other event is not a Material Adverse Effect.
Now, as I argued above, on the correct reading of the MAE definition, acquirers enjoy a certain natural advantage in MAE disputes. That is, the acquirer prevails if there is even one Material Adverse Effect, that is, even one unexcepted event that would reasonably be expected to have a material adverse effect. The existence of other events that are not Material Adverse Effects is irrelevant. By contrast, the target prevails only if every event is not a Material Adverse Effect, that is, every event is either excepted or would not reasonably be expected to have a material adverse effect. The court’s reading of the MAE definition negates this natural advantage enjoyed by the acquirer and confers an analogous advantage on the target. Under the court’s reading, if there is even one excepted event that would reasonably be expected to have a material adverse effect, then that material adverse effect is excepted, and no event, excepted or unexcepted, causing that effect is a Material Adverse Effect. Hence, for the acquirer to prevail, every event causing a material adverse effect must be unexcepted, and if there is even one excepted event causing that material adverse effect, the target wins. Put yet another way, if there are many events causing a material adverse effect, under the proper reading of the MAE definition, the acquirer wins if even one of them is unexcepted; under the court’s reading, the acquirer wins only if every one of them is unexcepted. By making the MAE exceptions apply to material adverse effects rather than the events causing them, the court’s reading has negated the natural advantage of the acquirer and conferred an analogous advantage on the target.
Furthermore, recall that, when the risk of a remote event E1 (such as a pandemic) was allocated to the acquirer and the risk of a proximate event E2 (such as lockdown orders) was allocated to the target, the acquirer’s natural advantage under the proper reading of the MAE definition (it takes only one unexcepted event having a material adverse effect for there to be a Material Adverse Effect) creates the possibility that the acquirer may ignore the principle that for purposes of the MAE definition an event includes all its reasonably-expected consequences and argue speciously that, even if the remote event E1 (the pandemic) was not a Material Adverse Effect, the proximate event E2 (the lockdown orders) resulting from E1 was a Material Adverse Effect. Recall, too, that such specious arguments can be blocked by language in the MAE definition introducing the exceptions and providing that events arising from excepted events are excepted. The court in AB Stable, by treating exceptions in the MAE definition as if they applied to material adverse effects rather than events causing material adverse effects, has not only negated the acquirer’s natural advantage under the MAE definition and conferred an analogous advantage on the target, but it has also created the possibility of the target making analogously specious arguments against the acquirer. That is, when the risk of a pandemic is allocated to the target, but the risk of changes in law is allocated to the acquirer, the target ought not be permitted to distinguish between the pandemic and any lockdown orders reasonably expected to arise from it. To block such a move, there is a drafting solution analogous to the language introducing the exceptions and providing that events arising from excepted events are excepted: such a solution would involve having the MAE definition provide that events arising from non-excepted events are not excepted.
Unsurprisingly, therefore, the court in AB Stable pointed out that its interpretation of the MAE exceptions could be blocked if the language in the exceptions included a proviso to the effect that otherwise excepted events would not be excepted after all if they arose from unexcepted causes.[17] Of course, such a proviso should be doubly unnecessary. It is unnecessary in the first instance because, in allocating the risk of an event to the target, the MAE definition allocates as well the risk of any event reasonably expected to follow from the event. It is unnecessary a second time because, if exceptions are understood to apply to events causing material adverse effects and not to material adverse effects themselves, even if an event arising from an unexcepted event is excepted and so not a Material Adverse Effect, nevertheless the unexcepted event from which the excepted event arises may be a Material Adverse Effect in its own right, which is all the acquirer needs to prevail. Hence, the fact that the court noted that parties could add a proviso to the MAE definition to make events arising from unexcepted events unexcepted shows again that the court had reversed the basic logical structure of that definition.
In sum, there are two problems with the reasoning in AB Stable. The first and less serious is a failure to appreciate that, in allocating the risk that a certain event will occur, the MAE definition also allocates the risk of all events reasonably expected to follow from the event, up to and including any reasonably-expected material adverse effect on the target. The second and more serious is that, by conflating Material Adverse Effects with material adverse effects at a critical point in the argument, the court has made exceptions in MAE definitions apply to material adverse effects rather than Material Adverse Effects,[18] which largely reverses the internal logic of the MAE definition.
The Origin of the Confusion in AB Stable
Now, as I mentioned above, even the most expert and experienced transactional lawyers sometimes conflate Material Adverse Effects and material adverse effects, which suggests that the AB Stable court ought not be judged harshly for falling into this mistake at a critical point in the argument. In fact, however, the particular form of the confusion in AB Stable, making exceptions in MAE definitions apply to material adverse effects instead of events causing them, is not the court’s fault at all. If anyone is responsible for this mistake, I am. The mistake existed in both scholarly and practitioner literature for years before AB Stable, but the earliest example of this mistake that I have found is in one of my own law review articles from 2009.[19] There, I said, “When … exceptions are present [in an MAE definition], adverse changes to the company resulting from such causes are not MACs within the meaning of the definition.”[20] Replace the word “changes” with “effects” and the abbreviation “MAC” with “MAE,” and what I said in 2009 is exactly what the court in AB Stable said in 2020: if an event causing a material adverse effect falls into an exception, the material adverse effect that the event causes is not a Material Adverse Effect, which makes the exceptions apply to material adverse effects rather than the events causing them, and so entails all the erroneous consequences exposed and deprecated above. The confusion I condemn here is thus one that I myself invented. Whether everyone who has fallen into this mistake has done so under the influence of my writings is doubtful; because of the pervasive confusion of Material Adverse Effects with material adverse effects, this was a mistake waiting to happen. But given the unpleasant choice, I would rather accept the whole blame and be accused of grandiosity in appropriating the responsibility to myself than blame others for making the mistake independently and be accused of shirking the responsibility for the mistake.
The Effect of the Language Introducing the Exceptions
There remains one final point about the language introducing the exceptions in the MAE definition. A new article by Professor Guhan Subramanian (Harvard University) and Caley Petrucci (Wachtell, Lipton, Rosen & Katz)[21] forthcoming in the Columbia Law Review includes an impressive empirical study of MAE definitions in public-company merger agreements and reports that the language introducing the exceptions in an MAE definition tends to come in one of two forms. Sometimes, as discussed above, the language introducing the exceptions provides that, besides events falling into the exceptions, events “arising from” excepted events are excepted; in other cases, the language provides that, besides events falling into the exceptions, events “related to” excepted events are excepted.[22] The authors suggest that the latter language is broader than the former, that is, would result in more events being excepted.[23]
To make sense of this, I think it helps to take a step back and recall that, in the simplest case, the language introducing the exceptions would say only that no event falling into an exception “is” or “shall constitute” a Material Adverse Effect. That is, if we understand the exceptions as listing certain kinds of events the risk of which are being allocated to the acquirer, the introductory language need only say that no event falling into an exception will count as a Material Adverse Effect even if the event, should it occur, would have or would reasonably be expected to have a material adverse effect on the target. Moving to more complex cases, we see that the introductory language can expand the set of excepted events to include as well events “arising from” events falling into the exceptions. Given the discussion above, the purpose of such language is clear: when an MAE definition allocates the risk of an event, by implication it allocates as well the risk of all events reasonably expected to follow from the event up to and including any material adverse effect on the target. But this is by implication, and adding the “arising from” language to the introduction of the exceptions makes this explicit. That is particularly important for the target, because, as explained above, given the logical structure of the MAE definition, the acquirer enjoys a natural advantage in that, under a proper reading of the definition, all events are non-excepted events (unless they happen to fall into an exception), and so in particular events arising from non-excepted events are non-excepted events (unless they happen to fall into an exception). To restore some form of parity between events the risk of which are allocated to the target and events the risk of which are allocated to the acquirer, parties can agree to language introducing the exceptions that provides that events arising from events falling into exceptions are also excepted.[24]
But what if the language introducing the exceptions excepts not just events arising from excepted events but also events merely “related” to excepted events? Wouldn’t this, as Subramanian and Petrucci say, greatly expand the scope of the exceptions? I don’t think so. In fact, reading this language expansively—i.e., reading “related” to mean “related in any way whatsoever”—would make nonsense of the definition and play havoc with the allocation of risks that the parties intend. Indeed, reading the language in this way would mean that an event that (a) causes a material adverse effect on the target, and (b) does not itself fall into an exception, would nevertheless not count as a Material Adverse Effect, if the event (c) was “related” in any way whatsoever toanyother event that did fall into an exception. That would make the set of excepted events extremely large. For example, in Akorn,[25] the emergence of new competitors had a material adverse effect on the target, and this event—the emergence of the new competitors—did not fall into an exception. Suppose that, while the new competitors were emerging, the economy slipped into recession. The recession would be a general change in economic conditions and so would fall within an exception covering such changes. Had the Fresenius-Akorn merger agreement used the “related” language rather than the “arising from” language, would the emergence of the new competitors, which caused a material adverse effect on Akorn, not have counted as a Material Adverse Effect because the emergence of the competitors occurred simultaneously with (and thus in a sense was “related to”) the recession, an excepted event, even though the recession had no causal connection either with the emergence of the new competitors or with the material adverse effect on the company? Reading the “related” language in this unrestricted manner implies that the emergence of the new competitors would no longer count as a Material Adverse Effect, but I cannot see how such an interpretation of the contract would serve any rational purpose. Sophisticated commercial parties would attribute no importance to the occurrence of events “related” to the event causing the material adverse effect if such events were not themselves causally related to either the material adverse effect or the event causing it.
Furthermore, if the phrase “related to” in the language introducing the exceptions meant “related to in any way whatsoever,” then there would almost certainly never be a Material Adverse Effect. For, whenever a non-excepted event caused a material adverse effect, we could always find some excepted event—some change in business, economic, market or industry conditions, some change in law or GAAP, some force majeure event—that was “related,” in some way or other, to the event causing the material adverse effect, which would mean that this event would not count as a Material Adverse Effect. Thus, when the language introducing the exceptions includes events “related” to excepted events, the meaning cannot be that the related events are related to the excepted events in just any way whatsoever, such as occurring simultaneously or being discussed in the same edition of The Wall Street Journal. The meaning has to be more restricted. The obvious way of restricting the meaning is to say that “related to” means “related to as effect to cause.” This interpretation has the virtue of making the resulting allocations of risk rational and consistent with the rest of the MAE definition, but it also makes “related to” equivalent to “arising from” and thus deprives the phrase “related to” of any independent meaning.
In KCake, the only Delaware case ever to consider the import of the language introducing the MAE exceptions, the court stated in dicta that the phrase “arising from or related to” “is broad in scope under Delaware law,” and the court clearly implied that “arising from” and “related to” have different meanings.[26] Beyond that, however, the court did further construe either phrase, and on the facts it was clear that the events “arising from or related to” the excepted events had arisen from the excepted events as effects from causes. The problem remains, then, whether the “related to” language can have some meaning beyond that of “arising from” but still not be so expansive as to amount to “related to in any way whatsoever.” One possibility would be to construe “related to” as meaning “correlated with.” In that case, an event would be “related to” an excepted event if the related event either arose from the excepted event or else both the related event and the excepted event arose from the same cause. This sounds promising, but the first possibility reduces to “arising from,” and the second possibility, which is doing all the work of giving “related to” some independent meaning, seems to produce anomalous results. That is, interpreted in this manner, the “related to” language would imply that there could be an event that (a) would reasonably be expected to have a material adverse effect on the target, and (b) does not itself fall into an exception, and yet (c) would not count as a Material Adverse Effect merely because it (d) arose from some event that also caused an event that did fall into an exception.
It is difficult even to construct a plausible example, but imagine that the President of the United States takes some highly controversial action, such as moving the American embassy in Israel from Tel Aviv to Jerusalem or declaring Turkish atrocities against the Armenians during World War I an act of genocide. As a result, the target company’s chief executive officer, who is deeply offended by the President’s decision, demands that the company cease doing business with the government of the United States, and when the board of directors refuses, he abruptly resigns. The resignation is not excepted under the MAE definition, and it results in a material adverse effect on the company. Meanwhile, the President’s decision also spurs various terrorist attacks against Americans around the world, but these events have no effect at all on the company. Terrorist attacks, however, are excepted events under the MAE definition. Now, the departure of the chief executive officer is both not excepted and reasonably expected to have a material adverse effect on the company. It would thus seem to be a Material Adverse Effect. Would anyone say that since the departure and the terrorist attacks, which had no effect on the company, arose from the same cause, and since the terrorist attacks were excepted, the departure should also be excepted because it was “related” to the terrorist attacks in the sense that both events arose from the same cause? It is hard to see why sophisticated commercial parties would attribute any importance to this fact. There would seem to be no economic rationale for treating the risk of the chief executive abruptly resigning merely because the cause prompting him to resign also resulted in terrorist attacks that had no effect on the company.
For such reasons, it is difficult to see what independent meaning, distinct from the meaning of “arising from,” can plausibly be ascribed to the phrase “related to” in the language introducing the exceptions in the MAE definition. Perhaps the best view is to construe “arising from or related to” as a legal doublet like “null and void” or “cease and desist” and limit the meaning to the causal interpretation.[27] If that is right, then it makes no difference whether the language introducing the exceptions excepts events “arising from” or “related to” events falling into such exceptions. Although transactional lawyers may sometimes argue about this issue as if it mattered,[28] the case may be analogous to distinctions between the various kinds of efforts clauses, about which transactional lawyers also argue about but among which the Delaware courts have been unable to meaningfully distinguish.[29]
[9] Notice that, when we ask what is reasonably expected to follow from an event, we ask what is reasonably expected to follow from the actual event that occurs, not what is reasonably expected to follow from an “average” or “typical” event of the relevant kind. In the example in the text, what matters is what is reasonably expected to follow from the actual decision by the FOMC in the actual circumstances in which the decision was made. Thus, what is reasonably expected to follow from an increase in the target Federal Funds Rate of 25 basis points is not what is reasonably expected to follow from an increase in that rate of 500 basis points. Similarly, if one party bears the risk of a pandemic and a pandemic occurs, we ask what is reasonably expected to follow from the actual pandemic that has occurred, which will depend on the nature of the actual pandemic occurring. Some pandemics are much worse than others (compare the H1N1 pandemic of 2009 with the COVID-19 pandemic of 2020), and so what would reasonably be expected to follow from one particular pandemic might not reasonably be expected to follow from another particular pandemic. In asking what would reasonably expected to follow from an event, we are asking what would reasonably be expected to follow from the actual event that has occurred, in all its existential particularity. The reason for this is that the MAE definition expressly speaks of events and what is reasonably expected to follow from them, not of kinds or types of events or of “average” or “typical” events of certain kinds.
[10] The court ultimately held that the acquirer bore the risk of a pandemic because an exception in the MAE definition included the terms “natural disaster” and “calamity,” and the COVID-19 pandemic was both of these. AB Stable VIII LLC, No. 2020-0310, at *57-59. Hence, the court’s discussion of whether other exceptions in the MAE definition would have applied if the target had borne the risk of a pandemic is dicta.
[12]Id. at *56. Court also says about root cause, but we can let that pass. “each exception applies on its face, not based on its relationship to any other exception or some other root cause
[18] The court in KCake makes exactly the same mistake. In that case, the acquirer had pointedly refused to agree that “pandemics” would be excepted events, thus allocating the risk of a pandemic to the target, KCake Acquisition, Inc., No. 2020-0282, at *6-7, but the parties had agreed that general changes in the economy, id., and changes in law would be excepted, id. at *35, and thus that the risk of such changes would be allocated to the acquirer. The court held that the target had not suffered a material adverse effect, which suffices to dispose of the case, but it then went to say in dicta that that “revenue declines arising from or related to changes in law fall outside of the definition of an MAE, regardless of whether COVID-19 prompted those changes in the law.” Id. As in AB Stable, this confuses events causing material adverse effects with the material adverse effects they cause. Perhaps “changes in law” and “revenue declines” are excepted events and so not Material Adverse Effects, but that does not prevent COVID-19, which caused the revenue declines, from being a Material Adverse Effect, unless the declines are treated as a material adverse effect, and this effect is deemed excepted because the court was applying the exceptions to effects rather than events. As in AB Stable, if a material adverse effect arises from an excepted event, then no event causing that material adverse effect can be a Material Adverse Effect.
[19] Robert T. Miller, The Economics of Deal Risk: Allocating Risk Through MAC Clauses in Business Combination Agreements, 50 Wm. & Mary L. Rev. 2007 (2009).
[22]Id. at 50. The authors state that only 47% of the agreements in their sample use the causal “arising from” (or similar) language, while 53% use the non-causal “related to” (or similar) language. Id. It turns out, however, that the authors counted such expressions as “impact of,” “resulting directly or indirectly,” and “arising in connection with” as non-causal. Id. at 37 n. 211. These expressions seem plainly causal to me. Accordingly, I doubt whether Subramanian and Petrucci’s breakdown of 47% (causal language) and 53% (relational language) is correct.
[24] Note that, to accomplish this goal, the phrase “arising from” in the language introducing the exceptions must be construed in the same way as the phrase “reasonably expected” in the base part of the definition. The “reasonably expected” language suggests the concept of proximate causation commonly used throughout the law. The “arising from” language certain can suggest the same concept, but it can also suggest the notion of but-for causation, which is also commonly used throughout the law. I think the two expressions should be read as having the same meaning, and that the meaning should be the proximate-causation meaning of the base part of the definition. That is, if the language in the base part of the definition speaks in terms of events “reasonably expected” to have a material adverse effect on the target, then any “arising from” language introducing the exceptions should be read as meaning “reasonably expected to arise from.” If the “arising from” language were read in terms of but-for causation, the results would be unpredictable and often irrational because the but-for effects of an event are multifarious, extremely far-reaching, and highly unpredictable. It is difficult to imagine that sophisticated commercial parties would allocate risks in such a haphazard manner.
[25] Akorn, Inc. v. Fresenius Kabi, AG, No. 2018-0300, 2018 WL 4719347 (Del. Ch. Oct. 1, 2018)
[26]KCake Acquisition, Inc., No. 2020-0282, at *35.
[27] This insightful point was suggested to me by Glenn West.
[28] Subramanian & Petrucci, supra note 24, at 53.
[29]Akorn, Inc., 2018 WL 4719347, at *8687; Williams Cos. v. Energy Transfer Equity, L.P., 159 A.3d 264, 272 (Del. 2017).
Landis Rath & Cobb LLP 919 N. Market St. Suite 1800 Wilmington, DE 19801 (302) 467-4400 www.lrclaw.com
Tyler O’Connell
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Authors
Samuel E. Bashman
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Albert J. Carroll
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Clarkson Collins, Jr.
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Damon B. Ferrara
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Eric Hacker
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Lewis H. Lazarus
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Matthew F. Lintner
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Albert H. Manwaring, IV
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Ian D. McCauley
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Kathleen A. Murphy
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Kuhu Parasrampuria
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Benjamin M. Potts
Wilson Sonsini Goodrich & Rosati LLP 222 Delaware Ave. Suite 800 Wilmington, DE 19801 (302) 304-7600 www.wsgr.com
Jonathan G. Strauss
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Bryan Townsend
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Patricia A. Winston
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
Kirsten A. Zeberkiewicz
Morris James LLP 500 Delaware Ave. Suite 1500 Wilmington, DE 19801 (302) 888-6800 www.morrisjames.com
§ 1.1 Introduction
The year 2020 saw numerous significant corporate law decisions from the Delaware courts. Stockholders’ requests for non-public information under Section 220 of the Delaware General Corporation Law continued to be litigated, with both the Delaware Supreme Court and Court of Chancery issuing decisions clarifying the stockholder’s relatively low burden of proof in this area. See § 15.2, infra. The Delaware courts also issued important corporate governance decisions addressing disclosure obligations among fellow directors, conflicting decisions of board committees, and the permissible extent of forum selection provisions in the organizational documents of Delaware corporations. See §15.3, infra. In the M&A context, the issues of whether a transaction involves a controlling stockholder or control group continued to be a subject of significant litigation, including whether adequate procedural protections were employed to permit deferential review of controlling stockholder transactions under the business judgment rule. The Delaware Court of Chancery also considered whether the current COVID-19 circumstances give rise to a “material adverse effect” within the intendment of an acquisition agreement. See § 15.4, infra. Appraisal litigation in the public company context continued to address deference to market indicators, with notable rulings including a decision affirming reliance upon a corporation’s unaffected trading price. See § 15.5, infra. On the regulatory front, Nasdaq recently proposed to the U.S. Securities and Exchange Commission new requirements mandating disclosures concerning corporate boards’ inclusion and diversity policies and practices. See § 15.8, infra. These developments, as well as demand futility decisions (§ 15.6) and advancement decisions (§ 15.7) are discussed herein.
§ 1.2 Books and Records
§ 1.2.1
AmerisourceBergen Corp. v. Lebanon Cty. Employees’ Ret. Fund, __ A.3d __, 2020 WL 7266362 (Del. Dec. 10, 2020). In this decision, the Delaware Supreme Court held that a stockholder who has a “credible basis” to investigate potential wrongdoing or mismanagement need not identify a specific intended use or “end” for the information requested. In addition, the Court clarified that a stockholder need not show, as a matter of law, that the potential wrongdoing is actionable. Rather, a “credible basis” to suspect possible wrongdoing or mismanagement is sufficient.
By brief background, stockholders of AmerisourceBergen Corporation (the “Company”), one of the nation’s largest distributors of prescription opioids, sought to inspect its books and records pursuant to 8 Del. C. § 220. The stockholder-plaintiffs wished to investigate potential wrongdoing or mismanagement relating to the Company’s alleged significant role in the opioid epidemic. Reports of government investigations and pending lawsuits alleged that the Company failed to comply with federal regulations by, inter alia, continuing to do business with suspicious pharmacies and failing to report suspicious orders to regulators. Over 1,500 civil lawsuits were then pending against the Company, with defense costs totaling over $1 billion, and the plaintiffs in those actions having rejected a $10 billion settlement offer. Analysts predicted that the Company may have to pay $100 billion to reach a global settlement.
The stockholder-plaintiffs sought books and records, with their demand letter (“Demand”) indicating purposes of investigating potential wrongdoing or mismanagement to “consider any remedies that may be sought” and to “evaluate litigation or other corrective measures[.]” Before the Court of Chancery, the Company argued that the stockholder-plaintiffs failed to sustain their burden to show a “proper purpose” because the Demand failed to specify the ultimate intended use of the documents or information sought. The Company also argued that a stockholder seeking to investigate potential wrongdoing must identify actionable wrongdoing, which the Company argued they could not do because their potential claims would be time-barred and because the Company’s directors were independent and would be entitled to exculpation. After a trial on a paper record, the Court of Chancery ruled for the stockholder-plaintiffs and rejected the Company’s arguments that they lacked a proper purpose.
Addressing the matter en banc, the Delaware Supreme Court affirmed the Court of Chancery’s decision. The Court first confirmed that a stockholder seeking to investigate potential wrongdoing or mismanagement need not specify the intended uses of any documents requested in her demand. The Supreme Court reasoned that a rule requiring disclosure of intended use made sense in the context of a request for stocklist materials, where it was necessary to assess the propriety of the purpose. Such a rule was inapt when the purpose is to investigate potential wrongdoing, where precedent recognizes that permitting an inspection upon the requisite showing of a “credible basis” serves the interests of all stockholders. Defendant-corporations remain able to inquire into the stockholder’s purposes and any intended use, and the Court of Chancery remains able to find the facts concerning such issues – all of which may inform the “proper purpose” inquiry. A stockholder, however, need not know the specific “ends” of the inspection, provided that she has a “credible basis” to suspect possible wrongdoing.
Regarding the Company’s alternative argument – that a stockholder must identify a basis to suspect “actionable wrongdoing” that may be remedied by litigation – the Delaware Supreme Court reasoned that the Demand properly asserted non-litigation purposes, which rendered it unnecessary to address the issue. But, to provide clarity in this area, the Supreme Court further explained: “we have stated that a stockholder is not required to prove that wrongdoing occurred, only that there is possible mismanagement that would warrant further investigation.” The Court reasoned that this approach struck the appropriate “balance” between stockholders’ informational rights and the rights of directors to manage the corporation without undue interference. It also was consistent with the intended “summary” nature of books and records proceedings to avoid evaluating merits-based defenses over the conduct stockholders seek to investigate. On the other hand, the Delaware Supreme Court reasoned that, in the rare case where bringing litigation is the sole purpose for a demand and such litigation would be barred due to an “insurmountable procedural hurdle,” the Court of Chancery remains able to deny an inspection. However, courts applying Section 220 generally should “defer the consideration of defenses that do not directly bear on the stockholder’s inspection rights, but only on the likelihood that the stockholder might prevail in another action.” The Delaware Supreme Court accordingly held “[t]o obtain books and records, a stockholder must show, by a preponderance of the evidence, a credible basis from which the Court of Chancery can infer there is possible mismanagement or wrongdoing warranting further investigation. The stockholder need not demonstrate that the alleged mismanagement or wrongdoing is actionable.”
§ 1.2.2
Juul Labs Inc. v. Grove, 2020 WL 4691916 (Del. Ch. Aug. 13, 2020). This decision holds that, pursuant to the internal affairs doctrine, inspection rights for a stockholder of a Delaware corporation are governed exclusively by Delaware law, not by laws of other jurisdictions, regardless of where a company’s principal place of business is located.
JUUL Labs is a privately held Delaware corporation with a principal place of business in California. After a JUUL Labs stockholder based his demand on California state law and threatened to bring suit in California state court to enforce his inspection rights, JUUL Labs sought declaratory relief in the Court of Chancery. JUUL Labs argued that the stockholder waived his inspection rights under certain form agreements; that in any event, Grove’s default statutory inspection rights were governed by Section 220 of the Delaware General Corporation Law (“DGCL”), not under Section 1601 of the California Corporations Code; and that the Court of Chancery had exclusive jurisdiction due to a forum-selection provision in JUUL Labs’ certificate of incorporation. Each side moved for judgment on the pleadings.
The Court first held that JUUL Labs failed to show that the stockholder was a party to an agreement reflecting the clear and affirmative language necessary to waive statutory rights. While some language purported to waive rights under Section 220 of the DGCL, none expressly referenced the California Corporations Code. Accordingly, it was necessary to determine what, if any, inspection rights the stockholder had under California law.
In this regard, the Court reasoned that stockholders’ statutory inspection rights are a core matter of the internal affairs of a Delaware corporation. Precedent from the U.S. Supreme Court and the Delaware Supreme Court requires that, where the laws of the state of incorporation differ from those of another state, the former govern matters relating to the corporation’s internal affairs. This is necessary as a matter of due process to provide certainty over which state’s laws apply. Reviewing California law in detail, the Court concluded that, while California’s books and records statutes were not “radically different” than Delaware’s, “California’s balancing of the competing interests between stockholders and the corporation differs from Delaware’s.” And California was not alone in granting inspection rights to stockholders of foreign corporations, creating a risk that “a Delaware corporation could be subjected to different provisions and standards in jurisdictions around the country.” Therefore, under the internal affairs doctrine, Delaware law applied. Relatedly, the terms of a Delaware exclusive forum provision in JUUL Labs’ certificate of incorporation applied, and the stockholder was required to bring any claim to enforce inspection rights in the Court of Chancery.
The Court granted JUUL Labs judgment on the pleadings. In doing so, the Court noted it was not deciding whether purported waivers of the stockholder’s statutory inspection rights under Section 220 in JUUL Labs’ form agreements would be enforceable. While some Delaware cases have not respected such waivers when located in a corporation’s constituent documents, waivers in a separate agreement might be viewed differently. Because the stockholder’s demands were not made under Section 220, the Court was not required to decide such issues.
§ 1.2.3
MaD Investors GRMD, LLC v. GR Cos., Inc., 2020 WL 6306028 (Del. Ch. Oct. 28, 2020). This decision confirmed that a stockholder plaintiff’s five business days under Section 220 between demand and suit does not expire until midnight on the fifth business day. The Court further held that the stockholder plaintiffs’ standing to pursue remedies under Section 220 that had been eliminated by merger between the filing and dismissal of its Section 220 action could not be revived under the Court’s equitable powers.
At 5:03 p.m., on the fifth day after serving a Section 220 demand (the “Demand”) on GR Companies, Inc. (the “Company”), MaD Investors GRMD, LLC and MaD Investors GRPA, LLC (together, “Plaintiffs”), filed a complaint to compel inspection of books and records pursuant to 8 Del. C. § 220 (the “Complaint”). The Company filed a motion to dismiss, asserting that Plaintiffs had filed the Complaint prematurely. Plaintiffs filed a cross-motion for leave to amend the Complaint (the “Leave Motion”).
Section 220(c) provides that stockholders may not file a books and records action until the company (1) refuses a demand to provide books and records, or (2) has not replied “within 5 business days after the demand has been made.” Here, the Demand was made on July 9 and the Complaint was filed at 5:03 p.m. on July 16. Because the Company never responded to the Demand, it argued that Plaintiffs could not file the Complaint prior to 12:00 a.m. on July 17. In response, Plaintiffs argued that they complied with the deadline because (1) the Company “refused” the Demand by requesting an extension to respond on July 15, and (2) the response period ended at 5:00 p.m. (the Court’s filing deadline) on the fifth business day following service of the Demand. In rejecting these arguments, the Court found that, because the request for an extension was not alleged in the Complaint, it was not properly before the Court and, in any event, this request did not constitute a refusal under Section 220. The Court also found that Section 220 refers to “business day” not “business hours,” and the commonly accepted meaning of a “business day” is “a twenty-four hour day other than weekends and holidays.”
Having found that the Plaintiffs had filed the Complaint prematurely, the Court held that it did not have jurisdiction over the Complaint or any request to supplement it. Furthermore, the Court held that, despite the fact that Plaintiffs no longer had standing as stockholders that would allow them to file a curative demand (due to the subsequent closing of a merger), there was no “equitable safe harbor” excusing the premature filing of the Complaint.
For the foregoing reasons, the Court dismissed the Complaint with prejudice and denied the Leave Motion.
§ 1.2.4
Pettry v. Gilead Sciences, Inc., 2020 WL 6870461 (Del. Ch. Nov. 24, 2020). This case illustrates that a Court applying Delaware law may award a stockholder attorneys fees and expenses as a means of addressing the overly aggressive defense of a books and records action. Section 220 of the Delaware General Corporation Law permits a stockholder plaintiff who has a “credible basis” to suspect wrongdoing by officers and directors to demand inspection of books and records relating to that misconduct. In this case, plaintiff-stockholders of Gilead Sciences, Inc. (“Gilead”) sought to inspect Gilead’s books and records to investigate misconduct. Gilead was subject to numerous lawsuits and government investigations arising out of alleged anticompetitive conduct, mass torts, breach of patents, and false claims relating to the development and marketing of its HIV drugs. The plaintiffs sought books and records about Gilead’s (1) anticompetitive agreements, (2) policies and procedures, (3) senior management materials, (4) communications with the government, and (5) director questionnaires. Gilead refused to produce any documents, even though the plaintiffs had a credible basis to suspect wrongdoing and the records they sought related directly to the misconduct. The Court of Chancery found that “Gilead exemplified the trend of overly aggressive litigation strategies by blocking legitimate discovery, misrepresenting the record, and taking positions for no apparent purpose other than obstructing the exercise of Plaintiffs’ statutory rights.” The Court, therefore, granted plaintiffs leave to move for fee shifting.
§ 1.2.5
Alexandria Venture Investments, LLC v. Verseau Therapeutics, Inc., 2020 WL 7422068 (Del. Ch. Dec. 18, 2020). In a dispute over a stockholder’s request for books and records, the Court held that the stockholder plaintiffs only needed to provide a credible basis for the court to infer wrongdoing, they did not need to state that the conduct to be investigated was actionable. The Court limited the stockholders’ inspection to the materials necessary to investigate the claims of wrongdoing and would not allow broad inquiry into the company’s financial condition.
Verseau Therapeutics, Inc. (the “Company”) is a company that is developing immunotherapies to treat certain cancers. Alexandria Venture Investments, LLC and Alexandria Equities No. 7, LLC (“Alexandria”) are stockholders in the Company. In 2020, the Company was seeking additional financing due to the likelihood it would run out of operating funds by early 2021. Alexandria made a financing proposal to the Company that included restrictions on cash payments to directors and Alexandria approval of related party transactions. The Company’s board rejected the financing proposal at an early June meeting. At that meeting, one of the directors indicated that his firm was working on an alternative bridge financing proposal that he believed would be more attractive to the Company. The Company’s board considered the Alexandria financing proposal again at a late June meeting and rejected the proposal.
On July 1, Alexandria made a books and records demand on the Company to investigate whether the board had breached its fiduciary duties in rejecting Alexandria’s proposed financing. Alexandria was unaware at the time of the demand of the June 29 board meeting. Alexandria then made a supplemental demand on July 9 related to the second rejection of its financing proposal. The Company did not respond to the second demand and Alexandria filed suit in the Court of Chancery on July 17.
The Company did not challenge whether Alexandria was a stockholder or had met Section 220’s technical requirements. It only challenged whether Alexandria had stated a proper purpose. Alexandria raised concerns with the Board’s ability to make an unbiased decision on the proposed financing due to the conflicts of interest of several board members. The Company argued that this could not be a proper purpose because the challenged decision had been approved by a majority of the disinterested members of the Company’s board. A fact that was unchallenged by Alexandria’s petition.
The Court rejected the Company’s argument citing the Supreme Court’s decision in AmeriSource Bergen Corp. v. Lebanon County Employees Retirement Fund and held that the appropriate inquiry on a books and records demand is whether the stockholder has alleged a credible basis from which the court can infer mismanagement. The stockholder is not required to allege an actionable claim to merit inspection. The court held that Alexandria’s allegations of conflict were sufficiently detailed and material to merit inspection of the books and records related to the June board meetings.
The Company did not press its claim that Alexandria had an ulterior motive for its inspection request, therefore the Court did not rule on that issue. Finally, the Court limited Alexandria’s inspection rights to the materials necessary to determine whether a breach had occurred. The Court allowed inspection of the formal board materials related to the June meetings and directed the parties to meet and confer on the extent that the Company’s board informally considered Alexandria’s proposal via text or email and submit a proposed order on additional production.
§ 1.3 Corporate Governance
§ 1.3.1
Blackrock Credit Allocation Income Tr., et al. v. Saba Capital Master Fund, Ltd., 224 A.3d 964 (Del. 2020). The Delaware Supreme Court reversed the Court of Chancery’s decision requiring two closed-end trusts (together, the “Trusts”) to count the votes of Saba Capital Master Fund, Ltd’s (“Saba”) slate of dissident nominees at the Trusts’ respective annual meetings. The Supreme Court ruled that Saba’s nominations were ineligible because Saba had failed to respond to the Trusts’ request for supplemental information within the clear and unambiguous five day compliance deadline in the Trusts’ advance notice bylaws (the “Bylaws”).
In response to Saba’s notice that it planned to present a slate of dissident nominees at the Trusts’ annual meetings, the Trusts sent out supplemental questionnaires (the “Questionnaires”) requesting more information about the slate. Saba failed to make any response to the request within the five business day compliance deadline, and the Trusts declared the nomination notice invalid. In the proxy contest that followed, the Trusts urged stockholders not to return proxy cards sent by Saba.
Saba filed suit and asked the Court of Chancery to enjoin the Trusts from interfering with its attempt to present a slate of nominees. On “a highly expedited and pre-discovery record,” the Court granted Saba’s request and required the Trusts to count the votes for Saba’s nominees. While the Court agreed that the Trusts could request supplemental information from Saba pursuant to the Bylaws, it held that the Questionnaires “went too far” because the information was not “reasonably requested” or “necessary” as required by the Bylaws. The Trusts appealed.
The Supreme Court held that, although the Court of Chancery interpreted the Bylaws correctly, it erred in granting injunctive relief because Saba failed to meet the Bylaws’ clear and unambiguous five day compliance deadline. The Court noted that while concerns about the breadth of the Questionnaires could be valid, Saba should have raised those concerns before the expiration of the deadline. The Court “was reluctant to hold that it is acceptable to simply let pass a clear and unambiguous deadline in an advance-notice bylaw, particularly one that had been adopted on a ‘clear day.’” The Court further noted that “encouraging [] after-the-fact factual inquiries into missed deadlines could potentially frustrate the purpose of advance notice bylaws”—to permit orderly meetings and proxy contests and provide fair warning to the corporation. Thus, the Court found Saba’s nominations to be ineligible and remanded the case to the Court of Chancery for further proceedings.
§ 1.3.2
Salzberg v. Sciabacucchi, 227 A.3d 102 (Del. 2020). Reversing the Court of Chancery, the Delaware Supreme Court concluded that federal forum selection clauses, requiring that litigation under the Securities Act of 1933 (“‘33 Act”) only be filed in federal courts, are allowable provisions in a Delaware corporation’s certificate of incorporation or bylaws.
Under recent U.S. Supreme Court precedent, private plaintiffs may bring ‘33 Act claims in either federal or state court. A wave of securities class actions filings in state courts inspired corporations to consider limiting such actions to federal courts through charter or bylaw provisions. A stockholder-plaintiff sued seeking a declaration that provisions designed to limit a plaintiff’s choice of forum for an action arising under the ‘33 Act to federal courts were invalid under Delaware law. The Court of Chancery agreed with the plaintiff, holding that Section 102(b)(1) of the Delaware General Corporation Law (“DGCL”) prohibited a corporate charter from “bind[ing] a plaintiff to a particular forum when the claim does not involve rights or relationships that were established by or under Delaware’s corporate law.”
Specifically, under DGCL Section 102(b)(1), a corporate charter may contain (1) “any provision for the management of the business and for the conduct of the affairs of the corporation” and (2) “any provision creating, defining, limiting and regulating the powers of the corporation, the directors, and the stockholders, or any class of the stockholders, … if such provisions are not contrary to the laws of this State.” Citing Boilermakers Local 154 Ret. Fund v. Chevron Corp., 73 A.3d 934 (Del. Ch. 2013), the Court of Chancery held that Section 102(b)(1) endowed the corporation only with the power to govern claims arising under the internal affairs of the corporation – in this case, claims addressing “the rights and powers of the plaintiff-stockholder as a stockholder.” A federal securities claim involves a claim of fraud in connection with the sale of securities; the fact that the company involved might be incorporated in Delaware is “incidental” to the claim. Instead, the corporate charter must defer to the rights granted pursuant to the external federal statute, which allows for state and federal jurisdiction.
The Delaware Supreme Court reversed, finding that Section 102(b)(1) endowed Delaware charters with broad powers, and that the statute “bars only charter provisions that would achieve a result forbidden by settled rules of public policy.” The Court reasoned that “corporate charters are contracts among a corporation’s stockholders, … and that, Delaware’s legislative policy is to look to the will of the stockholders in these areas.” The Court agreed that Section 102(b)(1) precluded a charter from purporting to govern the location of filings of actions arising under a corporation’s external affairs, but held that federal securities laws were “Intra-Corporate Affairs” – an area that comprised a band of claims between truly external affairs (such as tort claims) and a corporation’s “internal affairs” (such as stockholder derivative actions). A ‘33 Act claim could be brought by an existing stockholder purchasing more shares, and such a claim would seem to fit within the language in Section 102(b)(1) allowing for provisions “creating, defining, limiting and regulating the powers of the … the stockholders, or any class of the stockholders.” As such, it could not be said that in all cases such provisions were invalid. The Supreme Court also held that corporate bylaws may similarly include such forum selection clauses.
§ 1.3.3
Cty. of Ft. Myers Gen. Employees Ret. Fund v. Haley, 235 A.3d 702 (Del. 2020). The decision is significant for articulating the standard applicable to evaluating director disclosure to fellow directors and what facts are necessary to plead that the business judgment rule does not apply when the plaintiff attacks the interest of only one officer and director.
This case involved a merger of equals, Willis Group Holdings Plc (“Willis”) and Towers Watson & Co. (“Towers”). When the parties announced the deal, market reaction was negative for the Towers stockholders. Analysts noted, for example, that the Towers stockholders’ shares in the exchange ratio were valued at 9% below the unaffected trading price even though the financial performance metrics for Towers were much stronger than those of Willis. In this atmosphere of uncertainty over deal consummation, a representative of Value Act, a large stockholder of Willis, proposed a compensation package (“the Proposal”) to the CEO of Towers, John Haley, who was to serve as the CEO of the combined entity. The Proposal would have significantly increased the upside potential over three years from Haley’s existing compensation plan of $24 million to $140 million. When the parties issued their joint proxy, they did not mention the Proposal, the extent of the post-signing discussions or Value Act’s role in the executive compensation discussions with Haley.
The market reaction was so negative that Towers adjourned its stockholder meeting when it had received only about 43% stockholder approval. Thereafter, the Towers board met to discuss potential revisions to the merger agreement. Haley did not disclose the Proposal at that meeting. The board agreed to increase a special dividend from $4.87 to $10 per share. Plaintiff alleged that, because of his interest in the undisclosed Proposal, this increase reflected the bare minimum necessary to assuage the Towers stockholders. The Towers stockholders later approved the revised deal at a reconvened stockholder meeting.
In the litigation that followed, the Court of Chancery held that plaintiff had failed to allege that the non-disclosure of the Proposal was material because the Towers board knew that Haley was going to be the CEO of the combined entity and that his compensation would be greater because the entity would be larger. Second, the Court held the Proposal was not binding and reflected upside potential only for pie-in-the-sky circumstances. The Court thus held Plaintiffs had not overcome the business judgment rule and dismissed the complaint.
In reversing, the Supreme Court reaffirmed that to state a claim in these circumstances, a plaintiff would have to allege that a director was materially self-interested; that the director failed to disclose his interest to the board; and that a reasonable board member would find the director’s material self-interest a significant fact in their evaluation of the proposed transaction. The Court defined “materiality” as “relevant and of a magnitude to be important to directors in carrying out their fiduciary duty of care in decision-making.” Applying that standard, the Supreme Court held that “Plaintiffs are entitled to an inference that the prospect of the undisclosed enhanced compensation proposal was a motivating factor in Haley’s conduct on the renegotiations to the detriment of Towers stockholders.” The Court noted that the fact that the compensation package ultimately approved post-closing had even greater upside reward led to the reasonable inference that the board and Haley believed the milestones were attainable. The Court also found that Plaintiffs adequately alleged that Haley did not disclose the Proposal to the Towers board. Finally, the Court also found that testimony from a disinterested director who served as Chair of the Compensation Committee that he would have wanted to know about the Proposal indicated that a reasonable director would have viewed the Value Act Proposal as a significant fact in the evaluation of the transaction.
§ 1.3.4
Palisades Growth Capital II, L.P. v. Bäcker, 2020 WL 1503218 (Del. Ch. Mar. 26, 2020). In this case, the Delaware Court of Chancery held that it may void an action by a board of directors – even where the action is not otherwise in violation of the corporate charter or the Delaware General Corporation Law (“DGCL”) – when equity so requires.
Defendant Alex Bäcker (“Bäcker”) was the co-founder and former CEO of the nominal defendant corporation, QLess, Inc., as well as one of its five directors. Following internal employee reports that his leadership was threatening the stability of the corporation, however, the board voted to remove him as the CEO. After initially protesting the decision, Bäcker appeared to approve of the replacement CEO, and likewise appeared to agree with the board’s plans to create a sixth board seat for the newly appointed CEO to occupy. The board therefore scheduled a meeting in November 2019, at which the new CEO board seat would be created and filled by the new CEO.
Prior to the board meeting, all five board seats were occupied: Bäcker and his father held two seats; Palisades Growth Capital (“Palisades”), the majority holder of Series A shares, held one seat; the non-party majority holder of the Series A-1 shares held a fourth seat; and an independent director held a fifth seat. Shortly before the board meeting, however, the non-party preferred shareholder and the independent director both unexpectedly resigned their respective seats, leaving only three directors on the board in advance of the meeting. Believing that he held a 2-1 majority, Bäcker allegedly “seized the moment by scheming with [his co-defendant director] (and counsel) to take control of the Company in advance of the November 15 meeting.” At the meeting, the defendants prevented the expected resolutions from being adopted. The defendants instead, with their two to one majority, voted to terminate the newly appointed CEO, to reappoint Bäcker as the CEO (allowing him to occupy the newly-created CEO director seat), and to appoint a new director to fill Bäcker’s newly-vacant director seat.
In response, Palisades brought a Section 225 action against Bäcker and his father, seeking a declaratory judgment that the defendants’ actions during the meeting were invalid for a multitude of reasons. Palisades’ availing argument was that the defendants’ actions were inequitable, and therefore invalid, because the defendants lured the Palisades director to the meeting under the false pretense of planning to vote to appoint the new CEO as a sixth director and to appoint a replacement for the newly-vacant preferred shareholder seat.
While the Court found that the defendants did not violate any specific provisions of the corporate charter, bylaws, or the DGCL, the Court nevertheless noted “[i]t is bedrock doctrine that this Court will not sanction inequitable action by corporate fiduciaries simply because the act is legally authorized.” The Court clarified that, before equity may be invoked in a case such as this, the defendants (acting as fiduciaries) must be shown to have actually affirmatively deceived the plaintiffs. Here, the defendants represented their intentions to vote the new CEO into a director seat, and even suggested that they believed the new CEO already effectively occupied a director position. In light of this affirmative deception, the Court rendered a decision voiding “all actions taken at the contested November 15 meeting.”
§ 1.3.5
In re WeWork Litig., 2020 WL 7346681 (Del. Ch. Dec. 14, 2020). In this case the Delaware Court of Chancery assessed the claims of competing board committees to authorize and to revoke authorization for litigation against the company’s controlling stockholders and determined that a modified Zapata standard is appropriately used to review such committee decisions.
In this case, the board of directors of The We Company (“Company”) created a special committee (“Special Committee”) to negotiate a multi-step transaction (“MTA”) that would resolve the company’s liquidity crisis as well as transfer majority ownership of the Company from Adam Neumann to SoftBank Group Corp. (“SBG”) and SoftBank Vision Fund (AIV MI) L.P. (“Vision Fund”). Part of the MTA was a tender offer. The tender offer opened, but was terminated by SBG and Vision Fund before it could close. The Special Committee initiated litigation before the Court of Chancery against SBG and Vision Fund for breach of the MTA for failing to make best efforts to complete the tender offer (“Litigation”).
SBG and Vision Fund immediately protested the filing of the Litigation to the Company’s management and board. After receiving these complaints, the board of directors approved the appointment of two new directors to form a committee (“New Committee”) to review the authority for and propriety of the Special Committee’s Litigation. The New Committee subsequently issued a report stating that the Special Committee was not authorized to initiate the Litigation and that the Litigation was not in the best interests of the Company. The New Committee then brought a 41(a) motion to dismiss the Litigation initiated by the Special Committee.
The parties presented multiple standards under which the New Committee’s decision to terminate the Litigation should be evaluated. These ranged from business judgment to entire fairness. The New Committee while advocating that the most stringent standard for evaluating its decision would be business judgment, allowed that the Court could apply the Zapata analysis for evaluating a committee’s decision to dismiss derivative litigation with prejudice. The Court found that a modified Zapata standard of review made the most sense under the circumstances.
In so holding, the Court stated that Zapata was the most analogous standard because the Company was seeking to dismiss litigation through use of a board committee in a scenario with the potential for abuse. The business judgment rule was too lenient and the entire fairness test did not fit the circumstance of action taken by a properly authorized board committee. Under the first prong of Zapata, the Court stated that the Company was required to establish that the New Committee was independent and acted reasonably and in good faith. The Court found that the New Committee was unquestionably independent. But, the Court found that the New Committee did not act reasonably. The Court performed a detailed analysis of the conclusions reached by the New Committee and found that the conclusions reached regarding the authority of the Special Committee to initiate the Litigation and whether the Litigation was in the best interests of the Company were not reasonable. Therefore, the Court denied the motion to dismiss under the first Zapata prong.
The Court recognized that the second Zapata prong allowed the Court to exercise its own judgment in determining whether the Litigation should be dismissed. The Court concluded that given the merits of the underlying breach of the MTA claim, the proximity of trial and the unlikelihood that the stockholders could pursue an alternate remedy to remediate SBG’s and Vision Fund’s alleged failure to use best efforts to close the tender offer that the motion to dismiss should be denied. The Court recognized that the Special Committee was not without conflict but in balancing the overall harm to the minority stockholders from dismissing the litigation with the potential for conflict, the Court held that the Litigation should be allowed to proceed.
§ 1.3.6
Pascal v. Czerwinski, 2020 WL 7383107 (Del. Ch. Dec. 16, 2020). This decision affirms that a direct claim for failure to disclose against a board of directors must meet a materiality threshold before it will provide a basis for relief. The plaintiff stockholder’s failure to allege that material information had been withheld was the basis for the court’s dismissal of the direct disclosure claim.
Plaintiff stockholder asserted direct and derivative claims against the board of directors of Columbia Financial, Inc. (“Columbia”) for breach of fiduciary duties related to the approval of bonuses for the directors. The derivative claims are not addressed in the opinion. The direct claim alleged a breach of duty due to failure of the board to adequately disclose material information related to the equity incentive plan when seeking stockholder approval. The stockholder requested that the entire equity incentive plan be voided for this failure to disclose.
Directors have a common law duty to disclose material information to stockholders when seeking their approval for corporate action. Information is material if, from the perspective of a reasonable stockholder, the information is substantially likely to significantly alter the total mix of information. Here the plaintiff stockholder alleged that the directors’ disclosure of the equity incentive plan indicated that it was to be an incentive for future performance. Plaintiff alleged that the equity incentive plan as adopted was actually intended to reward the directors for past efforts in taking Columbia public. As the Court framed it, the issue to be decided was whether the directors’ disclosure of the intent to compensate themselves generally as opposed to specific disclosure that compensation was for past performance related to taking Columbia public was material to stockholder approval of the equity incentive plan.
The Court analyzed the plaintiff’s two allegations of omission of material information. In reviewing the proxy statement, the Court held that it was clear that the board intended the awards to compensate the board for past performance. While the proxy statement did not specifically discuss the going public transaction, the Court held the failure to identify the specific event was not material. The plaintiff stockholder additionally complained of the failure to disclose the peer group of going public transactions on which compensation under the equity incentive plan would be modeled. The court found that adequate disclosure of the peer group that formed the basis for the plan was made in the proxy statement.
The Court dismissed the direct stockholder claim for breach of duty in failing to make adequate disclosures because the complaint did not allege any material undisclosed information that would have been likely to affect the stockholder approval of the equity incentive plan. The Court reserved the questions on the fairness of the equity incentive plan approved for consideration as part of the derivative breach of fiduciary duty claims.
§ 1.4 Mergers & Acquisitions
§ 1.4.1
In re Tesla Motors, Inc. S’holder Litig., 2020 WL 553902 (Del. Ch. Feb. 4, 2020). The Delaware Court of Chancery denied plaintiffs’ and defendants’ (including Elon Musk’s) motions for summary judgment on the grounds that genuine issues of material fact still remain to be determined at trial. The plaintiffs brought the action based on the allegation that Musk improperly influenced the Tesla board of directors to approve Tesla’s acquisition of SolarCity, another entity owned partially by Musk that was purportedly on the verge of insolvency.
The defendants asserted that the acquisition of SolarCity was approved by a fully informed and uncoerced vote of the minority stockholders, and therefore subject to business judgment review under Corwin. After discovery, defendants argued that there was no evidence that Musk, who controlled only a minority (22.1%) of Tesla’s voting power, had actually coerced Tesla’s other stockholders into approving the transaction, and on that basis sought summary judgment. The Court reasoned, however, that if Musk was found to be a controller and had the ability to exercise control over the vote, regardless of whether he actually did so, the transaction would remain subject to entire fairness review. In that regard, the Court explained that Delaware law recognizes that a controller can exert “inherent” coercion over shareholders facing a vote to approve a transaction. As articulated by the Court: “That conflicted controller transactions are inherently coercive … is a fixture of our law endorsed by our highest court and re-emphasized in numerous decisions of this Court.”
The Court acknowledged that leading Delaware jurists, through scholarly articles, have questioned why concerns about “inherent coercion” should justify imposing entire fairness review upon a transaction that rational investors have approved by a fully informed vote. Yet the Court also reasoned that Delaware Supreme Court precedent recognized the doctrine, which was dispositive. Accordingly, if Musk were a controller at the time of this acquisition, his status as such would result in a presumption of “inherent coercion” that prevents Corwin from securing business judgment review.
The Court found it could not, on the current record, determine whether Musk was a controller. Nor could it determine whether or not the stockholder vote was fully informed, or whether a majority of the board was independent when it approved the acquisition. Accordingly, the case will continue to trial, and should Musk be determined to be a controller, the transaction will be reviewed under an entire fairness standard.
§ 1.4.2
Voigt v. Metcalf, 2020 WL 614999 (Del. Ch. Feb. 10, 2020). This decision contains an instructive review of the factors the Court of Chancery will examine to determine whether a minority stockholder may in fact be a controlling stockholder in the circumstances of a specific transaction.
In July 2018, NCI Building Systems, Inc. (the “Company”) acquired Ply Gem Parent, LLC. At the time, a private equity firm (“CD&R”) owned 34.8% of the Company and had four designees on the Company’s twelve-member board. CD&R also owned 70% of the Ply Gem Parent. Company stockholders sued, alleging that three months before the transaction Ply Gem Parent was valued at roughly half the merger price, and accordingly that CD&R and various directors breached their fiduciary duties.
Addressing the defendants’ motion to dismiss, the Court analyzed a number of factors supporting a pleadings-stage inference that CD&R controlled the Company. Among other things, the Court examined the detailed rights CD&R obtained via a stockholders’ agreement, including consent (or veto) rights over matters that otherwise would be board-level decisions. CD&R also had other avenues of board influence, including a right to proportionate representation on committees. In addition to appointing four CD&R insiders to the board, CDR also had longstanding ties to two others, whom it had repeatedly appointed to boards paying significant directors’ fees. The Company’s public filings also indicated that, subject to their fiduciary duties, those two directors’ appointment furthered CD&R’s ability to exercise control at the board level. CD&R also had influence over two more directors by virtue of their employment as officers and, for one, an anticipated promotion in the post-transaction company. Although a special committee was used, it chose a financial advisor with a current relationship with CD&R without interviewing other candidates. The committee also chose not to interview or hire its own counsel, opting instead to proceed with Company counsel.
Of particular note is the Court’s discussion of how a non-majority equity stake factors into the control analysis. The Court observed that “simple mathematics” shows that “a relatively larger block size should make an inference of actual control more likely.” Even a “large stockholder with less than a majority of the voting power retains considerable flexibility to take action at a meeting” because “stockholders who oppose the blockholder’s position can only prevail by polling votes at supermajority rates.” The Court explained that a 35% blockholder like CD&R will win any vote so long as just one out of every seven other shares votes similarly, whereas opponents need to win over 90% of the unaffiliated votes. Thus, even though CD&R held less than a majority, its 35% position lent itself to a pleadings-stage inference of control.
As to the breach of fiduciary duty claim against the directors, the Court concluded that four of the directors were exculpated under a Section 102(b)(7) provision in the Company’s certificate of incorporation, because there were no properly plead allegations that they engaged in intentional wrongdoing – i.e., bad faith. Otherwise, the Court rejected a call by the CD&R-designated directors to dismiss them because they abstained from voting on the transaction. At the pleadings stage, the Court could not conclude that they did not participate in the negotiation or approval of the transaction, so the claim survived.
§ 1.4.3
DLO Enterprises, Inc. v. Innovative Chem. Prods. Grp., 2020 WL 2844497 (Del. Ch. Jun. 1, 2020). Defendants/Counterclaim Plaintiffs (“Buyers”) acquired substantially all of the assets of Arizona Polymer Flooring, Inc., later renamed DLO Enterprises, Inc. (“Sellers”). Sellers filed this action disputing who was financially responsible for certain defective products. During discovery, Sellers produced several pre-closing communications with their counsel that were redacted in part to protect the privilege. Buyers filed a motion to compel unredacted copies of the documents.
In denying Buyers’ motion, the Court found that the right to waive privilege over these documents did not pass to Buyers either by law or contract. The Court of Chancery has held that, in the merger context, the privilege over all pre-merger communications passes to the surviving corporation under Delaware statutory law (i.e., 8 Del. C. § 259) unless there is an express carve out in the merger agreement. See Great Hill Equity Partners IV, LP v. SIG Growth Equity Fund I, LLLP, 80 A.3d 155 (Del. Ch. 2013). The Court, however, reasoned that the same default rule does not apply when there is an asset purchase rather than a merger. In an asset purchase, the seller still exists and holds any assets and related privileges that were not explicitly purchased under the asset purchase agreement. Under the Purchase Agreement between Buyers and Sellers here, Buyers did not contract for the right to assert or waive privilege over Sellers’ communications about the transaction; therefore, that right remained with the Sellers.
The Court requested supplemental briefing on the issue of Sellers’ communications with counsel that were in Buyers’ possession because the email accounts were transferred to Buyers in the transaction. The Court noted, however, that upon realizing that they had potentially privileged documents, Buyers’ counsel should not have reviewed the content of those documents and should have segregated them pending resolution of the dispute. The Court held that, should any of those documents be found to be privileged, Sellers’ counsel may file a letter outlining any relief that they deem to be appropriate for Buyers’ review of such documents.
§ 1.4.4
Morrison v. Berry, 2020 WL 2843514 (Del. Ch. Jun. 1, 2020). This decision held that even if fiduciary duty of care claims against a target company’s board of directors are exculpated, an aiding-and-abetting claim against a financial advisor to the board may survive a motion to dismiss when the advisor is alleged to have knowingly misled the board and prevented the board from running a reasonable sales process.
The Apollo group of equity investors sought to acquire the Fresh Market grocery store chain in a going-private transaction in conjunction with other large equity holders. Fresh Market relied on its financial advisor, J.P. Morgan Securities, LLC (“J.P. Morgan”), which during its negotiations with Apollo generated downward adjustments to management projections and adjustments to its discounted cash flow analysis that resulted in a lower valuation range for Fresh Market. Apollo had paid J.P. Morgan $116 million in fees in the two years preceding the transaction. Throughout the sales process, Apollo allegedly communicated with its “client executive” at J.P. Morgan to solicit inside information about the bid process and negotiating dynamics. J.P. Morgan’s conflict of interest disclosures to Fresh Market’s board of directors indicated its “senior deal team members” were not currently “providing services” for the members of J.P. Morgan’s Apollo coverage team. The Court agreed with the plaintiffs that one could reasonably infer this disclosure was “artfully drafted” to omit the backchannel communications with Apollo. The Court found it reasonably inferable that Apollo outlasted other potential buyers and was able to acquire Fresh Market due to J.P. Morgan’s assistance.
The Court of Chancery thus held that at the pleadings stage, the plaintiff’s aiding-and-abetting claim against J.P. Morgan was legally sufficient. The Court reasoned that where a conflicted financial advisor has prevented the board from conducting a reasonable sales process, the advisor may be liable for aiding and abetting the board’s breach of fiduciary duties even if the individual directors are exculpated from liability for their breach. The Court explained that while Fresh Market’s directors were exculpated from their alleged duty of care breach of failing to comprehend J.P. Morgan’s conflict of interest, J.P. Morgan could nevertheless still be liable for aiding and abetting their breach of the duty of care based on its misleading statements, which prevented the board from conducting a reasonable sales process.
§ 1.4.5
In re Homefed Corp. S’holder Litig., 2020 WL 3960335 (Del. Ch. Jul. 13, 2020). This case illustrates that a Court applying Delaware law will apply the entire fairness standard to review a squeeze-out merger by a controller, if the controller engages in substantive economic discussions before the company has enacted the procedural protections outlined in Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”) that would permit business judgment review.
In this case, Jefferies Financial Group Inc. (“Jefferies” or the “Controller”), which owned 70% of HomeFed Corporation (“HomeFed”), acquired the remaining shares of HomeFed in a share exchange in which each HomeFed minority shareholder received two Jefferies shares in exchange for one of its HomeFed shares (the “Transaction”). A HomeFed director originally proposed the 2:1 share exchange to Jefferies in September 2017, and Jefferies subsequently discussed the share exchange with HomeFed’s second largest shareholder Beck, Mack and Oliver, LLC (“BMO”). In December 2017, HomeFed’s board of directors (the “Board”) formed a special committee (the “Special Committee”) that had the exclusive power to evaluate and negotiate a potential transaction. When the parties were unable to agree to merger terms, the Special Committee “paused” its process in March 2018. Despite pausing the Special Committee, Jefferies continued to discuss a potential transaction with BMO for the next year.
In early February 2019, BMO encouraged Jefferies to pursue the Transaction and indicated that it and another significant shareholder would vote for the Transaction. Jefferies announced the proposed 2:1 share exchange on February 19, 2019 (the “February 2019 Offer”) and the Board then reauthorized the Special Committee. During the Special Committee’s negotiations, Jefferies’ CEO reached out to BMO without the authorization of the Committee and implied that the 2:1 share exchange was a “take it or leave it” offer. The Special Committee and a majority of the minority shareholders approved the Transaction in May and June 2019, respectively.
The plaintiffs, who are former shareholders of HomeFed, claimed that the HomeFed directors and the Controller breached their fiduciary duties. In response, the defendants requested the Court of Chancery dismiss the case because the Transaction is subject to the business judgment rule under MFW. In MFW, the Delaware Supreme Court held that the business judgment rule applies to a squeeze-out merger by a controller “where the merger is conditioned ab initio upon both the approval of an independent, adequately-empowered Special Committee that fulfills its duty of care and the uncoerced, informed vote of a majority of the minority stockholders.”
The Court of Chancery denied the motion to dismiss because it found that the plaintiffs adequately pled that Jefferies did not impose the MFW conditions ab initio. This was because, among other things, the Board never dissolved the Special Committee, Jefferies had substantive economic discussions about a potential transaction when the Special Committee was paused, even though the Special Committee had the exclusive power to negotiate a transaction, and BMO consented to the Transaction before the Special Committee even began its negotiations. The Court held that it was reasonably conceivable that the February 2019 Offer was part of the same process that commenced in December 2017. The process failed to comply with MFW because Jefferies did not agree to the MFW protections before the December 2017 process began. Additionally, the Court explained that, even if the February 2019 Offer was part of a new process, the new process also failed to comply with MFW because Jefferies had substantive economic discussions with BMO and obtained the support of BMO and another crucial shareholder in early February 2019, before the Special Committee was reauthorized near the end of February 2019 and before HomeFed publicly announced that any transaction would be subject to MFW’s requirements. Jefferies’ discussions were contrary to the ab initio requirement, which bars the controller from having substantive economic discussions with the minority shareholders, and instead requires that the controller negotiate exclusively with a special committee acting on behalf of the minority shareholders. The Court explained that a controller cannot satisfy the MFW conditions if it undermines the Special Committee by engaging in substantive discussions with minority stockholders before the Special Committee is authorized to act. The Court, therefore, denied the defendants’ motion to dismiss.
§ 1.4.6
In re Baker Hughes, Inc. Merger Litig., 2020 WL 6281427 (Del. Ch. Oct. 27, 2020). This decision arose out of a merger involving Baker Hughes and the oil and gas segment of General Electric (GE). Stockholders of Baker Hughes brought post-closing breach of fiduciary duty claims against certain officers of Baker Hughes and aiding and abetting claims against GE, with the allegations focused on certain financial statements provided by GE in connection with the merger. GE did not maintain separate statements for its oil and gas business line in the ordinary course. The parties accounted for this by having GE prepare unaudited financial statements for that business line and conditioning closing obligations on GE providing audited financial statements that did not differ materially in an adverse manner.
In the ensuing lawsuit, the Court of Chancery dismissed the aiding abetting claim against GE for lack of a predicate breach of fiduciary duty by the Baker Hughes’ board, but upheld a claim for breach of fiduciary duty against the Baker Hughes’ CEO. Among the relevant rulings, the Court rejected the stockholder-plaintiffs’ theory that GE caused the disinterested and independent board of Baker Hughes to breach its fiduciary duties by creating an informational vacuum that induced the board to strike an allegedly bad deal based on the unaudited financial statements. Applying Revlon enhanced scrutiny, and citing, in part, the protections Baker Hughes secured in the merger agreement, the Court found that the Baker Hughes’ board acted reasonably in the circumstances of GE’s consolidated reporting practices. The Court also distinguished the “informational vacuum” decisions advanced by plaintiff (i.e., Rural Metro, PLX, KCG, and TIBCO). Unlike the arms’ length circumstances of this action, each of those cases “involved a player – privy to the internal deliberations or process of a target board that had conflicting financial interests – who deliberately withheld material information from the board, thus casting doubt on the integrity of a sale process.”
The Court, however, upheld a claim against Baker Hughes’ CEO for allegedly breaching his fiduciary duties in connection with the company’s proxy statement. The Court found that the omission of the unaudited financial statements from the proxy in the circumstances was an omission of material information supporting a disclosure violation. This was true even though the information contained in those statements was publicly available in GE’s SEC filings because, as the Court explained, Delaware law “does not impose a duty on stockholders to rummage through a company’s prior public filings” to obtain potentially material information. This disclosure violation prevented the stockholder vote approving the deal from invoking business judgment review under Corwin and supported a claim against the CEO, who was involved in the negotiations, signed the proxy, and conceivably may be liable for breaching his duty of care.
§ 1.4.7
AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020). Parties to a sale and purchase agreement (“SPA”) had planned to close a deal to sell fifteen luxury hotels for $5.8 billion. As the COVID-19 pandemic spread across the globe in early 2020 and battered the hotel industry, the buyer terminated the SPA. Seller sought specific performance in the Court of Chancery. After trial, the Court denied seller’s request for relief.
The Court first noted that the buyer did not have the right to terminate the SPA under its provision for a Material Adverse Effect (“MAE”) simply because a pandemic was ravaging the hotel industry. Seller asserted that the consequences of the COVID-19 pandemic fell within an exception to the definition of an MAE for effects resulting from “natural disasters and calamities.” Though the exception did not explicitly include the term “pandemic,” the Court pointed out that pandemics were included in the dictionary definition of “calamity.” The Court rejected buyer’s argument that a “calamity” had to constitute an MAE under the SPA unless—unlike COVID-19—it was similar to a natural disaster that is a sudden, single event that threatens direct damage to physical property. The Court reasoned that the plain meaning of “calamity” encompassed a pandemic. Surveying case law and commentary concerning MAE clauses, the Court reasoned that this result was consistent with the MAE clause in general, which was relatively seller-friendly. The parties’ competing expert witness analyses of MAE clauses in precedent transactions similarly did not show that sophisticated parties likely would have used the more specific word “pandemic,” as buyer contended. Thus COVID-19 fell within the SPA’s exception to an MAE. Consequently, the Court concluded that the business of the seller did not suffer an MAE as defined in the SPA.
The Court subsequently held, however, that the buyer was entitled to terminate the SPA because the seller failed to comply with its covenants between signing and closing. Seller’s covenants included a commitment that the business of seller would be conducted only in the ordinary course of business, consistent with past practices in all material respects. The Court explained that changes in response to a global pandemic and governmental guidelines did not control over the terms of the SPA. Buyer proved that due to the COVID-19 pandemic, the seller had made extensive operational changes to its hotels’ past-routine business practices. The Court reasoned that “[a] reasonable buyer would have found them to have significantly altered the operation of the business.” The test was not what reasonable managers would do in response to a pandemic. Therefore, the Court found that the seller failed to comply with the “ordinary course of business” covenant, relieving buyer of its obligation to close the deal. There were also complex factual issues involving a fraudulent scheme, title insurance, and the Delaware Rapid Arbitration Act, which also relieved buyer of its obligation to close.
Having concluded that the buyer was permitted to terminate the SPA, the Court denied seller’s request for specific performance. Under the plain language of the SPA, the Court awarded the buyer its $582 million transaction deposit with interest, its attorneys’ fees, and $3.685 million in transaction-related expenses.
§ 1.5 Appraisal
§ 1.5.1
Fir Tree Master Fund, L.P. v. Jarden Corp., 236 A.3d 313 (Del. 2020). Adding to its appraisal jurisprudence, the Supreme Court of Delaware affirmed the use of the unaffected trading price of a public corporation’s stock to determine its “fair value” in the circumstances presented, while clarifying that “it is not often that a corporation’s unaffected market price alone could support fair value.”
After the CEO and co-founder of the respondent corporation negotiated a sale of the company for $59.21 per share, several stockholders refused to accept the sale price and pursued their appraisal rights. Of the valuation methodologies presented at trial, the Court of Chancery determined that only the $48.31 unaffected market price reliably determined fair value. Because of a flawed sale process, a lack of comparable companies to assess, and wildly divergent discounted cash flow analyses, all other valuation methods received little to no weight.
On appeal, the Supreme Court rejected the petitioners’ argument that the Court’s earlier decision in Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 210 A.3d 128 (Del. 2019) foreclosed, as a matter of law, using the unaffected market price to support fair value The Court surveyed its more recent appraisal opinions in DFC Global Corp., Dell and Aruba. The Court explained that the DFC Global decision took issue with the Court of Chancery’s rejection of the deal price as relevant to fair value and specifically noted that the pre-transaction price of a public company may be relevant to a fair value analysis. In Dell, the Court of Chancery was reversed for assigning no weight to market value or deal price, which the Supreme Court found had substantial probative value in the circumstances of that case. Aruba discussed the considerable weight to be afforded the deal price absent deficiencies in the deal process, because a buyer possessing material non-public information about the seller is better positioned to value the seller when negotiating the purchase price. The Aruba Court further opined that when there were indications that the market was “informationally efficient” – i.e., that it digested and assessed all of the publicly available information such that it was quickly impounded into the stock price – then the market price may be indicative of fair value. The notable “takeaway” from these opinions – which the Supreme Court indicated the court-below got “exactly right” – is the requirement that the Court of Chancery explain its fair value calculation in a manner that is based upon the evidence presented.
Turning to the valuation methodologies presented to the Court of Chancery and its conclusions, the Supreme Court reasoned that the Court of Chancery did not abuse its discretion in rejecting those calculations, in arriving at factual conclusions reached in making that determination and in ultimately relying upon the unaffected market price. The court-below had a basis in the record to conclude that the market did not lack material information about the corporation’s prospects. The record supported the Court’s finding that the divergence of management’s and analysts’ projections was attributable to a difference of opinion, not a material difference in available information. The Supreme Court also declined to find fault with the Court of Chancery’s decision not to rely upon the deal price as a floor for its fair value analysis. The petitioners had attacked the sale process and the deal price it yielded as unreliable and argued to the court-below that synergies were only relevant if the deal price was reliable. After noting this differed from the petitioners’ argument below, the Supreme Court held that the Court of Chancery did not err in reasoning that, based on the record, the deal price included significant synergies. In any event, the trial court did not err in declining to give the deal price weight. The Supreme Court similarly affirmed the court-below’s decision to find certain market evidence more reliable, including the price of share issuances and repurchases occurring near in time, and to find certain other evidence as less reliable, such as certain analysts’ targets or certain results-oriented valuations in the record. Lastly, the Supreme Court held that the Court of Chancery did not abuse its discretion in calculating a terminal investment rate for its DCF model, a method the court used only as a check on the market price, based on convergence theory (also known as the McKinsey formula), as the Court of Chancery has done in certain other recent matters.
§ 1.5.2
Kruse v. Synapse Wireless, Inc., 2020 WL 3969396 (Del. Ch. Jul. 14, 2020). This case illustrates how appraisal works outside of the public market context when a lack of data hinders a reliable valuation. Here, stockholder William Richard Kruse (“Kruse”) sought appraisal of his shares of SynapseWireless, Inc. (“Synapse”), a privately-owned corporation. McWane Inc. (“McWane”) acquired Synapse in two rounds of investments: McWane, first, acquired a controlling interest in 2012, and, then, acquired the remaining Synapse shares in 2016 in a cash-out merger (the “Merger”). As part of the 2012 transaction, McWane gained the right to purchase newly issued Synapse shares at a price set by the 2012 acquisition. Synapse had disappointing performance after the 2012 merger, posting less than half of the projected revenues used to calculate the 2012 merger price. To mitigate Synapse’s poor performance, McWane provided loans and purchased Synapse shares at the price set by the 2012 merger. For example, in 2014, McWane bought $31 million of shares at $4.99 per share to keep Synapse afloat, and to increase McWane’s ownership of Synapse to realize tax benefits.
McWane bought the remaining Synapse shares in the 2016 Merger at $0.43 per share, but Kruse refused McWane’s offer and filed this appraisal action in the Court of Chancery. At trial, Kruse’s expert valued Synapse at $4.19 per share as of 2016, while Synapse’s expert calculated a value between $0.06 and $0.11 per share. Both experts used three valuation methods: (i) a Prior Company Transaction analysis; (ii) a Comparable Transactions analysis, and (iii) a Discounted Cash Flow (DCF) analysis. The Court of Chancery eschewed the first two valuation methods as unreliable, but adopted Synapse’s DCF analysis with minor adjustments. Accordingly, the Court appraised Synapse at $0.23 per share.
In assessing the parties’ contentions, the Court found that, because there was no market check or competitive sales process, there was no contemporaneous market evidence to aid the Court in determining fair value. The Court also ignored a report on Synapse’s value from an investment bank because no employee of the investment bank testified at the trial and hence was not subject to cross-examination.
In lieu of market data, the Court first considered the parties’ Prior Company Transaction analyses. These analyses derived the value of Synapse from the price McWane paid for Synapse shares in prior transactions. Because Synapse had dramatically underperformed the revenue projections used to calculate the 2012 merger price, the 2012 merger price was “stale as of the 2016 Merger.” Additionally, McWane’s purchases of Synapse stock in 2014 were at a price contractually agreed-upon at the time of the 2012 merger, and for that reason did not reflect fair value as of 2016.
The Court next considered the parties’ Comparable Transactions analyses, which estimated the value of Synapse by comparison with other transactions within a similar timeframe, industry and company size. The Court held that neither party had carried its burden to show that its Comparable Transactions analysis reflected Synapse’s fair value. This was because the experts each made thoughtful objections to the other’s analyses, including the comparability of the transactions, and neither expert successfully rebutted the other’s objections.
Finally, the Court evaluated the parties’ DCF analyses. According to the Delaware Supreme Court, a DCF analysis is “widely considered the best tool for valuing companies when there is no credible market information and no market check . . . .” The DCF measures a company’s value by projecting its future cash flows, and then discounting the projections to present value. The Court found Synapse’s DCF calculation more reliable because it better accounted for Synapse’s poor performance, and so adopted the calculation with minor adjustments, finding the fair value on the date of the Merger to be $0.23 per share.
§ 1.5.3
Manti Holdings, LLC v. Authentix Acquisition Co., 2020 WL 4596838 (Del. Ch. Aug. 11, 2020). This decision from the Court of Chancery clarifies the ability of corporate constituents to modify by agreement the rights associated with the statutory appraisal remedy, 8 Del. C. § 262. In a previous decision in the case, the Court denied a stockholder’s appraisal petition holding that an advance waiver of statutory appraisal rights in a stockholder agreement is permitted under Delaware law as long as the relevant contractual provisions are clear and unambiguous. Manti Holdings, LLC v. Authentix Acquisition Co., 2019 WL 3814453 (Del. Ch. Aug. 14, 2019). In its latest decision, the Court ruled that a prevailing party fee-shifting provision in the stockholder agreement did not contravene Delaware law and was likewise enforceable.
In connection with a prior merger of a previous company into the defendant Authentix Acquisition Company, Inc. (“Authentix”), petitioners entered into a Stockholders Agreement with the new stockholders as a condition of that merger. Under the Stockholders Agreement, petitioners agreed that “in the event that … a Company Sale is approved by the Board” they would “consent to and raise no objection against such transaction … and … refrain from the exercise of appraisal rights with respect to such transaction.” Petitioners also agreed to a prevailing party fee-shifting provision “[i]n the event of any litigation or other legal proceedings involving the interpretation of this [Stockholders] Agreement or enforcement of the rights or obligations of the Parties…”
In 2017, the Authentix board of directors approved a merger agreement with a third party. Petitioners refused to consent to the merger, sent appraisal demands, refused to withdraw their demands and filed an action seeking appraisal under 8 Del. C. § 262. After a grant of summary judgment in favor of the surviving corporation because petitioners had validly waived their appraisal rights in the Stockholders Agreement, the surviving corporation sought, and the Court granted, enforcement of the prevailing party fee provision to recover its attorney’s fees.
Acknowledging the contractual fee-shifting provision, the petitioners argued that it was unenforceable for reasons of statutory procedure, public policy and equity. The Court first addressed petitioners’ argument that the Delaware legislature’s enactment of 2015 amendments to §§ 102(f) and 109(b) of the Delaware General Corporation Law (“DGCL”) to proscribe fee-shifting provisions in corporate charters and bylaws for intracorporate litigation, established statutory norms that lower order documents such as stockholder agreements could not contravene. The Court rejected this argument because: (i) neither statutory provision specifically addressed stockholder agreements, and (ii) the legislative history evidenced an intent to carve-out stockholder agreements from the fee-shifting prohibitions. The Court reasoned that the amendment addressed the concern that corporate charters and bylaws, to the extent contractual, are analogous to contracts of adhesion. In contrast, stockholder agreements “signed by the stockholder against whom the provision is to be enforced” fall outside the intended prohibition of the section 102(f) and 109(b) amendments to the DGCL.
Further, the Court observed that the animating concern of the statutory amendments prohibiting fee-shifting was the perverse chilling effect of such provisions on stockholders’ ability to assert and enforce breach of fiduciary duty claims. Noting that breach of fiduciary duty claims were not before him in the appraisal litigation, the court cited the difference between limiting fiduciary duties and waiving statutory appraisal rights as an additional justification for upholding the fee-shifting provision when only appraisal rights are at stake.
§ 1.6 Demand
§ 1.6.1
McElrath v. Kalanick, 224 A.3d 982 (Del. 2020). In this decision the Supreme Court upheld a Court of Chancery dismissal for failure to adequately allege demand excusal. This case exemplifies the Delaware courts’ approach to examining demand futility.
In 2016, Uber Technologies, Inc. (“Uber”) acquired Ottomotto LLC (“Otto”), a company started by a contingent of employees from Google’s autonomous vehicles group, in order for Uber to gain expertise in developing autonomous vehicles. The shareholder-plaintiff brought a claim, on behalf of Uber, against some of Uber’s directors. The plaintiff alleged that Uber’s directors ignored the risks presented by Otto’s alleged theft of Google’s intellectual property, which eventually led to Uber paying a settlement of $245 million to Google and terminating its employment agreement with Otto’s founder.
The plaintiff argued that the directors should have informed themselves of the results of a report prepared by a forensic investigative firm hired by Uber to conduct due diligence on Otto. The report uncovered that Otto employees had misappropriated Google’s intellectual property. More specifically, the plaintiff contended that the directors were on notice to review the report. The directors should not have relied on the representations of then-CEO Travis Kalanick to acquire Otto because Mr. Kalanick had repeatedly flaunted laws applicable to Uber. Plaintiff also alleged that the directors were on notice because of unusual indemnification provisions in the merger agreement between Uber and Otto that protected Otto from liability for some of its disclosed bad acts and misstatements. Finally, the plaintiff claimed that the directors had notice to inquire about the results of the report because they were aware that Uber had requested the forensic investigative firm to prepare the report.
The Delaware Supreme Court affirmed the Court of Chancery’s dismissal of the plaintiff’s complaint because the plaintiff had failed to allege that a majority of Uber’s directors was not disinterested or independent. The Supreme Court held that the mere fact that Kalanick had appointed a director in a control dispute to the Uber board did not lead, without more, to the inference that that director was interested or not independent of Kalanick. In addition, Uber has an exculpatory charter provision, which shields its directors from liability for breaches of the duty of care, meaning that the otherwise disinterested and independent directors could be liable only for intentional misconduct. The plaintiff’s complaint and documents incorporated by reference reflected that the directors discussed the diligence prepared by the forensic accounting firm, were told that the diligence was “OK,” and noted the possibility of litigation with Google. The Supreme Court also found that the directors could have reasonably relied on Mr. Kalanick’s representations because Uber’s alleged past violations of laws under his leadership did not involve intellectual property, and Mr. Kalanick did not have a history of lying to the board. The Supreme Court therefore held that “[a]though there might have been reason to dig deeper into Kalanick’s representations about the transaction, the board’s failure to investigate further cannot be characterized fairly as an ‘intentional dereliction’ of its responsibilities.”
§ 1.6.2
Hughes v. Hu, 2020 WL 1987029 (Del. Ch. Apr. 27, 2020). This decision denied the directors’ motion to dismiss finding that plaintiff had adequately pled demand futility.
According to Plaintiff, for several years Defendants exercised no meaningful oversight over the company’s financial reporting and auditing. This alleged lack of oversight lead to, inter alia, failures to understand and disclose related-party transactions, company funds being held in directors’ personal accounts, and inaccurate financial and tax reporting. Although the company promised to correct these deficiencies in 2014, the problems persisted virtually unabated for three more years. For example, the company continued using problematic auditors, who while purportedly “independent” had no other clients, and the board’s audit committee typically met for less than one hour just once per year. Plaintiff asserted that demand would have been futile because four of the Defendants comprised a majority of the six-member board that would have considered the demand. And some of those same members had also been on the audit committee.
Before turning to the specifics of the case, the Court provided a thorough exposition of the observation that the Court and legal commentators have made for years: the two tests used to evaluate demand futility “ultimately focus on the same inquiry.” The Court began with a casebook-worthy history of the two tests, Aronson and Rales. The earlier Aronson framework applies when the directors who committed the alleged wrong are the same directors who would consider a plaintiff’s litigation demand. Under Aronson, a plaintiff must plead facts which create a reasonable doubt that the directors are disinterested and independent and that the board’s action was a valid exercise of business judgment. The broader Rales framework applies to all situations not addressed by Aronson, such as when the board failed to act or when the board’s membership changed. Rales requires a plaintiff to plead that a majority of directors are “either interested in the alleged wrongdoing or not independent of someone who is.” disinterested and independent and that the board’s action was a valid exercise of business judgment.
As the Court explains it, “[c]onceptually … the Aronson test is a special application of Rales” even though Rales came later. Rales asks generally “whether a director could be interested in the outcome of a demand because the director would face a substantial risk of liability if litigation were pursued” whereas Aronson examines a specific subset when the threat of liability comes from a transaction that the same directors approved.
Using this discussion as a springboard, the Court observed that the case illustrated the overlap between Rales and Aronson. Technically, Aronson would apply because a majority of directors considering the demand were same directors who allegedly failed to provide financial oversight. But because Plaintiff challenged an alleged failure of oversight — i.e., a Caremark claim — rather than a specific board act, the Court determined that the broader Rales standard would typically apply.
The Court concluded that, because the well-pled facts showed a majority of the board faced a substantial risk of liability under Caremark and its progeny, Plaintiff pleaded sufficient facts to establish demand futility. First, the Court concluded that the chronic deficiencies in financial oversight supported a pleadings-stage inference that the board (acting through its audit committee) failed to provide financial oversight or to install a system of financial controls. Defendants attempted to rely upon the fact that the company did have some financial controls – e.g., an audit committee. But Plaintiff had made a pre-suit inspection demand under 8 Del. C. § 220, and obtained books and records showing the board’s activities in this area over the pertinent time period, as well as a certification affirming that the production was complete with respect to its subject matter. The Court criticized the board and audit committee’s general lack of activity despite known problems with financial controls and obtaining transparency into related-party transactions. The Court concluded that the audit committee likely did not fulfill its obligations under its charter. Because of such deficiencies, four of the six board members faced a substantial likelihood of liability for breaching their duty of loyalty, and thus, the board lacked an independent, disinterested majority to consider a demand. The Court denied Defendants’ motion.
§ 1.6.3
Utd. Food and Comm. Workers v. Zuckerberg, 2020 WL 6266162 (Del. Ch. Aug. 24, 2020). The Court of Chancery discussed the legal tests to demonstrate demand futility in derivative actions under the seminal cases of Aronson and Rales. Reconciling longstanding and recent case law, the Court ruled that demand futility turns on whether at the time of filing of the complaint, the majority of a board of directors is disinterested, independent, and capable of impartially evaluating a litigation demand to bring suit on behalf of a company.
This derivative suit followed prior litigation that challenged a proposed, board-approved reclassification of Facebook stock that would have enabled Mark Zuckerberg to sell significant quantities of his stock without attendant stockholder voting rights to maintain his present level of control over Facebook. On the eve of trial in the reclassification litigation, Zuckerberg asked the Facebook board to withdraw the proposed reclassification. The plaintiff then filed derivative claims for breach of fiduciary duties, seeking damages in connection with the board’s approval of the stock reclassification.
The Court held that plaintiff failed to adequately plead demand futility under Court of Chancery Rule 23.1. Conducting a director-by-director analysis of the Facebook board, the Court found that the nine-member board could impartially consider a litigation demand if at least a majority, or five members, could exercise independent and disinterested judgment regarding a litigation demand. Two members were outside directors, who had joined the board after the proposed reclassification had been approved, and plaintiff had failed to plead non-conclusory allegations that called into question their disinterest or independence. For three other members, their alleged business relationships with Facebook or personal relationships with Zuckerberg did not support any inference that they were unable to independently consider a litigation demand. Nor did plaintiff plead any facts that would support a pleading-stage inference that they had received personal benefits from the proposed reclassification or committed a non-exculpated breach of fiduciary duty, and thus could face personal liability in the derivative litigation, as a result of voting to approve the reclassification.
In sum, the Court found that demand was not excused because a majority of the Facebook board was disinterested, independent, and capable of impartially considering a litigation demand regarding the board’s approval of the stock reclassification. Accordingly, the Court dismissed the complaint based on plaintiff’s failure to plead demand futility.
§ 1.7 Advancement and Indemnification
§ 1.7.1
Int’l Rail P’tners v. Am. Rail P’tners, 2020 WL 6882105 (Del. Ch. Nov. 24, 2020). This case considered whether an indemnification provision in a limited liability company agreement covered losses stemming from so-called “first-party” claims (i.e., claims between the parties to the contract, as opposed to so-called “third-party” claims brought by non-parties). The Court of Chancery interpreted the plain language of the provision against a background of advancement and indemnification case law, and distinguished this context from interpretive principles that apply to general indemnification provisions found in commercial contracts.
The individual plaintiff (“Plaintiff”), an officer of the defendant LLC (“Defendant” or the “Company”), brought an action in the Court of Chancery to enforce his rights to advancement under the Company’s LLC agreement. The advancement action arose out of an underlying dispute between the Company and Plaintiff, in which the Company alleged that Plaintiff mismanaged the Company and enriched himself to the detriment of the Company. Based on those allegations, the Company brought an action in the Delaware Superior Court seeking damages against Plaintiff (the “Superior Court Action”). Defendant responded to Plaintiff’s advancement action by arguing that Plaintiff was not entitled to advancement because Plaintiff was defending the Superior Court Action against the Company itself. According to Defendant, the Company’s LLC agreement did not provide for advancement where the claims were brought by or on behalf of the Company against the covered person (which Defendant referred to as “first-party claims”). In reaching this conclusion, Defendant reasoned that the LLC agreement did not expressly address first-party claims and, therefore, no advancement for such claims was allowed—even though the terms of the agreement provided for advancement and indemnification for expenses “arising from any and all claims” against a covered person (as Defendant conceded Plaintiff to be).
The Court rejected Defendant’s arguments, however, and granted judgment on the pleadings to Plaintiff. The Court reasoned that “[i]f Defendant’s position is to be accepted, an LLC Agreement that uses the precise language of the statute to provide for indemnification and advancement to all of its members, managers, and other specified persons as to ‘any and all claims whatsoever’ does not mean what it says.” The Court came to this conclusion despite Defendant’s reliance on Delaware case law relating to indemnification agreements in the bilateral commercial contract context. Those cases suggested that an indemnification provision in a bilateral commercial contract does not operate to shift fees in a claim between parties unless the contract explicitly addresses the issue. The Court noted that the leading Delaware case on this issue was TranSched Sys. Ltd. v. Versyss Transit Solutions, LLC, 2012 WL 1415466 (Del. Super. Mar. 29, 2012). The Court reasoned, however, that TranSched was inapplicable in the LLC indemnification context (under 6 Del. C. §18-108) because TranSched interpreted a standard indemnity clause in a bilateral commercial purchase agreement and was decided in the context of an arms-length transaction between two commercial entities. The TranSched Court reasoned that, if it interpreted such a standard indemnity agreement as shifting attorneys’ fees in a claim between the parties, the American Rule in Delaware would be eviscerated.
As such, the Court found that TranSched did not create a presumption that advancement for first-party claims was disallowed in the Section 18-108 context. Instead, the Court found that LLC indemnification agreements must expressly preclude first-party claims—if the parties wished to do so—reasoning that “[g]iven the statutory framework, the broad language of the LLC Agreement’s indemnification provision, and the strong public policy in favor of indemnification and advancement, … I decline to elevate an interpretive presumption applied to commercial contracts above the strong public policy of advancement and indemnification, particularly in light of the ‘capacious and generous standard’ articulated in the American Rail LLC Agreement.” The Court accordingly ordered the Company to the advance the Plaintiff CEO’s reasonable attorneys’ fees and expenses in defending against the Superior Court Action.
§ 1.7.2
Perryman v. Stimwave Tech., Inc., 2020 WL 7240715 (Del. Ch. Dec. 9, 2020). The Court upheld a charter amendment requiring that advancement agreements for executives be approved by the Series D shareholders. One of the plaintiffs’ advancement agreements was upheld despite the charter amendment, the other was denied as postdating and failing to comply with the charter amendment.
Plaintiffs Laura and John Perryman were directors of Stimwave Technologies Incorporated (“Company”) since 2010 and 2013, respectively. Laura Perryman also served as the Company’s chief executive officer through November 2019. The Company’s original charter adopted in 2010 provided that it would not be amended to change any advancement or indemnification provisions after the initiation of an investigation of any act or omission. The Company’s bylaws further provided that the corporation shall indemnify its officers and directors to the fullest extent permitted by Delaware law.
These provisions remained in place undisturbed until 2018 when the Company solicited additional investors. In connection with a $5 million investment in April 2018, the Company created a new series of preferred shares, Series D. In addition, the Company adopted a charter amendment that stated that the Company would not enter any agreements with its executives except with the approval of 68% of the outstanding Series D shares. A further revision in July 2018 provided that any unapproved agreements with executives were void abinitio.
In October 2019, the Department of Justice initiated a False Claims Act against the Company. In November 2019, Laura Perryman resigned as CEO. Around the time of her resignation she provided the Company with an advancement and indemnification agreement between her and the Company dated January 2018. Pursuant to the terms of the agreement, the Company began advancing fees to Ms. Perryman. In December 2019, the Company initiated a breach of fiduciary duty claim against Ms. Perryman with various allegations of financial misfeasance. The complaint was later amended to include a claim for breach of fiduciary duty against Mr. Perryman as well. Mr. Perryman submitted a claim for advancement to the Company and provided an advancement and indemnification agreement dated January 2015.
There was significant dispute and conflicting evidence about the date Ms. Perryman’s and Mr. Perryman’s advancement and indemnification agreements had been executed. The Court concluded after trial that Mr. Perryman’s agreement had been executed in April 2018 around the time the Company’s board approved entry into such agreement with the directors. The Court further concluded that Ms. Perryman’s agreement had not been executed until November 2019.
The court held that Mr. Perryman’s agreement was not subject to the approval requirements of the charter amendment because he was not an executive. In addition, Mr. Perryman’s agreement was executed while Ms. Perryman was still CEO, therefore it was a valid agreement with and binding on the Company. Mr. Perryman was awarded advancement of his attorneys’ fees and expenses.
Ms. Perryman’s indemnification agreement was executed after the charter amendment, was not approved by the Series D shareholders as a contract with an executive and was not enforceable. In denying Ms. Perryman advancement, the Court further noted that the charter’s provision directing indemnification of the Company’s officers and directors was of no import because advancement and indemnification were separate considerations. Without a valid advancement agreement, the Company had no obligation to advance Ms. Perryman’s legal fees.
§ 1.8 SEC Developments
2020 was a busy year at the Securities Exchange Commission (“SEC”), both in terms of new rulemaking and enforcement actions. But the most material development in terms of its potential effect on Delaware corporate law is a recent proposal Nasdaq submitted to the SEC regarding disclosures related to board diversity and inclusion. Although this proposal potentially raises difficult Delaware corporate law questions, it encouragingly signifies broader institutional support of board diversity initiatives and requirements.
According to Nasdaq, “[i]f approved by the SEC, the new listing rules would require all companies listed on Nasdaq’s U.S. exchange to publicly disclose consistent, transparent diversity statistics regarding their board of directors. Additionally, the rules would require most Nasdaq-listed companies to have, or explain why they do not have, at least two diverse directors, including one who self-identifies as female and one who self-identifies as either an underrepresented minority or LGBTQ+.”[1] Nasdaq’s proposal states that it is proposing the new listing rules because, “[w]hile gender diversity has improved among U.S. company boards in recent years, the pace of change has been gradual, and the U.S. still lags behind other jurisdictions that have imposed requirements related to board diversity. Moreover, progress toward bringing underrepresented racial and ethnic groups into the boardroom has been even slower.”[2]
If Nasdaq’s proposed listing rule passes, Delaware corporate law could be implicated in at least a couple of ways. First, the passage of the listing rule may increase support and momentum for Delaware’s legislature to create statutory board diversity requirements applicable to Delaware corporations—an issue on which the legislature has been silent to date. Second, the rule’s passage may result in litigation that forces Delaware courts to address the contours of the internal affairs doctrine as it relates to non-Delaware-law-based mandates for diversity on the boards of Delaware corporations. Some have forcefully argued that other states’ statutes cannot mandate Delaware corporations’ board diversity.[3] While the proposed listing rule is not a state statute, and may not be viewed as a mandate (given its “adopt or explain” structure), the possibility remains that challenges to the rule under the internal affairs doctrine may arise.
Whatever the outcome of these potential Delaware legislative or judicial endeavors, it is clear that business institutions are moving in the direction of better supporting gender and racial diversity on corporate boards. In addition to the Nasdaq proposal, institutional giants ISS and Glass Lewis have recently improved their policies related to board diversity.[4] Whether these developments prove to encounter resistance when stacked up against Delaware law, or instead harmonize nicely, remains to be seen. In any event, the likelihood that the advancement of board diversity initiatives and requirements will soon require Delaware corporate law to break its silence on the issue is increasing, and fast.
[1] Press Release, Nasdaq to Advance Diversity through New Proposed Listing Requirements Dec. 1, 2020) (available at https://www.nasdaq.com/press-release/nasdaq-to-advance-diversity-through-new-proposed-listing-requirements-2020-12-01).
[2] Nasdaq Stock Market LLC, Form 19b-4 (Dec. 1, 2020) at 8 (available at https://listingcenter.nasdaq.com/assets/rulebook/nasdaq/filings/SR-NASDAQ-2020-081.pdf).
[3]See, e.g., Joseph A. Grundfest, Mandating Gender Diversity in the Corporate Boardroom: The Inevitable Failure of California’s SB 826, Rock Center for Corporate Governance (Sept. 12, 2018) (available at https://www.law.berkeley.edu/wp-content/uploads/2019/10/SSRN-id3248791_3561624_1.pdf).
[4]See ISS, United States Proxy Voting Guidelines Benchmark Policy Recommendations (Nov. 19, 2020) at 61; Glass Lewis, 2021 Proxy Paper Guidelines: An Overview of the Glass Lewis Approach to Proxy Advice, at 26-27.
The UN Guiding Principles on Business and Human Rights require companies to embed their commitment to fulfill their responsibilities to respect human rights in the operational policies and procedures that apply throughout the business enterprise.[1] Embedding has been described as creating the right “macro-level” environment for the company’s human rights policies to be effective in practice through training, performance, and accountability structures, the tone at the top from the board and senior management, and a sense of shared responsibility for meeting the company’s human rights commitments.[2] There is no universal standard for embedding human rights in a company’s operations and organizational culture. However, there does appear to be a consensus that companies should begin the process with the full-scale assessment of human rights impacts, relying on both internal resources and external assistance, and then use the information collected during the assessment process to develop a human rights strategy with commitments and performance targets. Subsequent steps would typically include developing processes and procedures to integrate human rights throughout the organization, including extensive training, and monitoring and measuring progress toward the performance targets; setting up a framework for reporting on human rights activities and performance and other communications to stakeholders relating to human rights; and ensuring that the initiatives relating to human rights are regularly reviewed and that appropriate changes are made to continuously improve performance.[3]
Governance and Management
Research has found that corporate social responsibility (“CSR”) initiatives are most effective when CSR principles have been integrated into the company’s governance and management processes and its organizational culture. CSR governance begins at the top of the organization with the board of directors, which has been charged by emerging corporate governance guidelines and stakeholder expectations with responsibility for oversight of the environmental and social impacts of the company’s operations. The directors and members of the senior executive team must proactively respond to the serious challenges confronting business, and society in general, resulting from neglect of important environmental and social issues. The UN Guiding Principles explicitly call on businesses to demonstrate the commitment of senior management to the due diligence process from the very beginning. One of the first steps that should be taken is to design and implement appropriate high-level governance arrangements that have been publicly endorsed by the board of directors and senior management.[4]
CSR and human rights are like any other important management initiatives and require proactive leadership from the top of the organization. It is clear that the “tone at the top” is an important factor in the success or failure of any effort to embed and integrate human rights into a company’s operations and business relationships. The directors and senior managers of the company are uniquely positioned to act as internal champions of this process, and they should proactively communicate with everyone in the organization on a daily basis about the steps they believe are necessary to effectively manage the company’s human rights impacts. The directors and senior managers must also commit to investing the time and effort necessary to explain the company’s human rights initiatives to customers and other stakeholders and must develop and implement metrics for tracking and reporting progress. While social responsibility certainly extends “beyond the law,” directors and officers must be mindful of their fiduciary duties and understand how laws, regulations, and standard contract provisions are rapidly evolving to incorporate standards for respecting human rights.
Operations
Even in large organizations, concern for human rights due diligence may begin with just one person or a small group of persons with a passion for the subject. However, like any other important project, due diligence requires project management skills, structures and widespread participation and support. Companies should form a human rights steering or working group, either as a totally new entity or perhaps by extending the charter of an existing group working on related issues such as ethics. The working group should include senior managers from all relevant areas of the organization including social , legal, environmental and/or sustainability, human resources, worker/trade union representatives, operations/production, compliance and ethics, procurement (including supply chain and business relationships), sales and marketing, community development, external affairs/reporting, risk management, mergers and acquisitions, and audit. It is important for the working group to be cross-functional in order to avoid a “siloed” approach and ensure that input is solicited and obtained from stakeholders across all of the levels and functions within the organization. The specific composition of the working group will depend on the activities and size of the company and the specific risks it faces.
One important issue to consider when attempting to organize and manage a cross-functional initiative is ensuring that each of the functions and departments involved in the process understands why the company is undertaking human rights due diligence, their specific role in the process, how due diligence will impact their day-to-day activities, and how their performance will be assessed by senior management and others throughout the organization. Each function or department will have its own set of salient human rights issues based on its specific activities (e.g., human resources will be concerned with industrial relations and working conditions while the information technology group will be focused on privacy). Leaders of a function or department may be concerned about the effect that human rights due diligence will have on their limited resources and the changes that might have to be made in historical practices in order to accommodate the requirements of due diligence. While critics of corporate efforts to act responsibly complain when it appears that a decision to “do the right thing” turns on an attractive business case, the reality is that many managers will be more motivated when they are shown how addressing human rights risks will improve their traditional financial-based bottom line. However, the responsibility to carry out human rights due diligence applies regardless of any business case argument.[5]
Strategy
Once the assessment of the company’s human rights impacts has been completed and the company has identified and prioritized its own unique set of salient human rights issues and actions, attention needs to turn to:
developing a human rights strategy, a process which includes building support among the directors, senior management and employees;
researching what others are doing, and assessing the value of recognized voluntary human rights initiatives and instruments;
preparing a matrix of proposed actions; developing ideas for proceeding and the business case for them; and
deciding on direction, approach, boundaries, and focus areas.[6]
As with any other strategic initiative, human rights activities must be institutionalized in the organization in order to be sustainable and thus it is essential that respect for human rights be seen to be inherent in the organizational culture and adopted as part of the company’s long term strategy and decision-making rather than being seen as an “add on” that can be discarded when circumstances change (e.g., when an economic downturn creates pressures to divert resources away from sustainability initiatives).[7] Like any other strategy, a human rights strategy reflects decisions among multiple potential projects and provides a path for implementation, assigns roles and responsibilities throughout the organization, establishes timetables for completion of various tasks, and incorporates metrics to measure progress and performance. The strategy should also be aligned with the company’s core values and standards.
The strategy itself should include a mission statement, goals and commitments, policies and procedures, key performance indicators, a clear allocation of responsibilities for the implementation of the strategy, procedures for reporting on progress, and regular evaluation of the strategy. As the strategy moves toward finalization, it should circulated to key stakeholders for their input, a step that not only improves the strategy but creates a sense of participation among stakeholders that will help to ultimately garner their support.[8] Once the company is actively engaged in implementing the strategy, it is essential to measure and assure performance, engage stakeholders, and report on performance, both internally and externally. The human rights working group described elsewhere in this article must evaluate performance, identify opportunities for improvement, and engage with stakeholders on implementing changes.
Commitments
Once the human rights strategy has been completed, it is time to move forward with developing and implementing human rights commitments. Developing those commitments involves doing a scan of existing commitments relating to human rights issues; holding discussions with major stakeholders; creating a working group to develop the commitments; preparing a preliminary draft of the commitments; and consulting with the affected stakeholders. In order to implement the commitments, steps must be taken to develop an integrated decision-making structure; prepare and implement a strategic plan; set measurable targets and identify performance measures; engage employees and others to whom the commitments apply; design and conduct training; establish mechanisms for addressing problematic behavior; create internal and external communications plans; and make commitments public.
Commitments should address human rights-related targets for each of the company’s key stakeholders and institutionalize associated processes such as stakeholder engagement, collaborations with value chain partners, and sustainability reporting and communications. The commitments should be closely aligned to the list of salient human rights issues created earlier in the assessment and implementation process. Alignment makes it easier for the company to focus its attention on a relatively short list of commitments that are easily to describe, such as the following:[9]
Employee health and safety: Ensuring that employees work in a safe environment which meets or exceeds relevant regulatory expectations, addresses health and safety concerns as they arise, and mitigates opportunities for reoccurrence of incidents.
Product quality and safety to customers: Choosing materials from quality sources, complying with current “good manufacturing practice,” and delivering fit-for-purpose, safe products to customers that adhere to or exceed strict regulatory standards in all jurisdictions served by the company.
Corruption and bribery: Business must be conducted with transparency and free from unethical persuasion in every aspect of the company’s business from identifying product sources, through development of new products, transactions with regulatory bodies, and sale to customers.
Ethical purchasing and human rights in the supply chain: Responsibility to partners to ensure our product line is free from human rights concerns such as forced labor and trafficking, unsafe labor standards, and unfair treatment.
Compliance: Responsibility to drive compliance with legal and regulatory requirements applicable to our global business including training programs, continuous improvement, and striving for best practices.
Resource use and waste management: Reducing the environmental impact of the company’s operational activities by managing energy usage during manufacture and logistics, water usage, and waste as a by-product of manufacture.
Employee development: Offering employees the opportunity to develop their professional skills mentoring, technical training, and continuing education programs.
Making maximum use of new technology: Developing and acquiring new technologies to improve productivity and operational efficiency in an environmentally and socially responsible manner.
Human rights commitments are generally formalized in a separate commitment statement that is made available to all stakeholders for viewing on the company’s website along with other documents and instruments pertaining to the company’s governance and operational guidelines. Statements regarding human rights commitments are accompanied by principles and policies, including a code of corporate conduct that covers legal compliance, financial responsibility, fair competition, prohibitions on bribery and corruption, conflicts of interest, customer relationships, supply chain relationships, workplace conditions and employee wellbeing, environmental responsibility, and community relations; environmental policies; human resources policies; and principles of responsible purchasing.[10]
Performance Targets
Once the human rights commitments have been selected, the company needs to define the target level for its performance with respect to each of the commitments. When setting the targets, consideration should be given to both effectively managing material risks to the business and rights holders and meeting expectations of key stakeholders. The initial target level depends on the current status of the company’s activities, and companies should expect to periodically review and, as appropriate, reset the targets. At a minimum, companies need to comply with all laws and regulations applicable to their business operations. However, a serious effort goes beyond minimum compliance to include both surpassing the requirements of laws and regulations and making and keeping voluntary commitments selected by the company that are related to the company’s key human rights impacts. The next level is meeting the expectations of markets and stakeholders, which inevitably exceeds legal and regulatory compliance and can be understood only through a process of extensive engagement with investors and other key stakeholders. Finally, some companies may progress to the point where they become recognized as being among the leaders of best practices with respect to human rights due diligence.[11]
Processes and Procedures
Companies need to establish processes and procedures to support the implementation of their human rights strategies that span the full scope of their business activities and functions. Among other things, the company needs to implement processes for identifying its human rights-related risks and opportunities, such as the matrix approach described above, and understanding business, cultural, economic, and political conditions in each of the geographic locations in which it is currently operating or intends to operate in the future. It is particularly important for companies to establish control systems for managing the human rights-related aspects of their business. Common approaches include incorporating social and environmental criteria into every assessment of a new project; a supplier qualification process that considers compliance criteria along with other factors such as cost, speed, quality, and innovation; mandatory reviews of prospective customers’ human rights record and processes; codes of conduct; checklists and instructions for business operations in sensitive areas including scheduled and unscheduled inspections; supplier guidelines, including requirements for independent audits and certification in accordance with internationally-recognized standards and sector-specific initiatives; and mandatory requirements relating to human rights due diligence in standard contracts for common business relationships.[12]
Communications and Reporting
Companies should be prepared to communicate with stakeholders regarding their human rights strategies, policies, procedures, and performance using a variety of internal and external communications and reporting tools, including codes of conduct, the company’s website, company publications, annual reports, and notice boards. Information should be presented in local languages and stakeholders, particularly employees, should be able to understand the performance indicators that the company is using to track its human rights initiatives in order to influence behaviors and guide decision-making during day-to-day operational activities. Information should be readily accessible and should be presented in a format that can be readily understood by all affected stakeholders. Planning for communications should also include developing and publicizing tools for stakeholders to safely pose questions and raise concerns regarding the company’s human rights performance. Companies should engage regularly with key stakeholders to discuss issues relating to the relationship between them including dissemination of information and the effectiveness of consultation processes. Formal reporting, either in a free-standing document or as part of the company’s annual report, should not only conform to applicable legal requirements but also use an effective reporting format that addresses the company’s key stakeholders and provides them with a full and transparent picture of the impact of the company’s operations on human rights and the steps that the company is taking to prevent adverse impacts.[13]
Reviewing and Improving
Effective performance relating to social responsibility and respect for human rights depends on commitment, careful oversight, evaluation, and review of the activities undertaken, progress made, achievement of identified objectives, resources used, and other aspects of the company’s efforts. Regular monitoring and review of human rights performance ensures that the company understands whether its strategies and programs are proceeding as intended and allows the company to identify problems and issues and to take remedial actions including changes in programs and shifts in the human rights issues that are given the greatest attention. While many of the monitoring and review activities are internal—tracking metrics on progress toward human rights-related goals tied to operational matters—consideration must also be given to the opinions and insights available from external stakeholders. Companies must continuously review changing conditions or expectations, legal or regulatory developments affecting social responsibility, and new opportunities for enhancing their efforts on social responsibility.[14] One of the most important tools with respect to review and improvement is the grievance mechanisms that should be established as part of the human rights due diligence process, mechanisms which not only provide stakeholders with an easily accessible means for providing feedback on the company’s human rights performance but also enable the company to identify situations that require additional attention and perhaps changes in policies and practices.
This article is an excerpt from the author’s new book, Business and Human Rights: Advising Clients on Respecting and Fulfilling Human Rights, published by the ABA Section of Business Law. More information on the book is available here.
[1] Alan S. Gutterman is a business counselor and prolific author of practical guidance and tools for legal and financial professionals, managers, entrepreneurs and investors on topics including sustainable entrepreneurship, leadership and management, business law and transactions, international law and business and technology management. He is the co-editor and contributing author of several books published by the ABA Business Law Section including The Lawyer’s Corporate Social Responsibility Deskbook, Emerging Companies Guide (3rd Edition) and Business and Human Rights: A Practitioner’s Guide for Legal Professionals. More information about Alan and his work is available at his personal website at www.alangutterman.com.
[2] Doing business with respect for human rights: A guidance tool for companies (Global Compact Network Netherlands, Oxfam, and Shift, 2016), 40.
[3] For discussion of an effective enterprise-wide culture relating to respect for human rights, including schematic diagrams attempting to capture the spectrum of diverse corporate cultures in this context, see S. Maslow, Business and Ethical Challenges: Human Rights Requirements, Due Diligence, Remediation and Brand Protection (Business Law Today, November 4, 2019). The article suggests the following spectrum of corporate cultures: “good global citizen” (active anti-human rights violations policies and procedures), “rule follower” (some recognition of applicable law); “two-facer” (policies only); “eyes wide shut” (plausible deniability); “negligent actor” (“benign” neglect); and “bad actor” (endorsement). Each of these cultures has a unique approach to managing involvement in human rights harm and preventing violations.
[4] Background Note: “Corporate human rights due diligence—Identifying and leveraging emerging practice” (UN Working Group on Business and Human Rights, April 2018), 4-5.
[5] The report of the Working Group on the issue of human rights and transnational corporations and other business enterprises (UN Working Group on Business and Human Rights, July 16, 2018), 6.
[6] P. Hohnen (Author) and J. Potts (Editor), Corporate Social Responsibility: An Implementation Guide for Business (Winnipeg CAN: International Institute for Sustainable Development, 2007), 68.
[7] F. Maon, V. Swaen and A. Lindgreen, Mainstreaming the Corporate Responsibility Agenda: A Change Model Grounded in Theory and Practice (IAG- Louvain School of Management Working Paper, 2008), 37.
[8] CSR Self-Assessment Handbook for Companies (Vilnius, Lithuania: UAB “Baltijos kopija” (Financed by the European Union and United Nations Development Programme), 2010), 13-14.
[9] Based on Mayne Pharma Group Limited Sustainability Report 2016, 12, https://www.maynepharma.com/media/1896/myx_2016_sustainability_report.pdf.
[12] A Guide for Integrating Human Rights into Business Management (Business Leaders Initiative on Human Rights, United Global Compact and Office of the High Commissioner for Human Rights, 2004), 24-27. The Guide encouraged companies to tap into the resources of sector-specific initiatives with expertise in human rights codes and procedures including the Ethical Trading Initiative, Fair Labor Association, Social Accountability 8000, the Voluntary Principles on Security and Human Rights, the Extractive Industries Transparency Initiative, the Equator Principles and the Electronic Industry Code of Conduct. Id. at 27.
Hughes Hubbard & Reed LLP One Battery Park Plaza New York, NY 10004 (212) 837-6126 [email protected] www.hugheshubbard.com
Michael D. Rubenstein
Liskow & Lewis APLC 1001 Fannin Street, Suite 1800 Houston, TX 77002 (713) 651-2953 [email protected] www.liskow.com
§ 1.1 Recent Bankruptcy Litigation Decisions
§ 1.1.1 United States Supreme Court
Ritzen Group, Inc. v. Jackson Masonry, LLC, 140 S. Ct. 582 (2020). The Ritzen Group, Inc. agreed to buy real property in Nashville, Tennessee, from Jackson Masonry, LLC. The transaction was never consummated and Ritzen sued for breach of contract in state court. Days before trial was set to begin, Jackson filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. Section 362(a) of the Bankruptcy Code stayed the litigation. Ritzen filed a motion in the bankruptcy court for relief from the automatic stay. The bankruptcy court denied the motion. The bankruptcy court, in the context of an adversary proceeding, found that Ritzen was in breach of the contract because it had failed to secure the financing by the closing date. Accordingly, the bankruptcy court disallowed Ritzen’s proof of claim. Thereafter, the plan of reorganization was confirmed and all creditors were enjoined from commencing or continuing any proceeding against the debtor on account of claims. Following confirmation, Ritzen filed two separate notices of appeal. First, Ritzen challenged the bankruptcy court’s order denying stay relief. Second, Ritzen challenged the court’s resolution of its breach of contract claim. The district court, acting as the appellate court of first instance, dismissed the first appeal as untimely pursuant to 28 U.S.C. § 158(c)(2) and Rule 8002(a) of the Federal Rules of Bankruptcy Procedure. With respect to Ritzen’s appeal of the breach of contract claim, the district court rejected the appeal on the merits. The United States Court of Appeals for the Sixth Circuit affirmed.
The Supreme Court granted certiorari to resolve the question of whether orders denying relief from the automatic stay are final and, therefore, immediately appealable under Section 158(a)(1). Justice Ginsburg, delivering the opinion for a unanimous court, began by noting that a majority of the circuit courts and the leading treatises consider orders denying relief from the automatic stay as final, immediately appealable decisions. The Court agreed.
Jackson argued that adjudication of a stay-relief motion was a discrete proceeding, whereas Ritzen argued that it should be considered as the first step in the process of adjudicating a creditor’s claim against the estate. The Supreme Court agreed with the appellate court and Jackson that the appropriate “proceeding” is the stay-relief adjudication. The bankruptcy court’s order ruling on that motion disposed of “a procedural unit anterior to, and separate from, claim-resolution proceedings.” The Court noted that “[m]any motions to lift the automatic stay do not involve adversary claims against the debtor that would be pursued in another form but for bankruptcy. Bankruptcy’s embracive automatic stays stops even non-judicial efforts to obtain or control the debtor’s assets.” The Court reasoned that there was “no good reason to treat stay adjudication as the relevant ‘proceeding’ in only a subset of cases.” Because the appropriate “proceeding” was the adjudication of the stay-relief motion, the bankruptcy court’s order conclusively denying that request was “final.” It ended the stay-relief proceedings and left nothing more for the bankruptcy court to do. Accordingly, the appeal was untimely. The Court held that “the adjudication of a motion for relief from the automatic stay forms a discrete procedural unit within the embracive bankruptcy case. The unit yields a final, appealable order when the bankruptcy court unreservedly grants or denies relief.”
§ 1.1.2 First Circuit
Mission Prod. Holdings, Inc. v. Schleicher & Stebbins Hotels, LLC (In re Old Cold, LLC), 976 F.3d 107 (1st Cir. 2020). In the most recent litigation connected to the bankruptcy proceedings of Old Cold, LLC (the “Debtor”)—notable for spawning the Supreme Court’s decision in Mission Prod. Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019)—Mission Product Holdings, Inc. (“Mission”), a licensee of certain of the Debtor’s intellectual property, challenged the ability of the Debtor’s only secured creditor (and DIP lender), Schleicher & Stebbins Hotels, L.L.C. (“S & S”), to foreclose on the assets remaining in the Debtor’s estate following a section 363 sale process. In its decision, the First Circuit Court of Appeals held first that Mission’s failure to obtain a stay of the bankruptcy court order lifting the automatic stay did not moot the appeal before turning to the merits of Mission’s appeal. The First Circuit then affirmed the bankruptcy court order on the merits, overruling Mission’s arguments that Mission’s petition for certiorari divested the bankruptcy of jurisdiction on the lift stay motion and that S & S had implicitly waived its lien on certain Debtor assets when it agreed to exclude them as part of its bid during the course of the section 363 auction.
In 2015, the Debtor moved to sell all of its assets at auction pursuant to section 363 of the Bankruptcy Code. S & S, the Debtor’s DIP lender, agreed to be a stalking horse bidder, with authority from the bankruptcy court to credit bid pursuant to section 363(k). After a competitive bidding process, S & S’s bid, which excluded certain cash assets of the Debtor, was declared the successful bid and S & S entered into an Asset Purchase Agreement (APA) with the Debtor.
In 2018, S & S filed a motion for relief from the automatic stay, to which the Debtor assented, seeking to recover the then-sole remaining asset of the Debtor’s estate—$527,292 in cash that had been excluded from the 363 sale—by foreclosing on its valid, first-priority, perfected liens on the Debtor’s assets that it had received as a DIP lender. Mission objected, arguing that its then-pending petition for a writ of certiorari arising from a separate litigation related to the termination of certain exclusive and nonexclusive intellectual property licenses divested the bankruptcy court of jurisdiction to decide the stay relief motion because, if stay relief were granted, S & S would look to the assets of the estate, including the cash that was subject to S & S lien, to satisfy any potential judgment. Second, it argued that S & S no longer had a security interest in that property because, as part of the auction and sale, S & S had supposedly agreed either to recontribute those assets back into the estate free and clear of its liens or to waive those liens as part of the bidding process. The bankruptcy court granted the stay relief motion, overruling Mission’s objections.
Mission sought a stay of the relief order from the bankruptcy court pending its appeal, which the bankruptcy court granted in part, extending the automatic fourteen-day stay of such orders so that Mission could seek a further stay of the relief order from the BAP. In November 2018, the BAP denied Mission’s request for a further stay, concluding that Mission had not shown a likelihood of success on the merits or irreparable injury absent relief. Upon expiration of Mission’s stay pending appeal, S & S demanded the remaining cash from the Debtor, and the Debtor complied. The BAP then affirmed the bankruptcy court, concluding that both it and the bankruptcy court had jurisdiction to rule on the stay relief motion and that the bankruptcy court did not abuse its discretion in granting S & S relief from the stay.
On appeal, the First Circuit held that Mission’s failure to obtain a stay of the relief order and the subsequent disbursement of the Debtor’s remaining assets did not moot the appeal under Article III, the provisions of the Bankruptcy Code and rules, and equitable principles. The court dismissed S & S’s arguments that the failure to obtain a stay pending appeal of the bankruptcy court’s order mooted any appeal. Instead, the court noted that Mission was seeking a disgorgement of cash paid to S & S, and that a request for such relief did not result in “meaningful appellate relief [being] no longer practicable.” The court also held that the granting of Mission’s petition for a writ of certiorari did not divest the bankruptcy court of jurisdiction to decide the stay relief motion, holding that it could order a disgorgement in this case if S & S had no right to the assets, and noted that the Supreme Court recognized that the disbursement of the cash had no impact on its ability to decide Mission’s appeal as long as there was “any chance of money changing hands.” Mission Prod. Holdings, 139 S. Ct. at 1660. Lastly, the court rejected Mission’s challenge to the bankruptcy court’s order granting S & S the requested relief from the automatic stay. Mission’s primary argument was that S & S impliedly waived its liens on the Debtor’s property, as demonstrated by the discussion at the auction of a commitment to match Mission’s treatment of some Debtor assets by leaving them behind in the estate. The court noted that Mission’s unsuccessful bid, let alone the prevailing bid, could not have eliminated any liens on the estate, as Mission did not have the power to eliminate S & S’s liens on the Debtor’s assets merely by agreeing to leave the assets in the estate. As the court stated, “[t]he Bankruptcy Code itself plainly protects a security interest even when the assets to which the interests attach are sold in a section 363(f) sale, 11 U.S.C. § 363(e), which often means that those security interests attach to the proceeds of the sale.” The court pointed out that “[i]t would be strange indeed to conclude that an auction that did not even result in the sale of that same asset would somehow destroy the security interest.”
Fin. Oversight & Mgmt. Bd. for P.R. v. Andalusian Glob. Designated Activity Co. (In re Fin. Oversight & Mgmt. Bd. for P.R.), No. 19-1699 (Jan. 30, 2020). In one of the latest decisions stemming from the proceedings under Title III of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the First Circuit recently affirmed the finding of the court overseeing the Title III proceedings (the “Title III Court”) that the security interest held by holders of municipal bonds (“Bondholders”) issued by the Employees Retirement System of the Government of the Commonwealth of Puerto Rico (the “System”) did not extend to postpetition, statutorily required employer contributions to the Systems over the Bondholders’ opposition, overruling the Bondholders’ various arguments on the basis of section 552 of the Bankruptcy Code that the liens did extend to postpetition employer contributions.
The System is an independent agency of the Commonwealth that provides pensions and retirement benefits to employees and officers of the Commonwealth government, municipalities, and public corporations, as well as employees and members of the Commonwealth’s Legislative Assembly. The System was funded through mandatory contributions from both employers and employees, as well as investment income. In 2008, the statute authorizing the System was amended to authorize the System to issue bonds. On January 24, 2008, the System’s Board adopted a resolution to issue $2.9 billion in bonds. Per the resolution, the bonds would be secured by, among other things, “All Revenues” and proceeds thereof, where “Revenues” includes “Employers’ Contributions.” The System also executed a security agreement with the Bondholders, which granted them a security interest in the property discussed above and “all proceeds thereof and all after-acquired property, subject to application as permitted by the Resolution.”
In 2016, shortly after the enactment of PROMESA, Puerto Rico and its various agencies, including the System, filed petitions for relief under Title III of PROMESA. Sometime thereafter, the System sought a declaratory judgment against the Bondholders as to the “validity, priority, extent and enforceability” of the Bondholders’ asserted security interest in the System’s postpetition assets, including employer contributions received postpetition. The Bondholders argued, both before the Title III Court and the First Circuit, that (i) their security interest extended to postpetition employer contributions by virtue of section 552(b)(1), incorporated into PROMESA by 48 U.S.C. § 2161(a); (ii) the section 552(a) bar did not apply pursuant to the exception under section 928, incorporated into PROMESA by 48 U.S.C. § 2161(a); and (iii) applying the section 552(a) bar to postpetition employer contributions amounted to a Fifth Amendment taking. The First Circuit addressed and rejected each of the Bondholders’ arguments in turn.
The court held that the postpetition employer contributions did not qualify as “proceeds” within the meaning of section 552(b)(1). The court analyzed the System’s statutory authority to receive postpetition Employers’ Contributions, distinguishing between the System’s expectancy in future contributions and a “property right.” The court found that, since the amount of Contributions depended on work occurring on or after the petition date, the statutory merely afforded the System an expectancy in postpetition contributions, not a property right in postpetition contributions. As a result, the Bondholders lacked any secured interest in the property that could produce postpetition “proceeds” to which they could be entitled under section 552(b)(1).
The court further held that the employer contributions were not “special revenue” as contemplated by section 928 of the Bankruptcy Code. Looking at sections 902(2)(A) and 902(2)(D) of the Bankruptcy Code, the court noted that the analysis turned on whether the Employers’ Contributions are “derived from” the ownership or operation of “other services” provided by the System or the “particular functions” of the System. Pointing to the plain language of the statute, the First Circuit held that the “special revenue” provisions could not apply because neither the System’s “particular function” nor its “ownership” or “operation” of providing pension services produced any revenue. Because the System merely functioned as a “conduit for the distribution of Employers’ Contributions,” the contributions themselves could not be properly characterized as revenue produced by the System. Therefore, the Employers’ Contributions did not qualify as “special revenue” under sections 902(2)(A) or 902(2)(D) of PROMESA.
Finally, the court ruled that there could be no impermissible taking under the Fifth Amendment because Congress clearly intended section 552 to apply retroactively to security interests created before the enactment of PROMESA. In so doing, the court overruled the Bondholders’ argument that, because section 552 did not apply to the Bondholders’ liens when the bonds were authorized, it could not be applied to the Bondholders’ liens now by virtue of PROMESA without raising “grave constitution questions.”
In re Montreal, Maine & Atlantic Railway, Ltd., 956 F.3d 1 (2020). The First Circuit affirmed a ruling that a secured creditor could not object to the release of claims, over which the creditor purportedly had a security interest, as part of a settlement where the creditor had failed to prove the value of the claims being released.
In 2013, a train carrying crude oil, arranged by Western Petroleum Company and affiliates (“Western”), derailed, causing a fire that killed 48 people. Soon after, the train operator, Montreal, Maine & Atlantic Railway, Ltd. (the “Debtor”), filed a Chapter 11 petition in the District of Maine for the purpose of liquidating its assets. At the time of filing, the Debtor’s secured creditors included Wheeling & Lake Erie Railway Co. (“Wheeling”), which extended a $6 million secured line of credit to the Debtor in 2009. Wheeling’s collateral included the Debtor’s accounts and other rights to payment, which encompassed any non-tort claims accrued by the Debtor.
In January 2014, the Debtor brought suit against Western to resolve liability between itself and Western. The parties ultimately agreed to settle the suit, with Western agreeing, among other things, to pay $110 million for the benefit of the derailment victims in exchange for a release by the Debtor of its non-tort claims against Western, which constituted part of Wheeling’s collateral. The bankruptcy court approved the settlement and confirmed the Debtor’s liquidating Chapter 11 plan over Wheeling’s objection, although the confirmed plan reserved Wheeling’s right to contend that its security interest attached to the settlement payments made in consideration of the released claims.
During a subsequent trial of the issue of whether Wheeling was entitled to compensation for the release of its non-tort claim collateral, the bankruptcy court held that (i) the Debtor did not have any cognizable non-tort claims against Western, and (ii) that even if the claims did exist, Wheeling had not carried its burden to establish the value of those claims in accordance with section 506(a)(1). Wheeling had relied solely on the value of the economic damages as stipulated between Wheeling and the Debtor to support its contentions regarding value of the claim.
On appeal, the First Circuit affirmed the bankruptcy court. The court held that, even assuming that the estate held cognizable non-tort claims against Western in which Wheeling held a security interest, there was “no clear error in the bankruptcy court’s finding that Wheeling failed to carry its burden of proving the value of the non-tort claims.” The court reasoned that a claim’s settlement value involves many different factors, including, inter alia, the strength of the evidence, the viability of any defenses, the ability of the defendant to satisfy a judgment, and the litigation cost. Wheeling’s stipulated “net economic damages” estimate was “plainly insufficient” to satisfy its burden of proving the value of its collateral by enabling the bankruptcy court either to assess the likelihood of recovery or to “gauge any of the relevant factors other than the estate’s potential recovery that may have affected the settlement value of the non-tort claims.” Nor did Wheeling offer any expert testimony concerning a range of value for the settlement of non-tort claims.
§ 1.1.3 Second Circuit
In re Lehman Bros. Holdings Inc., 792 F. App’x 16 (2d Cir. 2019). The Second Circuit upheld the determination of the bankruptcy court that former employees of Lehman Brothers Inc. (“LBI”), who had agreed to defer portions of their compensation into a deferred pension plan in return for tax benefits and a favorable interest rate, were bound by subordination provisions contained in the plan agreements. The court found that the claims were clearly and unambiguously subordinated.
In the 1980s, Shearson Lehman Brothers Inc., a predecessor entity to LBI, created deferred compensation plans for certain executives called the Executive and Select Employees Deferred Compensation Plan (the “ESEP Agreements”). The ESEP Agreements explicitly provided that “the obligations of Shearson hereunder with respect to the payment of amounts credited to his deferred compensation account are and shall be subordinate in right of payment and subject to the prior payment or provision for payment in full of all claims of all other present and future creditors of Shearson whose claims are not similarly subordinated…” After LBI’s collapse and the commencement of liquidation proceedings, the former employees submitted claims in connection with their deferred compensation under the ESEP Agreements. Pursuant to the ESEP Agreements, the Trustee determined that these claims were subordinated.
The former employees sought to avoid the subordination provisions on the basis that (1) the subordination provisions only applied to Shearson Lehman Brothers Inc., not LBI; (2) LBI materially breached the ESEP Agreements and, thus, could not compel performance; and (3) the ESEP Agreements were rejected executory agreements. These arguments were rejected by the bankruptcy court and the district court. The Second Circuit found that LBI was a continuation of Shearson Lehman Brothers Inc. and a series of name changes was not sufficient to prevent application of the subordination provisions. The court further determined that any breach was irrelevant because the Trustee was not trying to compel performance, but rather merely to classify the former employees’ claims. Similarly, the court found that whether the ESEP Agreements were rejected executory contracts would have no impact on the subordination provisions.
Marsh USA, Inc. v. The Bogdan Law Firm (In re Johns-Manville Corp.), No. 18-2531(l) (2d Cir. Feb. 19, 2020). The U.S. Court of Appeals for the Second Circuit held that the appointment of a future claims representative ensured future asbestos-related claimants sufficient due process to be barred by the asbestos channeling injunction entered in 1986 in the Johns-Manville bankruptcy.
Salvador Parra, Jr. (“Parra”) argued that asserted state-law, asbestos-related claims against Marsh, a former insurance broker for Johns Manville, should not be enjoined and channeled into the trust. He argued that the channeling injunction should not be enforceable against him because he had not received sufficient due process during the Manville bankruptcy proceeding. The bankruptcy court rejected Parra’s argument, finding that the injunction was enforceable because Parra’s interests were represented in absentia by the future claims representative (the FCR) that was appointed during the Manville bankruptcy. The bankruptcy court held that the FCR represented future claimants as to both their in rem and in personam claims. The district court reversed.
The Second Circuit affirmed the bankruptcy court, finding no clear error where the bankruptcy court had relied on evidence in the bankruptcy proceedings demonstrating that the FCR had, in fact, argued against the order channeling in personam claims to the trust in 1985. Thus, the bankruptcy court concluded, the FCR was engaged to advocate for future claimants in connection with their potential in personam claims, as well as their potential in rem claims.
The Second Circuit further held that the notice provided to future claimants “was constitutionally sufficient” because it “was designed to inform as many future asbestos claimants as possible . . . [about the] proceedings,” including national TV and radio ads and newspaper ads in U.S. and Canadian newspapers.
In re Motors Liquidation Company, 957 F.3d 357 (2d Cir. 2020). The Second Circuit held that the new General Motors (“New GM”) did not contractually assume liability for punitive damages arising from post-closing accidents involving cars produced by its predecessor (“Old GM”) when it purchased Old GM’s assets in a bankruptcy sale.
Following General Motors’ bankruptcy filing in June 2009, New GM purchased substantially all of Old GM’s assets. The sale agreement provided that the purchaser would assume the liability of Old GM with respect to post-sale accidents involving automobiles manufactured by Old GM, including claims by those who did not transact business with Old GM (such as individuals who never owned Old GM vehicles and persons who bought Old GM used cars after the bankruptcy sale). When New GM recalled certain Old GM vehicles in 2014, a number of lawsuits followed, including suits seeking punitive damages. New GM moved the bankruptcy court to enforce the “free and clear” terms of the sale order. In a November 2015 decision, the bankruptcy court determined that New GM could not be liable for punitive damages by reason of the conduct of Old GM.
In July 2017, the bankruptcy court again revisited its decision when certain claimants argued that they were not bound by the November 2015 decision on the basis that they were not party to the bankruptcy proceedings. The bankruptcy court reaffirmed its November 2015 decision, applying it as “law of the case.” The District Court affirmed and the claimants appealed.
On appeal, the Second Circuit considered not only whether the bankruptcy court correctly interpreted the sale order and agreement, but also whether res judicata applied. On the res judicata point, the court held that because the appellants were not served with notice of the scheduling order in connection with the November 2015 decision, there was not a sufficient identity between the litigants such that res judicata would apply. When considering the sale agreement, the Second Circuit concluded that New GM did not assume liability for punitive damages because punitive damages neither provide compensation “for” death and injuries, nor “ar[i]se directly out of” death and injuries. Finally, the court held that the appellants could not escape language in the sale order providing that the sale “shall be free and clear of all liens, claims, encumbrances and other interests of any kind or nature whatsoever . . . , including rights or claims based on any successor or transferee liability,” solely by virtue of the fact that they had no relationship with Old GM at the time the sale order was entered. The court dismissed this argument, determining that the issue of successor liability had no impact on whether New GM assumed liability for punitive damages.
In re Tribune Co. Fraudulent Conveyance Litig., 946 F.3d 66 (2d Cir. 2019). In the wake of the Supreme Court’s decision in Merit Management Group., LP v. FTI Consulting, Inc., 138 S. Ct. 883 (2018), the Second Circuit was asked to revisit its decision in In re Tribune Co. Fraudulent Conveyance Litigation, 818 F.3d 98 (2d Cir. 2016). Because the Second Circuit determined that the holding in Merit Management did not address the question of whether section 546(e) preempts the creditors’ state law, constructive fraudulent conveyance claims, it reaffirmed its prior decision, which upheld the dismissal of the creditors’ state law, constructive fraudulent conveyance claims on preemption grounds.
In 2007, a struggling Tribune Media Company (“Tribune”) cashed out its shareholders in a leveraged buyout (“LBO”) for more than $8 billion. Tribune effectuated the LBO by transferring the $8 billion sum, at least in part, to Computershare Trust Company, N.A. (“Computershare”), which acted as depositary in connection with the LBO. In its capacity as depositary, Computershare received and held Tribune’s deposit of the aggregate purchase price for the shares and then received the tendered shares on Tribune’s behalf, and paid the tendering shareholders.
On December 8, 2008, Tribune and nearly all of its subsidiaries filed for bankruptcy in the District of Delaware. An official committee of unsecured creditors (the “Committee”) was appointed. In November 2010, the Committee commenced an action for an intentional fraudulent conveyance under section 548(a)(1)(A) of the Bankruptcy Code against the cashed-out Tribune shareholders, various officers, directors, financial advisors and others who allegedly profited from the LBO. Two subsets of unsecured creditors subsequently moved the bankruptcy court to rule that (i) after the expiration of the two-year statute of limitations period during which the Committee was authorized to bring avoidance actions under section 546(a), eligible creditors regained the right to prosecute their state law creditor claims; and (ii) the automatic stay was lifted to permit filing of such complaints. The bankruptcy court granted the relief sought in April 2011. In June 2011, the creditors filed state law, constructive fraudulent conveyance claims in various federal and state courts, alleging that the LBO payments were for more than the reasonable value of the shares and were made at a time when Tribune was in financial distress. These complaints were consolidated, along with the Committee’s complaint (now being prosecuted by a litigation trust pursuant to Tribune’s now-confirmed plan), in a multi-district litigation proceeding before the Southern District of New York.
After consolidation, the Tribune shareholders moved to dismiss the creditor’s state law, constructive fraudulent conveyance claims. The district court granted the motion to dismiss on the grounds that the automatic stay prevented the creditors from having statutory standing to assert such claims while the litigation trust was pursuing avoidance of the same transfers under a theory of intentional fraud. The district court rejected the Tribune shareholders’ argument that section 546(e) barred the creditors’ actions because the statute referred only to actions brought by a bankruptcy trustee. The creditors appealed on the dismissal for lack of statutory standing, while the Tribune shareholders cross-appealed the rejection of their argument that the creditors’ claims were preempted by section 546(e). The Second Circuit affirmed on the basis that section 546(e) preempts fraudulent conveyance actions, even those brought by creditors, as long as they fall within the statutory parameters of section 546(e). Section 546(e) covers transfers “made by or to (or for the benefit of) a … financial institution … in connection with a securities contract, as defined in section 741(7).” 11 U.S.C. § 546(e).
While the creditors pursued further appellate relief, the Supreme Court handed down its decision in Merit Management, which held that section 546(e) did “not protect transfers in which financial institutions served as mere conduits.” 138 S. Ct. at 892. Following the decision, Justices Kennedy and Thomas issued a statement suggesting that the Second Circuit recall its prior mandate in this case.
First addressing the question of statutory standing, the Second Circuit held that both the bankruptcy court’s prior order and the confirmed plan ensured that the creditors’ state law, constructive fraudulent conveyance claims were not subject to the automatic stay. The bulk of the opinion, however, was spent discussing whether the creditors’ state law, constructive fraudulent conveyance claims were preempted by section 546(e).
Because Merit Management foreclosed the basis upon which the Second Circuit had originally ruled that the payments challenged by the creditors’ complaint fell within the scope of section 546(e)—that they were payments in which a “financial institution” served as an intermediary—the court had to reconsider whether either Tribune or the shareholders qualified as a covered entity under section 546(e). Looking to the definition of “financial institution” in section 101(22) of the Bankruptcy Code, the court held that, because Tribune was a customer of Computershare, which was itself a qualifying “financial institution,” and because Computershare functioned as Tribune’s agent in the LBO, Tribune was imputed to be a “financial institution” as well, pursuant to the statutory definition under the Bankruptcy Code. See 11 U.S.C. § 101(22)(A) (defining “financial institution” to include, inter alia, “an entity that is a commercial or savings bank, … trust company, … and, when any such … entity is acting as agent or custodian for a customer (whether or not a ‘customer,’ as defined in section 741) in connection with a securities contract (as defined in section 741) such customer”) (emphasis added).
After concluding not only that Tribune was an entity covered by section 546(e), but also that the transfers at issue were covered as transfers “in connection with a securities contract,” the court considered whether the presumption against preemption applied where Congress had not explicitly stated its intention that state laws should be limited by federal law. The court found that the regulation of creditors’ rights has “a history of significant federal presence,” and there was not a “significant countervailing pressure[] of state law concerns” to militate against preemption.
Lastly, the court rejected the creditors’ legal theory that, upon the filing of the bankruptcy proceeding, the bankruptcy trustee merely interrupts the creditor’s ability to bring state law avoidance claims. Rather, the court held that the causes of action become part of the bankruptcy estate, meaning that they become subject to the limitations of section 546(e) in all respects. The termination of the bankruptcy trustee’s ability to bring the claims does not somehow remove the limitation of section 546(e) from the claims.
Accordingly, while the Supreme Court may have limited the ability to use section 546(e) as a shield in connection with LBOs by the mere presence in the transaction of a “financial institution,” the Second Circuit has ensured that LBO transactions remain unavoidable, holding that customers of “financial institutions” will also merit protection under section 546(e).
§ 1.1.4 Third Circuit
In re Millennium Lab Holdings, LLC, 945 F.3d 126 (3d Cir. 2019). In a narrow ruling on “exceptional facts,” the Third Circuit affirmed that bankruptcy courts have jurisdiction to confirm plans of reorganization that contain nonconsensual third-party releases and injunctions, but only if the releases satisfy the parameters laid out in Stern v. Marshall, 564 U.S. 462 (2011)—that the matter must be integral to the restructuring of the debtor-creditor relationship, notwithstanding whether the matter is dedicated by federal statute to the “core” jurisdiction of the bankruptcy court.
Millennium Lab Holdings, II, LLC and its wholly owned subsidiaries (collectively, “Millennium”) were providers of laboratory-based diagnostic services that entered into a $1.825 billion credit agreement with multiple lenders including certain funds managed by Voya Investment Management Co. LLC and Voya Alternative Asset Management LLC (collectively, “Voya”). Millennium’s main shareholders were TA Millennium, Inc. (“TA”) and Millennium Lab Holdings, Inc. (“MLH”). Millennium used the funds from the credit agreement to refinance certain existing debts while also paying almost $1.3 billion in dividends to shareholders. Following a Department of Justice investigation, Millennium agreed to settle certain claims with various government entities for $256 million, which left Millennium unable to satisfy its obligations under the credit agreement.
Certain creditors formed an ad-hoc group to negotiate with Millennium to restructure its obligations, resolve other potential claims against it, and enable Millennium to pay the settlement with the government. A restructuring support agreement was negotiated under which TA and MLH would pay $325 million and relinquish their equity interests in exchange for full releases under Millennium’s plan of reorganization, including the release of claims related to the credit agreement. However, Voya refused the terms of the restructuring support agreement, preferring instead to preserve its legal claims in connection with the credit agreement. When Millennium filed for Chapter 11 protection, seeking approval of a prepackaged plan of reorganization, Voya objected on the basis that the releases to TA and MLH were unlawful and the bankruptcy court lacked constitutional authority to approve them.
The central question before the Third Circuit was whether the bankruptcy court was “resolving a matter integral to the restructuring of the debtor-creditor relationship.” Reflecting on the Supreme Court’s decision in Stern v. Marshall, the court indicated that (1) a bankruptcy court can violate Article III even where it has statutory authority over a “core” matter; (2) a bankruptcy court is within constitutional limits where it is resolving a matter that is integral to a debtor-creditor relationship; and (3) when determining constitutional authority, the court should look to the content of the proceeding rather than focusing on the category of “core.”
The court found that the sophisticated negotiations over the restructuring agreement suggested that, absent the releases, TA and MLH would not have contributed to the restructuring and Millennium would have been liquidated. As a result, the bankruptcy court had authority to approve the plan because the releases were “integral” to the restructuring of the debtor-creditor relationship. The court was careful to limit its holding to the facts of the case and noted that the ample evidentiary record that the bankruptcy court had relied on in making its ruling was instrumental to the result of the appeal. The court also affirmed the district court’s decision that Voya’s remaining claims were equitably moot, since the plan—including the nonconsensual third-party releases—was substantially consummated and the releases could not be unwound without doing harm to the entirety of the plan.
In re Energy Future Holdings Corp., 949 F.3d 806 (3d Cir. 2020). In In re Energy Future Holdings Corp., the Third Circuit determined under what circumstances a bankruptcy court could discharge the claims of latent asbestos claimants. In a Chapter 11 reorganization plan, the discharge of latent asbestos claims was permissible as long as the claimants received an opportunity to reinstate their claims after the debtor’s reorganization that comported with due process. Because latent asbestos claimants were allowed to file proofs of claim after the bar date if they showed excusable neglect, the claimants’ right to due process was not compromised because the combination of both the pre-confirmation notice provided and the post-confirmation hearing were adequate.
Burdened with asbestos claims and liabilities, Energy Future Holdings Corporation (“EFH”) and its subsidiaries commenced Chapter 11 proceedings. However, rather than establishing a section 524(g) trust, EFH relied instead on Rule 3003(c)(3) of the Federal Rules of Bankruptcy Procedure, which authorizes a court to extend the time for filing a claim “for cause shown.” Future claimants—whose claims would be discharged by the order confirming the Chapter 11 plan—could obtain permission to file their claim after the bar date under Rule 3003(c)(3), and seek reinstatement of their discharged claims on due process grounds. The bankruptcy court accepted this approach, set a bar date, and confirmed the plan.
Several claimants who did not file claims by the bar date and later were stricken by mesothelioma (the “Claimants”) appealed the bankruptcy court’s confirmation order, arguing that (i) the failure to include a pre-discharge process for addressing claims and (ii) deferring to the Rule 3003(c)(3) mechanism each amounted to a violation of their due process rights. The district court rejected the challenge under section 363(m) of the Bankruptcy Code as statutorily moot. The Claimants appealed to the Third Circuit Court of Appeals.
The Third Circuit held that section 363(m) partially barred, but did not entirely bar, the Claimants’ appeal. The Third Circuit rejected the Claimants’ argument that there is a due process exception to section 363(m). The court also rejected that the confirmation order was not “an authorization … of a sale” within the meaning of section 363(m), or that the Claimants’ appeal would “affect the validity of [the] sale.” Based on these determinations, the court concluded that it was barred from considering the Claimants’ argument that they were entitled to a pre-discharge claims process. However, section 363(m) did not bar the Circuit Court from considering the adequacy of the Rule 3003(c)(3) procedure because the review of the Rule 3003(c)(3) process could not “affect the validity of the sale.”
The Third Circuit, therefore, turned to consider whether the Rule 3003(c)(3) process comported with due process. Although the Claimants had demonstrated that the Rule 3003(c)(3) process deprived individuals of an interest “that is encompassed within the Fourteenth Amendment’s protection of life, liberty, or property,” the Claimants failed to demonstrate that the Rule 3003(c)(3) procedures were constitutionally inadequate. EFH had published notices in consumer magazines, newspapers, union publications and Internet outlets encouraging latent claimants to file proofs of claim by the bar date. Under established law, claimants who are unknown at the time of discharge are only entitled to publication notice. However, because the bankruptcy court retained jurisdiction for the purpose of determining whether an individual latent claimant had demonstrated sufficient “cause” for filing an untimely proof of claim, adequate process was afforded.
The Third Circuit concluded by noting that this case is a “cautionary tale for debtors attempting to circumvent [section] 524(g).” While EFH’s approach resulted in a similar outcome of a section 524(g) trust, it added unnecessary litigation that could have been avoided by opting to follow the process contained in section 524(g).
In re Tribune Co., 972 F.3d 228, 235 (3d Cir. 2020). The Third Circuit affirmed the order of the U.S. Bankruptcy Court for the District of Delaware confirming the plan of reorganization of the Tribune Company and its affiliated debtors, over the objections of certain senior noteholders, holding $1.283 billion in notes issued by Tribune (the “Senior Noteholders”). The Senior Noteholders argued that (1) the bankruptcy court erred when it failed to strictly enforce the subordination provision in the indenture governing the senior notes, which required repayment of the senior notes before any other debt incurred by the company; and (2) the failure to strictly enforce the subordination provision resulted in the plan’s unfairly discriminating against the Senior Noteholders, in violation of section 1129(b)(1) of the Bankruptcy Code. The Third Circuit rejected both arguments, determining that the section 1129(b)(1) cramdown provision allows for more flexible enforcement of subordination agreements where it would increase the likelihood of a successful plan and that the bankruptcy court’s analysis of any unfair discrimination was appropriate in the circumstances.
The Tribune Company (“Tribune”) was a large media company, composed of national newspapers, regional newspapers, and television and radio stations. A failed leveraged buyout left Tribune with roughly $13 billion in debt, forcing the company to file for Chapter 11 protection. Prior to the leveraged buyout, Tribune had previously issued unsecured notes, the indenture for which contained subordination provisions that required the notes to be paid before any other company obligations. Two other debt instruments explicitly provided that they were subordinate to the Senior Noteholders: the so-called “PHONES Notes” and the “EGI Notes.”
Notwithstanding the contractual provision, which stated that the Senior Noteholders would be paid before any other debts of the company, the Tribune plan sought to subordinate the PHONES and EGI Notes—not just to the Senior Noteholders, but to certain unsecured “swap” claimants, retirees and trade creditors as well. Rather than paying the Senior Noteholders the entirety of the recovery that would have been due to the PHONES and EGI Notes, Tribune sought to reallocate those recoveries equally among the Senior Noteholders, the swap claimants, the retirees, and the trade creditors.
The Senior Noteholders objected to the plan of reorganization on the basis that the approximately $30 million in recoveries that would have been paid to the PHONES and EGI Notes in the absence of the subordination provision should have been directed solely to the Senior Noteholders, and should not be shared amongst the Senior Noteholders, the swap claimants, the retirees, and the trade creditors. As discussed above, the argument was twofold: first, the subordination should be strictly enforced pursuant to section 510(a) of the Bankruptcy Code; and, in the alternative, the plan should be rejected as unfairly discriminating against the Senior Noteholders in favor of the swap claimants, retirees, and trade creditors. The bankruptcy court rejected these arguments, in part because under the plan, the Senior Noteholders would receive an equal distribution to other similarly situated unsecured creditors. The bankruptcy court also found that the Senior Noteholders’ recovery under the plan would not be materially impacted by the reallocation of the $30 million from the PHONES and EGI Notes as contemplated by the plan versus as if the $30 million was allocated only to the Senior Noteholders and the swap claimants (who, the Senior Noteholders agreed, were also senior to the PHONES and EGI Notes). The decrease in the Senior Noteholders’ percentage recovery was 0.90%.
On appeal, the Third Circuit considered both arguments. As to the question regarding strict enforcement of the subordination provision in accordance with section 510(a), the court focused on the plain language of section 1129(b)(1), which uses the phrase “notwithstanding section 510(a).” Based on prior precedent interpreting the term “notwithstanding” in the bankruptcy context, the court held that, as used in section 1129(b)(1), “notwithstanding section 510(a)” meant “[d]espite the rights conferred by [section] 510(a).” Accordingly, section 1129(b)(1) trumped section 510(a), and the Bankruptcy Code allowed courts to flexibly construe subordination agreements when considering whether to confirm a plan vis-à-vis a cramdown under section 1129(b)(1).
As to the question regarding unfair discrimination, the court first described the different methods of analysis used by other courts to evaluate unfair discrimination: the “mechanical” test, the “restrictive” approach, the “broad” approach, and the “rebuttable presumption” test. From these different approaches, the court distilled eight principles for determining unfair discrimination: (1) plans may treat like creditors differently, but not so much as to be unfair; (2) unfair discrimination applies only to classes of creditors rather than individual creditors; (3) unfair discrimination is considered from the perspective of the dissenting class; (4) the classes must be aligned correctly; (5) the court should determine recoveries based on the present value of payments or the allocation of risk connected with the proposed distribution; (6) subordinated sums should be included when the court considers the pro rata baseline distribution to creditors of the same class; (7) if there is a “materially lower” recovery or greater risk in connection with the proposed distribution to the dissenting class, there is a presumption of unfair discrimination; and (8) the presumption of discrimination is rebuttable.
Applying these principles to the case at hand, the Third Circuit found that the bankruptcy court did not err when it compared the Senior Noteholders’ recovery under the plan as against what the Senior Noteholders and the swap claimants would have received if only they were to benefit from the subordination. Although the Senior Noteholders argued that the bankruptcy court should have compared their own recovery absent subordination (21.9%) to the recovery of the trade creditors under the plan (33.6%) who were unfairly favored by the plan, the court ruled that there was no per se requirement that the bankruptcy must compare discrimination as between classes. Accordingly, although the court noted that the bankruptcy court’s analysis in this case was “not the preferred way to test whether the allocation of subordinated amounts under a plan to initially non-benefitted creditors unfairly discriminates,” the court found the minimal impact of the reallocation to the Senior Noteholders’ recoveries—0.90% as measured by the bankruptcy court—was not material and, thus, did not unfairly discriminate. The court went further to emphasize that the unfair discrimination analysis “exemplifies the Code’s tendency to replace stringent requirements with more flexible tests that increase the likelihood that a plan can be negotiated and confirmed.”
Wells Fargo, N.A. v. Bear Stearns & Co., Inc. (In re HomeBanc Mortg. Corp.), 945 F.3d 801 (3d Cir. 2019). The Third Circuit provided clarity on certain issues in a contentious bankruptcy litigation matter involving certain securities subject to one of two repurchase agreements. The decision covers the gamut, running from the good faith of the non-debtor repurchase counterparty in holding an auction for the subject securities to which statutory safe harbor afforded the counterparty the right to liquidate the securities at issue to simple matters of contractual compliance.
Debtor HomeBanc Corp. (“HomeBanc”), who was in the business of originating, securitizing, and servicing residential mortgage loans, obtained financing from Bear Stearns & Co. and Bear Stearns International Ltd. (together, “Bear Stearns”) pursuant to two repurchase agreements (“repos”) between 2005 and 2007. The repos required Bear Stearns to reach a “reasonable opinion” of the fair market value of the securities outstanding in the event of HomeBanc’s default
On August 7, 2007, certain of HomeBanc’s repo transaction became due, requiring HomeBanc to buy back thirty-seven outstanding securities at an aggregate price of $64 million. Bear Stearns, concerned about HomeBanc’s liquidity, offered two alternative solutions to HomeBanc: (1) extend the repurchase deadline in exchange for roughly $27 million, or (2) purchase thirty-six of the securities outright for $60.5 million. HomeBanc rejected both proposals and failed to repurchase the securities by the due date. Bear Stearns notified HomeBanc of the default the next day. Thereafter, on August 9, 2007, HomeBanc filed voluntary petitions for relief under Chapter 11.
Bear Stearns, claiming outright ownership of the securities, decided to auction them to determine their fair market value. The auction was managed by Bear Stearns’ finance desk. Bid solicitations were sent to approximately 200 different entities, including, subject to additional safeguards to prevent any insider advantage, Bear Stearns’ own mortgage trading desk. Only two bids were received: (i) one bid for two securities in the amount of approximately $2.2 million and, (ii) an “all or nothing” bid by Bear Stearns’ mortgage trading desk for $60.5 million. Bear Stearns was declared the winning bid and the purchase price was allocated across the thirty-six purchased securities: $52.4 million for twenty-seven securities and $900,000 each for the nine securities at issue.
After HomeBanc’s bankruptcy was converted to a Chapter 7, years of litigation ensued between Bear Stearns and the trustee, primarily regarding Bear Stearns entitlement to auction the securities as well as the conduct of the auction as a measure of fair market value. Ultimately, these litigations reached the Third Circuit.
Two principal questions came before the Third Circuit as part of this appeal: (1) whether section 559 or section 562 controlled in determining whether Bear Stearns violated the automatic stay; and (2) whether the bankruptcy court correctly concluded that the Bear Stearns auction was conducted in good faith to ascertain fair market value of the securities.
The HomeBanc trustee first challenged whether the safe harbor provision of section 559 or section 562 applied to Bear Stearns. Section 559 applies broadly to repurchase agreements, while section 562 is more limited, requiring proof of damages. Looking to section 101(47)(A)(v)’s definition of repurchase agreement, the court held that “damages” encompasses legal claims for money. Accordingly, because Bear Stearns did not initiate a damages action, section 559 was the relevant safe harbor, notwithstanding that the auction did not yield any excess proceeds.
The court then considered whether Bear Stearns adhered to the liquidation provisions of the repos, as required under section 559. The bankruptcy court had found that Bear Stearns valued the securities at issue in good faith compliance with the relevant repo after a six-day trial, overruling several arguments from the trustee. First, the bankruptcy court rejected the trustee’s claim that the repos required Bear Stearns to sell the securities to an outside party. Second, the bankruptcy court rejected the trustee’s claims that the market for mortgage-backed securities in August 2007 was dysfunctional, such that it would not accurately price the securities. On this point, the bankruptcy court held explicitly that the market was sufficiently function to conduct an auction as required by the repo. The Third Circuit noted that the trustee overlook the crucial distinction between a declining market and a dysfunctional one. Finally, the bankruptcy court concluded that auction procedures were not flawed. The Third Circuit refused to disturb any of the bankruptcy court’s findings since the trustee failed to show that the bankruptcy court had clearly erred.
In re Wilton Armetale, Inc., No. 19-2907 (3d Cir. Aug. 4, 2020). The Third Circuit ruled that a Chapter 7 trustee may restore creditors’ statutory standing to pursue a cause of action that became property of the debtor’s estate by explicitly abandoning such causes of action.
When debtor Wilton Armetale, Inc. (“Wilton”) failed to pay creditor Artesanias Hacienda Real S.A. de C.V. (“Artesanias”) for the purchase of their wares, Artesanias obtained a judgement against Wilton for approximately $900,000 and all the owner’s shares in Wilton. As a consequence of recovering all of the shares in Wilton, Artesanias obtained access to privileged documents held by Wilton’s law firm. From these documents, Artesanias learned not only that Wilton was insolvent, but also that its previous owner and North Mill Capital, another creditor, had plotted with the law firm to plunder Wilton’s remaining assets. After discovering the scheme, Artesanias sued North Mill and the law firm, seeking damages and an order stopping North Mill, who had obtained a lien on Wilton’s valuable warehouse, from foreclosing on the property. Two months after Artesanias brought the suit, Wilton filed for Chapter 7 bankruptcy and a trustee was appointed to liquidate Wilton’s remaining assets.
At the same time, Artesanias’s claim against North Mill and law firm continued in District Court. However, the District Court declined to rule on defendants’ motion to dismiss and instead referred the whole action to the bankruptcy court handling Wilton’s liquidation. On referral, the bankruptcy court found that Artesanias lacked standing to sue because, once Wilton declared bankruptcy, the claims became property of the estate and, therefore, only the trustee had standing to sue on Wilton’s behalf. Artesanias appealed and the District Court affirmed the Bankruptcy Court’s dismissal of the claims for lack of standing.
Applying the Supreme Court’s decision in Lexmark Int’l, Inc. v. Static Control Components, Inc., 572 U.S. 118, 125-28 & n.4 (2014), which distinguished between constitutional standing and additional statutory requirements that may be imposed, the Third Circuit reversed the District Court’s decision. It held that “standing,” as used in the bankruptcy context, imposes additional requirements on litigants that exceed the three elements of constitutional standing required under Article III. In so doing, the Third Circuit court adopted the Seventh Circuit’s interpretation of the term, clarifying that “standing to pursue causes of action that become the estate’s property means its statutory authority under the Bankruptcy Code, not its constitutional standing to invoke the federal judicial power.” Based on this distinction, the Third Circuit determined that the bankruptcy proceedings did not divest Artesanias of its constitutional standing, but rather only its statutory standing to pursue the claims that were property of the Wilton bankruptcy estate, and committed to the purview of the Chapter 7 trustee. However, the court determined that the trustee explicitly abandoned the right to pursue the claims against North Mill and the law firm pursuant to an order of the bankruptcy court. Accordingly, Artesinias’ standing to pursue its initial causes of action was restored by the trustee’s actions. The court further noted that the instant decision was consistent its prior decision in Official Comm. of Unsecured Creditors of Cybergenics Corp. ex rel. Cybergenics Corp. v. Chinery (In re Cybergenics Corp.), 226 F.3d 237, 244-45 (3d Cir. 2000), which the district court had relied on in its holding that the trustee could not transfer a cause of action because Artesinias’ suit would benefit only itself and not the entire creditor body. Thus, when a creditor pursues an asset recovery action prepetition, the trustee may restore the cause of action to that creditor, for its own benefit, rather than the benefit of all creditors, by abandoning the claim.
§ 1.1.5 Fourth Circuit
Ayers v. U.S. Dep’t of Def., No. 19-2230 (4th Cir. Sept. 20, 2020). Adding greater clarity to the corpus of case surrounding the question of appellate jurisdiction of bankruptcy court orders, the Fourth Circuit has held that bankruptcy court orders that do not completely dispose of adversary proceedings are not appealable. An individual debtor brought an adversary proceeding against one of her creditors, the United States Department of Defense. The bankruptcy court dismissed all but one of her claims challenging her debt and denied her motion to amend all but one claim—her request for an undue hardship discharge pursuant to 11 U.S.C. § 523(a)(8). The Fourth Circuit held that the bankruptcy court’s order was not a final, appealable order because the “discrete dispute” was the adversary proceeding itself, notwithstanding that the bankruptcy court’s order conclusively disposed of all but one of the debtor’s causes of action. Because one cause of action remained viable, subject to amendment of the complaint, the Fourth Circuit held that it did not have jurisdiction to review the bankruptcy court’s order dismissing the other claims.
In re Highland Construction Management Services, L.P., No. 18-2450 (March 30, 2020). Affirming the decisions of the U.S. Bankruptcy Court and District Court for the Eastern District of Virginia, the Fourth Circuit Court of Appeals agreed that a security interest in the debtor’s membership interest in an unrelated LLC could only extend to the debtor’s own property interest, and did not encompass the debtor’s economic interest in the unrelated LLC through the debtor’s subsidiary’s separate interest in the same LLC.
Prior to declaring bankruptcy, debtor Highland Construction Management Services, LP (“Highland Construction”) entered into a security agreement in favor of Creditor Wells Fargo Bank, for the benefit of Jerome Guyant IRA (“Guyant IRA”). The security agreement assigned fifty percent of Highland Construction’s membership interest in Sanford, LLC to Guyant IRA. Since Highland Construction had a twenty percent membership interest in Sanford, Highland Construction argued in the bankruptcy proceeding that the agreement assigned to Guyant IRA a ten percent membership interest in Sanford. Creditor Guyant IRA interpreted the scope of the security agreement differently and contended that, rather than assigning half of its twenty percent membership interest in Sanford LLC, Highland Construction assigned to Guyant IRA sixteen percent of all funds it received from distributions from Sanford. Guyant IRA argued that it was owed the extra six percent based on debtor Highland Construction’s interest in a second LLC, named Foothills, LLC. Highland Construction had a fifty percent membership interest in Foothills, LLC, which had its own twenty-four percent interest in Sanford. Guyant IRA argued that Highland Construction’s fifty percent interest in Foothills meant that Highland Construction received an additional twelve percent distribution from Sanford through Foothills, and, therefore, Guyant IRA had a fifty percent interest in Highland Construction’s indirectly held twelve percent interest of Sanford, in addition to the twenty percent that Highland Construction held directly. However, Foothills, LLC was not named in the security agreement. Notwithstanding that the recitals of a 2008 amendment to the security agreement between Highland Construction and Guyant IRA referred to a sixteen percent interest in Sanford,the Bankruptcy Court agreed with the debtor Highland Construction, holding that Highland Construction only owed Guyant IRA fifty percent of its directly held membership interest in Sanford, LLC—i.e., ten percent. The District Court affirmed without issuing a written opinion.
The Fourth Circuit affirmed the decision, explaining that Virginia corporations law would only ever allow Highland Construction to assign a portion of its own property; therefore, Highland Construction could not have assigned any portion of Foothills’ property, including its interest in Sanford, LLC. Since Highland Construction could not have assigned Foothills’ membership interest in Sanford in the security agreement, the fifty percent membership interest assignment in the security agreement could only be Highland Construction’s twenty percent direct membership interest in Sanford, LLC. Therefore, the Bankruptcy Court had correctly interpreted the scope of the security interest.
§ 1.1.6 Fifth Circuit
In re DeBerry (Whitlock L.L.C. v. Lowe), 945 F.3d. 943 (5th Cir. 2019). The debtor’s wife opened a joint bank account with her sister-in-law, Ms. Whitlock. The joint bank account was funded with a cashier’s check for $275,000.00 that had been withdrawn from a joint marital account. Three days after opening the account, the debtor’s wife removed herself from the newly opened joint account, leaving it solely in Ms. Whitlock’s name. One month later, the $275,000.00 was transferred out of the account in a series of transactions. Two wire transfers were at the heart of the case. Ms. Whitlock signed these wire transfers at the debtor’s wife’s request and had no knowledge regarding the transfers. The trustee commenced an adversary proceeding against the sister-in-law to recover a total of $275,000.00 in fraudulent transfers. Following the settlement with the debtor’s daughter, $241,500.00 was at issue. The trustee argued that Ms. Whitlock was liable for the entire amount pursuant to Section 550 of the Bankruptcy Code, which allows a bankruptcy trustee to recover fraudulently transferred funds from transferees. Ms. Whitlock contended that she was not a “transferee” because the money never belonged to her and that she was a mere conduit. Second, Ms. Whitlock argued that the funds had already been returned to the debtors via the wire transfers, so they could not be recovered.
The bankruptcy court held that, as Ms. Whitlock was the sole owner of the bank account, she was the initial transferee of an avoidable transfer subject to recovery under Section 550(a)(1). Although the Bankruptcy Code provides that the trustee is “entitled to only a single satisfaction” for avoided transfers, 11 U.S.C. § 550(a) & (d), the bankruptcy court took the view that the single-satisfaction rule does not apply to funds that were returned to the debtor prior to the petition date. Accordingly, the bankruptcy court entered judgment for the trustee. The question for the Fifth Circuit was whether the trustee can recover funds that were already returned to the debtor. The court began by noting that Section 550(a) permits the trustee to “recover” the property. The court found that obtaining a duplicate of something is not getting it back, which is the definition of “recover,” but that it would be a windfall. Property that has already been returned simply cannot be recovered.
Every other court to consider this issue has agreed with the foregoing plain reading of the text. Some courts cite Section 550(d)’s ‘satisfaction rule’ and others rely on the bankruptcy court’s equitable powers. The trustee could not point to a single decision supporting his reading of Section 550, but raised four arguments in opposition to the uniform interpretation of Section 550. The trustee’s primary argument was that a plain reading of Section 550(d) means the single satisfaction rule does not extend to a prepetition reconveyance directly to the debtor. Instead, the trustee argued that the single-satisfaction rule only applies to a satisfaction pursuant to Section 550(a), which a prepetition transfer could not be. The court rejected “this strained reading.” Looking to the plain meaning of the word “satisfaction,” the court held that, if an obligation has already been satisfied, the transferee has no further obligation. That is “the trustee’s ‘avoidance action was satisfied before it was ever commenced.’” Second, the trustee argued that nothing in the legislative history suggested that Congress intended Section 550(d) to be triggered by a prepetition repayment to the debtor. The court noted that legislative history is not the law. However, even assuming that the legislative history was relevant in general, it found the particular bit of legislative history cited by the trustee to be irrelevant. Third, the trustee argued that, because the bankruptcy estate does not exist until the petition is filed, a prepetition satisfaction does not count as recovery “for the benefit of the estate.” The court rejected this argument because it did not hold that the return of the property constituted a recovery for the benefit of the estate under Section 550(a), but instead held that there cannot be a recovery at all if the property has already been returned. Fourth, and finally, the trustee argued that the bankruptcy court cases rejecting his reading were distinguishable because they actually involved a windfall to the bankruptcy estate. The trustee argued that the recovery in this case could not provide a windfall to the estate because it did not remain in the estate at the time of the petition. The Fifth Circuit noted that the bankruptcy code does not give the trustee the power to review for reasonableness the debtor’s prepetition expenditures. Whether the debtor frittered away the money or not was simply irrelevant to the case. Accordingly, the judgment was reversed.
In re Willis (Tower Loan of Mississippi, L.L.C. v. Willis), 944 F.3d. 577 (5th Cir. 2019). The debtor commenced an adversary proceeding pursuant to the Truth in Lending Act. The lender moved to dismiss or, in the alternative, to compel arbitration. The bankruptcy court denied the motion and the district court affirmed. On appeal, the Fifth Circuit began by focusing on the agreement signed by the debtor when he borrowed money from the lender. The court noted that “in signing the loan agreement, [the debtor] agreed to an arbitration agreement found on its back side.” Similarly, in an insurance policy purchased in connection with the loan, the debtor agreed to a second arbitration agreement. The lender did not sign the second agreement, but its representative handed it to the debtor for his signature. The two arbitration agreements were similar but not identical. Both broadly required arbitration for all disputes, including for any arising pursuant to the loan or the insurance policies. Further, both agreements gave the arbitrator the power to decide gateway arbitrability. The agreements, however, conflicted with respect to several procedural aspects of arbitration: e.g., selection and number of arbitrators, time to respond, location, and fee shifting.
In denying the lender’s motion, the bankruptcy court held that the first and second arbitration agreements formed a single contract and the conflicting provisions meant that the debtor and the lender had not formed a sufficiently definite contract to arbitrate under state law. The court began its analysis with state law to determine whether the parties formed an arbitration agreement at all. If so, the court would interpret the contract to determine whether the claim at issue was covered by the agreement. This second step is normally for the court, but this analysis changes where the agreement delegates that question to the arbitrator.
The Fifth Circuit, applying Mississippi law, agreed with the lower courts that the two agreements constituted a single contract. However, the Fifth Circuit disagreed with the bankruptcy court’s holding that conflicts between the two agreements prevented a meeting of the minds. The court found that, notwithstanding these conflicts, the parties’ intention was unmistakable: “They wished to arbitrate any dispute that might arise between them.” The conflicting terms were not essential and, as a matter of Mississippi law, the parties validly contracted to arbitrate. Turning to whether the claim was arbitrable, the court found that there was clear intent to have the arbitrator decide the issue. Accordingly, it was for the arbitrator to decide whether the Truth in Lending Act claim was subject to arbitration and to resolve the inconsistent procedural terms. The court reversed and remanded to the district court with directions to refer the dispute to arbitration.
In re Sherwin Alumina Co. (Port of Corpus Christi Auth. v. Sherwin Alumina Co.), 952 F.3d. 229 (5th Cir. 2020). The Port of Corpus Christi Authority owned an 1,100-acre parcel of land adjacent to land owned by the debtor. The Port also held an easement granting use of and access to a private road on the debtor’s land, which provided the primary means of commercial access to the Port’s land. The debtor sought Chapter 11 relief from the United States Bankruptcy Court for the Southern District of Texas and filed its initial joint plan for reorganization. In that plan, the debtor proposed to sell its real property free and clear of all liens, claims, charges, and other encumbrances in accordance with Section 363(f) of the Bankruptcy Code. In accordance with bankruptcy court-approved bidding procedures, an auction was held and a third party emerged as the successful bidder. Over the subsequent months, the debtor filed various modified plans and purchase agreements. In each such document, it was clear that encumbrances other than those deemed permitted would be stripped off the estate’s property in accordance with Section 363(f). Although permitted encumbrances were to be defined in a future proposed confirmation order, no document ever suggested that the Port’s easement would be a permitted encumbrance.
On the day of the confirmation hearing, the debtor filed a proposed confirmation order that defined permitted encumbrances to include a number of specific servitudes, easements and encumbrances, but the Port’s easement was not included. The Port was served with that proposed confirmation order. At the confirmation hearing that day, debtor’s counsel stated that the proposed order had been submitted with extensive modifications but he did not believe those modifications were material. The bankruptcy court entered the order without objection and the plan was confirmed.
More than a month after confirmation, a subsequent owner of the debtor’s property notified the Port that its easement had been extinguished by the sale of the land pursuant to the plan. Because the time to appeal the confirmation order had expired, the Port commenced an adversary proceeding to collaterally attack the confirmation order as having been procured by fraud, obtained via a denial of due process for want of notice, and as having barred by sovereign immunity. The bankruptcy court dismissed the claims of fraud and sovereign immunity without leave to amend but failed to dismiss the due process claim. The Fifth Circuit considered the Port’s appeal of the dismissal.
With respect to the question of sovereign immunity, the court looked to the United States Supreme Court’s decision in Tennessee Student Assistance Corporation v. Hood, which held that “a bankruptcy court’s discharge of an individual’s debt to the state of Tennessee did not violate the Eleventh Amendment.” In that decision, the Supreme Court found that a discharge proceeding was an exercise of the bankruptcy court’s in rem jurisdiction over the debtor’s estate; that the debtor did not seek affirmative relief against the state; and that the proceeding did not subject the state to any coercive judicial process. Accordingly, the Eleventh Amendment was not violated. The Fifth Circuit reached a similar conclusion in connection with the Port’s appeal. The court noted that the servient land was part of the bankruptcy estate and that the Port’s easement was “a non-possessory property interest” in that land. Because the bankruptcy court’s order authorizing the sale free and clear of the Port’s interest neither awarded affirmative relief nor deployed coercive judicial process, the bankruptcy court was not exercising in personam jurisdiction over the state. The court found that the Port’s easement was similar to Tennessee’s debt in the Hood case. The Port held an interest burdening the bankruptcy res. Moreover, the bankruptcy court properly exercised its in rem jurisdiction over the estate to extinguish that burdensome interest.
The court noted that it was not considering whether the proposed sale met the requirements for a sale free and clear pursuant to Section 363(f). That argument was foreclosed because it had not been raised on direct appeal and could not be raised in a collateral attack.
The court then turned to Section 1144 of the Bankruptcy Code, which provides “[o]n request of a party in interest at any time before 180 days after the date of entry of the order of confirmation, and after notice and a hearing, the court may revoke such order if and only if such order was procured by fraud.” The appellate court rejected the Port’s Section 1144 claim because it failed to allege any intentional false representation. In reviewing the record, the court of appeals noted that from the initial bankruptcy filing until the confirmation hearing, more than a year later, the debtor had always proposed a sale in which property of the estate would be sold free and clear of all liens, claims, charges, and other encumbrances. The court noted that under Texas law an easement is a type of encumbrance. While the last-minute submission of the proposed confirmation order did carve out certain encumbrances from the sale order, there were not any changes at all with respect to the Port’s easement. Accordingly, the court affirmed the dismissal of the Port’s Eleventh Amendment and fraud claims, but noted that the due process claim was still pending before the bankruptcy court and that it was not addressed.
In re Hidalgo County Emergency Services Found. (Hidalgo County Emergency Services Found. v. Carranza), 962 F.3d. 838 (5th Cir. 2020). Congress responded to the coronavirus pandemic by enacting the Coronavirus Aid Relief and Economic Security Act (the “CARES Act”). Among other things, the CARES Act made available government-guaranteed loans to qualified small businesses through the Paycheck Protection Program (“PPP”). The PPP is administered by the Small Business Administration (“SBA”). The SBA promulgated regulations concerning PPP eligibility. One of those regulations provided that a debtor in a bankruptcy proceeding would be ineligible to receive a PPP loan. A Chapter 11 debtor alleged that it was denied a PPP loan based on its status as a bankruptcy debtor and filed an adversary proceeding against the SBA. The debtor contended that the SBA’s decision to preclude bankrupt parties from obtaining PPP loans violated Section 525(a) of the Bankruptcy Code which prohibits discrimination based on bankruptcy status and was arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law, and finally that it was in excess of the statutory jurisdiction granted to the SBA. The bankruptcy judge agreed with the debtor and issued a permanent injunction mandating that the SBA handle the debtor’s PPP application without consideration of its ongoing bankruptcy. The case was certified for direct appeal to the United States Court of Appeals for the Fifth Circuit. On appeal, the SBA Administrator argued that the Small Business Act prohibited injunctive relief against his office. 15 U.S.C. § 634(b)(1). The Fifth Circuit had previously held “that all injunctive relief directed at the SBA is absolutely prohibited.” The court noted that the “issue at hand is not the validity or wisdom of the PPP regulations and related statutes, but the ability of a court to enjoin the administrator, whether in regard to the PPP or any other circumstance.” The court held that “under well-established Fifth Circuit law, the bankruptcy court exceeded its authority when it issued an injunction against the SBA Administrator.” Accordingly, the preliminary injunction was vacated.
In re Ultra Petroleum Corp. (Three Rivers Holdings, L.L.C. v. Ad Hoc Committee of Unsecured Creditors of Ultra Resources, Incorporated), 943 F.3d. 758 (5th Cir. 20219). In this case, the Fifth Circuit addressed what it considered “exceedingly anomalous facts.” Those anomalous facts were that the debtor entered its bankruptcy proceeding insolvent, but then became solvent. These unique facts arose “by virtue of a lottery-like rise in commodity prices.” As a result, “the debtors proposed a rare creature in bankruptcy—a reorganization plan that (they said) would compensate their creditors in full.” With respect to certain unsecured notes, the debtors proposed to pay three sums: “the outstanding principal on those obligations, pre-petition interest at a rate of 0.1%, and post-petition interest at the federal judgment rate.” Based on this treatment, the debtors’ plan treated this class of creditors as unimpaired, who could, therefore, not object to the plan. Notwithstanding their designation as unimpaired, the class of creditors objected insisting that they were impaired because the plan did not provide for payment of a contractual make-whole premium and additional post-petition interest at contractual default rates. The make-whole premium was triggered upon prepayment and was designed to provide compensation for the noteholder’s right to maintain its investment free from repayment. The relevant loan agreements provided that a bankruptcy petition made the outstanding principal, any accrued interest, and the make-whole amount immediately due and payable. The debtors acknowledged that their plan did not call for payment of the make-whole amount or provide post-petition interest at the contractual rates. They nonetheless insisted that the creditors were not impaired because federal law barred them from recovering the make-whole premium and entitled them to receive post-petition interest only at the federal judgment rate.
The Fifth Circuit began its analysis by noting that the Bankruptcy Code “provides that a class of claims is not impaired if ‘the [reorganization] plan … leaves unaltered the legal, equitable, and contractual rights to which such claim … entitles the holder.” The court noted section 502(b)(2) of the Code requires a court to disallow a claim to the extent it seeks unmatured interest. The debtors argued that the make-whole amount qualified as unmatured interest. They also argued that it was an unenforceable liquidated damages provision under New York law. As a result, something other than the plan, either the Bankruptcy Code or New York law, prevented this class of creditors from recovering the disputed amount. The debtors made a similar argument with respect to post-petition interest. Section 726(a)(5) of the Code entitles creditors at most, to post-petition interest at the legal rate, and not the contract rate. The bankruptcy court rejected these arguments. It held that New York law permitted recovery of the make-whole premium and imposed no limit on contractual post-petition interest rates. The Fifth Circuit noted that the bankruptcy court did not address whether the Bankruptcy Code disallowed the make-whole amount as unmatured interest or what section 726(a)(5)’s “legal rate” of interest means. Based on these holdings, the bankruptcy court ordered the debtors to pay the make-whole premium and post-petition interest at the contractual rate. The question was certified for direct appeal to the Fifth Circuit.
The appellate court found that the plain text of section 1124(1) requires that the alteration of the creditor’s rights be as a result of a plan and not otherwise, in order for that creditor to be impaired. It held that “a creditor is impaired under [section] 1124(1) only if ‘the plan’ itself alters a claimant’s ‘legal, equitable, [or] contractual rights.’” The court noted that the creditors could not point to a single decision suggesting otherwise. To the contrary, the court noted that Collier on Bankruptcy “states the point in unequivocal terms: ‘Alteration of Rights by the Code Is Not Impairment under Section 1124(1).’” The court, therefore, concluded that, when “a plan refuses to pay funds disallowed by the Code, the Code—not the plan—is doing the impairing.” The court then turned to the question of whether the Bankruptcy Code disallowed the claims for the make-whole amount and post-petition interest at the contractual rate. The creditors argued that their contract should be honored “under bankruptcy law’s long-standing ‘solvent-debtor’ exception.” The debtors argued that no such exception exists under the Bankruptcy Code. The Bankruptcy Court had never reached these questions. The Fifth Circuit noted that the issue of make-whole premiums had become a common issue in modern bankruptcy. While the court cited cases holding that it was sometimes very easy to tell whether such premiums were effectively unmatured interest that was disallowed by section 502(b), it also cited cases finding that it can be a harder question depending “on the dynamics of the individual case.” The court noted that the bankruptcy court would be best equipped to address this question and the question of post-petition interest. The court noted that its review of the record revealed no reason why the solvent-debtor exception could not apply in applying that exception. Moreover, other circuits had held that “absent compelling equitable considerations, when a debtor is solvent, it is the role of the bankruptcy court to enforce the creditors’ contractual rights.” The appellate court, therefore, remanded the matter to the bankruptcy court.
§ 1.1.7 Sixth Circuit
Fed. Energy Reg. Comm’sn v. First Energy Sols. Corp. (In re First Energy Sols. Corp.), 945 F.3d 431 (6th Cir. 2019). In a ruling at the intersection of energy law and bankruptcy, the Sixth Circuit held that (i) energy contracts do not amount to de jure regulations in the context of bankruptcy, and are, thus, capable of rejection; (ii) bankruptcy courts do not have unfettered jurisdiction superior to that of the Federal Energy Regulatory Commission (“FERC”), although the bankruptcy court may enjoin FERC from acting in circumstances where FERC might seek to directly interfere with a bankruptcy proceeding; and (iii) rejection of energy contracts should be governed by a standard that scrutinizes the impact of rejection on the public interest—something more than ordinary business judgment—aligning itself with the Fifth Circuit.
FirstEnergy Solutions Corp. (“FirstEnergy”) and its subsidiary commenced Chapter 11 proceedings in March 2018. The day after it commenced bankruptcy proceedings, it filed an adversary proceeding against FERC seeking a declaratory judgment that the bankruptcy court’s jurisdiction was superior to FERC’s and injunctions prohibiting FERC from interfering with FirstEnergy’s intended rejection of certain energy contracts that it had previously filed with FERC. The bankruptcy issued broad injunctions against FERC, prohibiting it from taking any action with respect to FirstEnergy.
The first question the court addressed was whether contracts filed with FERC cease to be ordinary contracts once they are filed, and instead become de jure regulations, which should not be subject to rejection in bankruptcy. Considering the public necessity of federal regulation of the energy alongside the public necessity of ensuring the ability of energy companies to survive, even when burdened with unprofitable contract, the court determined that “the public necessity of available and functional bankruptcy relief is generally superior to the necessity of FERC’s having complete or exclusive authority to regulate energy contracts and markets.” Thus, for bankruptcy purposes, the subject contracts were not de jure regulations beyond the ambit of rejection under the Bankruptcy Code.
The second question that the court addressed was whether the bankruptcy court was entitled to enjoin FERC “from doing anything and everything—from entering any orders or even holding its own hearing.” Id. at 448 (emphasis original). The Sixth Circuit held that the bankruptcy court’s order strayed too far from precedent established under Chao v. Hospital Staffing Services, 270 F.3d 374 (6th Cir. 2001). Although the Circuit Court did not necessarily disagree with the bankruptcy court’s holding that FERC proceedings were not excepted from the automatic stay under the public-policy test, it concluded that the bankruptcy court was wrong not to limit its holdings to the facts at hand (the bankruptcy court’s holding would have held that FERC’s interest in preventing bankruptcy rejection of any filed contract would be only incidentally public, and, thus, would always be subject to the automatic stay). The Sixth Circuit further noted that the bankruptcy court improperly omitted a crucial point in Chao—that any conflict in jurisdiction should be decided by an appellate court with jurisdiction to hear appeals from both fora.
The Sixth Circuit further held that section 105(a) of the Bankruptcy Code did not provide the bankruptcy court with unfettered power to enjoin FERC. Instead, relying heavily on the Fifth Circuit’s interpretation of a similar question in In re Mirant Corporation, 378 F.3d 511 (5th Cir. 2004), the Sixth Court held that section 105(a) afforded the bankruptcy court only the power to enjoin FERC from issuing potentially contradictory orders. Because the bankruptcy court’s injunction prohibited FERC from taking any action whatsoever, even so far as holdings its own hearing, it went too far. Thus, the court concluded that the bankruptcy court has jurisdiction superior to FERC in matters which might interfere with the bankruptcy proceeding, but does not have the unfettered right to enjoin FERC from “risking its own jurisdictional decision, conducting its (otherwise regulatory mandated) business, or issuing orders that do not interfere with the bankruptcy court.”
Finally, the Sixth Circuit decided the standard applicable to rejection of a FERC-regulated contract. Relying on the standard established by the Fifth Circuit in Mirant, the court determined that the bankruptcy court must consider rejection of executory power contract in the context of the public interest, including the consequential impact on consumers and any tangential contract provisions concerning, for instance, decommissioning, environmental management, and future pension obligations, to ensure that “the equities balance in favor of rejecting the contracts.” Id. at 454 (citing Mirant, 378 F.3d at 525).
§ 1.1.8 Seventh Circuit
In re hhgregg, Inc., 949 F.3d 1039, 1041 (7th Cir. 2020). In a priority contest between a supplier seeking reclamation of inventory provided to the debtor and the debtor’s secured DIP lender with a floating lien on all of the debtor’s assets, including existing and after-acquired inventory and its proceeds, the Seventh Circuit Court of Appeals held that the secured lender’s interest in the inventory is superior to the supplier’s pursuant to section 546(c) of the Bankruptcy Code.
The debtor hhgregg, Inc. (the “Debtor”), which sold home appliances, electronics and related services to consumers, filed for Chapter 11 bankruptcy. A prepetition lender, Wells Fargo Bank (“Wells Fargo”), became a DIP lender with the bankruptcy court’s approval, and obtained a priming, first-priority floating lien on substantially all of the Debtor’s assets, including existing and after-acquired inventory and its proceeds. Subsequently, one of the Debtor’s suppliers, Whirlpool, sent a reclamation demand seeking the return of appliances it had delivered in the 45-day period before the bankruptcy petition.
Whirlpool then filed an adversary action against Wells Fargo seeking a declaration that its reclamation claim was first in priority as to the reclaimed goods, alleging, among other things, that Wells Fargo had not acted in good faith because it knew the Debtor was insolvent and still continued to provide financing, enabling the Debtor to acquire additional inventory from suppliers like Whirlpool in order to expand Wells Fargo’s own collateral base. Wells Fargo moved to dismiss. The bankruptcy judge treated the motion as one for summary judgment and entered final judgment for Wells Fargo. The judge noted that the 2005 amendments to the Bankruptcy Code, which resulted in the current form of section 546(c), expressly made a seller’s reclamation right “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof,” and held that Whirlpool’s reclamation claim was subordinate to Wells Fargo’s prior, unbroken lien chain on the Debtor’s assets. The district court affirmed.
The Seventh Circuit Court of Appeals also affirmed. The court held that a reclamation claim was governed by 11 U.S.C. § 546(c), as modified by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which provides that a seller’s right to reclaim goods is “subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof.” The court examined the history of section 546(c), noting that although priority was uncertain under the old version of section 546(c), the 2005 amendments made it “crystal clear that a seller’s reclamation claim is subordinate to ‘the prior rights of a holder of a security interest.’ [11 U.S.C.] § 546(c)(1). What this means as a practical matter is that ‘if the value of any given reclaiming supplier’s goods does not exceed the amount of debt secured by the prior lien, that reclamation claim is valueless.’” In re hhgregg, Inc., 949 F.3d 1039, 1048 (7th Cir. 2020) (quoting In re Dana Corp., 367 B.R. 409, 419 (Bankr. S.D.N.Y. 2007)).
The court found that, under the terms of the DIP financing agreement and effective upon entry of the court’s interim DIP financing order, Wells Fargo obtained a perfected, first-priority security interest in all hhgregg assets, including the reclaimed goods, and it maintained a continuous lien chain that preceded Whirlpool’s reclamation demand. Specifically, the court rejected Whirlpool’s argument that its reclamation claim was “in effect” as of the March 6 petition date and “jumped into first position” during a “gap in the lien chain” that occurred between March 6, when Wells Fargo’s prepetition security interest was superior, and March 7, when Wells Fargo’s postpetition security interest attached pursuant to the DIP financing order, finding that Whirlpool had no right under section 546(c)(1) until it served its written reclamation demand on March 10.
The court further dismissed Whirlpool’s arguments referring back to state law principles as explicitly overridden by the adoption of the federal priority rule implemented pursuant to section 546(c).
§ 1.1.9 Eighth Circuit
In re Peabody Energy Corporation, No. 19-1767 (8th Cir. May 6, 2020). The Eighth Circuit curtailed the ability of municipalities to make public nuisance-type claims against companies that have emerged from bankruptcy, when the behavior giving rise to the claim is abated prepetition. The court affirmed decisions of the U.S. Bankruptcy Court and the U.S. District Court for the Eastern District of Missouri, finding that the plaintiff municipalities were barred from asserting claims for “contributions for global warming” from the debtor’s export of coal from California.
In April 2016, Peabody Energy Corporation (“Peabody”) filed for Chapter 11 bankruptcy. Ultimately, Peabody emerged from bankruptcy as a reorganized company. Several months after Peabody emerged from bankruptcy, three California municipalities sued it—along with over thirty other energy companies—alleging claims of negligence, strict liability, trespass, private nuisance and public nuisance for the defendants’ former and ongoing contributions to global warming. The public nuisance claims sought, among other things, damages and disgorgement of profits. In response, Peabody moved the bankruptcy court to enjoin the municipalities from pursuing their claims and dismiss them with prejudice on the ground that the court-approved plan of reorganization had discharged the claims. The bankruptcy court granted Defendant Peabody’s request, finding that the plaintiffs’ claims focused on acts occurring from 1965 to 2015 (except for Peabody’s continued export of coal from California), and was, therefore, discharged by Peabody’s plan as relating to Peabody’s prepetition conduct.
The Eighth Circuit rejected the municipalities’ arguments on appeal. First, the Eighth Circuit agreed with the bankruptcy court that the municipalities’ common law claims did not qualify as “Environmental Laws,” as defined in Peabody’s plan, that were specifically excepted from discharge. The court then affirmed that the municipalities’ claims were not an exercise of their police power because the municipalities were seeking money as victims of alleged torts, rather than exercising regulatory or police authority over Peabody.
The court also rejected the plaintiffs’ argument that their representative public-nuisance claims were exempt from discharge because the public-nuisance claims, asserted on behalf of the people of California, were not claims under bankruptcy law since California law does not permit them to recover damages under that theory. Rather than relying on the statutory language, which limited recovery on public nuisance claims to an “equitable decree,” the Court probed further, and upon finding that such equitable decrees could include obligations to pay money, found that those claims too were dischargeable in bankruptcy. It did not matter that the municipalities were not requesting this remedy in their complaint; the court found that fact that a California court could order the remedy was sufficient to make the claim dischargeable in bankruptcy. Finally, the court rule that allegations in the complaint extending to Peabody’s postpetition conduct, exporting coal, were insufficient to change the nature of the complaint to one for postpetition conduct.
In re Family Pharmacy, Inc., No. 19-6025, 2020 WL 1291112 (8th Cir. BAP Mar. 19, 2020). The Bankruptcy Appellate Panel for the Eighth Circuit has held that oversecured creditors have an unqualified right to recover interest under section 506(b), and such right is not subject to reconsideration on the basis of enforcement as a penalty under Missouri law, nor is it subject to rebuttal based on equitable considerations.
Between July 2014 and March 2018, the Bank of Missouri (“BOM”) made eight loans in the total amount of approximately $11 million to Family Pharmacy, Inc. and four related entities (the “Debtors”). The debt to BOM was secured by a first priority lien on the Debtors’ assets, consisting primarily of inventory, equipment and real estate used in operating their business. The Debtors’ assets were also encumbered by two other secured creditors: Cardinal Health, who had a second priority lien securing $1 million in debt, and J M Smith Corporation and Smith Management Services, LLC (together, “Smith”), which had a third priority lien securing $18 million in debt.
In April 2018, the Debtors filed for Chapter 11. They subsequently sold their assets at an auction free and clear of all liens in the amount of $13.975 million. The bankruptcy court entered a sale order approving Smith as the purchaser. BOM, as an over secured creditor, later filed a motion under 11 U.S.C. § 506(b) seeking allowance of interest calculated at a high default rate on the basis that it was oversecured. The bankruptcy court denied BOM’s motion, holding that the default rate constituted an unenforceable liquidated damages penalty under Missouri law. The bankruptcy court also held that the default interest rate could not be enforced based on equitable considerations.
On appeal, the Eighth Circuit Bankruptcy Appellate Panel reversed. The Panel began its analysis by acknowledging that all over secured creditors are entitled to postpetition interest. The Panel observed that most courts have concluded that such postpetition interest should be calculated at the rate provided in the contract. It also noted that the parties had agreed that the substantive law of the state of Missouri would apply. Missouri law permits parties to loans to agree in writing to any rate of interest, fees and other terms and conditions.
The Panel pointed out that liquidated damage provisions and default interest provisions are often conflated. However, default interest is not subject to rebuttal if it is construed as a penalty. The analysis is more straightforward—if there has been a default, the default interest rate negotiated by the parties will apply; a liquidated damages provision merely fixes the amount of damages payable in the event of a specified breach. The panel held that the bankruptcy court erred by applying a liquidated damages analysis because doing so imputed a “reasonableness” analysis to the question of BOM’s unqualified right to interest.
The Panel also reversed the bankruptcy court’s ruling that the equities of the case mandated disallowance of the default interest rate, noting that “no section of the Bankruptcy Code gives the bankruptcy court authority, equitable or otherwise, to modify a contractual interest rate prior to plan confirmation.” It concluded that absent some compelling reason to the contrary, BOM should be permitted to collect interest at the higher rate if the bankruptcy court concluded that the default rate applied. The Panel remanded the matter for further proceedings before the bankruptcy court.
§ 1.1.10 Ninth Circuit
In re Gardens Reg’l Hosp. & Med. Ctr., Inc., 975 F.3d 926 (9th Cir. 2020). The Ninth Circuit recently added greater contours to the definition of recoupment versus setoff when it affirmed in part and reversed in part a bankruptcy court determination that the California Department of Health Care Services (the “State”) was entitled to recoup a debtor’s prepetition and postpetition health-related tax assessments from the obligations the State owed to the debtor. The court held that, while one of the State’s obligations running to the debtor bore the necessary logical connection to the assessment to qualify for recoupment, the other stream of payments from the State to the debtor, just by virtue of arising out of the State’s Medicaid program from which the assessment arose, did not.
The State imposed a Hospital Quality Assurance Fee (“HQAF”) on private hospitals that the debtor, Gardens Regional Hospital and Medical Center, Inc. (“Gardens Regional”) failed to pay before filing for bankruptcy. If a hospital failed to pay, the State was authorized by statute to immediately deduct the unpaid assessment from any payments the State owed to the hospital. California’s Medicaid program used a “fee-for-service” system through which a covered individual would receive treatment with a participating hospital and the state would pay the provider for the service. As a result of the fee-for-service system, the State owed certain payments to Gardens Regional. The State also owed Gardens Regional certain “supplemental” payments that resulted from the HQAF scheme. The State recovered the entirety of its prepetition debt arising from the HQAF assessments, as well as a significant portion of HQAF assessments arising postpetition, by withholding portions of the fee-for-service payments as well as the supplemental payments to which Gardens Regional was entitled.
Gardens Regional filed a motion to compel the State to return the amounts, arguing that the withholdings were in violation of the automatic stay and constituted an impermissible setoff. The State maintained that the withholdings were exempt from the automatic stay under the equitable doctrine of recoupment. The bankruptcy court held that the HQAF assessments had a logical relationship to the fee-for-service payments and the supplemental payments, and denied the Gardens Regional’s motion. The BAP affirmed the holding of the bankruptcy court.
Before discussing the case at hand, the Ninth Circuit described the difference between setoff, the exercise of which is subject to the automatic stay, and recoupment, the exercise of which is not subject to the automatic stay. While setoff involves mutual debts and claims these debts and claims could arise from different transactions. Recoupment, on the other hand, involves defining the amount owed under a single claim. However, the rights giving rise to recoupment must also stem from the same transaction or occurrence. The court emphasized that the most important consideration when analyzing a claim for recoupment was whether the claims or rights for which recoupment was sought by the creditor had a “logical relationship” to the obligations owed by the debtor to the creditor.
The Ninth Circuit considered both compensation streams from which the State withheld payment to Gardens Regional. It found there was a direct connection between the HQAF payments, which went to a segregated fund, and the supplemental payments that were made to hospitals from that very same fund. Further, the HQAF statute explicitly detailed that the purpose of the HQAF program was to allow for certain fees to be paid by hospitals, which would then be used to increase federal financial participation which allowed the State to then make supplemental payments back to the hospitals. Gardens Regional argued that federal law actually prohibits any specific linkage between the HQAF assessments of a taxpayer and the amount of Medicaid payments made to that taxpayer however the Court indicated that, while this was true, the HQAF program created an “overall linkage” between the payment systems in and out of the fund which was sufficiently connected as to permit recoupment. However, with regards to the payments owed to the Gardens Regional under the fee-for-service payments, the court found that these deductions were an improper setoff because the same statutory relationship that existed as between the supplemental payments and the HQAF assessments was lacking as between the fee-for-service payments and the HQAF assessments such that the payments lacked any legal or factual connection to the HQAF assessments.
Blixseth v. Credit Suisse, No. 16-35304 (9th Cir. June 11, 2020). Overturning a district court’s dismissal of a challenge to an exculpation provision under a Chapter 11 plan on equitable mootness grounds, the Ninth Circuit nonetheless affirmed the dismissal on its merits. The Court held that section 524(e) did not bar a narrow exculpation provision contained in the plan, notwithstanding that the exculpation barred certain claims against non-debtors for actions related to the plan approval process.
In 2000, Timothy Blixseth (“Blixseth”) and his wife (“Edra”) founded the Yellowstone Club in Big Sky, Montana. In 2005, Blixseth obtained a $375 million loan from Credit Suisse and other lenders, secured by the assets of companies related to the Yellowstone Club (collectively, the “Yellowstone Entities”). When Blixseth and Edra divorced in 2008, Edra became the indirect owner of the Yellowstone Entities. Largely because Blixseth had “mismanaged and misused” the 2005 loan proceeds, which the companies could not afford to pay back, Edra decided to pursue an asset sale through a Chapter 11 proceeding.
The exculpations became a hot button issue as the parties came to the plan negotiation stage of the Chapter 11 proceedings. Credit Suisse objected to confirmation, in part on grounds that the releases then contained in the plan were over-inclusive and, therefore, forbidden in the Ninth Circuit. Eventually, Credit Suisse, the Yellowstone Entities, and the asset purchaser entered into a global settlement, upon which an amended plan was formulated. The amended plan included an exculpation which extended to Credit Suisse, the asset purchaser, and Edra for “any act or omission in connection with, relating to or arising out of the Chapter 11 Cases, the formulation, negotiation, implementation, confirmation or consummation of this Plan, Disclosure Statement, or any contract, instrument, release or other agreement or document entered into during the Chapter 11 Cases or otherwise created in connection with this Plan.” Blixseth, who has not covered by the exculpation, objected to the plan. The bankruptcy court approved the plan over Blixseth’s objection. Blixseth appealed to the district court, which reversed based on the breadth of the exculpation. On remand, the bankruptcy court again confirmed the plan, without modification, holding that the exculpation was “narrow in both scope and time.” Again, Blixseth appealed to the district court. This time, the district court dismissed the appeal for Blixseth’s lack of standing, after rejecting the plan proponents’ argument that the appeal was barred by equitable mootness. The Ninth Circuit revered in part and affirmed in part, holding that Blixseth had standing to pursue the appeal, which was not equitably moot. The Circuit Court remanded to the district court for a determination on the merits of Blixseth’s appeal. However, on remand, the district court did not reach the merits, instead ruling that Blixseth’s appeal was barred by equitable mootness.
After refusing to dismiss Blixseth’s appeal for failing to abide by certain scheduling orders, the Ninth Circuit determined, as it had previously, that Blixseth’s appeal was not equitably moot. Because the court had the capacity to fashion a remedy that would resolve Blixseth’s appeal, at least in part, the appeal was not moot. Furthermore, because the Ninth Circuit had already ruled on the issue, its prior decision was binding as law of the case.
Nonetheless, since Blixseth’s appeal involved only questions of law regarding the validity of the exculpation, the Ninth Circuit proceeded to the merits of Blixseth’s appeal: whether the bankruptcy court could release Credit Suisse, as a creditor, from liability for certain potential claims against it by approving the exculpation provision. The basis for Blixseth’s argument was that the exculpation amounted to a discharge of the debt of a non-debtor under section 524(e). Considering the history and purpose of section 524(e), the court concluded that section 524(e) was intended to prevent non-debtors from discharging debts on which they were co-liable with the debtors, and for which the debtors had received a discharge. Because the claims released in the exculpation provision were unrelated to the Yellowstone Entities’ discharged debts, the limitation in section 524(e) did not apply to bar the exculpation provision at issue.
§ 1.1.11 Tenth Circuit
Drivetrain, LLC v. Kozel (In re Abengoa Bioenergy Biomass of Kansas, LLC), No. 18-3120 (10th Cir. May 5, 2020). The Tenth Circuit Court of Appeals extended the applicability of its equitable mootness doctrine to Chapter 11 plans of liquidation, rather than limiting the doctrine solely to plans of reorganization.
Debtor Abengoa Bioenergy Biomass of Kansas (“ABBK”), which constructed and operated an ethanol conversion facility in Kansas with the financial support of its four subsidiaries, converted a Chapter 7 proceeding into a voluntary petition for reorganization pursuant to Chapter 11. The bankruptcy plan was confirmed, over Drivetrain’s objection, and substantially consummated when ABBK auctioned the Kansas facility and distributed most of the estate’s other assets to creditors, subordinating all inter-company claims.
Drivetrain sought to stay the plan’s enforcement and implementation, which the bankruptcy court denied on the ground that Drivetrain had failed to demonstrate a likelihood of success in overturning the plan. Drivetrain appealed the stay denial, while the ABBK trustee moved before the district court to dismiss Drivetrain’s appeal of the plan confirmation as equitably moot, given that the plan had been substantially consummated. After the district court granted that motion, on the basis that a successful appeal of the plan confirmation could harm innocent third-party creditors, the Tenth Circuit consolidated both matters on appeal.
Drivetrain argued that the equitable mootness doctrine only applies to conventional reorganizations—not cash-only liquidations under Chapter 11. However, the Tenth Circuit held that the flexible, multi-factor test guiding equitable mootness in the context of substantially completed plans—factors which include, among other things, the effect of the relief requested on the plan and the harm to third parties who have justifiably relied on the plan’s confirmation—does apply to Chapter 11 liquidation plans. Abengoa Bioenergy Biomass of Kansas, LLC, 958 F.3d 949, 956 (10th Cir. 2020) (citing Search Market Direct, Inc. v. Paige (In re Paige), 584 F.3d 1327, 1335 (10th Cir. 2009)). The court noted that other circuits (including the Tenth Circuit) have affirmed equitable mootness rulings within the context of Chapter 11, and refused to “erect a categorical bar to equitable mootness in the context of a Chapter 11 liquidation.” Id. at 957. The court found that the factors in the Paige test—in particular, the impact on reorganization, the costs created by ongoing litigation, and the benefits provided by a successful reorganization—enable courts to evaluate the propriety of equitable mootness within the context of a cash-only liquidation. Id. at 954 n.3, 956.
The court then applied the six-factor Paige inquiry and found that, among other things, the substantial consummation of the plan, the negative effects of reversing the plan on innocent third parties’ rights, and the need for creditors to be able to rely upon decisions of the bankruptcy court, weighed in favor of equitable mootness. Accordingly, the Tenth Circuit held that the district court did not abuse its discretion in dismissing Drivetrain’s appeal of the confirmed plan of liquidation as equitably moot.
In re Rumsey Land Co., LLC, 944 F.3d 1259, 1265 (10th Cir. 2019). Debtor Rumsey Land Company, LLC (“Rumsey”) commenced the adversary proceeding that spawned this appeal against Pueblo Bank & Trust Company, LLC (“PBT”) and Resource Land Holdings (“RLH”) in 2015, asserting, among other things, claims for fraudulent concealment and violations of section 363(n)’s prohibition on collusive bidding. The bankruptcy sale in question took place in 2011. The Tenth Circuit affirmed the decision of the district court dismissing the claims on various grounds, although the court emphasized that the alternative forms of relief demanded in connection with the section 363(n) claim needed to be addressed separately.
Rumsey filed for bankruptcy in January 2010. Soon thereafter, in March 2010, Rumsey sought to sell certain real property, encumbered by a first deed of trust held by PBT, to RLH for approximately $7.5 million. However, multiple creditors objected to the transaction and the bankruptcy court ordered that Rumsey market the property more broadly.
In December 2010, having failed to purchase the property directly from Rumsey in the bankruptcy sale, RLH signed a loan purchase agreement with PBT to purchase Rumsey’s debt. However, on February 1, 2011, PBT refused to close on the loan purchase agreement. Thereafter, RLH sued PBT to enforce the loan purchase agreement. Rumsey did not know about the loan purchase agreement or the lawsuit at the time.
Meanwhile, in March 2011, Rumsey obtained bankruptcy court approval of its sale and notice procedures. RLH submitted a $4 million stalking horse bid in cash. PBT submitted a competing $5 million credit bid as the stalking horse bid. Rumsey chose to proceed using PBT’s $5 million credit bid as stalking horse. Although a third party was selected as the winning bid in May 2011, when the successful bidder was not able to close in August 2011, Rumsey accepted PBT’s bid as the backup.
In September 2011, RLH and PBT settled their lawsuit. As part of the settlement, PBT and RLH agreed that RLH would buy the Rumsey property from PBT for $4.75 million after the bankruptcy sale. After the bankruptcy sale to PBT closed on October 6, 2011, PBT then transferred the property to RLH on October 13. Rumsey did not learn of this transaction until 2015, at which point Rumsey initiated the adversary proceeding against PBT and RLH, alleging six causes of action on the premise that they entered into a secret, collusive agreement that undermined the auction. After RLH filed a motion to withdraw the reference, the proceedings were transferred to the district court where summary judgment was granted on the merits on all six claims.
Only Rumsey’s fraudulent concealment claim and collusive bidding claim under section 363(n) were challenged on appeal. With regards to fraudulent concealment, as to RLH, the circuit court ruled that RLH was not a party to a business transaction with Rumsey and had no duty to disclose any information to Rumsey. As to PBT, the court ruled that Rumsey had waived its claim for fraudulent concealment against PBT because Rumsey failed to advance any specific arguments regarding PBT’s duty to disclose. With regard to the collusive bidding claim under section 363(n), the circuit court found that the district court had erred by considering both Rumsey’s claim for damages and avoidance of the bankruptcy sale barred by Federal Rule of Civil Procedure 60(c)(1). Instead, the court determined that the Rule 60(c)(1) limitation applied only to Rumsey’s claim to avoid the sale; the claim for damages was not barred by Rule 60(c)(1). Nonetheless, the district court did not err in its ruling because, as the circuit ruled, Rumsey had failed to prove that the purpose of PBT and RLH’s agreement was to control the price of Rumsey’s original section 363 sale.
§ 1.1.12 Eleventh Circuit
In re Bay Circle Properties LLC, 955 F.3d 874 (2020). The Eleventh Circuit Court of Appeals added further clarity to the parameters for standing to bring an appeal of a bankruptcy court order when it held that an individual who is not himself the owner of a parcel of real property on which a creditor foreclosed, but only asserts some undefined “beneficial” interest therein and claims to be the guarantor of underlying debt, lacked standing not only because he had suffered no injury but also because he was not a “person aggrieved” by an order of the bankruptcy court.
This case featured co-plaintiffs Chittranjan Thakkar (“Thakkar”) and DCT Systems Group, LLC (“DCT”), with which Thakkar claim to “affiliated.” Both Thakkar and DCT had separate loans issued by Wells Fargo. When DCT declared bankruptcy, both parties entered into a settlement agreement with the bank, offering two properties DCT owned and to which Thakkar asserted a “beneficial interest” as collateral for the loans. The settlement agreement included a deeds-in-lieu-of-foreclosure remedy, which allowed Wells Fargo to recover the encumbered property without necessity of a foreclosure judgment. At some point thereafter, Wells Fargo sold its interest in the settlement to Bay Point Capital Partners (“Bay Point”). DCT subsequently defaulted on the loans and Bay Point chose to record the properties deeds and pursue foreclosure on both properties. Two days before the foreclosure sale, DCT purported to offer $2.8 million in payment of the remaining debt to Bay Point, but Bay Point did not respond to the offer. Bay Point then sold the properties through the foreclosure sale for $2.85 million.
Thakkar and DCT sued Bay Point in state court, alleging that Bay Point’s foreclosure of the two properties caused Thakkar to lose the collateral’s value exceeding the debt balance and to suffer mental anguish. Bay Point removed the case to the U.S. Bankruptcy Court for the Northern District of Georgia and moved for judgment on the pleadings, which the bankruptcy court granted. The District Court for the Northern District of Georgia affirmed the bankruptcy court’s ruling in all respects. Originally, both Thakkar and DCT appealed to the circuit court, but DCT eventually settled with Bay Point, agreeing to relinquish all claims regarding the two properties. As a result, Thakkar became the sole appellant, challenging both Bay Point’s decision to record both properties deeds, as opposed to one, and Bay Point’s failure to accept the purportedly proper “tender.”
The Eleventh Circuit analyzed the three elements for Article III standing to determine that Thakkar alone did not have standing to bring the case because he had not suffered an injury personal to him. The court noted that DCT undoubtedly had standing, but since it had relinquished all claims, Thakkar could “no longer piggyback” on its standing. Since Thakkar pled that it was DCT that owned the two properties and failed to elaborate on his “beneficial interest” in DCT, the court could not find that Thakkar personally suffered an actual injury.
The court also found that Thakkar did not have standing under the “person aggrieved doctrine,” which limits the right to appeal a bankruptcy court order to those parties having a direct and substantial interest in the question being appealed. The standard imposes an additional limitation on constitutional standing, over and above Article III’s requirements. The court found that Thakkar’s inability to articulate his financial interest in DCT’s properties meant that he was not directly harmed by the bankruptcy court’s order. In addition, the Court dismissed Thakkar’s argument that the lack of “inherent fairness of the bankruptcy proceeding” was sufficient to meet the “person aggrieved” standard because his interest in the DCT properties did not fall within the scope of the Bankruptcy Code.
It has never been more important for organizations to enact purposeful agendas around workplace harassment and diversity, equity and inclusion (“DEI”). When implemented thoughtfully, high quality training programs can be vital and cost-effective tools for improving workplace culture while mitigating the significant risks the modern world carries.
Companies have long used training to meet compliance requirements. Harassment prevention training focuses on the difficult topic of sexual harassment, as well as other forms of harassment and discrimination. DEI training demonstrates how employees experience the workplace differently depending on their identities; how unconscious bias, microaggressions and other forms of exclusion cause harm; and how everyone can support DEI initiatives. Effective training should be deeply engaging and should reinforce your organization’s policies while providing practical tools for addressing issues that arise.
Traditionally, these issues have fallen to human resources, but in our current climate they represent enterprise risks that demand attention from the highest levels. It’s important for all risk and compliance professionals to grasp the real stakes of this training.
Understanding the Cost of Training
The true cost of harassment prevention and DEI training can be deceptive: it’s easy to focus on the price of obtaining the training, when in fact it is a small expense when measured against your total costs.
The first hidden cost to consider is the opportunity cost of your employees’ time while training. Like all-staff meetings costing thousands per minute, having everyone in an organization complete a training is inherently expensive. Employers are right to look for the highest quality training to ensure employees receive the greatest value and learning for time spent.
The cost of training administration is also easy to overlook. HR teams can invest significant time and money keeping records of completed trainings and managing annual and state-specific training for both employees and managers.
Online training has emerged as an option that delivers a consistent, convenient and impactful experience. Though training may cost thousands of dollars depending on organization size, it is powerful and easy to administer, especially with the shift to remote work.
Accounting for Risk
There is, however, even more to the cost story around this training. From a risk management perspective, these prevention costs are easily offset against the real risks of harassment and discrimination, or the failure of a company’s DEI efforts. There can also be a compliance component, depending on the state.
Of course, harassment and discrimination can have a lasting, harmful impact on those who endure it that organizations must consider first and foremost when planning prevention efforts. Beyond that, companies must consider the impact of costly lawsuits or administrative proceedings, in which damages and penalties can be significant if you lose, and legal fees in the hundreds of thousands even if you win. By adopting a comprehensive anti-harassment policy and providing adequate training, employers show that they’ve made good faith efforts to prevent harassment.
Training can even protect your company from claims for punitive damages, according to Kevin O’Neill, a principal at the employment law firm Littler. “If you have done effective training,” says O’Neill, “it has been deemed through case law to be one of the strongest mitigating factors to avoid punitive damages exposure.” The quality of training can also mitigate a company’s risk. High-quality training is a “huge element of proof and effectiveness when you have to show that you have done all that you could to prevent and correct the harassment,” says O’Neill.
Even more serious, however, are the indirect costs and risks to an organization, including:
Employee attrition, lost productivity and depressed morale. Employees who suffer harassment or an unfair environment are likely to leave, and replacing these employees costs employers billions of dollars annually. Even when employees don’t leave, failure to reckon with these issues can harm productivity and hamper innovation and collaboration for the victims and their colleagues alike.
Management and governance continuity risk. For years we’ve witnessed managers, executives, and board members resign for failing to respond effectively to harassment. This trend is only continuing.
Reputation and brand risk. Stakeholders, as well as regulators and the media, have high expectations that organizations will prevent harassment and discrimination and, increasingly, demonstrate real improvements in DEI. No organization is exempt, which is why companies are retiring out-of-date and offensive brands despite the massive cost.
Eroding customer and market position. Organizations that suffer reputational and brand damage can lose valuable customers and market positioning. The days when companies can remain neutral on these topics are over — your customers expect more.
Vendor risk and insurance costs. Failure to cure harassment can also lead to increased insurance costs and companies to be cut off from vendor relationships.
If you think spending four or five figures to obtain high-quality training is expensive, consider the costs of not advancing a safe and inclusive culture.
Making an Informed Selection
Given these risks and costs, it is vital that you select the highest quality provider that meets your needs. The bar for these training programs is high. Content needs to approach Netflix quality we’ve come to expect from subscription streaming services, or employees will tune out — programs that rely on stock videos and images or green screens are not compelling and will fail to have the needed impact.
Moreover, it’s important to work with a provider that has deep experience and is able to create program content that can genuinely influence employees. Free or low-cost options can be appealing when budgets are tight. However, saving money in this way carries its own risks. Employees are increasingly vocal about negative training experiences relating to these issues, and companies can find themselves embroiled in social media crises simply by selecting a low-quality option.
Investing in high-quality, comprehensive training is about more than just reducing risk and liability. As Sarah Rowell, CEO of Kantola Training Solutions, says: “It also has the ability to change behavior, if not that of an egregious harasser, then that of bystanders, managers, front line supervisors or oblivious offenders.”
Courses that address cultural trends and engage learners in real-world experiences will prepare employees to identify and address workplace issues. Immersive training that goes beyond checking boxes can change corporate culture and how employees experience the workplace, leading to real, lasting change.
Mantese Honigman, PC 1361 E. Big Beaver Road Troy, MI 48083 248.457.9200 www.manteselaw.com
Benjamin R. Norman Daniel L. Colston
Brooks, Pierce, McLendon, Humphrey & Leonard LLP 2000 Renaissance Plaza 230 North Elm Street Greensboro, NC 27401 336.271.3155 www.brookspierce.com
Thomas Rutledge
Stoll Keenon Ogden PLLC 500 West Jefferson Street, Suite 2000 Louisville, KY 40202 502.333.6000 www.skofirm.com
Jennifer Rutter
Gibbons P.C. 300 Delaware Avenue, Suite 1015 Wilmington, DE 19801 302.518.6320 www.gibbonslaw.com
Michael J. Tuteur Andrew C. Yost
Foley & Lardner LLP 111 Huntington Avenue, Suite 2600 Boston, MA 02199 617.342.4000 www.foley.com
Marc E. Williams Alex C. Frampton
Nelson Mullins Riley & Scarborough LLP 949 Third Avenue, Suite 200 Huntington, WV 25701 304.526.3500 www.nelsonmullins.com
Stephen P. Younger Muhammad U. Faridi Louis M. Russo
Patterson Belknap Webb & Tyler LLP 1133 Avenue of the Americas New York, NY 10036 212.336.2000 www.pbwt.com
§ 1.1 Introduction
The 2021 Recent Developments describes developments in business courts and summarizes significant cases from a number of business courts with publicly available opinions.[1]
There are currently functioning business courts of some type in cities, counties, regions, or statewide in twenty-four states: (1) Arizona; (2) Delaware; (3) Florida; (4) Georgia; (5) Illinois; (6) Indiana; (7) Iowa; (8) Kentucky; (9) Maine; (10) Maryland; (11) Massachusetts; (12) Michigan; (13) Nevada; (14) New Hampshire; (15) New Jersey; (16) New York; (17) North Carolina; (18) Ohio; (19) Pennsylvania; (20) Rhode Island; (21) South Carolina; (22) Tennessee; (23) West Virginia; and (24) Wisconsin.[2] Wyoming has established a Chancery Court, which is not yet operational at the time of this writing in 2020.[3] States with dedicated complex litigation programs encompassing business and commercial cases, among other types of complex cases, include California, Connecticut, Minnesota, and Oregon.[4] The California and Connecticut programs are expressly not business court programs as such.[5
§ 1.2 Recent Developments
§ 1.2.1 Business Court Resources
American College of Business Court Judges. The American College of Business Court Judges (ACBCJ) provides judicial education and resources, in terms of information and the availability of its member judges, to those jurisdictions interested in the development of business courts.[6] The ACBCJ’s Fifteenth Annual Meeting took place in Savannah, Georgia from October 28, 2020 to October 30, 2020.[7] Like much else in 2020, the meeting focused on COVID-19’s impact. Among other topics, the meeting addressed shareholder value, business interruption insurance and COVID-19, the impacts of emergency relaxation of licensing and other regulatory requirements in response to COVID-19, state court receiverships in light of COVID-19’s economic impact, docket and court resource management, pharmaceutical regulation, and force majeure and frustration of contract.
Section, Committee, and Subcommittee Resources.In 2020, The Business Lawyer’s 75th Anniversary edition published two articles on business courts. The first article, Through the Decades: The Development of Business Courts in the United States of America,[8] by attorneys Lee Applebaum, Mitchell Bach, Eric Milby and Richard Renck, completes a trilogy of Business Lawyer articles on the history and development of business courts.[9] The second, an essay by Michigan business court judge Christopher P. Yates, The ABA’s Contribution to the Development of Business Courts in the United States,[10] provides an overview of the Section of Business Law’s 25-year involvement in developing business courts.
The Section of Business Law has created a pamphlet, Establishing Business Courts in Your State.[11] The Business and Corporate Litigation Committee’s Subcommittee on Business Courts provides 150 documents and/or hyperlinks to business court resources.[12] This includes links to public sources and legal publications, as well as business court related materials and panel discussions presented at ABA Section of Business Law meetings. The Section’s Judges Initiative Committee also provides links to business court resources, such as judicial opinions published by various business courts, and standardized forms used in business and complex litigation courts. [13] The Section also has established a Business Courts Representatives (BCR) program,[14] where a number of specialized business, commercial, or complex litigation judges are selected to participate in and support Section activities, committees, and subcommittees. These BCRs attend Section meetings, and many have become leaders within the Section. The Section also has a Diversity Clerkship Program that sponsors second year law students of diverse backgrounds in summer clerkships with business and complex court judges.[15] Finally, this publication has included a chapter on updates and developments in business courts every year since 2004.
Other Resources. “The National Center for State Courts (NCSC) and the Tennessee Administrative Office of the Courts have developed an innovative training curriculum[16] and faculty guide[17] – along with practical tools – to help state courts establish and manage business court dockets more efficiently and effectively.”[18] The Business Courts Blog[19] aims to serve as a national library to those interested in business courts, with posts on past, present, and future developments. This includes posts on reports and studies going back twenty years,[20] as well as recent developments in business courts. In 2020, in addition to the two Business Lawyer articles mentioned above, there were other articles and reports addressing some aspects of business courts.[21] There are also various legal blogs addressing business courts in particular states.[22]
§ 1.2.2 Developments in Existing Business Courts
Arizona Commercial Court
In 2019, the Commercial Court became a permanent part of the Arizona judicial system after operating as a pilot program since 2015.[23] The Commercial Court hears cases seeking monetary relief in excess of $300,000 that involve business organizations or business transactions.[24] Both plaintiffs and defendants can request assignment to the Commercial Court, and it is mandatory that all qualifying cases proceed in Commercial Court.[25]
There were no substantial changes to the structure or rules of the Commercial Court in 2020. In a year of countless unknowns and unanticipated delays, as courts nationwide transitioned from in person hearings to remote proceedings, the Commercial Court carried on. In 2020, the Commercial Court heard matters ranging from contract disputes regarding commercial lease spaces[26] to temporary injunctions challenging executive orders in the wake of COVID-19.[27] While still in its infancy, the Commercial Court has become an indispensable part of Arizona’s judicial process.
Florida’s Complex Business Litigation Courts
Regular readers of this update will recall that the Ninth Judicial Circuit’s complex business litigation (CBL) court re-opened last year after a one-year closure due to funding limitations. With the re-opening of the court, the Ninth Judicial Circuit took the opportunity to revise the jurisdiction of its sole CBL court.[28] The original administrative order establishing the court’s jurisdiction provided for blanket jurisdiction over eleven general case types without any minimum amount-in-controversy requirements (and also specifically identified certain case types that are not generally assigned to the CBL division). The amended administrative order now provides for jurisdiction over 16 case types (but makes no changes to the list of specifically excluded case types), the majority of which have a $500,000 minimum amount-in-controversy threshold.[29] Additionally, the order provides that, for those cases with an amount-in-controversy requirement, plaintiffs must set forth the actual amount at issue in the matter in their complaint, rather than simply pleading that the amount at issue is in excess of the threshold.[30]
As it was last year, Florida is lucky enough to have six circuit court divisions dedicated to resolving CBL. Florida’s six CBL judges are spread across Orange County (Ninth Judicial Circuit), Miami-Dade County (Eleventh Judicial Circuit), Hillsborough County (Thirteenth Judicial Circuit), and Broward County (Seventeenth Judicial Circuit). The judges currently assigned to hear CBL cases are: Judge John E. Jordan (Division 01) in Orlando,[31] Judges Michael A. Hanzman (Division 43) and William Thomas (Division 44) in Miami,[32] Chief Judge Jack Tuter (Division 07) and Judge Patti Englander Henning (Division 26) in Fort Lauderdale,[33] and Judge Darren D. Farfante (Division L) in Tampa.[34] Judges Michael A. Hanzman and John E. Jordan began their respective CBL assignments during 2020, and Judge Darren D. Farfante began his CBL assignment in January 2021.
Cases may be directly filed or reassigned/transferred to a complex business division based on a number of factors, including: the nature of the case; complexity of the issues; complexity of discovery; number of parties in the case; and specific criteria enumerated by each circuit.
Indiana Commercial Courts
In August 2020, the Indiana Office of Court Services created a new beta search engine for substantive Indiana Commercial Court Orders.[35] The database allows users to narrow their search by date and the specific commercial court. Users are encouraged to provide feedback, as the Court staff works to identify and build historical content.
Additionally, the Indiana Commercial Courts Handbook, which is updated regularly, continues to be an aid for both judges and attorneys, covering topics such as case management conferences, discovery, and trial preparation, and including sample case documents and forms.[36]
On January 1, 2021, Indiana’s Commercial Court expanded to four new counties, bringing the total number of counties with a Commercial Court to ten.[37]
Iowa Business Specialty Court
The goal of the Iowa Business Specialty Court (Iowa Business Court) is to provide litigants with an expeditious and cost-effective court system where parties and their attorneys can have their cases heard before one of five judges with business litigation experience.[38] The Iowa Business Court became a component of the Iowa court system in 2016.[39] Since its inception, the Iowa Business Court has disposed of 69 cases and approximately 37 cases are pending.[40]
A case is eligible for the Iowa Business Court if it meets or exceeds $200,000 in compensatory damages or the claim primarily seeks injunctive or declaratory relief.[41] The case must also meet one of nine dispute types, including but not limited to business disputes involving breach of contract, fraud, or misrepresentations and tort claims between or among business entities.[42]
Starting January 1, 2020, the State Court Administrator is expected to report findings from annual reviews and make recommendations for the Iowa Business Court’s improvement to the Iowa Supreme Court.[43]
Michigan Business Courts
In response to the Coronavirus pandemic, the Michigan Supreme Court issued nineteen administrative orders addressing modifications to court protocol.[44] Perhaps the most noteworthy is Administrative Order 2020-6 (AO 2020-6), dated April 7, 2020.[45] This requires all Michigan judges to “conduct proceedings remotely whenever possible using two-way interactive videoconferencing technology…,” like Zoom. The effects of AO 2020-6 hit Michigan courts almost overnight.[46] In fact, the statewide justice system surpassed one million hours of Zoom hearings in six months.[47] Today, Zoom proceedings have become common practice for Michigan courts, including business courts, with Zoom proceedings ranging from status conferences to motion hearings and bench trials. Douglas L. Toering polled many of the Michigan business court judges on their use of Zoom for the Michigan Business Law Journal. The consensus was clear: Zoom proceedings are “here to stay.”[48]
To address various concerns about court proceedings via Zoom, the Michigan State Court Administrative Office released the Michigan Trial Courts Virtual Courtroom Standards and Guidelines on April 7, 2020 (revised August 5, 2020).[49] These guidelines recommend that courts and parties agree in advance as to how exhibits will be displayed to witnesses. Additionally, the revised guidelines address concerns as to potential witness coaching. Courts may now, sua sponte, order parties to readjust cameras so that all present persons are visible. AO 2020-6 directly addressed Michigan’s backlogged dockets stemming from this public health crisis by directing that “all matters…proceed as expeditiously as possible under the circumstances….” This is consistent with one of the purposes of the Michigan business court statute, which is to resolve business disputes with the “expertise, technology, and efficiency required by the information age economy.”[50] Opinions from the Michigan business court judges continue to be posted on a comprehensive website, which includes twenty-five categories of business court opinions. In February 2020, a new category, “Discovery,” was added.
New York Commercial Division
Justice Robert Reed Appointed to New York County Commercial Division. On October 5, 2020, just days after Justice Peter Sherwood and Justice Marcy Friedman announced their upcoming retirements from the bench, the Chief Administrative Judge announced the news that Justice Robert Reed would join the New York County (Manhattan) Commercial Division. Justice Reed started hearing cases in the Court in October 2020.[51]
Rule 11-g Amended to Include “Attorneys Eyes Only” Designation. On September 23, 2020, Chief Administrative Judge Marks amended Commercial Division Rule 11-g and the Division’s Standard Form Confidentiality Order (SFO) to allow parties to designate certain documents as highly confidential for attorney’s eyes only (AEO). Such a designation already exists in federal court, and it will be useful in the Commercial Division in matters involving particularly confidential issues such as the disclosure of confidential business information between competitors and disclosure of trade secrets.[52]
Rule 6 Amended to Require Hyperlinking in Documents. On September 29, 2020, Chief Administrative Judge Marks amended Commercial Division Rule 6, effective November 16, 2020. The amendments consist of adding subsections (b) and (c) concerning the use of hyperlinks and bookmarks in electronically filed documents.[53] Hyperlinking is to external documents, and bookmarks link to other parts of the same document. Hyperlinking to docketed documents is required unless those documents are under seal. In addition, a court “may require that electronically submitted memoranda of law include hyperlinks to cited court decisions, statutes, rules, regulations, treatises, and other legal authorities in either legal research databases to which the Court has access or in state or federal government websites. If the Court does not require such hyperlinking, parties are nonetheless encouraged to hyperlink such citations unless otherwise directed by the Court.”
Philadelphia Commerce Court’s Temporary Financial Monitor Program in Response to COVID-19 Business Crisis
Philadelphia’s Court of Common Pleas has considerable experience in creating programs responsive to financial crises.[54] In that tradition, a new program has been created in Philadelphia’s Commerce Court, the Temporary Financial Monitor Program. This program will use volunteer lawyers and accountants as Temporary Financial Monitors (TFM) “to provide assistance to keep local enterprises operational,” during the COVID-19 pandemic. There is a petition process for bringing troubled businesses and their creditors into the program. Once a matter is initiated, the TFM “shall be responsible for evaluating the financial information provided by the petitioning entity and, upon consultation with the entity and its creditors, shall prepare a proposed Operating Plan to enable the entity to resume and/or continue operations while paying off its accumulated debts.”
The program will be under Commerce Court Supervising Judge Gary S. Glazer’s general supervision. The Court’s enabling Order[55] observes that the Commerce Court has jurisdiction over “disputes between or among two or more business entities and handles dissolution and liquidation of business entities,” and “takes judicial notice that the COVID-19 pandemic has caused significant economic harm to local for-profit businesses and non-profit institutions, many of which were forced to close for lengthy periods of time and have been unable to generate sufficient income to pay their debts or retain their staff, and it appears that the current economic climate threatens their ability to operate in the future….”
The enabling Order has six parts: (1) “Establishment and Eligibility of the Monitor Program”; (2) “Assignment to Monitor the Program”; (3) “Information to be included in the Petition”; (4) “Court Review and Assignment of Temporary Financial Monitor”; (5) “Duties and Obligations of Temporary Financial Monitor”; and (6) “Termination or Conclusion of Assignment of Temporary Financial Monitor”.
Rhode Island Superior Court Business Calendar Non-Liquidating Receivership Program, and Protocols during COVID-19 Pandemic
On March 31, 2020, Rhode Island Superior Court Presiding Justice Alice Gibney entered an Order allowing the Superior Court Business Calendar to administer a more measured response to the COVID-19 crisis in the form of a business protection/recovery program, designated the “COVID-19 Non-Liquidating Receivership Program.”[56] The purpose of the Program is to allow the Business Calendar of the Superior Court to supervise and provide protection from creditors through injunctive relief for eligible Rhode Island business entities in order that they might remain operational while seeking new capital and rearranging their debt structure. This is not, however, a debt discharge program.
Under the Order, a business entity, including a sole proprietorship, which was not in default of its obligations as of January 15, 2020, may voluntarily seek to be petitioned into a Non-Liquidating Receivership, whereby the business entity may demonstrate eligibility for the Program, have a Temporary Non-Liquidating Receiver appointed, and while protected by a Superior Court injunction and stay order, proceed to secure the approval of the Superior Court of a “Recommended Operating Plan,” whereupon the Temporary Non-Liquidating Receiver may be appointed as the permanent Non-Liquidating Receiver to administer the Program. During the non-liquidating receivership, management remains in place and must develop an operating plan to address its pre-receivership debts and continue to pay current debts as they become due. If the business defaults on its plan, the court may convert the case to a liquidating receivership. The ultimate objective being that a Receivership Business might exit the Non-Liquidating Receivership as a viable continuing business under order of the Superior Court.
On the same date of March 31, Presiding Justice Gibney also entered an Order identifying the Program Coordinators, who under Section 8(b) of the Order are assigned to interface with members of the Bar to assist business entities in entering the Program, and to provide other services relating thereto.
On April 21, 2020, Rhode Island Superior Court Business Calendar Justices Brian P. Stern and Richard A. Licht issued an Order setting forth “Protocols” for “Providence and Out-County Business Calendars—Proceedings during COVID-19 Crisis.”[57] This order provides the procedural rules for matters to be considered on the Superior Court business calendar. All matters are to be done remotely. Parties may request that a matter be decided on the pleadings. If a matter cannot be determined on the pleadings, the hearing will be held remotely by WebEx Videoconferencing. Parties may also request a conference with a judge by emailing the request to the judge’s clerk. Conferences will also be held by WebEx Videoconference.
Tennessee Business Court
This year, the Tennessee Administrative Office of the Courts, in collaboration with the National Center for State Courts and the State Justice Institute, developed and released an innovative curriculum and training guide designed to help states establish and manage business court dockets.[58] The curriculum was developed as part of Tennessee’s Business Court Docket Pilot Project, which was initially established in 2015 to address complex corporate and commercial cases.[59]
The training program will help other states that are embarking on the creation of their own business courts by providing them with a blueprint for managing their own business court dockets.
West Virginia Business Court Division
In the past year, 14 motions to refer cases to the West Virginia Business Court Division were filed. Of these, 10 were granted. Since its inception, there have been 179 motions to refer filed, with a total of 103 of those motions granted. The Business Court Division has resolved 86 of these. Currently, there are 17 cases pending before the Business Court Division with an average age of 451 days.[60]
Wisconsin Commercial Docket Pilot Project
On April 11, 2017, Wisconsin’s Supreme Court issued an order creating a “pilot project for dedicated trial court judicial dockets for large claim business and commercial cases.”[61] The order includes an appendix with interim rules.[62] A majority of the court approved the pilot project, with a written dissent from two of the seven justices. The original three-year pilot program began on July 1, 2017, and was established in Waukesha County and in Wisconsin’s Eighth Judicial Administrative District.[63] In February 2020, the program was extended to 2022 to include the Second and Tenth Judicial Districts and Dane County.[64] The commercial docket pilot program may be expanded in the future to other Wisconsin counties and districts. The new court rules allow for cases outside these regions to be heard within the new docket, subject to the discretion of the chief judge within the regions.
The new docket includes both mandatory and discretionary case assignment. There are seven categories of cases subject to mandatory assignment. These include: (1) internal business organizational claims; (2) prohibited business activity (e.g., “tortious or statutorily prohibited business activity, unfair competition or antitrust . . . claims of tortious interference with a business organization; claims involving restrictive covenants and agreements not to compete or solicit; claims involving confidentiality agreements”); (3) business sale/ consolidation/ merger; (4) sale of securities; (5) intellectual property rights; (6) franchisor/ franchisee claims; and (7) UCC claims greater than $100,000.[65] The categories of cases were expanded in 2020 to include (8) receiverships in excess of $250,000; (9) confirmation of arbitration awards and compelling/enforcing arbitration awards; and (10) cases involving commercial real estate construction disputes over $250,000. There is also a specific list of excluded cases, including consumer claims, claims where a government entity is a party, and disputes involving enforcement of various civil rights, environmental, and tax statutes and regulations.[66] Discretionary inclusion exists for cases that are neither expressly mandatory nor excluded. Under the new rules, parties may jointly move the chief judge of the judicial administrative district in which the Commercial Court sits for discretionary assignment of a case to the Commercial Court docket. The chief judge of the judicial district shall consider the parties to the dispute, the nature of the dispute, the complexity of the issues presented, and whether the Commercial Court’s resolution of the case will provide needed guidance to influence future commercial behavior or assist in resolving future disputes.[67] The chief judge’s decision cannot be appealed.
The rules set out the parties’, judges’, and court clerks’ roles in case assignment, and the court has created forms to be used in connection with commercial docket cases. A training program for clerks of court has been initiated so that they better recognize when a case qualifies as a commercial case under the program. The pilot program also establishes recommended customs and practices for judges assigned to the commercial court dockets including ESI awareness and case management, timing of mediation, early consideration of protective orders, regular status conferences, and written published decisions.
Since its inception in 2017, the commercial docket has handled 103 total cases, 69 of which are now closed.[68] The commercial docket has published sixteen decisions, ten from 2019 and 2020 alone.[69] The vast majority of the cases have dealt with prohibited business activities or internal business organization (71 of 103) and have been resolved within six months of filing (48 of 61).
§ 1.2.3 Other Developments
State-wide Business Court in Georgia Begins Operations
Georgia’s new State-wide Business Court officially began its operations in 2020, with Judge Walter W. Davis serving as the first judge of the court.[70] The State-wide Business Court has jurisdiction to hear a wide variety of claims relating to disputes involving corporations, partnerships, or other business entities, including those arising under Georgia’s Uniform Commercial Code, Uniform Securities Act, Business Corporation Code, and Trade Secrets Act.[71] Cases involving only claims for damages must have an amount-in-controversy of at least $500,000 ($1 million for cases involving commercial property) to fall within the jurisdiction of the State-wide Business Court. Cases may be filed directly with the State-wide Business Court or transferred to the State-wide Business Court from another state court if one or more parties files a petition for transfer within 60 days after service of a pleading that is within the jurisdiction of the State-wide Business Court.[72] The State-wide Business Court began accepting case filings on August 1, 2020 but has not yet issued any substantive opinions. Proposed rules for the State-wide Business Court were developed by an eight-person rules commission consisting of private lawyers, judges, and a law professor, and these rules must be approved by the Georgia Supreme Court before taking effect.[73] The State-wide Business Court does not replace the Metro Atlanta Business Case Division, which continues to adjudicate business disputes in Fulton and Gwinnett Counties.
Kentucky’s Business Court Docket
Kentucky began its experiment with the business courts with the Business Court Docket of the Jefferson County Circuit Court, it becoming effective January 1, 2020. While it is anticipated that the Business Court Docket of the Jefferson Circuit Court will be emulated in other counties, no additional steps have yet been taken in that direction, no doubt consequent to both the early stage of the effort in Jefferson County (which comprises Louisville, the largest city in the state) and as well the COVID-19 pandemic of 2020. Currently, the judges on the Business Court Docket are Charles Cunningham and Angela McCormick-Bisig. Only cases filed on or after January 1, 2020 have been eligible for assignment to the Business Court Docket. Through October 30, 2020, sixty-nine cases have been assigned to the Business Court Docket. For example, as of the end of August, cases currently pending included:
a breach of contract action against a municipal authority with respect to roadwork;
a dispute between a homeowners association and a condo owner with respect to short-term leases;
challenges to noncompetition limitations in an employment agreement;
several actions for breach of real estate lease agreements;
a dispute over a lease of the commercial hauling vehicle;
trademark infringement with respect to sport official uniforms;
a dispute between a subcontractor and the general contractor with respect to work performed on an elementary school renovation;
an action for breach of an employment agreement and violation of wage and hour laws based upon failure by a defendant to pay the plaintiff;
an action for breach of a real estate purchase agreement and specifically the failure to pay taxes due; and
an action for breach of contract and fraud in the failure to install swimming pools.
Substantive descriptions of the Business Court Docket are published on the Business Court Docket webpage of the Kentucky Department of Justice website.[74] The only decision published to date was rendered by Judge McCormick-Bisig in the case of Isco Industries, Inc. v. O’Neill.[75] In a judgment entered on June 2, 2020, a temporary injunction was denied in connection with a suit brought based upon the defendant’s alleged violation of the terms of certain restrictive covenants he entered into as an employee of the plaintiff, that denial of the injunctive relief being based upon the plaintiff’s failure to carry its burden.
Pennsylvania Legislation to Create Statewide Appellate and Trial Level Commerce Courts
Pennsylvania’s Legislature unanimously adopted legislation,[76] Senate Bill 976, to create Commerce Courts in the Superior Court of Pennsylvania, an intermediate appellate court, as well as in Pennsylvania’s trial courts, the Courts of Common Pleas. Senate Bill 976 was submitted to Governor Wolf on October 26, 2020, and signed into law on November 3, 2020.[77] This new statute creates the first appellate business court in the United States. It ultimately remains within each court’s discretion, however, whether to create Commerce Courts within their jurisdictions.
Pennsylvania has two existing business courts. The Philadelphia Court of Common Pleas has a twenty-year-old Commerce Case Management Program,[78] and the Allegheny County Court of Common Pleas in Pittsburgh has had its Commerce and Complex Litigation Center[79] since 2007.[80] The new law should not require any changes in these well-established programs. The legislation also gives Pennsylvania’s Supreme Court authority to create an advisory council, and the position of Commerce Court coordinator to work with the Courts of Common Pleas in establishing and developing Commerce Courts.
The legislation includes identical subject matter jurisdiction for the appellate and trial level Commerce Courts, identifying two basic areas: (1) a wide range of internal business disputes and (2) “disputes between or among two or more business enterprises relating to a transaction, business relationship or a contract.” This contrasts to some degree with the more detailed list of case types used to define subject matter jurisdiction in Philadelphia’s Commerce Court, but the basic concept is the same, i.e., jurisdiction is limited to business and commercial disputes only. Both the Superior Court and Courts of Common Pleas may adopt rules governing their Commerce Courts, but these rules must be consistent with the general rules of court established by Pennsylvania’s Supreme Court. The new statute also makes clear that it does not alter the Superior Court’s jurisdiction.
Notably, the legislature is neither going to provide additional funding for any of these Commerce Court programs, nor for the coordinator position or advisory committee.
Wyoming Chancery Court
In March 2019, the Wyoming Legislature established the Chancery Court of the State of Wyoming.[81] The Wyoming Supreme Court has been vested with the overall creation, management, supervisory powers, and the authority to promulgate rules of civil procedure for the new chancery court by January 1, 2020.[82]
With rulemaking underway through the newly created Chancery Court Committee, which was created and appointed by the Wyoming Supreme Court and made up of Judges, practitioners, court clerks, and various representatives from State Government, Wyoming is actively building out an administrative framework for Wyoming Chancery Court launch within the next two years.
The Wyoming Chancery Court is a court of limited jurisdiction, hearing cases related only to commercial, business, trust disputes or disputes relating to topics as discussed below.[83] The court is further limited to presiding over cases where the relief sought is in equity, declaratory relief or monetary damages in excess of $50,000 excluding punitive or exemplary damages, attorneys’ fees, costs, etc.[84] In addition, matters coming before the court must be accompanied with a filing fee of no less than $500.[85] The Wyoming Chancery Court strives for an efficient and expeditious disposition of matters before the court and as such, cases are to be resolved within one hundred and fifty (150) days from the date of filing.[86] As a result of such expeditious resolution of disputes, the Wyoming Chancery Court provides no supplemental jurisdiction to claims that are not specifically covered in the statute.[87] The chancery court shall comprise of a maximum of three (3) judges who meet the statutory requirements to preside over matters coming before the court.[88] However, initially the Wyoming Supreme Court is enabled to employ a panel of sitting District Court Judges to serve as the initial Chancery Court Judges. Pending Wyoming legislation may extend the allowable use of this panel until 2026.[89]
Though the new Wyoming Chancery Court’s jurisdiction is limited in nature, the scope of matters the court may preside over includes a wide variety of legal topics such as breach of contract, fraud, misrepresentation, environmental insurance coverage, transactions governed by the UTC and commercial class actions, securities, corporate law, and general business matters, to name a few. Additionally, the court may preside over cases related to entity dissolutions, but the monetary minimum in such cases is waived by the court.[90]
The Wyoming Rules of Civil Procedure for Chancery Court take effect November 15, 2020, and provide litigants with ample resources to resolve all their commercial and business disputes, including an electronic database to search cases and matters resolved in the court and advanced courtroom technology for remote attendance by participants.[91] Given the plethora of attractive corporate features Wyoming provides for businesses, adding this new chancery court feature should propel more corporate action in the Equality State.
§ 1.3 2020 Cases
§ 1.3.1 Arizona Commercial Court
Mountainside Fitness Acquisitions, LLC v. Ducey[92](Demonstrating the diversity of commercial disputes adjudicated by the Commercial Court, which include issues of Constitutional law). In response to the Coronavirus pandemic, the State of Arizona issued Executive Order 2020-43, which provided that “indoor gyms and fitness clubs or centers had to pause operations until at least July 27, 2020” and further required the gyms, clubs, and centers to “complete and submit” a state health department form proving their “compliance with guidance issued by [the health department] related to COVID-19 business operations.” The form did not “give fitness centers an opportunity to re-open during any mandatory shutdown period. Rather, gyms that fill out the form must attest that they will remain closed through any mandatory shutdown periods.” Mountainside Fitness, a gym operating in Arizona, challenged the Executive Order, arguing that it violated their “Constitutionally-protected post-deprivation procedural due process rights and substantive due process rights” and sought injunctive relief.
The Commercial Court first considered whether gyms had a Constitutionally protected property interest to conduct business. The Court answered affirmatively. The Court found that “the government forcing a business to shut down indefinitely, to the point where it might not be able to survive, implicates a property interest.” Having found a Constitutionally protected interest, the Court considered the “unprecedented” nature of the Executive Order to determine that it was neither legislative or quasi-legislative, thus requiring the State to afford the businesses due process. The Court reasoned that the State had not afforded the gyms procedural due process, as there was no “system for applying to reopen” but had satisfied the requirements of substantive due process, because there was “some rational basis” for the Executive Order. Upon weighing the hardships and determining the indefinite nature of the gym closures, the Court ordered the state to provide the gyms post-deprivation due process in the form of an opportunity to apply for reopening.
§ 1.3.2 Delaware Superior Court Complex Commercial Litigation Division
Specialty Dx Holdings v. Lab. Corp. of Am. Holdings[93](Active participation in litigation will waive a contractual right to arbitration). In Specialty Dx Holdings, the parties entered into an asset purchase agreement containing an arbitration clause. The plaintiffs originally filed an action in the Delaware Court of Chancery for breach of contract. After the defendant filed a motion to dismiss one of five counts relating to the breach, and it was fully briefed by the parties, the Court of Chancery transferred the case to the Superior Court’s CCLD. The Superior Court ordered supplemental briefing on the motion to dismiss, held a hearing, and issued an extensive opinion staying the dismissal pending arbitration. Two months later, the defendant filed a second motion to dismiss. In its second motion to dismiss, the defendant argued for the first time that the court lacked subject matter jurisdiction over the remaining counts for breach due to the asset purchase agreement’s arbitration clause. Specifically, it argued that lack of subject matter jurisdiction due to an arbitration agreement cannot be waived. The court expressly rejected this argument. Although Delaware’s policy strongly supports the resolution of matters through arbitration, the court will not allow parties to waste the court’s limited resources and “test the waters” through litigation before asserting their contractual right to arbitration. The court reiterated that the goal of arbitration is to secure the speedy and efficient resolution of disputes, which is not how the defendant proceeded here. Therefore, although the court agreed that the additional counts were subject to arbitration, it held that the defendant waived its right to arbitration through its litigation conduct.
Infomedia Group, Inc. v. Orange Health Solutions, Inc.[94](Sophisticated parties’ agreements to limit their reliance to contractual interpretations will be enforced). Pursuant to an asset purchase agreement, the buyer purchased the seller’s rights and obligations under a series of service contracts. In performing its due diligence, the buyer specifically asked the seller whether any of its customers had expressed an intent to change or terminate their contracts as a result of the proposed sale. On several occasions during negotiations, the seller represented to the buyer that it was not aware of any such issues. But two weeks before signing the asset purchase agreement, the seller had in fact received oral notice from a customer that it intended to terminate its contract. Under the terms of the asset purchase agreement, however, the seller only represented that it had not received written notice from any customers of an intent to terminate their contract. Because the contract contained an anti-reliance clause, and the parties to the agreement were sophisticated, the court held that the buyer could not state a claim for fraudulent inducement or negligent misrepresentation based on extra-contractual representations. “Rather, sophisticated parties are free to limit the possibility of future claims of fraud or misrepresentation by contractually specifying what representations the parties are and are not making and relying upon.” This decision upholds Delaware’s firm public policy against fraud while preserving its abundant body of precedent enforcing sophisticated parties’ contracts as written.
Ferrellgas Partners L.P. v. Zurich Am. Ins. Co.[95](Reasonable invoices for fees can be submitted in support of declaratory judgment enforcement). In Ferrellgas Partners L.P., the plaintiffs sought declaratory relief against their insurance companies for the alleged breach of director and officer liability policies based on the insurance companies’ failure to pay defense costs in excess of $1,000,000.00. The court granted the plaintiffs’ motion for partial summary judgment requiring one of the defendant insurance companies to advance and reimburse the plaintiffs’ defense expenses for the underlying litigation. When the insurance company failed to make those payments, the plaintiffs renewed their previous request for declaratory relief rather than seek a rule to show cause as to why the insurance company should not be held in contempt for failure to comply with the court’s order requiring payment. The court again held that the plaintiffs are entitled to advancement for reasonable fees, and that the burden is on the advancement claimant to prove the reasonableness of the fees. It did not require the insured to further seek the entry of a final monetary judgment to enforce its rights. Notably, the court detailed the exact procedure to be used for advancement requests going forward by referring to the well-established and time-tested protocol used in the Delaware Court of Chancery.[96] The court required the parties to follow the Fitracks-style protocol of invoice submission, review, and dispute resolution going forward and for those invoices to be unredacted to the greatest extent possible.
§ 1.3.3 Florida’s Complex Business Litigation Courts
In Re: Assignment for the Benefit of Creditors of Miami Perfume Junction, Inc.[97](Power to hold and assert attorney- and accountant-client privileges passed from assignors to Chapter 727 assignee upon executions of assignments for the benefit of creditors). Four insolvent companies executed assignments for the benefit of creditors pursuant to Chapter 727, Florida Statutes. Although the assignments expressly included all company books, records, and electronic data, the assignors subsequently challenged their assignee’s ability to review pre-assignment communications between assignors and their counsel and accountants, as well as the assignee’s right to subpoena privileged communications from the assignors’ former counsel. After the assignee moved for a ruling from the court on the issue, Judge William Thomas of the 11th Judicial Circuit’s Complex Business Litigation division granted the assignee’s motion and found that control of the privileges passed to the assignee by virtue of the assignments. In coming to his decision, Judge Thomas considered the purpose of Chapter 727 and the nature of a Chapter 727 assignee’s duties, and found that the assignee would be unable to fully or effectively discharge his obligations without full and complete access to all books, records, and communications of the corporation. The assignors appealed the ruling to the Third District Court of Appeal, which denied their petition for writ of certiorari.
Luzinski v. Bond[98](Chapter 727 assignee can, on behalf of assignor corporation, bring claims in Florida where forum selection clause provides that corporation may consent to jurisdiction outside of Delaware). An insolvent Delaware corporation headquartered in Hillsborough County, Florida executed an assignment for the benefit of creditors under Chapter 727. When the assignee brought claims for breach of fiduciary duty against the former officers and directors of the assignor in Hillsborough County, the defendants moved to dismiss on the basis of a forum selection clause in the assignor’s articles of incorporation. The clause provided that Delaware was the exclusive jurisdiction for certain types of claims, including claims against the officers and directors, but that the corporation could consent to litigating such claims in other venues. Arguing that the assignee was not empowered to take what the defendants alleged were the “general corporate acts” of bringing the claim and consenting to jurisdiction outside of Delaware, the defendants urged Judge Scott Stephens of the 13th Judicial Circuit’s Complex Business Litigation Division to dismiss the case for improper venue. During the hearing on the motion to dismiss, Judge Stephens found that the ability to consent to the suit being brought in a particular place passed to the assignee with the execution of the assignment, and denied the motion to dismiss. The defendants have appealed the ruling to the Second District Court of Appeal.
§ 1.3.4 Indiana Commercial Court
Frontier Prof’l Baseball, Inc. v. Murphy[99](Denying defendant’s motion to dismiss for lack of personal jurisdiction). In Frontier, defendant Ysursa, an attorney licensed in Illinois and Missouri, had served as outside counsel to Frontier from 2009 until early 2019. Frontier sought advice from Ysursa, during the course of a shareholder derivative action in an Indiana federal court. Despite advising Frontier that he could not represent it because he was a potential witness and recommending the selection of Murphy as litigation counsel, Ysursa continued to provide substantive advice for the duration of the federal case. On January 4, 2019, Frontier filed a legal malpractice action in Indiana Commercial Court against multiple defendants including Ysursa, as a result of the defendants’ handling of the federal court action.
On August 5, 2019, the Court denied Ysursa’s Motion to Dismiss for Lack of Personal Jurisdiction. The Court found that while Ysrusa may not have had a substantial number of contacts with Indiana prior to or even during the federal lawsuit, his alleged involvement related directly to the actions which constituted the malpractice that was said to have occurred during that lawsuit. Although he did not appear in the matter, he was heavily involved in drafting a report and providing an affidavit that was used in support of Frontier’s failed summary judgment motion in the federal case. The Court found that Ysursa’s act of knowingly offering assistance in a case being adjudicated in Indiana constituted sufficient minimum contacts for finding personal jurisdiction over any claims arising from that assistance. The Court also noted that Indiana had an interest to oversee malpractice claims that arose out of Ysursa’s specific actions in Indiana.
In the same Order, the Court also denied defendant’s Motion for Summary Judgment which was based on the argument that Frontier was not the real party in interest. The Court found that there was contractual language identifying Frontier as the client in any subsequent malpractice cases and that Frontier stood to receive amounts from the judgment or settlement award, even though any award would first go to the litigation coordinator until his legal costs were satisfied. The fact that Frontier permitted another party to control the direction of the malpractice litigation did not prevent Frontier from being the real party in interest.
On December 12, 2019, the Court granted Ysursa’s Motion to Certify the August 5th Order for Interlocutory Appeal.[100] Despite its previous ruling that the facts and case law supported a finding of personal jurisdiction, the Court agreed that the issue presented a substantial question of law. Although there were appellate opinions providing guidance on when an out-of-state attorney’s conduct might subject them to Indiana’s personal jurisdiction, there had not been any appellate decisions analyzing when an out-of-state attorney serving as inside counsel to a business involved in Indiana litigation may become subject to Indiana’s personal jurisdiction as a result of their representation. The Court held that this lack of clarity affects attorneys serving as inside counsel to multi-state companies, especially for attorneys practicing on areas bordering other jurisdictions. The Indiana Court of Appeals affirmed the Commercial Court’s decision to deny the motion to dismiss.
Walters v. Andy Mohr Auto. Group, Inc.[101](Denying defendants’ combined motion to dismiss based on the alter ego doctrine and standing). In Walters, plaintiffs filed a class action against a group of automotive dealerships alleging violation of the Indiana Deceptive Consumer Sales Act, constructive fraud, and unjust enrichment. Each of the plaintiffs purchased or leased a vehicle from one of the named automotive dealerships and alleged that the itemized documentation preparation fee (Doc Fee) included in the total purchase price was inflated. The plaintiffs further alleged that seventy-seven of the defendants (in addition to the dealerships involved directly in the transactions) operated as alter egos of each other and as a single business enterprise with respect to the charging of the alleged unlawful Doc Fee. The defendants filed a motion to dismiss based on the alter ego doctrine and standing.
The court analyzed the sufficiency of the complaint under Trial Rule 12(B)(6). First, the court evaluated whether plaintiffs pled sufficient facts to support their alter ego claims against the defendants that were not involved directly in the transactions at issue. The court noted that—as alleged by plaintiffs—the Alter Ego Defendants and the Transaction Defendants: (1) shared similar corporate names; (2) shared overlapping offices; (3) had similar business purposes; and (4) often had the same phone number and certain shared offices. Based on these factors, the court held that the plaintiffs demonstrated a claim under the alter ego doctrine, making dismissal improper.
Second, the court analyzed whether plaintiffs lacked standing to pursue claims against the Alter Ego Defendants. The court held that the plaintiffs did have standing as they demonstrated a personal stake in the outcome of the lawsuit and that they sustained some direct injury as a result of the conduct at issue. Additionally, the court held that the juridical link doctrine did apply in this case. The plaintiffs’ complaints specifically alleged the class action was a result of numerous individuals suffering an identical injury at the hands of several defendants related by way of a conspiracy or concerted scheme surrounding dealership Doc Fees. Further, the complaints alleged in detail how the defendants were juridically linked together such that neither Transaction Defendants nor Alter Ego Defendants should be dismissed.
On September 16, 2020, the court granted defendants’ motion to certify its July 31, 2020 Order for interlocutory appeal.[102] To date, the appeal remains pending.
First Fin. Bank v. TA Partners, LLC[103](Granting plaintiff’s partial motion for summary judgment holding a valid savings clause existed). Throughout July 2019, First Financial Bank (tenant) failed to timely pay rent as required by its lease with TA Partners, LLC (landlord). On July 23, 2019, TA Partners, LLC notified First Financial Bank that their lease was being terminated and that TA Partners, LLC was accelerating rent for the balance of the term and demanding payment of the accelerated rent. First Financial Bank field suit for declaratory judgments and breach of contract. Both parties filed cross-motions for partial summary judgment.
The court analyzed whether the lease had a valid savings clause, and whether the tenant accrued liability for future rent following the landlord’s termination of the lease. First, the court held that the lease contained a valid savings clause. The general rule in Indiana is that after termination of a lease, all liability under the lease for future rent is extinguished. However, an exception to the general rule applies when the lease includes a savings clause that expressly states that the landlord is entitled to future rents after the termination of the lease. Based on Indiana law and the court’s reading of the lease, the court held that the savings clause was clear and unambiguous that the landlord could recover accelerated unpaid rent in the event of default.
Additionally, the court analyzed whether evidence submitted with TA Partners, LLC’s partial motion for summary judgment, including emails and prior drafts of the lease, should be excluded as inadmissible parol evidence. The court noted that under Indiana law extrinsic evidence may be considered only if the language of a contract is ambiguous. However, Indiana law is clear that a written instrument governs, and evidence of prior negotiations, and evidence of such matters as prior expectations and conversations, cannot be allowed to alter its terms. Therefore, the court held that any reference to prior drafts of the lease was inadmissible.
§ 1.3.5 Iowa Business Specialty Court
EMC Ins. Group, Inc. v. Shepard[104](Perfection of statutory appraisal rights). In EMC Insurance Group, Inc. v. Shepard, pursuant to a merger, the Court reviewed summary judgment motions relating to a merger and the sale of the defendant Gregory M. Shepard’s (Shepard) minority shares and his failure to perfect his appraisal rights. Employers Mutual Casualty Company (EMCC) purchased 1.1 million shares of stock from Shepard, who was the largest single minority shareholder of EMC Insurance Group, Inc. (EMC). EMC argued that Shepard failed to perfect his appraisal rights because he did not obtain consent from the legal titleholder of his shares, Cede & Co. (Cede), prior to the date of the merger.
The first issue in front of the Business Court was one of statutory interpretation where the Court had to determine the scope of what persons or entities are the registered titleholders in a corporation’s records under Iowa Code § 490.1301(8). Specifically, the court analyzed whether Shepard did not obtain the required consent because he obtained consent from Morgan Stanley Smith Barney, LLC (Morgan Stanley), which held corporate records in “street name” as holder of Shepard’s 1.1 million shares instead of Cede.
The court entered summary judgment for EMC and concluded the record shareholder is the person whose name is registered in the records of the corporation, and those records do not include participants such as brokers. Accordingly, because Shepard did not obtain written consent to assert his appraisal rights from Cede, he failed to perfect his rights as required by Iowa law.
The second issue the court reviewed was whether EMC waived and/or was equitably estopped from arguing Shepard failed to comply with the strict requirements of the appraisal provision because EMC did not comply with statute and concealed material facts from Shepard to his detriment. The court found that Shepard did not establish facts in support of his motion for summary judgment on either of his defenses.
First, Shepard argued that EMC waived any challenges to his appraisal rights because it did not strictly comply with the appraisal statute. The court disagreed and concluded EMC complied with its obligations by sending Shepard a notice acknowledging EMC’s receipt of Shepard’s intent to seek appraisal rights and advising Shepard what he needs to do to seek those rights.
Second, Shepard argued that EMC concealed its belief that the consent obtained from Morgan Stanley was insufficient to perfect his appraisal rights, and because EMC knew he intended to exercise his appraisal rights, Shepard’s statutory non-compliance was excused. The court held that Shepard could not establish EMC made any false representations or concealed any material facts.
§ 1.3.6 Maine Business and Consumer Docket
H&B Realty, LLC v. JJ Cars, LLC[105](Racial discrimination claim in commercial sublease claims). This matter arose from a commercial lease dispute and involves a claim that the landlord racially discriminated against the tenant’s sublessees. H&B Realty, LLC (H&B) was the owner of property in Portland, Maine, and Sterling Boyington (Boyington) was H&B’s sole member. In May of 2011, H&B leased the property to JJ Cars, LLC (JJ Cars), with Mokarzel as its sole member. From July 2011 to February 2013, Mokarzel operated his car dealership at the property. During this period, Boyington would occasionally stop by to check on the property and to socialize. During his visits, Boyington would make racist remarks about people of color to the Caucasian employees of JJ Cars. By February 2013, Mokarzel was in financial duress, and decided to close his business and sublease the property. JJ Cars sublet the property to several individuals for consecutive periods, and although Mokarzel did not provide H&B with the prerequisites necessary to obtain H&B’s consent to sublet the property, Boyington nevertheless consented or never objected. On one instance, Boyington made racist comments and used expletives about people of color to one of the subleasing tenants. Finally, by November 2015, JJ Cars attempted to sublease the property to a Caucasian individual, but Boyington refused to meet with the individual and approve a sublease.
The property sat unoccupied. Mokarzel ceased paying rent, and Boyington took no steps to find a new tenant but simply decided that he no longer wanted H&B to lease the property. In March 2016, a FED action was commenced and Boyington eventually obtained judgment. H&B sold the property in April 2016. H&B filed a Complaint seeking damages for unpaid rent for the period November 2015 through April 2016. JJ Cars attempted to avoid paying damages on several grounds. The court found that Boyington, pursuant to the Lease Agreement, “unreasonably withheld or delayed” his consent to the proposed sublease to the Caucasian individual, and that had he provided reasonable consent, JJ Cars would have been able to pay rent from November 2015 through April 2016. Although in the commercial lease context a landlord has no duty to mitigate damages, the lease provisions here imposed such an obligation. Additionally, the court concluded that because when JJ Cars began missing rent payments, Boyington took no steps to lease the property to someone else, he failed to mitigate damages. The court granted judgment to JJ Cars and Mokarzel on Boyington’s complaint.
In their third party complaint against Boyington, JJ Cars and Mokarzel sought damages for public accommodation discrimination pursuant to the Maine Human Rights Act, 5 M.R.A. § 4592. Their theory was that Boyington harbored racial animus, harassed and discriminated against JJ Cars’ subtenants, and caused those subtenants to vacate. However, the court determined that the evidence did not support the theory, at least as to causation. Boyington’s bigoted comments credibly established by the evidence occurred while JJ Cars was still in business, but there was no evidence that Boyington made similar comments “directed at” the subtenants of JJ Cars or caused them to vacate the property. On the contrary, Boyington consented to subletting to subtenants who were persons of color, objecting only to the Caucasian subtenant. The court concluded that JJ Cars and Mokarzel did not satisfy their burden of proving discrimination, and granted judgment to Boyington on the third party complaint.
Clavet v. Dean[106](Fiduciary duty forms basis of failure to disclose claim against LLC member). This Order for Entry of Judgment followed a 2019 bench trial, which centered around a September 2016 purchase by the defendants of the plaintiff’s membership interests in two entities they jointly owned: Blue Water, LLC and Covered Marina, LLC (hereinafter, the “Marinas”). The parties had a long history of operating businesses in Maine and Texas, including real estate development, hotels, a storage facility, a car wash, two small insurance entities, and the utility Electricity Maine. Both business partners and good friends, the parties owned the Marinas for over ten years on the gulf coast of Texas. Finding the Marinas both unprofitable and difficult to insure, the parties sought to sell the Marinas. In September 2016, a broker called Dean to discuss a purchase. In reviewing the documented communications between the parties, the court found that Dean breached a number of legal duties he owed to Clavet.
Specifically, the court found that Dean intentionally omitted material information that he had a duty under Maine law to provide to the other member of Blue Water, Clavet. The information consisted of the inquiries and communications from the broker to purchase the Marinas for a sum of 8 million dollars, which changed to 7.5 million dollars two days before Dean emailed Clavet to tell him that their wives needed to provide personal guarantees in order to have a line of credit. The purchase and sale agreement between Dean and the broker was completed shortly thereafter, and Clavet, on that same day and completely in the dark about the agreement between Dean and the broker, signed over his membership interest in the Marinas to Dean. Further, Clavet was not told about the sale of the Marinas until months later, when prior disclosure would have revealed to Clavet that Dean had timed and manipulated his buyout of the Marina interests from Clavet in order to keep the proceeds for himself—at the same time Dean made the contract to sell the Marinas for 7.5 million dollars, he was persuading Clavet to sell him his membership interests for a significantly lower price.
The court held that an omission by silence could constitute the supplying of false information as proof of intentional misrepresentation, but only in circumstances where there exists a special relationship such as a fiduciary relationship, which imposes an “affirmative duty to disclose.” The information was intentionally withheld “for the purpose of inducing” Clavet to refrain from acting in reliance upon it. The court further found that the omissions were material, “if for no other reason but that there is such a substantial difference between the sales price of 7.5 million dollars … and the purchase price of Clavet’s interest for 2.5 million dollars by Dean.” The court entered judgment for plaintiff on the counts for fraudulent misrepresentation and breach of fiduciary duty. The court also entered judgment for defendants on the counts for unjust enrichment and fraudulent transfer.
§ 1.3.7 Maryland’s Business and Technology Case Management Program
SACHS Capital Fund I LLC v. EM Group LLC[107](Granting dismissal as to all but one of defendants’ claims).SACHS Capital Fund I LLC, et al. v. EM Group LLC, et al., concerned a derivative action that was brought in an attempt to undue a $17 million loan that was made to EMSG, LLC, a Maryland limited liability company (EMSG), by TZG-Sachs Empire, LLC (TZG Sachs) to fund its expansion. EMSG was formed by EM Group LLC, a Maryland limited liability company (EM Group), owning 67% of EMSG and the plaintiffs, Sachs Capital Fund I, LLC, Sachs Capital-Empire, LLC, and Sachs Capital-Empire B, LLC (collectively, the “Sachs Entities”), owning 33% of EMSG. The lender, TZG-Sachs, agreed to amend the loan such that the maturity date was extended by three years from November 21, 2016 to November 21, 2019. Beginning in April 2019, however, EMSG began to materially and repeatedly breach the payment terms of the amended promissory note. The court, applying the Tooley test,[108] denied EM Group’s direct claims on the basis that they were largely derivative claims and that any recovery EM Group would receive would be based on its interest in EMSG, as EM Group and the other plaintiffs did not suffer injury that was distinct from the injury suffered by EMSG itself.
The court also considered EM Group’s claim that challenged the operating agreement that formed EMSG as an enforceable contract. According to EM Group, the operating agreement favored the Sachs Entities to EM Group’s disadvantage. The court, in applying Maryland contract law, concluded that EM Group was a sophisticated entity that should have readily understood the clear terms of the operating agreement. The court, however, preserved EM Group’s declaratory judgment claim, which sought an interpretation of what proceeds could be distributed under the terms of the operating agreement. EM Group also sought a declaration that the loan from TZG-Sachs was void and unenforceable because Sachs members of EM Group had failed to disclose that they (Sachs members) would reap a financial benefit in the event that EM Group defaulted on the loan. The court, having found that the time for rescission had passed, dismissed this count.
Additionally, EM Group claimed that Mr. Sachs, the sole member of the managing member of the Sachs Entities, and TZG-Sachs fraudulently induced EM Group to enter into the EMSG operating agreements by: (1) making false representations regarding the treatment of EM Group under the terms of the agreements; (2) failing to disclose that the law firm that drafted the operating agreement held equity interests in the Sachs Entities; or (3) failing to disclose the interests of Mr. Sachs and TZG-Sachs in connection with the Sachs Entities and the loan being made to EMSG. According to EM Group, it did not learn of these fraudulent statements and omissions until 2018 and 2019. The court dismissed the claim finding that EM Group failed to plead fraud with the required requisite particularity.[109] The court went on to note that Mr. Sachs’ failure to disclose that he had a 9.2% interest in TZG-Sachs and the law firm’s 1% interest in the Sachs Entities were not material conflicts of interest and therefore could not support a fraud claim. The court also noted that EM Group’s claim was untimely as the President of EMSG had been on inquiry notice of the various interests as early as 2011, when it received letters describing both Mr. Sachs and TZG-Sachs interests and roles of the parties to the loan.
The court also dismissed EM Group’s civil conspiracy claim on the basis that EM Group had not met the clear and convincing standard for this claim.[110] The court dismissed EM Group’s breach of fiduciary claim which alleged that Mr. Sachs owed EMSG and the investors a duty as a board member and financial advisor and that he violated this duty through a lack of disclosure of his investments that competed with EMSG. The court concluded that there was no breach of any fiduciary duty, as the operating agreement expressly permitted the Sachs to invest in competing entities. Finally, the court dismissed EM Group’s unjust enrichment claims on the basis that there was a valid contract between the parties.
United Cmty. Patrol Servs., Inc. v. Sepehri[111](Awarding a non-breaching party 49% ownership of stock in the breaching party). In United Community Patrol Services, Inc., et al. v. Sepehri, the Circuit Court for Montgomery County ordered the defendants to transfer shares in United Community Patrol Services, Inc. (United) such that Plaintiff McClure, would own 49% in United. In his complaint, Plaintiff McClure alleged that United had breached its contract to sell United stock to the plaintiff, a shareholder of United. In February 2015, McClure, who had worked for United for over a year as a 1099 independent contractor, was terminated. In April 2015, McClure paid $49 to Mr. Sepehri, a 49% owner of United, for the purchase of 49 shares of United. McClure and Mr. and Mrs. Sepehri executed a Stock Purchase Agreement (the “Purchase Agreement”) which memorialized McClure’s purchase of the 49 shares of United.
Although his role as owner of United had not been discussed prior to the execution of the Purchase Agreement, McClure assumed that he would be responsible for bringing in business to the company. Further, the extent of the discussion regarding compensation only involved an agreement between McClure and Mr. Sepehri that money would not be taken out of the business to compensate the parties. From 2015 to 2018, McClure worked to secure business for United and became so involved with United that he had hired and managed its employees. As of April 2018, however, McClure had not received a stock certificate or a transfer of Mr. or Mrs. Sepehri’s stock in United. In fact, the Sepehris began excluding McClure on integral business decisions and terminating employees who had been hired by McClure. McClure filed suit after his inspection of United’s accounting statements showed that Mrs. Sepehri had been paid $87,692.00 in wages in 2018 compared to the $18,500 issued to McClure in 1099 wages.
The court, in considering McClure’s breach of contract claims, held that the Purchase Agreement was valid, dismissing the defendants’ contention that the Purchase Agreement was an “agreement to agree.” According to the court, the Purchase Agreement could not be interpreted as contemplating future negotiations, which is a critical feature of agreements to agree. The court noted that this interpretation was also buttressed by the fact that the Sepehris accepted McClure’s $49 as payment for the shares of United stock. The court determined that the plaintiff’s expert, who determined that United had a total gross income of $2,164,585.00 for the years 2015 to 2019, was not credible due to the expert’s failure to consider the entirety of the United’s financial records, including its debt. Without the expert testimony, the court found that McClure had failed to prove his compensatory damages. Rather, the court fashioned a remedy in which the Sepehris were ordered to issue stock in United such that McClure would become an owner of 49% of United’s issued and outstanding stock.
The court dismissed McClure’s derivative claims on the basis that McClure had not and would not become a stockholder until the Sepehris issued the stock pursuant to the court’s order.
Connaughton v. Day[112](Denying plaintiffs’ motion for class certification). In Connaughton, et al. v. Day, et al., the Circuit for Montgomery County denied the plaintiffs’ motion for class certification in a securities fraud lawsuit. The plaintiffs alleged that the named defendants were principals of a “feeder fund” that procured investors for a Ponzi scheme run by non-party entities (the “MLJ Group”). Plaintiffs alleged that the defendants solicited and sold investments in securities offered by the MLJ Group who would then use the proceeds to acquire debt portfolios. Over the course of the litigation, the defendants grew in number from 4 to 18, a group that included the entities to which the original defendants allegedly funneled money and the counsel for one of the original named defendants.
Plaintiffs sought a class certification of “all persons who lent money to the MLJ Borrowers,” and excluded from the class, individuals who made a net profit on the participation in the Ponzi Scheme and those who were affiliates of the 18 defendants or the MLJ Group. The court found that the plaintiffs did not meet three of the four threshold requirements for class certification under Maryland law.[113] Specifically, the court found that plaintiffs neither demonstrated how joinder of the purported 35 class members would not be impracticable, nor did they demonstrate the typicality of the class. With regard to typicality, the court found that purported class members received varying non-scripted emails and calls from defendants before the plaintiffs decided to complete the transactions. Thus, different plaintiffs may have relied upon different misrepresentations from defendants, which negated any typicality amongst the class. Finally, the court concluded that the class representatives could not adequately represent the class because of the difference in what the representations that were relied upon by the class representatives and other class members and because the class representatives could not represent the interests of another plaintiff who was also the target of potential claims of the other class members.
After finding that the plaintiffs had failed to meet the threshold requirements for class certification, the court considered plaintiffs’ claims under Maryland Rule 2-231(c)(3). The court, having concluded that common law fraud claims are not susceptible to class action treatment because reliance can be unique to each class member, found that individual questions of fact predominated the putative class.
RCPR Acquisition Holdings, LLC v. Zurich Am. Ins. Co.[114](Granting plaintiff’s motion to compel privileged documents). In RCPR Acquisition Holdings, LLC v. Zurich American Insurance Company, the Circuit Court for Montgomery County granted plaintiff’s motion to compel the production of documents that defendant claimed were privileged communications between counsel and client.
The plaintiff, RCPR Acquisition Holdings, LLC (RCPR), is the owner of the Ritz Carlton San Juan hotel and casino in San Juan, Puerto Rico and the defendant is RCPR’s insurer. Plaintiff filed a complaint against defendant on November 1, 2018, following the defendant’s alleged failure to satisfy its contractual obligations to indemnify plaintiff for property damage, business interruption and other losses sustained by RCPR as a result of Hurricane Maria under plaintiff’s insurance policy with defendant. In connection with RCPR’s first set of requests for production of documents, the defendant withheld certain documents and provided a privilege log showing the nature of the documents and emails. With respect to each document that was withheld, the defendant asserted that the document was protected by the attorney-client privilege because it was communications between counsel and client for purposes of providing legal advice. In filing its motion to compel, the plaintiff asserted that defendant has failed to show that any privilege was applicable and that, even if the documents were privileged, the privilege was waived when the documents and emails were exchanged with an outside adjuster that was neither an employee of or counsel to the defendant.
The court determined that communications, which concerned insurance coverage, were not privileged as they were not exchanged for the purpose of seeking legal advice.[115] The court found that, although the defendant’s outside counsel had been included on the emails, the emails demonstrated that counsel was included for the purpose of being involved in the insurance claim process and not for the purpose of providing legal advice. In addition, the court noted that although the timing of the emails and the nature of the insurance claim at issue indicated that the communications with outside counsel were made at a time when the defendant could have anticipated litigation, the defendant had not provided any information to the court suggesting that that was in fact the case. Ultimately, the court, finding that the communications were not privileged, ordered the defendant to produce the communications.
§ 1.3.8 Massachusetts Business Litigation Session
Attorney General v. Facebook, Inc.[116](Attorney-client privilege and work product doctrine). The Massachusetts Attorney General (AG) filed a petition to compel Facebook, Inc.’s compliance with a civil investigative demand (CID) issued in connection with the AG’s investigation into Facebook’s management of Facebook user data. Beginning in late 2015, Facebook’s privacy policies came under increasing scrutiny after media outlets reported that a University of Cambridge professor, Aleksandr Kogan, managed to collect personally identifying information from the accounts of approximately 87 million Facebook users through a Facebook app that Professor Kogan had developed. Professor Kogan then sold some of this data to a political data analytics and advertising firm, Cambridge Analytica, which used the data to send targeted campaign advertisements to Facebook users during the 2016 U.S. presidential election. Facebook responded to these news reports by launching an internal App Developer Investigation (ADI) to audit Facebook apps for compliance with Facebook’s policies concerning the collection and use of user data. Facebook retained a law firm, Gibson Dunn & Crutcher LLP, to design and direct the ADI. In the ensuing months and years, Facebook issued periodic statements to update the public on the ADI’s progress. In March 2018, the Massachusetts AG opened its own investigation into Facebook’s user data policies, issuing three CIDs that sought, among other things, information about the ADI and any apps that Facebook identified as problematic. Facebook refused to produce documents generated in the course of the ADI, arguing that the material was protected by the work-product doctrine and attorney-client privilege.
The court first addressed Facebook’s claims of work product, emphasizing that the doctrine only protects material “prepared in anticipation of litigation or for trial.” As the court concluded, the history of the ADI and Facebook’s own public statements showed that the ADI was not undertaken in anticipation of litigation; rather, the ADI was undertaken as part of Facebook’s normal business operations, being another iteration of its continuing efforts to ensure that app developers complied with Facebook’s policies concerning user data. The court rejected Facebook’s argument that documents generated in the ADI were work product because the ADI was a “lawyer-driven effort.” In the alternative, the court held that the AG had overcome the qualified protection of the work-product doctrine, concluding that the majority of the requested information was fact work product, and that the AG had demonstrated a substantial need for the information and an inability to obtain it from other sources. Turning to Facebook’s claims of attorney-client privilege, the court similarly concluded that internal communications generated in the course of the ADI were not categorically privileged. The attorney-client privilege, for example, did not extend to “any underlying facts or other information learned by Facebook during the ADI, including the identity of the specific apps, groups of apps, and app developers” that Facebook might have flagged. Moreover, Facebook’s public statements about the ADI were inconsistent with its broad assertion of attorney-client privilege because “Facebook has touted the ADI as an investigation and enforcement program undertaken for the benefit of the Company’s users, and it has pledged to share information of suspected data misuse uncovered in the course of the ADI with its user community.” The court recognized that some internal communications sought in one disputed CID request might contain privileged information, giving Facebook an opportunity to identify these documents in a privilege log. Yet, the court held that the remaining five requests in dispute sought factual materials pertaining to an investigation that Facebook “touted . . . to the public in an effort to explain and defend its actions,” and therefore were not protected by attorney-client privilege.
Jinks v. Credico (USA) LLC[117](Employee classification under state wage and overtime statutes). The plaintiffs sued their former employer, DFW Consultants, Inc. (DFW), a marketing and sales company that provides door-to-door sales services. In 2013 and 2015, respectively, DFW entered into a “Subcontractor Agreement” and a “Services Agreement” with Credico (USA) LLC (Credico), in which DFW agreed to provide sales services to Credico’s clients, and Credico agreed to compensate DFW for those services. DFW hired the plaintiffs to do door-to-door marketing work for Credico’s clients. The plaintiffs brought claims alleging that they were improperly classified as independent contractors and for violation of the Massachusetts minimum wage and overtime statutes. In addition to their direct employer, DFW, the plaintiffs brought claims against Credico, alleging that DFW and Credico were “joint employers.”
The court disagreed, granting Credico’s motion for summary judgment on the ground that Credico was not a joint employer. The court first rejected Credico’s argument that the minimum wage and overtime statutes only contemplate that an employee has a single employer. Although the statutes use the singular term “employer,” the court concluded, based on appellate precedent and the remedial purpose of the statutes, that the statutes should be construed to encompass claims against joint employers. The court then addressed what test determines whether a defendant is an “employer” under the Massachusetts statutes. Under the common law “right to control” test, a company could be deemed a joint employer if it has “sufficient control over the work of the employees of another company.” The plaintiffs argued that the “ABC Test,” outlined in a Massachusetts statute defining “independent contractor,” had supplanted the common law “right to control” test. But the court rejected this argument, holding that the independent contractor statute “applies only where a worker provides services directly to a potential employer.” Because the plaintiffs never provided services to Credico directly, the “right to control” test still determined whether Credico could be deemed a “joint employer.” Applying the “right to control” test, Credico could not be deemed a joint employer because the undisputed evidence showed that Credico had no power to hire or fire the plaintiffs; no authority over their work schedules or compensation; and did not maintain employment records for them.
The minimum wage and overtime claims against DFW turned on whether the plaintiffs fell within certain statutory exemptions for workers engaged in “outside sales.” To be exempt under the minimum wage statute, a worker engaged in “outside sales” cannot make daily reports or visits to the employer. The court denied the summary judgment motions of DFW and its manager, Jason Ward, because there was a genuine dispute of material fact as to whether the plaintiffs did so. The court held, however, that the outside sales exception to the overtime statute applies regardless of whether an employee makes daily reports. As such, it granted summary judgment for DFW and Ward on the overtime claims. The court also granted summary judgment for certain plaintiffs on their misclassification claims, concluding that the undisputed facts showed that they were improperly classified as independent contractors.
CommCan, Inc. v. Baker[118](Equal Protection challenges to Governor’s executive order). On March 10, 2020, the Governor of Massachusetts, Charlie Baker, declared a state of emergency in Massachusetts due to the spread of the COVID-19 virus. The Governor subsequently ordered all businesses in Massachusetts to close their brick-and-mortar workplaces and facilities unless they provided certain “COVID-19 Essential Services.” The orders included liquor stores and licensed medical marijuana treatment centers in the lists of essential businesses allowed to remain open. The orders did not include nonmedical adult-use marijuana retailers as essential businesses, requiring such stores to close. The plaintiffs—nonmedical marijuana retailers, marijuana cultivators that sell to nonmedical retailers, and an individual that uses marijuana medically but lives over an hour away from the nearest medical marijuana treatment center—brought a constitutional challenge to the Governor’s orders, arguing that they violated the equal protection provisions of the Fourteenth Amendment of the U.S. Constitution and Articles 1 and 10 of the Massachusetts Declaration of Rights. The plaintiffs sought a preliminary injunction barring enforcement of the Governor’s closure orders against them.
The court denied the plaintiffs’ request for a preliminary injunction, concluding they ultimately would not succeed on the merits of their claims. To begin, the court emphasized the broad powers of the State to restrain liberty and the use of private property to protect the public health. At the same time, the court rejected the Governor’s argument that the court lacked subject matter jurisdiction over the case because the Massachusetts declaratory judgment statute does not allow for declaratory relief against the Governor. Even if declaratory relief were not available by statute, an executive order of the Governor “may be challenged on the grounds that it is unconstitutional or otherwise unlawful.” “The fact that the challenged orders were issued under the Governor’s broad emergency powers does not mean that they are immune from judicial review.” Turning to the merits, the court held that because the “right to pursue one’s business” is not a “fundamental right,” the constitutional question turned on whether there was a “rational basis” for the Governor’s orders to draw a distinction between, on the one hand, medical marijuana treatment centers and liquor stores, and, on the other hand, nonmedical marijuana retailers. The Governor put forth two justifications for not exempting nonmedical marijuana retailers from the COVID-19 closure orders. First, nonmedical marijuana retailers tend to attract large crowds of customers because there are so few of these businesses licensed in the Commonwealth. Second, nonmedical marijuana retailers tend to attract out-of-state customers. The plaintiffs “convincingly” argued that both concerns could be addressed by less burdensome alternative measures. This argument failed, however, because equal protection does not require the State to employ less burdensome alternatives. Moreover, the Governor was not required to cite or rely upon these justifications when he actually issued the orders. Accordingly, because the Governor’s orders requiring nonmedical marijuana retailers to close were not “arbitrary or capricious,” they passed constitutional muster.
§ 1.3.9 Michigan Business Courts
Farm Bureau Gen. Ins. Co. of Mich. v. ACE Am. Ins. Co.[119](Insurance dispute). On remand from the Michigan Supreme Court, the Kent County Business Court addressed whether Farm Bureau could rescind its policy that was procured through fraud when an innocent third party is involved under the framework in Bazzi v. Sentinel Ins. Co., 502 Mich. 390, 919 N.W.2d 20 (2018). Relying on Bazzi, the court found that plaintiff was not entitled to rescission.
In this case, the injured claimant, the wife of the named insured, attempted to claim no-fault benefits through her husband’s policy with plaintiff.[120] On May 22, 2013, the wife was injured as an intoxicated pedestrian when a vehicle failed to yield. However, on his insurance application to plaintiff, the insured husband had omitted his wife as a named insured under the policy—only indicating that he was married.[121] Without further inquiry into the wife’s identification and driving history, plaintiff issued the policy on February 25, 2013. However, due to the omissions on the husband’s application, plaintiff issued a notice of policy cancellation on April 22, 2013, effective May 25, 2013. The subject accident occurred two days before the cancellation date.
Plaintiff filed suit to rescind the insurance policy based on fraudulent inducement after discovering the wife’s history of drunk driving, leading to a license suspension. In finding that plaintiff was not entitled to rescission, the court noted that while insurers may rescind insurance contracts based on fraud, the court must balance the equities to determine which innocent party should assume the loss. There the court conducted a two-day evidentiary hearing. The court found, among other things: (1) plaintiff should have immediately investigated the glaring omissions on the application; (2) despite intoxication, the wife had the right-of-way and was not at fault for the accident; (3) and plaintiff waited six months after the policy cancellation date to refund the premiums. Thus, plaintiff was not entitled to rescission.
Happy Little Tree Co., LLC v. Prof’l Prop. Dev., LLC[122](Breach of commercial lease). This case addresses the budding uncertainty in Michigan regarding the application of contract principles to commercial lease disputes in the medical marijuana industry. In Happy Little Tree, the court found in favor of plaintiff, a licensed medical marijuana growing facility, on its breach of commercial lease agreement and related claims.
Plaintiff and defendant entered into a commercial lease for plaintiff to operate a medical marijuana growing facility. The subject property was in total disrepair. As such, the lease term would not commence until and unless defendant made specific repairs within forty-five days of the lease execution date. When defendant failed to timely repair the premises, plaintiff offered to purchase the property and continue operations independently. Defendant refused. Subsequently, defendant discovered that there was a current city ordinance halting the opening of new medical marijuana facilities. Defendant informed plaintiff of this and provided an ultimatum: plaintiff could either terminate the lease or continue paying rent. Plaintiff declined both offers and retained access to the property until defendant changed the locks and leased it to a new tenant.
Plaintiff filed suit for breach of commercial lease, unjust enrichment, and violations of the Michigan Anti-Lockout Law. The court held that defendant breached the lease by failing to complete the repairs within the required time frames. Further, the court rejected defendant’s argument that it could not have breached the lease because the purpose of the lease was banned by city ordinance. The court reasoned that the ban was lifted in enough time for plaintiff to fulfill the lease purpose, had defendant timely completed the repairs. The court also noted that the lease provided that the premises could be utilized for any other agreed use. Finally, the court held that defendant violated Mich. Comp. L. § 600.2918, Michigan’s Anti-Lockout Law, because defendant interfered with plaintiff’s possessory interest in the property.
Liberty Plus, LLC v. Vill. Crest Condo. Ass’n[123](Breach of contract, unjust enrichment, and constructive trust). In this case, a delay in discovery proceedings due to the COVID-19 pandemic precluded summary disposition under Mich. Ct. R. 2.116(C)(10) (the state counterpart to Fed. R. Civ. Pro. 56). At issue was the validity of an affidavit submitted by Village Crest in opposition to Liberty’s motion for summary disposition. The affidavit was not notarized due to COVID-19 restrictions. With a seamless balance of fairness and public safety, the court observed that “while the [a]ffidavit … is not notarized” Liberty initiated suit on February 12, 2020, one month before the “pandemic effectively shut down the country,” causing significant delays in the litigation process. As such, the court held that “in light of the need for [additional] discovery,” summary disposition was not appropriate.
Corktown Hotel, LLC v. Caspian Constr. Grp., Inc.[124](Negligence and commercial construction dispute). This business dispute involved whether defendant Caspian Construction Group (Caspian), the substitute general contractor, could be held liable to plaintiff hotel, in contract or tort, for non-code installation of shower handles that defendant did not design or select. Plaintiff hired ROK Construction Services, LLC (ROK) to perform construction management services in connection with its plan to renovate an old Holiday Inn. Plaintiff also contracted with an interior designer to design a two-handle shower valve. Plaintiff approved the design and authorized the replacement of the valves, which were installed by ROK on half the floors before Caspian replaced ROK. Subsequently, plaintiff hired Caspian to complete the renovation. The contract between plaintiff and Caspian specifically called for the remaining showers to be equipped with the two-valve design. Additionally, permits and plans were specifically excluded from the scope of the contract. Upon completion of the renovation, the valve design was found to violate city code, and plaintiff did not receive its necessary permit.
Plaintiff filed suit for breach of contract and negligence based on the non-code installation of the shower valves. In granting summary disposition on both counts for Caspian under Mich. Ct. R. 2.116(C)(10), the court held, “[d]efendant owed no professional duty of care (tort) to Corktown independent of the contract” unless plaintiff demonstrated a duty “separate and distinct from the contractual obligation.” Thus, because the shower handles were included in the contract, plaintiff was barred from recovery.
§ 1.3.10 New Hampshire Commercial Dispute Docket
Control Techs. v. ENE Systems of New England[125](Nondisclosure agreements). This case stems from a dispute between two commercial entities, both of whom are building management solution providers that design, install, and maintain commercial heating and ventilation systems. Defendant hired co-defendant from plaintiff. According to plaintiff, prior to leaving for defendant, co-defendant accessed numerous confidential client files and sent the confidential information to defendant in violation of a nondisclosure agreement. In ruling in favor of the plaintiff during a preliminary injunction hearing, the court found that, although the noncompetition agreement between plaintiff and co-defendant was overbroad, the nondisclosure provisions of the agreement were still enforceable. According to the court, “when a noncompetition agreement is overbroad on its face, the court need not consider whether it could be narrowed where the relief requested is enforcement of misappropriation of confidential information.”
Here, the nondisclosure provision was enforceable because (1) plaintiff had a significant and legitimate interest in preventing employees from appropriating its goodwill to its detriment, (2) the provisions did not impose an undue hardship upon the co-defendant, and (3) the nondisclosure agreement was not injurious to the public interest. Finally, the court held injunctive relief was appropriate because irreparable injury can occur if appropriation of trade secrets such as confidential information is not enjoined, and it is difficult to quantify the impact of lost sales and diminished customer relationships.
High Liner Foods (USA), Inc. v. Groves[126](Noncompetition agreements, RSA 275:70, modification of restrictive covenant by court, trade secrets, preliminary injunctions). This case arose out of a former employer’s effort to enforce restrictive covenants and confidentiality obligations in an employment agreement. The novel issue presented was whether the employee’s agreement occurred before or after the restrictive covenants were reflected in a formal written agreement. New Hampshire has a statute that prohibits an employer from enforcing a noncompete agreement unless it was provided to the prospective employee prior to the acceptance of an offer of employment. The statute does not affect other provisions of such an agreement, including confidentiality, nondisclosure of trade secrets, intellectual property assignment, or other similar provisions.
Here, the prospective employee met with a representative of the employer, and reached an understanding regarding the basic terms of the proposed employment, reflected in notes on a napkin. The so-called “Napkin Memo” did not include any description of the noncompete agreement, but this was reflected in the formal offer of employment that came from authorized representatives of the employer, and was ultimately executed by the employee. The business court determined, on these facts in the context of a request for preliminary injunctive relief, that Napkin Memo was not the offer of employment, and that accordingly, the restrictive covenants in the formal written agreement would be enforceable. The decision also applied customary standards to the request for injunctive relief, as well as the law regarding enforceability of restrictive covenants, including redlining to cure overbroad provisions.
Legacy Global Sports, LP v. St. Pierre[127](Choice of law, breach of contract, wrongful termination, aiding and abetting breach of fiduciary duty, tortious interference with contractual relations, fraudulent inducement to contract, indemnification of corporate officers, intervention). This matter has resulted in a number of decisions from the business court respecting several theories of liability in a commercial dispute context. This decision deals with several of them.
The New Hampshire Supreme Court has never addressed the theory of aiding and abetting a breach of fiduciary duty, but a federal appellate opinion predicted that New Hampshire would do so if and when the issue was presented. The business court agreed with this prediction, adopting the formulation in Restatement (Second) of Torts § 876(b): (1) a breach of fiduciary obligations; (2) knowing inducement or participation in the breach by the one aiding and abetting; and (3) damages as a result of the breach. The court went on, however, to find that the complaint did not adequately allege facts to support each of these elements, and dismissed the claim. The dismissal of this claim, as well as one for conspiracy, was also based on the principle that a corporation cannot conspire with its agents, as now reflected in numerous decisions, although again, not as yet addressed directly by the New Hampshire Supreme Court.
The court also dismissed a claim of breach of the implied covenant of good faith and fair dealing. Noting that a “party who pleads a breach of an express term of a contract can hardly assert a breach of contract based upon the same term, alleging that it is implied.” For this reason, this claim was also dismissed. Finally, the court declined to dismiss a fraudulent inducement claim, addressing an argument that a party seeking rescission based upon a fraudulent concealment must tender any benefits received under the contract. In contrast, a tort claim for damages when there has been a fraudulent concealment does not seek rescission, and accordingly, the tender rule does not apply.
Legacy Global Sports, LP v. St. Pierre[128](Electronic discovery). This same matter produced a decision focused solely on discovery subpoenas issued for emails, both to parties and non-parties. There were also subpoenas directed toward Google for these same parties and non-parties, and the court dealt with motions to quash them, basically on over-breadth, and therefore abusive, grounds.
The subpoenas to Google requested so-called “header information,” i.e., from and to, date, and subject matter for a specified email address, as well as information about the owner of the account associated with the address. The subpoenas further sought information regarding any deleted emails during a relevant timeframe.
While recognizing that the request was “akin to a privilege log,” the court found that these requests were classic examples of fishing expeditions, and quashed them. Likewise, without an adequate basis to identify potentially relevant communications, and the need for them in the circumstances, the subpoenas to the parties and non-parties were also quashed.
Boudreau v. Wax Specialists, LLC[129](Restrictive covenant not to compete). In this case, defendant required plaintiff (an esthetician) to sign three separate non-competition agreements while she worked for defendant. In determining that the non-competition agreements were unreasonable, the court applied a three-part test and found in favor of plaintiff regarding each factor.
First, the non-competition agreement was not reasonably limited in geographic scope and was not advanced for a legitimate business purpose. Estheticians do not have assigned territories and are not traditionally positions subject to non-competition agreements. The fact defendant paid for plaintiff’s training also did not justify the non-competition agreement because defendant required the training as part of the job and plaintiff signed an agreement indicating she would repay the cost of training if she left employment early. Second, the court found an undue burden on plaintiff. Enforcement of the non-competition agreement had already cost plaintiff one job, and there was a real risk that enforcement would jeopardize plaintiff’s ability to provide for her children as the sole financial support for her family. Finally, the court held the work of an esthetician is personal in nature, and the public has an interest in enabling customers of the service provided by plaintiff and defendant to see the provider of their choice.
§ 1.3.11 New Jersey’s Complex Business Litigation Program
Hana Trading Corp. v. Cardinale[130](Defendants’ distinct entities, no breach of fiduciary duty). New Jersey Bergen County Superior Court Complex Business Litigation Judge Robert C. Wilson ruled in favor of defendants’ summary judgement motion finding the defendants were separate legal entities and they did not breach their fiduciary duty owed to the plaintiff. Plaintiff Hana Trading Corp. (Hana), a business involved in exporting scrap materials from the United States to Asia, agreed to purchase batteries from Jutalia Recycling (Jutalia). Hana traveled to Jutalia’s New Jersey yard twice, and on both occasions, failed to observe the batteries being loaded into containers. Hana only relied upon the fraudulent invoices, packing slips, and sale orders issued by Jutalia and its agent. Hana hired Defendants World Logistics USA, LLC (World LLC) and Olympiad Line, LLC (Olympiad) to assist in the shipment of Hana’s purchased scrap batteries to export to South Korea.
In its discussion, the Superior Court first determined that Defendants World Inc., World LLC, and Olympiad were not one entity as Hana alleged in its amended complaint. The court reasoned that they were set up as separate corporate structures for separate business purposes. The court next analyzed whether the defendants breached their fiduciary duty to Hana. The court concluded that Hana did not ensure it was receiving the correct amount of batteries when it purchased the order from Jutalia even though it traveled to Jutalia’s New Jersey property and confirmed the numbers were accurate. Defendant Olympiad had no way of knowing the information it received from Hana was false, did not have prior access to the containers, and did not receive tickets that would show a weight discrepancy; and therefore, did not commit a breach of fiduciary duty to Hana.
L’Oreal USA, Inc. v. Wormser Corp.[131](Plaintiff cannot ignore its own forum selection clause). Complex Business Litigation Judge Wilson ruled that the New Jersey Superior Court did not have subject matter jurisdiction when the parties were governed by a forum selection clause selecting a foreign jurisdiction, even when the Court had jurisdiction over a place of business for the plaintiff and the defendant’s principal place of business. L’Oreal (plaintiff) filed suit against Wormser and Process Technologies and Packaging LLC (defendants) in the District Court of New Jersey, subsequently withdrew that suit due to lack of federal diversity jurisdiction, and then filed suit in Bergen County, New Jersey. Further, plaintiff ultimately filed an amended complaint, which contended that Bergen County was the appropriate venue because it was defendant Wormser’s principal place of business. The relationship between all parties was governed by an agreement that was not negotiated between the parties, but rather contained plaintiff’s unilaterally dictated terms.
Moreover, the agreement contained a forum selection clause and choice-of-law provision that stated, “any dispute shall be brought before the Courts of the city where [plaintiff]’s registered address is located and the laws of the state of such registered address shall apply.” The plaintiff claimed that “registered address” referred to a New Jersey office; however, the court found that the plain and ordinary meaning of “registered address” is the address of plaintiff’s USA headquarters, which was used by the plaintiff when it was required to register an address with the United States Trademark Office and the Federal Trade Commission. The court held that because the plaintiff drafted the forum selection clause, the plaintiff cannot in turn claim fraud, undue influence, or a violation of public policy and a forum selection clause will govern even when an alternative forum contains a place of business for the plaintiff and the principal place of business for the defendant.
§ 1.3.12 New York Supreme Court Commercial Division
Lazar v. Attena, LLC[132](Petition for dissolution of LLCs). In Lazar, Justice Andrea Masley of the New York County Commercial Division granted Arik Mor and Uriel Zichron’s (together, “Respondents”) motion to dismiss a petition to dissolve three limited liability companies, Attena LLC, Hemera LLC, and Nessa LLC (collectively, the “LLCs”). The court’s opinion addressed whether the LLCs should be dissolved on the ground that they were no longer functioning in accordance with their stated purpose, which was defined broadly to include “any lawful business purpose.”
Gabriel Lazar and Joel Scheinbaum (Petitioners), who were members of the LLCs, initiated a special proceeding under New York Limited Liability Company Law § 702 to dissolve the LLCs. Section 702 permits judicial dissolution of an LLC, upon application of one of its members, “whenever it is not reasonably practicable to carry on the business in conformity with the articles of organization or operating agreement.” In order to show entitlement to such a dissolution, the member seeking such relief “must establish, in the context of the terms of the operating agreement or articles of incorporation, that (1) the management of the entity is unable or unwilling to reasonably permit or promote the stated purpose of the entity to be realized or achieved, or (2) continuing the entity is financially unfeasible.”[133]
Petitioners alleged that: (1) the sole purpose of the LLCs was to acquire, own, and operate five separate multi-family properties located in Manhattan; (2) such properties were acquired between 2012 and 2013; and (3) all of these properties were sold in 2015. Accordingly, petitioners alleged, the LLCs had run their course and could no longer be operated consistent with their purpose.
The court began its analysis by rejecting petitioners’ allegation regarding the purpose of the LLCs. The court stated that, “[n]owhere in the operating agreements does it state, as [p]etitioners allege, that the ‘sole purpose of the LLCs was to acquire, own and operate five separate multifamily properties located in Manhattan.’” Rather, the court explained, the stated purpose of the LLCs according to their operating agreements was “any lawful business purpose.” And, the court noted, petitioners had not claimed that “[r]espondents have failed to promote or permit [that] stated purpose.” Thus, the court held that petitioners had not satisfied the failed-purpose test of Section 702. In so holding, the court distinguished two cases cited by petitioners, Matter of Fassa Corp. and Matter of 47th Rd. LLC.[134] The court distinguished Fassa Corp., in part, because the operating agreement in that case specifically provided that the company’s purpose was to acquire real property and resell the property. And the court found that 47th Rd. was distinguishable because there was clear evidence in that case that the broad stated purpose of the company was no longer being fulfilled. The court then cited Yu v. Guard Hill Estates, LLC[135] as an example of another case where the Commercial Division dismissed a dissolution petition on the basis of a broad purpose provision. In Yu, the operating agreement provided that “the purpose of the companies was to acquire certain real property and engage in any other lawful act or activity for which limited liability companies may be formed under [New York law] and engaging in any and all activities necessary or incidental to the foregoing.” The court next held that petitioners failed to satisfy the financial-failure test of Section 702, noting that there was “no evidence that the LLCs are in financial turmoil, insolvent or otherwise cannot meet their debts and obligations.” Finally, the Commercial Division held that petitioners’ allegations regarding Respondents’ “oppressive conduct,” even if true, did not justify dissolution.
Setter Capital, Inc. v. Chateauvert[136](Personal jurisdiction as a factor in obtaining preliminary injunction). In Setter, Justice Andrea Masley of the Commercial Division ruled that the issue of whether a court has personal jurisdiction over a defendant is relevant to determining whether to grant a motion for a preliminary injunction. In Setter, plaintiff Setter Capital, Inc. (Setter), a financial services firm, moved pursuant to CPLR § 6301 for a preliminary injunction against defendant Maria Chateauvert, Setter’s former employee. The motion sought to restrain her from soliciting or recruiting Setter’s customers or otherwise interfering with its business relationships. Chateauvert’s job had involved calling potential clients to identify buyers and sellers of securities. A resident of Canada, Chateauvert had previously signed an agreement with Setter which contained confidentiality and non-compete clauses. The agreement also contained a choice-of-law clause providing it was governed by the laws of New York, and a forum-selection clause in which the parties agreed to submit to the jurisdiction of the Division. Under New York law, a plaintiff moving for a preliminary injunction bears the burden of establishing: (1) a likelihood of success on the merits; (2) the danger of irreparable injury in the absence of preliminary injunctive relief; and (3) that the balance of equities favors the plaintiff. However, as the Commercial Division explained, whether the court has jurisdiction over the defendant is a “threshold issue” that is relevant to determining the plaintiff’s likelihood of success on the merits.
Here, it was unclear whether the Commercial Division could exercise jurisdiction over Chateauvert pursuant to the agreement, because under N.Y. Gen. Oblig. Law §§ 5-1401 and 5‑1402,[137] choice-of-law and forum-selection provisions in contracts for labor or personal services are not enforceable against non-residents, and Chateauvert’s agreement with Setter specified that it was a “personal service” agreement. Additionally, the Commercial Division questioned whether Chateauvert, who was only two years out of college when she signed the agreement, “was the sophisticated business person the legislature envisioned in 1985 when GOL §5-1401 and §5-1402 were enacted.” Setter therefore bore the burden of establishing jurisdiction over Chateauvert without reference to the agreement. Justice Masley ruled that “this was an issue of fact that undermines plaintiff’s likelihood of success.” The Commercial Division concluded that Setter had otherwise failed to show likely success on the merits, given that there was no showing of protected trade secrets and Setter’s rating system was available online. The court also ruled that Setter had not shown irreparable harm, and that the balance of equities favored Chateauvert. Accordingly, the Commercial Division denied Setter’s motion for a preliminary injunction. Setter illustrates that on a preliminary injunction motion, the issue of whether the court has jurisdiction over the defendant may be a threshold issue of fact that must be satisfied in determining the plaintiff’s likelihood of success on the merits.
South Coll. St., LLC v. Ares Capital Corp.[138](Corporate veil piercing in New York Debtor and Creditor Law claims). In South College Street, Justice Schechter of the New York State Supreme Court, Commercial Division, dismissed petitioner’s New York Debtor and Creditor Law claims, which were premised on alter ego liability. The opinion addressed the types of allegations a plaintiff must make in order to successfully plead a veil-piercing claim. The case involved South College Street, LLC, a company that purchased a property in North Carolina that was subject to a lease for Charlotte School of Law (CSL). The lease was guaranteed by CSL’s parent company, InfiLaw Corporation (InfiLaw). In October 2017, CSL stopped paying its rent, so plaintiff commenced a North Carolina action against CSL and InfiLaw to enforce the lease. In that action, plaintiff obtained a judgment against CSL and InfiLaw, jointly and severally, for $24.55 million. Plaintiff then commenced a New York lawsuit against Ares Capital Corporation (Ares), a creditor of InfiLaw and a company to which InfiLaw’s parent company, InfiLaw Holding, LLC (InfiLaw Holding), had conveyed certain payments. Specifically, plaintiff asserted New York Debtor and Creditor Law (DCL) claims, arguing that “between June 2015 and August 2016, more than $32 million was fraudulently conveyed to Ares” and seeking to “enforce its judgment against [InfiLaw] by setting aside those conveyances.” Ares moved to dismiss plaintiff’s complaint.
In considering Ares’s motion to dismiss, the court noted that although DCL claims can generally only be asserted by creditors of the transferor, DCL liability can extend to alter egos. “Alter ego liability requires piercing the corporate veil, which is an exception to the presumption that corporate entities are distinct from their owners[.]” As Justice Schechter explained, “[w]hether veil piercing is warranted, is governed by the law of the state of incorporation of the entities whose veils were sought to be pierced[.]” Because InfiLaw and InfiLaw Holding are both incorporated in Delaware, the Court applied Delaware law. Under Delaware law, “to state a veil-piercing claim, the plaintiff must plead facts supporting an inference that the corporation, through its alter-ego, has created a sham entity designed to defraud investors and creditors[.]” The court remarked that it is “difficult” to meet this standard because a plaintiff must allege facts showing a parent company’s domination over its subsidiary, as well as facts demonstrating that the corporate structure itself was used to perpetuate a fraud.
Justice Schechter concluded that plaintiff had not adequately alleged facts supporting a reasonable inference that the corporate structure of and InfiLaw and InfiLaw Holding was designed to defraud InfiLaw’s creditors. Specifically, the court found that “[w]hile plaintiff alleges that [Infilaw Holding] dominates and controls [Infilaw], that is not enough.” Instead, the court reasoned, “plaintiff must plead, for instance, that the capital structure of [InfiLaw Holding] and [InfiLaw] was specially designed to ensure [InfiLaw]’s creditors would be left seeking to collect from an empty shell.” The court further noted that “the fraud prong of a veil piercing claim must rely on something other than merits of the underlying claim on which alter ego liability is sought[.]” Thus, the court concluded that plaintiff’s allegations supporting its DCL claims—that CSL was destined to fail because of InfiLaw’s underlying debt structure—were insufficient to plead alter ego liability. Accordingly, the court granted Ares’s motion to dismiss.
Matlick v. AmTrust Fin. Servs., Inc.[139](Failure to disclose delisting of securities). In Matlick, et al. v. AmTrust Financial Services, Inc., Commercial Division Justice Andrew Borrok found that an issuer cannot be held liable under the Securities and Exchange Act of 1933 for the failure to disclose the risk that certain securities could be delisted when the issuer never guaranteed the listing of such securities in the first instance.
In January 2019, AmTrust announced that it would delist and deregister certain securities that it had issued between 2013 and 2016, effective the following month. As a result of this announcement, the stock price of the securities fell by approximately 35%. Each offering of the relevant securities was registered through a number of offering documents that included representations, including that the securities were listed with the SEC, and AmTrust would list the securities on the New York Stock Exchange. Plaintiffs sued AmTrust for delisting the securities asserting claims for violations of Sections 11 and 12(a)(2) of the Securities and Exchange Act, based on AmTrust’s alleged material misstatements in and omissions from the offering documents, as well as claims for breach of contract, breach of the implied covenant of good faith and fair dealing, and promissory and equitable estoppel.
Justice Borrok focused on the language of the offering agreements in ruling for AmTrust. As the Court explained, “the gravamen of the Plaintiffs’ Complaint is that AmTrust failed to disclose in its Offering Documents that delisting the Securities was a possibility.” However, courts evaluate whether statements are false or misleading at the time they were made—“not retroactively, in hindsight.” The court held that plaintiffs had failed to allege any actionable misstatement or omission as required to state their Securities and Exchange Act claims because AmTrust was under no obligation to disclose publicly available information and its “ability to delist is publicly set forth by statute, in regulation, and in the NYSE rules.” The Commercial Division went on to explain that “all the Complaint alleges is that AmTrust should have disclosed the fact that the company could delist at some point in the future,” and this “is, indeed, too speculative (and, indeed, too obvious) to have required disclosure.” Justice Borrok also dismissed the contract claims, concluding that there was no contractual promise to list the securities or to keep them listed forever. Other claims were dismissed on technical grounds. Under the Commercial Division’s ruling in Matlick, the onus is on purchasers of securities to familiarize themselves with publicly available information, which need not be disclosed in the offering documents.
§ 1.3.13 North Carolina Business Court
Reynolds Am., Inc. v. Third Motion Equities Master Fund, Ltd.[140](Appraisal rights). In this appraisal action, dissenting former shareholders of Reynolds American, Inc. (Reynolds), the holding company that owned R.J. Reynolds Tobacco Company, asserted that they did not receive fair market value for their shares in connection with the purchase of Reynolds by British American Tobacco (BAT). Dissenters argued that despite a general decline in the tobacco industry, Reynolds had enjoyed strong revenues and earnings growth leading up to the transaction, which was not reflected in the offer price. They claimed that BAT’s 42 percent ownership in Reynolds tainted the transaction and that Reynolds should have pursued negotiations with other potential buyers.
Ultimately, the court found the dissenters’ valuation of the shares “unreasonable both as a matter of common sense fact-finding and under North Carolina law,” concluding that the fair market value of the shares was what they had been paid. Recognizing the lack of North Carolina appellate authority on the court’s appraisal process, the court turned to Delaware law to determine the fair value, “a price that is one that a reasonable seller, under all of the circumstances, would regard as within a range of fair value; one that such a seller could reasonably accept[.]” The court determined that in this instance, the deal price was a fair price because Reynolds stock traded in an efficient market, the deal was an arm’s-length transaction, there was sufficient publicly available information about the company, and there were no conflicts of interest among members of the board and transaction committee. Notably, the evidence showed that Reynolds had managed to negotiate four price increases from BAT during the course of the transaction.
The court rejected the dissenters’ theory that Reynolds should have solicited other bidders and pressed BAT to encourage other bids, concluding that there were few if any alternative bidders in the heavily consolidated tobacco market, none of which had expressed any interest in purchasing Reynolds. Additionally, despite their expert’s testimony, the dissenters also failed to provide evidence of any negative effect on the deal price stemming from BAT’s large ownership interest in Reynolds. Finally, the court rejected the dissenters’ claims that the Reynolds management and financial advisors conspired to sell the company at a depressed price. In conclusion, the court determined the “imperfect, but nonetheless robust, deal process” resulted in a fair deal price of $59.64 per share.
Aldridge v. Metro. Life Ins. Co.[141](Effect of bankruptcy settlement on defendants’ motion to dismiss). This case arose out of an alleged Ponzi scheme operated by Charlotte businessman Richard C. Siskey prior to his suicide in 2016, after the FBI publicly revealed that they were pursuing fraud charges against him. Plaintiffs were investors who claimed that MetLife was on notice of the “routinely questionable transactions” that Siskey engaged in, but it did nothing to stop Siskey once it learned of his fraudulent behavior. Rather, plaintiffs asserted that MetLife actively worked to conceal Siskey’s actions. Plaintiffs also claimed that several individual defendants at MetLife had aided Siskey in inducing them to invest in the scheme.
In January 2017, an involuntary bankruptcy proceeding was initiated against one of Siskey’s entities involved in the alleged scheme. Several of Siskey’s other entities plaintiffs had invested in entered bankruptcy as well. Plaintiffs filed proof of claim forms, and in late 2018, the Bankruptcy Trustee entered into a settlement agreement releasing all claims against MetLife in exchange for MetLife’s contribution to a bankruptcy settlement fund. Thus, in considering defendants’ motion to dismiss for lack of standing, the Business Court was required to construe the scope of the “first-crack” doctrine. This doctrine relies on the premise that only the Bankruptcy Trustee has standing to pursue claims that belong to the bankruptcy estate unless and until the trustee abandons those claims. Therefore, defendants argued that plaintiffs lacked standing to bring individualized claims.
The Business Court determined that the first-crack doctrine would not be applicable to all of plaintiffs’ claims. Under North Carolina law, plaintiffs would have standing if they could show (1) an individualized injury separate from damages to the bankrupt entities; or (2) a special duty owed to them by defendants. The court found that plaintiffs had individualized injuries with respect to the individual defendants, as they would never have invested but for being enticed by the individual defendants. However, the court granted the motions seeking dismissal of plaintiffs’ fraud, constructive fraud, and negligent misrepresentation claims brought directly against MetLife. In those cases, plaintiffs failed to show any individualized harm because they failed to show any misrepresentation made by MetLife. Likewise, plaintiffs failed to plead any special duty owed to them by MetLife that would give them individual standing. The court further found that plaintiffs’ claims against MetLife for its negligent supervision of Siskey failed to show individualized harm and dismissed them. Nevertheless, the court concluded that plaintiffs’ claims were allowed to go forward to the extent they sought to hold MetLife liable for the actions of Siskey and the individual defendants on a theory of vicarious liability. Finally, the court determined that certain plaintiffs who failed to allege their policies were involved in the Ponzi scheme had failed to allege a particularized injury with respect to their unfair trade practices claims, and thus lacked standing to pursue those claims.
Klos Constr., Inc. v. Premier Homes & Props., LLC[142](Fiduciary duties in the context of an LLC operating agreement). On these cross motions for summary judgment, the court had to determine whether and to what extent the parties owed each other fiduciary duties. In late 2008, plaintiff formed Premier Homes and Properties, LLC with defendants Key Marco Consulting and Marketing, Inc. and Alpat Properties, LLC for the purposes of constructing homes in a real estate development near Wilmington, North Carolina. The operating agreement disclaimed liability for managers to the company or other members for any of the following: (1) conflicts of interest; (2) any transaction from which a manager derived an improper personal benefit; or (3) any acts or omissions occurring prior to the date the agreement became effective. Furthermore, the agreement stated that upon any amendment to the North Carolina Limited Liability Act, liability for managers would be limited to the fullest extent possible under the amended Act. Premier Homes and Properties then entered into an agreement whereby T. Ando Construction and Consulting, Inc. and its owner, licensed real estate broker Terrance Ando, would be its “sales manager” and “broker-in-charge” for the newly constructed homes.
Construction began in 2009. However, in 2015, Key Marco’s sole shareholder, Robert Weinbach, formed another entity, Premier Homes and Communities, LLC, with Ando also for the purpose of building homes in the same residential community. Plaintiff brought suit alleging that Weinbach, Key Marco, and Ando had, among other things, breached their fiduciary duties owed to Premier Homes and Properties. Construing the agreement, the court found that Weinbach was not a party to the operating agreement, but instead was merely a designee who signed on behalf of Key Marco. As a result, the court denied plaintiff’s motion for summary judgment and granted Weinbach’s motion with respect to plaintiff’s claims for breach of fiduciary duty, constructive fraud, and breach of the implied covenant of good faith and fair dealing. Additionally, the court determined that the plain language of the operating agreement clearly gave the parties the right to establish competing businesses. The court also noted that in 2014, the North Carolina Limited Liability Act was amended to allow managers to waive their duty of loyalty. Thus, the court granted Key Marco’s motion for summary judgment on plaintiff’s breach of fiduciary duty and constructive fraud claims because the operating agreement no longer required any duty of loyalty among the managers. However, the court denied Key Marco’s motion with respect to the breach of the duty of good faith claim, explaining that unlike the duty of loyalty, contractual obligations of good faith cannot be waived in an operating agreement. Finally, the court determined that Ando and T. Ando Construction did owe fiduciary duties to Premier Homes and Properties by virtue of their agreement to be its real estate broker, thus denying their motions for summary judgment on plaintiff’s fiduciary duty and constructive fraud claims.
Rickenbaugh v. Power Home Solar, LLC[143](Class action arbitration). James and Mary Rickenbaugh brought suit on behalf of a class of plaintiffs alleging they were fraudulently induced to purchase defendant’s solar panels based on promises of energy savings that never materialized. The parties’ contract contained a broad arbitration provision stating that “any dispute arising out of . . . any aspect of the agreement” would be settled according to the AAA Construction Industry Rules. The court was called on to determine (1) whether the FAA or the North Carolina Uniform Arbitration Act applied; (2) whether the parties agreed that arbitrability was a matter for the court or the arbitrator to decide; and (3) whether the availability of class arbitration was an issue for the court or the arbitrator to determine.
First, the court determined that despite language in the arbitration clause stating that North and South Carolina law would apply, the FAA preempted the parties’ choice of law provision because plaintiffs’ claims were based on an alleged fraudulent scheme occurring in five states, thus evidencing a transaction involving interstate commerce. Secondly, the court determined that based on the broad language of the arbitration clause and the inclusion of the AAA Rules, under North Carolina precedent, there was “clear and unmistakable evidence” showing that the parties agreed the arbitrator would determine issues of substantive arbitrability. Finally and most importantly, the court determined that the parties had “clearly and unmistakenly agreed” that the availability of class arbitration was also a decision for the arbitrator. The court recognized the federal circuit split on the issue but determined that the inclusion of the AAA Construction Rules provision showed that the parties had agreed that the arbitrator would decide the scope of the arbitration proceedings, including whether class arbitration was available. Defendants have currently appealed the ruling on the class certification issue to the North Carolina Supreme Court.
Vanguard Pai Lung, LLC v. Moody[144](Advancement of litigation expenses for an LLC manager). Defendant William Moody served as president and CEO of plaintiff for nearly a decade. Plaintiff alleged Moody engaged in wide-ranging misconduct detrimental to plaintiff, including the siphoning of money and assets from plaintiff. Plaintiff sued Moody, three members of his family, and two entities he owns. Plaintiff’s lawsuit alleged sixteen causes of action, including fraud, embezzlement, breach of fiduciary duty, and breach of contract. Moody was fired prior to the institution of the lawsuit, but remained a manager of plaintiff.
Moody contended that plaintiff must advance his expenses incurred in legal defense of the lawsuit pursuant to the terms of plaintiff’s operating agreement, including attorneys’ fees. Moody asserted a counterclaim demanding the advancement of those expenses, and moved for judgment on the pleadings on his advancement counterclaim. The operating agreement provided a broad, mandatory right to advancement if two conditions were met: (1) the manager must have been sued “by reason of the fact” that he was an authorized representative of plaintiff; and (2) that the manager must repay the advancement if ultimately determined not to be entitled to indemnification. The parties contested whether the first condition was met. Citing supportive Delaware law, the court found the phrase “by reason of the fact” only requires a “nexus” between the underlying claim and the official’s corporate capacity. The court concluded that all claims against Moody “arise ‘by reason of the fact’ that he was a manager and officer of [plaintiff].” Therefore, the court determined that Moody was entitled to the advancement of his litigation expenses in defending the lawsuit. Further, the court allowed advancement related to Moody’s counterclaims for advancement and indemnification, but did not allow advancement related to Moody’s counterclaims that did not directly respond to the allegations against him. The court rejected plaintiff’s arguments that Moody forfeited his right to advancement based on its affirmative defenses against Moody’s counterclaims, including that Moody allegedly materially breached the parties’ contract. The court also rejected plaintiff’s arguments that determination of the advancement claim was improper for a motion for judgment on the pleadings. The court advised future litigants to bring an advancement dispute to the court’s attention in the case management report to allow early motions practice and limited discovery if necessary on the issue.
§ 1.3.14 Philadelphia Commerce Case Management Program
Chhaya Mgmt., LLC v. Cigar Wala, LLC[145](Cannot pierce corporate veil against uninvolved owners who did not benefit from fraud). Chhaya Management won a $660,000 judgment against Cigar Wala, but could not pierce the corporate veil against two principals named as defendants, Shah and Patel. The Commerce Court found that a third principal, Desai, solely caused Cigar Wala’s breach by diverting its funds to himself, leaving Cigar Wala unable to make payments due to Chhaya Management. Plaintiff did not name Desai as a defendant. There was no evidence, however, linking Shah and Patel to Desai’s fraudulent conduct, “or to any conduct giving rise to a piercing of a corporate veil as to them.”
The court first held Chhaya’s claims were for breach of contract, and dismissed its tort claims for conversion and conspiracy under the gist of the action doctrine. As to piercing the corporate veil, courts will pierce the corporate veil against equity owners who control the business and misuse it to their personal benefit. The court found Shah and Patel did not control Cigar Wala at the time Desai pilfered its funds for his own use. Even though the court earlier determined Shah and Patel should have been the controlling (75%) owners of Cigar Wala, Desai had frozen them out. Thus, at the time of the breach, Shah and Patel neither had the ability to control Cigar Wala, nor did they gain any benefit from Desai’s fraud. Rather, Desai’s fraud harmed Shah and Patel as well. The decision was affirmed on appeal in relevant part.
Humphrey v. GlaxoSmithKline PLC[146](Non-signatories not bound by arbitration agreement). In Humphrey, the Commerce Court addressed the issue of whether non-signatories to an arbitration agreement could be bound by the agreement. Plaintiffs were two individuals and a corporation, ChinaWhys Company, Ltd. Another company they owned, ChinaWhys (Shanghai) Consulting Co. Ltd., entered a consulting agreement with a foreign subsidiary of GlaxoSmithKline PLC (GSK PLC) to carry out an investigation. That agreement included an arbitration clause. Plaintiffs allege they were imprisoned and otherwise subjected to considerable suffering in connection with the investigation, and sought relief in the Commerce Court against GSK PLC and another subsidiary, GlaxoSmithKline, LLC (GSK LLC). Plaintiffs did not name GSK PLC’s foreign subsidiary as a defendant, nor was ChinaWhys (Shanghai) named as a plaintiff. One of the individual plaintiffs, however, signed on ChinaWhys (Shanghai)’s behalf. The defendants moved to compel arbitration of the entire matter under the consulting agreement.
Supervising Commerce Court Judge Gary S. Glazer observed that the usual presumption favoring enforcement of arbitration clauses does not apply to non-signatories. In those circumstances, “the parties opposing arbitration … are given the benefit of all reasonable doubts and inferences that may arise.” Here, four of the five parties did not sign the agreement at issue, and the individual plaintiff only signed on the corporation’s behalf and not in his individual capacity. Judge Glazer found the facts alleged in the complaint “completely extrinsic” to the consulting agreement embodying the arbitration clause. Plaintiffs did not seek relief under the contract, but brought tort claims against non-parties to that contract, to which plaintiffs were also not parties. Although the individual plaintiffs were principals of ChinaWays (Shanghai), their individual claims were unrelated to the ChinaWays (Shanghai)’s consulting agreement. The court rejected defendants’ arguments that there was an “obvious and close nexus” between plaintiffs, their claims, and the consulting agreement. Judge Glazer likewise rejected defendants’ agency, estoppel, alter ego and contract assumption theories.
Am. Entrance Servs., Inc. v. ACME Mkts., Inc.[147](Abuse of process and wrongful use of civil proceedings distinguished). In American Entrance Services, the Commerce Court found no abuse of process, and described the difference between “abuse of process” and “wrongful use of civil proceedings” under Pennsylvania law. ACME had joined American as a third party defendant in numerous personal injury suits concerning maintenance of automatic doors. The factual gravamen of American’s abuse of process claim was the allegation that American repeatedly forewarned ACME there was no factual basis for these joinders, because ACME itself failed to maintain and upgrade the doors contrary to American’s advice. Judge Ramy I. Djerassi found these allegations did not make out an abuse of process case.
The court defined common law abuse of process “as the use of legal process against another primarily to accomplish a purpose for which it is not designed.” There must be “some definite act or threat not authorized by the process, or aimed at an objective not legitimate in the use of the process….” “[T]here is no liability where the defendant has done nothing more than carry out the process to its authorized conclusion, even if done with bad intentions, though not necessarily the case here.” At best, American was attempting to state a claim for wrongful use of civil process in initiating meritless claims. Abuse of process claims, however, are not based on improperly initiating a case, but “on a perversion of the legal process after it is initiated.” Thus, American’s allegations of improperly filing meritless joinder claims did not fall within the abuse of process penumbra.
§ 1.3.15 Rhode Island Superior Court Business Calendar
Richmond Motor Sales, Inc. v. Nationwide Mut. Ins. Co.[148](Insurer cannot be sued directly). A rental company rented motor vehicles to various customers. The customers provided their own motor vehicle insurance information to the company as proof of insurance. The vehicles were returned with damage, and the rental company sued the insurance carriers directly for the damage. The court held that R.I. Gen. Laws Sections 27-7-3 and 27-7-6 did not give the rental company the right to pursue the carriers.
Cashman Equip. Corp., Inc. v. Cardi Corp.[149](Motion to strike jury demand). Before the court was plaintiff Cashman Equipment Corporation, Inc.’s (Cashman) motion to strike defendants RT Group, Inc. (RTG), James Russell, and Steven Otten’s jury demand. At issue was whether the action must be tried without a jury.
Here, the applicable statute provides that:
any person, firm, or corporation which is awarded a contract subsequent to July 1, 1977, with the state of Rhode Island, acting through any of its departments, commissions, or other agencies, for the design, construction, repair, or alteration of any state highway, bridge, or public works other than those contracts which are covered by the public works arbitration act may, in the event of any disputed claims under the contract, bring an action against the state of Rhode Island in the superior court for Providence county for the purpose of having the claims determined
and that “[t]he action shall be tried to the court without a jury.” G.L. 1956 § 37-13.1-1(a).
The court found there was no question that Cashman’s amended complaint, and this entire case, arose out of disputes related to the contract between RIDOT and Cardi. Section 37-13.1-1 clearly states that disputes arising out of a contract with the State involving the “design, construction, repair, or alteration of any state . . . bridge” must be tried “without a jury.” This statute must be strictly construed, and it does not provide any exception for cases in which the State is a third-party defendant or is not the subject of direct claims by the original plaintiff to the case. Instead, the statute has been strictly construed to apply to and protect the State’s sovereign immunity in cases when the State is a third-party defendant in cases involving disputes between subcontractors and general contractors such as the dispute here. Therefore, the motion to strike jury demand was granted, and the case must be tried without a jury.
Premier Land v. Kishfy[150](Party breached contract through non-payment and change in scope of work). Defendant Kishfy entered into a construction contract with the plaintiff pursuant to which the defendant agreed to perform certain renovations as set forth in a scope of work and subject to certain cost allowances. Defendant agreed to pay for such renovations in monthly installments. Defendant ended up substantially modifying the scope of work, which led to increased costs and delays. He subsequently stopped making payments on the grounds that the project was taking too long to complete. The court found that the defendant had materially breached the contract through his nonpayment and his increases to the scope of work.
Sadler v. 30 Route 6, LLC[151](Real estate purchaser granted right to specific performance). The court granted a real estate purchaser specific performance against his vendor. Although the purchaser missed the stated closing date, there was no “time of the essence” clause in the contract. Further, the purchaser worked in good faith to prepare for the closing. The vendor could not use the purchaser’s failure to obtain financing as an excuse, because the financing contingency was solely for the benefit of the purchaser. Finally, the vendor’s notice that it did not intend to close constituted an anticipatory breach that excused the purchaser but did not terminate the contract.
Atsalis Bros. Painting Co. v. Aetna Bridge Co.[152](Subcontractor permitted to correct technical defect in making good faith claim). Aetna entered into a $39 million Contract Agreement (Prime Contract) with Rhode Island Turnpike and Bridge Authority (RITBA) to perform certain rehabilitation work on the Claiborne Pell Bridge (Project). The Agreement between Aetna and RITBA incorporated into it inter alia the Rhode Island Department of Transportation, Division of Public Works standard specifications for road and bridge construction (the Blue Book) and other supplemental materials. Aetna entered into a $26 million contract (Subcontract) with Atsalis Brothers Painting Co. (Atsalis) as subcontractor to perform approximately two-thirds of the work on the project called for by Prime Contract. The subcontract contained a provision that made the Prime Contract documents between Aetna and RITBA, including the Blue Book, a part of the Subcontract. The Blue Book required that a subcontractor certify that its claims for payment were made in good faith. The plaintiff made a claim, but failed to include that certification. The court held that this was a formal defect that “can easily be rectified” and gave the plaintiff leave to amend its certificate if it could in fact assert its claim in good faith. The subcontractor also claimed that the contractor defrauded the subcontractor when it said it would settle up at the end of the contract. Analogizing from Massachusetts common law and Rhode Island law on false pretenses, the court denied the contractor’s motion to dismiss a fraud claim, because a promise to do something in the future can still constitute fraud if the party never intended to act.
§ 1.3.16 Tennessee Business Court
Falcon Pictures Group v. HarperCollins Christian Publ’g, Inc.[153](Motion for summary judgment and judgment on the pleadings). This case involves a dispute between two businesses in the entertainment industry. The plaintiff and the defendant entered into a business relationship in 2006. The plaintiff was to produce, and the defendant was to market and sell, a product known as the New Testament Audio Bible. The parties entered an agreement for the defendant to advance funds to plaintiff and to pay royalties according to the terms of the contract. Additionally, the parties entered into separate contracts for an Old Testament Audio Bible and a Kids Audio New Testament. Eventually, plaintiff began to question whether defendant was properly calculating and paying royalties.
The court found that the defendant was entitled to dismissal of the claim for breach of the duty of good faith and fair dealing under Rule 12. That cause of action is not an independent cause of action in Tennessee, but must be brought in conjunction with and as part of a breach of contract claim. The court dismissed that cause of action on that basis. The court denied all the other relief requested by the defendant pursuant to Rule 12 or 56 because the plaintiff was able to demonstrate sufficient factual disputes to prevent judgment or was entitled to develop the facts for the court’s consideration.
Romohr v. The Tenn. Credit Union[154](Motion to dismiss).Romohr v. The Tennessee Credit Union involves a dispute between plaintiff, individually and on behalf of all others similarly situated, and the Tennessee Credit Union (TCU). The complaint alleges that Romohr is a member of the TCU and has a checking account governed by TCU’s Membership Account Agreement. The central issue of the lawsuit centers around insufficient funds penalties and the pertinent language of the membership account agreement. Romohr alleges that TCU charged three separate insufficient funds penalties against his account following attempted charges by a third-party vendor. Romohr brings this suit for breach of contract and unjust enrichment.
The court noted a multitude of pending litigation involving this subject matter and further noted that each case pivots on the specific language within each agreement, specifically, whether or not certain terms contained therein are sufficiently defined. Because the agreement in question contains some ambiguities, this case survived a Rule 12.02(6) motion to dismiss.
Family Trust Servs., LLC v. Green Wise Homes, LLC[155](Civil conspiracy, fraud, and defamation of title). This case with a lengthy history involves an alleged civil conspiracy related to fraudulently created documents to misappropriate and undercut the Tennessee redemption process following delinquent tax sales in Middle Tennessee. The plaintiffs alleged that the defendants engaged in a systematic conspiracy by creating and recording false deeds in various counties to undermine the redemption process and profit at the expense of purchasers for value at tax sales. Plaintiffs brought causes of action for civil conspiracy, defamation of title, fraud, trespass, and unfair competition, and sought to certify a class action for similarly situated victims.
This case has, thus far, involved removal and remand to bankruptcy court and criminal contempt charges against a defendant. Recently, the court considered a motion to dismiss and motion for class certification. Ultimately, the court dismissed plaintiffs’ claim for conversion of the intangible right of redemption and denied class certification. Litigation will continue.
§ 1.3.17 West Virginia Business Court Division
Highmark W. Va., Inc. v. MedTest Labs., LLC[156](Personal jurisdiction over third-party defendants). This case was referred to the Business Court Division on June 18, 2019, and arises from a contractual dispute between a West Virginia-based insurance carrier, Highmark West Virginia, and a West Virginia-based medical test provider, MedTest Laboratories. Initially, Highmark filed this suit alleging that MedTest was carrying out a fraudulent billing scheme. However, it is the counterclaim and third party action instituted by MedTest that prompted the order being discussed. Highmark is part of the national Blue Cross Blue Shield insurance network. MedTest has a contract with Highmark to provide laboratory testing services to anyone in the national Blue Cross Blue Shield network in exchange for payment from Highmark, allowing Blue Cross Blue Shield’s insureds to receive coverage for healthcare regardless of where they were in the country. MedTest’s counterclaim and third party action centered on Highmark’s failure to pay MedTest for services performed as required by contract. In response, the third party defendants filed a motion to dismiss, alleging that West Virginia lacked personal jurisdiction over the third party defendants.
The Business Court Division disagreed and found that West Virginia had personal jurisdiction over the foreign third party defendants. First, the court found that West Virginia’s long-arm statutes were met. The court reasoned that the contracts involved meant that MedTest would provide a service, Highmark would process and pay the claim, and then the third party defendants would reimburse Highmark. Further, each of the third party defendants was required to participate in the program. This was enough to satisfy West Virginia’s long-arm statutes. Second, constitutional due process was satisfied when all of the third party defendants listed MedTest as an available provider in their provider directory. Because the third party defendants advertised—even just through an online post of provider directories—to their insureds that they could use MedTest and be covered by their plan that they had purposefully availed themselves of the forum and were thus subject to personal jurisdiction. The court handed down the order denying the motion to dismiss on March 27, 2020.
The third party defendants filed a petition for writ in prohibition with the Supreme Court of Appeals of West Virginia, seeking review of the finding by the Business Court that there was personal jurisdiction over all of the out of state Blue Cross plans. The Supreme Court of Appeals issued a rule to show cause and has the case under submission for decision.
Am. Bituminous Power Partners, LP v. Horizon Ventures of W. Va., Inc.[157](Commercial lease dispute). Two orders come from this case, which arose from a decades-long dispute over the terms of a lease between American Bituminous, the operator of a power plant, and Horizon Ventures, the landlord, which was only referred to the Business Court Division on January 10, 2019. The lease required American Bituminous to use locally mined coal to produce electricity, and foreign fuel could only be used for non-operational purposes. Monthly rent is a percentage of the power plant’s gross revenue, varying based on the type of fuel on site. If locally-sourced fuel is used, rent is 3% of gross revenue; if foreign fuel is used, rent is only 1% of gross revenue. However, subsequent to the lease, the parties agreed that if any Local Fuel remained on the premises—whether useable or not—the rent would be 2.5% of gross revenue. Eventually, American Bituminous stopped using Local Fuel, but did not ask Horizon Ventures to reduce its rent. The action before the Business Court Division involved a dispute over the percent of gross revenue paid as rent and whether American Bituminous’s use of Foreign Fuel was within the discretion provided by the lease contract.
The court entered two separate orders granting summary judgment on these issues. First, the court granted summary judgment to Horizon Ventures regarding American Bituminous’s claim that the percent of gross revenues paid as rent was too high. Looking at the length of the dispute between the parties, and the origin of the contracts, the court reasoned that the doctrines of waiver and laches apply. American Bituminous had known since 1989 that its rent could be reduced based on the usage of foreign fuel, and knew it had stopped using Local Fuel for operating purposes; American Bituminous’s failure to act was an indication it had waived the contractual right and had otherwise waited too long to assert the claim. Second, the court granted American Bituminous summary judgment with regards to the assertion that American Bituminous had been arbitrary and capricious in its decision to use Foreign Fuel. The court looked at American Bituminous’s decision-making process, including factors such as cost, safety, and longevity of the power plant, and determined that American Bituminous had considered all relevant factors such that its conduct was not arbitrary and capricious as defined by law. As a result, the court granted American Bituminous summary judgment on the final issue before the court and the matter was dismissed.
§ 1.3.18 Wisconsin Commercial Docket Pilot Project
Mattheis v. Ihnen[158](Judicial estoppel and sham affidavit rule). In Mattheis, the court was asked to interpret both the doctrine of judicial estoppel and the sham affidavit rule as it relates to statements made by a party in previous court cases. The defendant Ihnen moved for summary judgment on all Mattheis’s claims, each of which suggested that Mattheis had alleged ownership interest in various entities. As the court outlined in its decision, Mattheis had previously testified via interrogatories, deposition, and affidavits in both a divorce proceeding and a federal case for fair wage violations that he had sold his ownership interest in both companies.
Using the doctrine of judicial estoppel, the court cited State v. Ryan[159] and found that the three elements for judicial estoppel were satisfied: (1) the later position must be clearly inconsistent with the earlier position; (2) the facts at issue should be the same in both cases; and (3) the party to be estopped must have convinced the first court to adopt its position. The court found that all these elements were met even though the earlier position was taken in other cases and that to meet the third element, the previous court need not explicitly find that the position at issue was adopted. Instead, following Seventh Circuit precedent, the court found that it was enough that the party prevail using the inconsistent statement. For Mattheis, the court was persuaded that Mattheis was able to leverage the positions taken in his divorce proceeding and federal case to sidestep a determination of the disputed issue of his ownership interests and prevailed. As such, the court granted summary judgment to Inhen based on judicial estoppel and dismissed all claims.
Similarly, the court applied the sham affidavit rule as another basis to grant summary judgment. Just as with the judicial estoppel argument, the court held that statements in Mattheis’s affidavit were directly contrary to his statements in the divorce proceedings and in his state and federal income tax returns, which stated that he sold his business shares. Following a recent decision from the United States District Court for the Eastern District of Wisconsin,[160] the court found that the earlier statement (in this case, the divorce proceeding and tax returns) must stand unless the party can adequately explain why the recent statement was necessary. Here, the court was unconvinced that Mattheis provided any legitimate explanation as to the recent statements and struck his affidavit pursuant to the sham affidavit rule, again granting summary judgment to Inhen.
[1] For a more detailed discussion on what may be defined as a business court, see generally A.B.A. Bus. Law Section, The Business Courts Bench Book: Procedures and Best Practices in Business and Commercial Cases (Vanessa R. Tiradentes, et al., eds., 2019) [hereinafter Business Courts Bench Book]; Mitchell L. Bach & Lee Applebaum, A History of the Creation and Jurisdiction of Business Courts in the Last Decade, 60 Bus. Law. 147 (2004) [hereinafter Business Courts History].
[2] For an overview of business courts in the United States, see, e.g., Business Courts Bench Book, supra note 1, Business Courts History, supra note 1, Lee Applebaum & Mitchell L. Bach, Business Courts in the United States: 20 Years of Innovation, in The Improvement of the Administration of Justice (Peter M. Koelling ed., 8th ed. 2016); Joseph R. Slights, III & Elizabeth A. Powers, Delaware Courts Continue to Excel in Business Litigation with the Success of the Complex Commercial Litigation Division of the Superior Court, 70 Bus. Law. 1059 (Fall 2015); John Coyle, Business Courts and Inter-State Competition, 53 Wm. & Mary L. Rev. 1915 (2012); The Honorable Ben F. Tennille, Lee Applebaum, & Anne Tucker Nees, Getting to Yes in Specialized Courts: The Unique Role of ADR in Business Court Cases, 11 Pepp. Disp. Resol. L. J. 35 (2010); Ann Tucker Nees, Making a Case for Business Courts: A Survey of and Proposed Framework to Evaluate Business Courts, 24 Ga. St. U. L. Rev. 477 (2007); Tim Dibble & Geoff Gallas, Best Practices in U.S. Business Courts, 19 Court Manager, no. 2, 2004, at 25. Further, the Business Courts chapter of this publication has provided details on developments in business courts every year since 2004. Finally, the Business Courts Blog went online in 2019, and serves as a library for past, present and future business court developments, www.businesscourtsblog.com (last visited Oct. 26, 2020).
[9] ABA Ad Hoc Comm. On Business Courts, Business Courts: Towards a More Efficient Judiciary, 52 Bus. Law. 947 (1997); Business Courts History, supra note 1.
[48] For those interested in learning more about the use of Zoom in Michigan business courts, see Douglas Toering & Ryan Hansen, Touring the Business Courts, Mich. Bus. L. J., Summer 2020 at 11, https://connect.michbar.org/businesslaw/newsletter/summer20 (last visited Oct 30, 2020).
[63] This district covers circuit courts in a number of northeastern Wisconsin counties including Door, Kewaunee, Brown, Marinette, Oconto, Waupaca, and Outagamie.
[64] PowerPoint Presentation, Thomas Schappa, Dist. Court Adm’r, Com. Ct. Docket Pilot Program (Oct. 2020) (on file with author).
[97] No. 2020-012763-CA-44 (Fla. 11th Jud. Cir. Sept. 1, 2020) (Order On Assignee’s Motion to Determine Who Owns Assignor’s Attorney-Client and Accountant-Client Privileges).
[98] No. 20-CA-001233 (Fla. 13th Jud. Cir. April 30, 2020) (Order Denying Defendants’ Motion to Dismiss for Improper Venue Based Upon a Mandatory Forum Selection Clause).
[120] See Mich. Comp. L. § 500.3114 (1) on priority.
[121] The husband omitted the wife’s name, date of birth, and all other identifying information; however, he did provide all identifying information for his daughter and listed her as a named insured.
[137] N.Y. Gen. Oblig. Law § 5-1401 provides for the enforcement of choice-of-law provisions in contracts over $250,000 and N.Y. Gen. Oblig. Law § 5-1402 provides for the enforcement of forum selection provisions in contracts over $1 million.
Snell & Wilmer L.L.P. One Arizona Center 400 E. Van Buren Phoenix, AZ 85004-2202 (602) 382-6366 [email protected] www.swlaw.com
§ 1.1 Tribal Litigation & The Third Sovereign
We have been writing this annual update of cases relevant to tribal litigation for years. Recognizing that the average practitioner consulting this volume may not have much experience with federal Indian law, we have endeavored to provide historical context and citation to most relevant circuit and even district court cases in every volume. This had resulted in a chapter that had grown to almost 70 pages in length and had increasingly made it difficult for the reader to identify the most recent cases.
To both be more consistent with the other chapters in this volume, and to focus on the cases decided in the last year, we decided to change the format of this chapter beginning with the 2019 Edition. This chapter will continue with that format and focus on cases decided between Oct. 1, 2019 – Oct. 1, 2020. While other chapters have arranged themselves by circuit, we will begin with a Supreme Court overview and then structure this chapter around sovereigns; Indian Tribes, the United States, and the fifty sister States. Within each sovereign we now provide a more concise overview of each subject, with more limited and deliberate citation, followed by longer and more intentional discussion of recent cases. We hope the reader appreciates the change in format and we welcome comments via email to any of the chapter authors.
Retired Supreme Court Justice Sandra Day O’Connor has aptly referred to tribal governments as the “third sovereign” within the United States.[1] Much like federal and state governments, tribal governments are elaborate entities often consisting of executive, legislative, and judicial branches.[2] Tribes are typically governed pursuant to a federal treaty, presidential executive order, tribal constitution and bylaws, and/or tribal code of laws, implemented by an executive authority such as a tribal chairperson, governor, chief, or president (similar to the president or a state’s governor) and a tribal council or senate (the legislative body). Tribal courts adjudicate most matters arising from the reservation or under tribal law.[3]
Indian tribes are “distinct, independent political communities, retaining their original natural rights” in matters of local self-government.[4] Thus, state laws generally “have no force” in Indian Country.[5] While in the eyes of federal and state government, tribes no longer possess “the full attributes of sovereignty,” they remain a “separate people, with the power of regulating their internal and social relations.”[6]
This chapter explores the repose of tribal sovereignty, federal plenary oversight of that sovereignty, and perennial state encroachment upon that sovereignty. Federal trial and appellate courts issue more than 650 written opinions in cases dealing with Indian law each year,[7] and settle, dismiss, or resolve without opinion countless others. This chapter introduces those cases most relevant to a business litigation focused audience.
§ 1.2 Indian Law & The Supreme Court
§ 1.2.1 The 2019–2020 Term
The Supreme Court hears an average of between two and three new Indian law cases every year.[8] During the 2019-2020 term, the Court decided only a single Indian law case, but one of incredible importance to federal Indian law and to practitioners in Oklahoma or who regularly do business with the Five Tribes.
McGirt v. Oklahoma, 140 S. Ct. 2452 (2020).McGirt is an extension of a case granted last term, Carpenter v. Murphy, where the Court deadlocked 4-4 after Justice Gorsuch was recused for having participated in a decision not to review the case en banc while still a member of the Tenth Circuit. Instead of affirming the case by an equally divided Court, the Court ordered re-argument. It then granted McGirt raising the same issue—whether the Muscogee (Creek) Reservation had been diminished.
Diminishment is discussed in more detail in Section 8.4.1, but, functionally, the question deals with whether an Indian tribe may continue to assert its inherent powers over land owned by non-members of the tribe but within the original boundaries of the reservation. The presumption has always been that a reservation retains its Indian status (and is thus not diminished) unless Congress expressed its clear intent to diminish the reservation. In order to determine Congressional intent the Court has traditionally looked at three factors: (1) the statutory language of the relevant allotment act(s), which opened the land on the reservation to non-Indian settlement, (2) the events surrounding passage of the act, and (3) the Indian character of the land.
In a 5-4 opinion authored by Justice Gorsuch, the Court in McGirt held that the Muscogee (Creek) reservation was not diminished, and it modified the test to virtually eliminate all but the first factor.
Justice Gorsuch opened the opinion with a line that will be cited in Indian law cases for generations: “On the far end of the Trail of Tears was a promise.” The opinion makes clear that Indian reservations remain intact unless modified by Congress and that, to “ determine whether a tribe continues to hold a reservation, there is only one place we may look: The Acts of Congress.” The Court expressly rejected the idea that the events surrounding passage, or the Indian character of the land must be considered, reasoning that, if the statutory language used by Congress is unambiguous, there is no need to look anywhere else for Congressional intent. “When interpreting Congress’s work in this arena, no less than any other, our charge is usually to ascertain and follow the original meaning of the law before us. That is the only ‘step’ proper for a court of law. *** Nor may a court favor contemporaneous or later practices instead of the laws Congress passed. As Solem explained, ‘[o]nce a block of land is set aside for an Indian reservation and no matter what happens to the title of individual plots within the area, the entire block retains its reservation status until Congress explicitly indicates otherwise.’”
As a result of the opinion, the entire Muscogee (Creek) reservation remains Indian country, and the tribal government may extend its inherent powers over even non-members of the tribe in some circumstances. Moreover, the tribal courts may generally hear disputes arising on the reservation, even those concerning non-members. The Muscogee (Creek) reservation includes the southern portion of the City of Tulsa, and the case sets a precedent that other members of the Five Tribes (Cherokee, Choctaw, Chickasaw, and Oklahoma Seminole) with similar treaty and allotment histories may also remain Indian country.
While the McGirt case was ostensibly a case about criminal jurisdiction, the conclusion that the reservation is undiminished will have potentially large consequences for everything from taxation and regulation[9] to forum selection and adjudicative powers for the tribal courts.
§ 1.2.2 Preview of the 2020-2021 Term
As of October 1, 2020, the Supreme Court has not granted certiorari to any Indian law case for the 2020–2021 term, although there is always the possibility that additional cases will be added to the docket and still decided before June 2021. If any new cases are granted and decided, they will be included in next year’s volume.
There one was notable dissent from denial of cert. in a relevant Indian law case. On Oct. 19, 2020, Justice Thomas dissented from the denial of cert. in Rogers County Board of Tax Roll Corrections v. Video Gaming Technologies Inc. 592 U.S. ___ (2020). The case is discussed in more detail in §8.5 below—but, briefly, the Supreme Court of Oklahoma had ruled that the Indian Gaming Regulatory Act preempted the State of Oklahoma’s ad valorem tax on gaming machines used exclusively on an Indian reservation at the tribal casino but owned by a non-Indian entity. The County appealed the decision to the U.S. Supreme Court and the Court denied cert.
In his dissent from the denial of certiorari, Justice Thomas explained that he would have ordered the case considered. In his short dissent, Justice Thomas explained that the Court has applied a “flexible” test to the preemption of state taxes on non-Indian property in Indian country and has provided little guidance other than that courts should “balance federal, tribal, and state interests.” He would have granted the case to clarify to what extent a state may tax non-Indian property in Indian country, and he noted that the clarity is particularly needed now because McGirt (discussed above) had enlarged Indian country substantially in Oklahoma.
§ 1.3 The Tribal Sovereign
§ 1.3.1 Tribal Courts
More than half of the 574 federally recognized tribes have created their own court systems and promulgated extensive court rules and procedures to govern criminal and civil matters involving their members, businesses, and activity conducted on their lands. Notwithstanding federal restrictions on tribal adjudicatory power, tribes have extensive judicial authority. As the complexity of life on reservations has increased, so has Congress’s willingness to enhance and aid tribal courts’ adjudicatory responsibilities.
While tribal courts are similar in structure to other courts in the United States, the approximately 275 Indian courts currently functioning throughout the country are unique in many significant ways.[10] It cannot be overemphasized that every tribal court is different and distinct from the next.[11] For example, the qualifications of tribal court judges vary widely depending on the court.[12] Some tribes require tribal judges to be members of the tribe and to possess law degrees, while others do not.[13] Some tribal courts meet regularly and have a fairly typical court calendar, while others may meet on Saturdays or only a couple days a month in order to meet the more limited needs of a court system serving a smaller population or particularly isolated tribal community.
Tribal courts can have their own admissions rules and counsel should not assume that because they are licensed in the state where the tribal court is located that they can automatically appear in tribal court. While many tribes allow members of the state bar to join the tribal bar, often for a nominal annual fee, the requirements vary from one tribe to another. For example, the Navajo tribe has its own bar exam that tests knowledge of Navajo tribal law.[14]
Counsel should keep this uniqueness in mind when addressing a tribal court orally or in writing. If counsel has never appeared before a particular tribal court previously, it would be wise to solicit common court practice from persons who regularly appear before the court.
Tribal court jurisdiction depends largely on (1) whether the defendant is a tribal member[15] and (2) whether the dispute occurred in Indian Country,[16] particularly lands held in trust by the United States for the use and benefit of a tribe or tribal member or fee lands within the boundaries of an Indian reservation.[17] These two highly complex issues should be analyzed first in any tribal business dispute.
In the context of a tribe’s civil authority, the important distinction is between tribal members and non-members (whether or not the non-member is an Indian). Generally, tribal courts have jurisdiction over a civil suit by any party, member, or non-member against a tribal member Indian defendant for a claim arising on the reservation.[18] Even in tribal court, claims against the tribe itself require a waiver of tribal immunity.[19] Indian tribes also generally have regulatory authority over tribal member and non-member activities on Indian land.[20]
In the “pathmaking” decision of Montana v. United States,[21] however, the U.S. Supreme Court held that a tribal court cannot generally assert jurisdiction over a non-tribal member when the subject matter of the dispute occurs on land owned in fee by a non-member, explaining that “exercise of tribal power beyond what is necessary to protect tribal self-government or to control internal relations is inconsistent with the dependent status of tribes, and so cannot survive without express Congressional delegation.”[22] To help lower courts determine when the assertion of tribal power is necessary, the Court articulated two exceptions: (1) a tribe may have civil authority over the activities of non-tribal persons who enter into consensual relations with the tribe or its members via a commercial dealing, contract, lease, or other arrangement; or (2) the tribe has civil authority over non-Indians when their actions threaten or have a direct effect upon the “political integrity, the economic security, or the health or welfare of the tribe.”[23]
These exceptions are “limited,” and the burden rests with the tribe to establish the exception’s applicability.[24] The first exception specifically applies to the “activities of non-members,” and the second exception is extremely difficult to prove, as it must “imperil the subsistence of the tribal community.”[25] These exceptions have, oddly, become known as the “Montana rule.”
There are new opinions issued every year on the limits of tribal court jurisdiction that are built upon Montana and its exceptions. This section highlights a couple of the most relevant.[26]
FMC Corp. v. Shoshone-Bannock Tribes, 942 F.3d 916 (9th Cir. 2019): FMC operated an elemental phosphorous plant, which produced 22 million tons of hazardous waste stored on fee land located within the Shoshone-Bannock Fort Hall Reservation. In 1990, the EPA classified the site as a National Priority List Superfund Site under CERCLA and, in 1997, charged FMC with violating the Resource Conservation and Recovery Act (RCRA). Consequently, FMC agreed to a Consent Degree in which it would obtain a permit from the tribe to continue storing the hazardous waste for $1.5 million per year, but it stopped paying in 2002 after ceasing active plant operations.
FMC had regularly applied to the Tribe’s Land Use Policy Commission for a use permit for the land. The Commission provisionally granted a use permit but imposed an annual permit fee of at least $1.5 million and a one-time building permit fee. FMC twice appealed to the Fort Hall Business Council, which affirmed the Commission’s decision. FMC then appealed to the tribal court.
The tribal trial court and court of appeals held that the Tribe had regulatory and adjudicatory powers over FMC. The appellate panel held that the Tribe had regulatory and adjudicatory jurisdiction under the second Montana exception because FMC’s storage threatened the welfare and cultural practices of the Tribe. FMC then sued the Tribe in federal district court, which affirmed the Tribal Court but held that the judgment was enforceable under the first but not the second Montana exception. FMC appealed to the Ninth Circuit.
The Ninth Circuit held that the Tribes had regulatory and adjudicatory jurisdiction under both Montana exceptions, that FMC was not denied due process, and that the Tribal Court of Appeals’ judgment was enforceable under principles of comity. First, it held that, under the first Montana exception, FMC had entered into a consensual relationship with the Tribes when it negotiated and entered into the permit agreement. The Consent Decree was a “sweetheart” business deal that was not the product of coercion, and, because of FMC’s long history of prior business dealings with the Tribe, it should have reasonably anticipated that its interactions with the Tribe might trigger tribal authority.
Second, the Ninth Circuit found that, under the second Montana exception, the storage of hazardous waste on the reservation constituted a threat to tribal natural resources and tribal self-governance, health, and welfare. As noted by the EPA in the Tribal Court of Appeals’ evidentiary hearing, millions of tons of toxic, carcinogenic, and radioactive hazardous waste directly threatened the tribes’ political integrity, economic security, and health and welfare. FMC petitioned to the Supreme Court of the United States for review and the Court called for the views of the Solicitor General. As of this writing, the case has not yet been granted or denied.
Employers Mut. Cas. Co. v. McPaul, 804 F. App’x 756 (9th Cir. 2020): The Navajo Nation sued Employers Mutual Casualty Company (EMC) in tribal court, alleging that EMC failed to defend and indemnify its insureds after the insureds caused a gas leak on tribal lands. The Navajo tribal court denied EMC’s motion to dismiss for lack of subject matter jurisdiction and the Navajo Nation Supreme Court denied a writ of prohibition. EMC then sued Navajo Nation officials in federal district court, which granted summary judgment for EMC, concluding that the tribal court lacked jurisdiction. The Navajo Nation officials then appealed to the Ninth Circuit.
The Ninth Circuit addressed each Montana exception in turn. It dismissed the first exception because both parties stipulated that EMC’s relevant actions (which involved “negotiating and issuing general liability insurance contracts to non-Navajo entities”) occurred outside of tribal land. It then rejected the second exception because EMC’s conduct took place outside the reservation and its refusal to defend and indemnify its insureds does not “imperil the subsistence of the tribal community.” Therefore, the Ninth Circuit affirmed the district court’s holding, recognizing that the tribal courts lacked jurisdiction under either of the two Montana exceptions.
Walker v. Boy, No. 19-0043, 2019 WL 5700770 (D. Mont. Nov. 4, 2019): Plaintiff, a member of the Gros Ventre Tribe, sued his former employer, the Rocky Boy Health Center, and its CEO, a member of the Assiniboine Tribe, in district court for gender discrimination and retaliation. The health center is located on the Rocky Boy’s Indian Reservation on property held in trust by the federal government for the benefit of the Rocky Boy Chippewa Cree Tribe. Defendants filed a motion to dismiss alleging that the Plaintiff had failed to exhaust his tribal court remedies, the federal court lacked subject matter jurisdiction over the claims, and the federal statutes cited in Plaintiff’s complaint were inapplicable and provided no basis for jurisdiction.
The district court held that Plaintiff had not exhausted his tribal court remedies because tribal jurisdiction was “colorable” for two reasons. First, the claims were based on events that allegedly occurred on trust land within the exterior boundaries on the Reservation. Second, the claims arose out of a consensual employment agreement between the Plaintiff and the tribal entity, which satisfied the first Montana exception even if the events had occurred off tribal land. Thus, the district court granted Defendant’s motion to dismiss.
Rosebud Sioux Tribe v. Trump, 428 F. Supp. 3d 282 (D. Mont. 2019): Rosebud Sioux Tribe and Fort Belknap Indian Community sued President Trump and other government entities alleging that they violated various treaties, the Foreign Commerce Clause, the tribes’ inherent sovereign powers, and various federal statutes when the President issued a Presidential permit to build the Keystone XL oil pipeline.
The federal district court addressed several claims, the most relevant of which involves Defendant’s motion to dismiss. It held that, because tribes have inherent authority to exclude non-Indians from their reservations, under Montana’s second exception, they may exercise civil authority over the conduct of non-Indians on fee lands when that conduct threatens the political integrity, economic security, or health and welfare of the tribe. Therefore, because Rosebud alleges that Keystone will cross over tribal surface and mineral estates, the court determined that they alleged enough facts at this point in the litigation to support that they have jurisdiction over Keystone.
Gustafson v. Poitra, 2020 ND 9, 937 N.W.2d 524(2020): The parties before the court were involved in three prior actions. The first action involved a foreclosure on two parcels of Defendant’s property, where tribal jurisdiction was raised in the district court, but not the appeal. The second case involved an action in which Plaintiff sued Defendants in district court claiming that one of the Defendant’s estates owed him money for maintenance and repairs, but the court vacated judgment on appeal because the district court lacked subject matter jurisdiction over the lease. Finally, in the third action, Plaintiff sued two of the Defendants, alleging that Plaintiff was a non-Indian fee owner of two parcels within the Turtle Mountain Reservation. There, the district court quieted title to the Plaintiff, and the North Dakota Supreme Court affirmed that the tribal courts lacked jurisdiction under either Montana exception.
In this action, Plaintiff sued Defendants in state court to evict them from the property in the prior quiet title action. The district court determined that it had subject matter jurisdiction over the claim and granted the eviction. Defendants appealed, arguing that the district court lacked jurisdiction over an eviction regarding non-Indian fee land located within the reservation, that the eviction should have been brought in tribal court, and that sending a North Dakota law enforcement officer onto the reservation to evict them was a clear violation of Montana.
On appeal, the Supreme Court of North Dakota held that Defendants failed both to meet their burden under either Montana exception or to explain how a district court lacked subject matter jurisdiction to grant a judgment of eviction. The burden rested on the Tribe to establish that one of Montana’s exceptions applied to allow extension of tribal authority to regulate nonmembers on non-Indian fee land, and these limited exceptions should not be constructed in a way that swallows the rule. The court found no discernable argument by Defendants addressing the first exemption, and although Defendants argued that Plaintiff’s use of a nonfederal law enforcement officer from a foreign jurisdiction to enforce the eviction harmed the political integrity and health and welfare of the tribe, they failed to provide legal support for this argument. Thus, Defendants failed to meet their burden and the state had authority to enforce the eviction ordered by the district court.
Warfield for Cheryl Sam & Carleen Sam Bankr. Estates v. Ledbetter Law Firm PLC, No. 1 CA-CV 18-0636, 2019 WL 6215905 (Ariz. Ct. App. Nov. 21, 2019): The Tabaha family sued members of the Navajo Nation (Carleen and Cheryl Sam) for personal injury in the Navajo Nation District Court after the Sams injured them in a car accident on the Navajo Reservation. The Sams’ insurance company, State Farm, retained the Ledbetter Law Firm, who attempted to settle with the Tabahas. The Tabahas refused to accept a settlement, and Ledbetter recommended that the Sams declare bankruptcy. The bankruptcy court then discharged the Sams’ personal liability for pre-bankruptcy debts.
Warfield, the trustee for the Sams’ bankruptcy estate, claimed that the orders enjoined the Tabaha family from collecting any debt from the Sams’ post-petition assets. Ledbetter, on the other hand, claimed that the orders discharged any personal liability to the Tabaha family. Warfield then sued State Farm and Ledbetter in Maricopa County Superior Court, alleging breach of contract, breach of the implied covenant of good faith and fair dealing, aiding and abetting bad faith, legal malpractice, and punitive damages. After the case transferred to Yavapai County, Ledbetter moved for summary judgment for lack of subject matter jurisdiction. The trial court dismissed most of Warfield’s claims and granted Ledbetter’s motion for summary judgment for lack of subject matter jurisdiction.
On appeal, the Arizona Court of Appeals recognized that, because neither Warfield nor Ledbetter was a member of the Navajo Nation, jurisdiction presumptively lay in state court. However, Ledbetter argued that the tribal court has exclusive jurisdiction over the claims because the Montana exceptions applied. The court rejected this argument, holding that Montana never held that the tribal court has exclusive jurisdiction just because it establishes one of the Montana exceptions. Rather, even if the tribal court has jurisdiction, it does not preempt state court jurisdiction unless it unduly infringes on tribal self-governance. Because this case is between two non-Indians, the Arizona appellate court reasoned that the infringement test did not preclude state court jurisdiction.
§ 1.3.2 Exhaustion of Tribal Court Review
The doctrine of exhaustion of tribal remedies reflects the ongoing tension between tribal and federal courts. If a tribal court claims jurisdiction over a non-Indian party to a civil proceeding, the party usually[27] is required to exhaust all options in the tribal court prior to challenging tribal jurisdiction in federal district court.[28] If tribal options are not exhausted prior to bringing suit in federal court, the federal court will likely dismiss[29] or stay[30] the case.
Ultimately, the question of whether a tribal court has jurisdiction over a nontribal party is one of federal law, giving rise to federal questions of subject matter jurisdiction.[31] Thus, non-Indian parties can challenge the tribal court’s jurisdiction in federal court.[32] Pursuant to this doctrine, a federal court will not hear a matter arising on tribal lands until the tribal court has determined the scope of its own jurisdiction and entered a final ruling.[33] Ordinarily, a federal court should abstain from hearing the matter “until after the tribal court has had a full opportunity to determine its own jurisdiction.”[34] And again, notwithstanding a provision that appears to vest jurisdiction with an arbitrator, several federal courts have ruled that a tribal court should be “given the first opportunity to address [its] jurisdiction and explain the basis (or lack thereof) to the parties.”[35]
After the tribal court has ruled on the merits of the case[36] and all appellate options have been exhausted,[37] the non-tribal party can file suit in federal court, whereby the question of tribal jurisdiction is reviewed under a de novo standard.[38] The federal court may look to the tribal court’s jurisdictional determination for guidance; however, that determination is not binding.[39] If the federal court affirms the tribal court ruling, the nontribal party may not relitigate issues already determined on the merits by the tribal court.[40]
There are several exceptions to the exhaustion doctrine. First, federal courts are not required to defer to tribal courts when an assertion of tribal jurisdiction is “motivated by a desire to harass or is conducted in bad faith . . . or where the action is patently violative of express jurisdictional prohibitions, or where exhaustion would be futile because of the lack of an adequate opportunity to challenge the court’s jurisdiction.”[41] Second, when “it is plain that no federal grant provides for tribal governance of non-members’ conduct on land covered by Montana’s main rule,” exhaustion “would serve no purpose other than delay.”[42] Third, where the primary issue involves an exclusively federal question, exhaustion of tribal remedies may not be mandated.[43]
Because litigation is expensive, the question of whether the defendant is required to exhaust their tribal court remedies before challenging the jurisdiction of the tribal court is regularly litigated. Several of these cases were decided in the last year.[44]
Magee v. Shoshone Paiute Tribes of Duck Valley Reservation, 19-0697, 2020 WL 2468774 (May 11, 2020 D. Nev.): The Duck Valley Tribe brought suit against their CFO for financial impropriety in tribal court. The CFO claimed sovereign immunity based on his status as a tribal employee and asked for the case to be dismissed for lack of subject matter jurisdiction. The Tribal Court denied the motion and the Tribal Appellate Court refused to hear the appeal because the trial court’s order was merely interlocutory. The CFO then sought an order from the federal district court prohibiting the tribal court from continuing the proceedings on the basis of a lack of jurisdiction.
The district court held that the CFO had not yet exhausted all tribal remedies, and therefore, dismissed the federal action. Federal courts give broad latitude to tribal courts to exercise authority under their jurisdiction. The CFO asserted that the tribal suit was commenced in bad faith, and, therefore, falls within the bad faith exception to exhaustion. The district court clarified that bad faith applies only to the tribal court acting in bad faith, not the parties in litigation. With no alternative justification to assert bad faith, the court concluded there was no relevant exhaustion exception.
Hanson v. Parisien, No. 19-0270, 2020 WL 4117997 (July 20, 2020 D.N.D.): In a dispute about whether a non-Indian contractor had to pay TERO fees for work performed on the reservation the North Dakota Supreme Court ultimately held that exhaustion of tribal court remedies required of tribal administrative remedies, as well as judicial remedies. In this case, a non-Indian contractor obtained a letter from tribal legal counsel advising that it would not owe TERO fees on a bid for services, but the TERO office ended up issuing a fee anyway. The non-Indian contractor contested the fee in tribal court and prevailed, but, on appeal, the Turtle Mountain Court of Appeals reversed and remanded the case to the TERO Commission. At that point the non-Indian contractor filed a suit in federal court.
The federal court held that the Plaintiffs had not yet exhausted their tribal remedies and therefore it was premature for the suit to be brought in federal court. The Court reasoned that tribal exhaustion applies to administrative, as well as judicial, proceedings and is mandatory. The federal court reasoned that the non-Indian contractor must first exhaust their tribal administrative remedies before seeking redress in the federal court and emphasized that additional tribal proceedings would assist in developing the factual record for the case, as well as provide additional expertise from the Tribe. Therefore, the court dismissed the instant action as premature until all tribal avenues—administrative or judicial—have been exhausted.
Hengle v. Asner, 433 F.Supp. 3d 825 (E.D. Va. 2020): This class action suit is based off several payday loan companies created by the Habematolel Pomo of Upper Lake, a federally recognized Native American tribe. With the help of their attorneys, the Tribe set up several companies that issued small payday loans ($1,000) to qualified buyers. The loans had unusually high interest rates that violated usury laws in many states. Plaintiffs filed a class action suit in district court with counts including RICO claims, usury violations, and declaratory judgment relief to nullify the loans.
In this case, Defendants filed a motion to compel arbitration pursuant to the loan contracts. In addition to the arbitration clause, Defendants sought to have the claims adjudicated in the “Tribal Forum” as specified in the contract. Stemming from the Tribal Forum Clause, the Defendants claimed there was a lack of exhaustion of tribal remedies before filing suit in federal court. Plaintiffs countered that there is no comparable claim in a tribal court, so comity cannot apply.
The court denied the motion to compel arbitration and denied the claim seeking tribal exhaustion. The Court reasoned that there was no basis for tribal court jurisdiction over non-members for loans that existed outside of the reservation so exhaustion would serve no purpose other than delay.
Corporation of President of Church of Jesus Christ of Latter-Day Saints v. BN, No. 19-0062, 2019 WL 5423937 (Oct. 23, 2019 D. Utah): A law suit was brought in Navajo tribal court on behalf of a Navajo minor who alleged that she was injured while participating in the Indian Student Placement Program, which placed tribal members with church families so that they can attend school. The Church claimed that there was no tribal jurisdiction, since none of the placements took place on the reservation. It sought a writ of prohibition from the Navajo Nation Supreme Court, holding that it did not have sufficient information to determine jurisdiction because no trial court record had yet been created.
The Church then sought an order from the federal district court that the tribal court had no jurisdiction. It claimed that it had first sought the order from the Navajo Nation Supreme Court and so it had exhausted its tribal court remedies. The District Court disagreed. It held that the Navajo Nation had not yet had an opportunity “to determine its own jurisdiction.” “At minimum, exhaustion of tribal remedies means that tribal appellate courts must have the [full] opportunity to review the determinations of the lower tribal courts,” which includes complete appellate review. Because the Navajo Nation Supreme Court did not yet decide its jurisdiction, the Church had not exhausted its tribal court remedies.
Clements v. Confederated Tribes of Colville Reservation, No. 19-0201, 2019 WL 6051104 (Nov. 15, 2019 E.D. Wash.): A non-Indian business entered into a contract to install fiber optic cable for the Confederated Tribes of the Coleville Reservation. The contract stipulated the tribal court would govern all disputes under the contract. The business then “walked off” the job and the Tribe brought suit in tribal court seeking the return of funds advanced for incomplete work. The tribal court denied a motion to dismiss for lack of jurisdiction and the non-Indian business filed in federal court seeking a declaration that the tribal court lacked jurisdiction over the subject matter.
The federal court held that the Plaintiff had not exhausted its tribal court remedies; it had merely lost a preliminary motion to dismiss. It further reasoned that tribal court jurisdiction was colorable under the first Montana exception because there was a contract for services between the Plaintiff and the Tribe. In this case, the Tribal Court had yet to make any determination on jurisdiction. It therefore dismissed the complaint until exhaustion of tribal court remedies could be completed.
§ 1.3.3 Tribal Sovereignty & Sovereign Immunity
An axiom in Indian law is that Indian tribes are considered domestic sovereigns.[45] Like other sovereigns, tribes enjoy sovereign immunity.[46] As a result, a tribe is subject to suit only where Congress has “unequivocally” authorized the suit or the tribe has “clearly” waived its immunity.[47] The U.S. Supreme Court, in a 2008 decision, pronounced that tribal sovereign immunity “is of a unique limited character.”[48] Unlike the immunity of foreign sovereigns, the immunity enjoyed by sovereign tribal governments is limited in scope and “centers on the land held by the tribe and on tribal members within the reservation.”[49]
Nontribal entities must be aware that, absent a clear and unequivocal tribal immunity waiver, tribes and tribal entities may not be subject to suit should a deal go bad. With regard to contracts, “[t]ribes retain immunity from suits . . . whether those contracts involve governmental or commercial activities and whether they were made on or off a reservation.”[50]
Tribal immunity generally shields tribes from suit for damages and requests for injunctive relief,[51] whether in tribal, state, or federal court.[52] Sovereign immunity has been held to bar claims against the tribe even when the tribe is acting in bad faith.[53]
Tribes enjoy the benefit of a “strong presumption” against a waiver of their sovereign immunity.[54] Moreover, federal courts have made clear that simply participating in litigation does not waive the tribe’s sovereign immunity.[55] Any waiver of tribal sovereign immunity “cannot be implied but must be unequivocally expressed.”[56]
Exactly what contract language constitutes a clear tribal immunity waiver is somewhat unclear.[57] The Supreme Court in C & L Enterprises, Inc. v. Citizen Band Potawatomi Indian Tribe of Oklahoma[58] ruled that the inclusion of an arbitration clause in a standard-form contract constitutes “clear” manifestation of intent to waive sovereign immunity.[59] In C & L Enterprises, the tribe proposed that the parties use a standard-form contract that contained an arbitration clause and a state choice-of-law clause.[60] Although the contract did not clearly mention “immunity” or “waiver,” the Supreme Court believed the alternative dispute resolution (ADR) language manifested the tribe’s intent to waive immunity.[61]
Finally, waivers of immunity must come from a tribe’s governing body and not from “unapproved acts of tribal officials.”[62] Attorneys must evaluate a tribe’s structural organization to determine precisely which tribal agents have authority to properly waive tribal sovereign immunity or otherwise bind the tribal entity by contract. If attorneys do not have a working knowledge of pertinent tribal documents, they risk leaving their clients without an enforceable deal. Below are summaries from some of the most relevant sovereign immunity cases of the last year.[63]
**Immunity may be asserted by tribal corporations, as well as tribal governments. Some recent sovereign immunity cases dealing with tribal corporations are collected and discussed in 8.3.4.
Drake v. Salt River Pima-Maricopa Indian Community, 411 F. Supp. 3d 513 (D. Ariz. 2019): Plaintiff, patron of Defendant’s casino, alleged Defendant violated the Americans with Disabilities Act (“ADA”) by not allowing her to bring her service dog inside casino. Defendant asserted tribal sovereign immunity and moved to dismiss the case. The Court granted Defendant’s motion to dismiss.
Relying on the language of the ADA, the Court stated, “Congress did not clearly waive tribal immunity [under the ADA], but did so with respect to the states’ sovereign immunity, demonstrat[ing] that the [Tribe’s] immunity should remain intact.”
Eglise Baptiste Bethanie De Ft. Lauderdale, Inc. v. Seminole Tribe of Fla., 19-62591, WL 43221 (S.D. Fla. Jan. 3, 2020): On July 26, 2014, Plaintiff Eglise Church’s pastor died. After his death, Co-Defendant Auguste (pastor’s wife) and the board of directors of the Church contended for church leadership. Id. On September 29, 2019, during a church service, co-defendant Auguste entered the church property with six officers from the Seminole Police Department, expelled the congregation, changed the locks and security system of the church, and began occupying the church.
Eglise Church filed suit against the Seminole Tribe alleging interference with business relationships and the Tribe moved for dismissal on the basis of sovereign immunity. The federal district court dismissed the complaint on the basis of tribal sovereign immunity. It explained, “absent some definitive language making it unmistakably clear that Congress intended to abrogate tribal sovereign immunity … Defendant Seminole Tribe is entitled to immunity from suit in the instant action.”
Caddo Nation of Oklahoma v. Wichita & Affiliated Tribes, 786 Fed. Appx. 837 (10th Cir. 2019): Plaintiff Caddo Tribe brought suit against Defendant Wichita Tribe for alleged violations of the National Environmental Policy Act (NEPA) and the National Historic Preservation Act (NHPA). Wichita was in the process of building a Tribal History Center funded by the Department of Housing and Urban Development (HUD). The district court denied Caddo’s temporary restraining order preventing construction of the History Center. On appeal, the Tenth Circuit Court of Appeals held it lacked jurisdiction because the History Center was completed during the pendency of the appeal. Caddo then filed an amended complaint and Wichita filed a motion to dismiss, arguing Caddo’s claims were mooted by completion of the History Center and the claims were also barred by tribal sovereign immunity. The district court held the claims were mooted by construction of the History Center and Caddo appealed to the Tenth Circuit.
The Tenth Circuit first examined Wichita’s assertion that Caddo’s claim was barred by sovereign immunity, reasoning that “a ruling in [Wichita’s] favor would fully resolve the appeal. The Court then held that the Wichita Tribe was barred from asserting tribal sovereign immunity against claims under the Administrative Procedures Act because the Tribe “accept[ed] and assum[ed] HUD’s rights, duties, and obligations to act in conformity with NEPA and NHPA. Thus, the tribe waiv[ed] its sovereign immunity for just the type of APA-based suit at issue in [the] case.” However, the Court found Caddo’s claims were moot because the History Center had already been completed.
Eyck v. United States, 19-4007, WL 2770436 (D.S.D. May 28, 2020): Plaintiffs are parents of Eyck, who was a passenger in a car pursued by South Dakota Highway Patrol, Moody County Sheriffs, and Flandreau Tribal Police Officers. No one in the car was Indian and the chase took place off tribal land. Defendant Neuenfeldt, Chief of Police for the Flandreau Santee Sioux Tribe, was assisting County Sheriff Deputies on non-tribally-owned land. The car chase ended with an accident that caused Eyck severe injuries and medical bills. The Plaintiff brought suit against the pursuers and Defendant Nuenfeldt claimed sovereign immunity.
Although Neuenfeldt argued that he was acting as the Tribe’s Chief of Police (and exercising inherent powers of the Tribe) during the car chase, the Court held that Neuenfeldt could not assert tribal sovereign immunity as a defense. It explained that Neuenfeldt was not exercising inherent sovereign powers of the Tribe during the chase because all persons involved were non-Indians and the chase took place entirely off tribal land.
Gilbert v. Weahkee, No. 19-5045, 2020 WL 779460 (D.S.D. 2020): Plaintiffs—Native Americans residing in Rapid City, SD—challenged the decision of the Indian Health Service to enter into a self-determination contract with the Great Plains Tribal Chairmen’s Health Board. The contract at issue permitted the Health Board, a non-profit organization, to operate portions of IHS’s facilities in Rapid City. The Health Board was established “to make known the needs and desires of the Indian people for assistance of the [IHS] in formulating programs and establishing services [on behalf of the United States in accordance with treaty obligations].” Plaintiffs argued the contract with the Health Board violated the Fort Laramie Treaty of 1868 and the Indian Self-Determination and Education Assistance Act (ISDEDA). Defendants filed a motion to dismiss, arguing Plaintiffs failed to join the Health Board, that the Health Board was an indispensable party that could not be joined due to sovereign immunity, and thus the case must be dismissed. The Court determined the Health Board was a tribal organization entitled to sovereign immunity under ISDEDA. The Court dismissed the case after determining the Health Board was an indispensable party that could not be joined due to its sovereign immunity.
Genskow v. Prevost, No. 19-1474, 2020 WL 1676960 (E.D. Wis. 2020): The Court held Plaintiff’s claim against the Tribe, related to her expulsion from a tribal meeting, was barred by tribal sovereign immunity because “the exercise of federal jurisdiction over the Oneida Nation’s ability to conduct [a] meeting of its governing body on its own land would be a blatant violation of its sovereignty.” Further, the Court held the tribal police officer who was asked to eject Plaintiff from the tribal meeting was entitled to sovereign immunity as an “arm or instrumentality of the state.” Finally, the Court ruled the Tribe did not waive its federal sovereign immunity when its tribal police department was deputized by a neighboring county sheriff office and as part of the agreement with the sheriff office “waive[d] [its] sovereign immunity to allow enforcement of liabilities [arising from acts of tribal police officers] in the courts of the State of Wisconsin.”
Holtz v. Oneida Airport Hotel, No. 19-1682, 2020 WL 2085287 (E.D. Wis. 2020): The Court granted Defendant hotel’s motion to dismiss Plaintiff’s employment discrimination claims because the hotel shared in the tribal sovereign immunity of the Oneida Nation when it was owned and operated by the Oneida Nation for the benefit of the Oneida Nation.
Kiamichi River Legacy Alliance v. Bernhardt, No. 19-0108, 2020 WL 1465885 (E.D. Okla. 2020): Environmental organization brought action against Secretary of Interior and multiple Indian Tribes alleging that parties to a tribal water settlement did not consult with U.S. Fish & Wildlife as required by the Endangered Species Act. The Court held Congress did not expressly waive tribal immunity when passing the Endangered Species Act and granted Tribes’ motions to dismiss because the Tribes were entitled to sovereign immunity.
§ 1.3.4 Tribal Corporations
A majority of non-Alaskan tribes are organized pursuant to the Indian Reorganization Act of 1934 (IRA).[64] Under Section 16 of the IRA, a tribe may adopt a constitution and bylaws that set forth the tribe’s governmental framework and the authority given to each branch of its governing structure.[65] A tribe may also incorporate under Section 17 of the IRA, under which the Secretary of the U.S. Department of the Interior issues the tribe a federal commercial charter.[66]
Through Section 17 incorporation, the tribe creates a separate legal entity to divide its governmental and business activities.[67] The Section 17 corporation has a federal charter and articles of incorporation, as well as bylaws that identify its purpose, much like a state-chartered corporation.[68] Section 17 incorporation results in an entity that largely acts like any state-chartered corporation.[69]
An Indian corporation may also be organized under tribal or state law.[70] If the entity was formed under tribal law, formation likely occurred pursuant to its corporate code; but it could have also occurred by tribal resolution (i.e., specific legislation chartering the entity).[71] Under federal common law, the corporation likely enjoys immunity from suit.[72] However, it is unclear whether a tribal corporation’s sovereign immunity is waived through state incorporation such that the entity may be sued in state court.[73]
Therefore, when negotiating a tribal business transaction, counsel should consult the tribe’s governmental and corporate information—for example, treaty or constitution, federal or corporate charters, tribal corporate code—which, taken together, identify the entity with which you are dealing, the authority of that entity, and any applicable legal rights and remedies.
There are comparatively few cases decided on the basis of tribal corporate formation, but tribal corporations are often able to claim immunity from suit. In addition to IRA Section 17 entities, Native Alaskan communities are organized as corporations under some unique provisions within the Alaska Native Claims Settlement Act. Below find a discussion of recent cases dealing with tribal corporations.[74]
** Some Cases Dealing with Tribal Corporations are discussed in 8.3.3 because they deal with whether a Tribal Corporation may assert their tribe’s sovereign immunity
Hwal’Bay Ba: J Enterprises, Inc. v. Jantzen in & for Cty. of Mohave, 458 P.3d 102 (Ariz. 2020): The Arizona Supreme Court set forth its first-ever test to determine whether an entity is a subordinate economic organization of a tribe and entitled to sovereign immunity. The plaintiff in this case was a white-water rafter that was injured on a boat operated by Hwal’Bay Ba: J Enterprises, Inc., d.b.a. Grand Canyon Resort Corporation (“GCRC”). “GCRC is a tribal corporation whose sole shareholder is the Hualapai Indian Tribe.” The Court decided to grant review here to finally create a state standard to determine when “a tribal entity enjoys sovereign immunity as a ‘subordinate economic organization’ of the tribe,” since this is “a recurring issue of statewide importance.”
The six factors the Court settled on are: (1) The entity’s creation and business form, (2) the entity’s purpose, (3) the business relationship between the tribe and the entity, (4) the tribe’s intent to share immunity with the entity, (5) the financial relationship between the entity and the tribe, and (6) whether immunizing the entity furthers federal policies underlying sovereign immunity. Applying the six factors to this case, the Arizona Supreme Court found that GCRC was not a subordinate economic organization of the Tribe. Accordingly, GCRC did not have sovereign immunity.
Applied Scis. & Info. Sys., Inc. v. DDC Constr. Servs., LLC, No. 19-0575, 2020 WL 2738243 (E.D. Va. Mar. 30, 2020): The Navajo Nation’s governing body created the Dine Development Corporation (DDC), “a wholly-owned corporation of the Navajo Nation, to ‘facilitate economic development in and for the Navajo Nation and its citizens by, among other things, forming and assisting to capitalize subsidiary corporations.’” Pursuant to the Navajo Nation Limited Liability Company Act, DDC’s Board of Directors established a limited liability company, DDC 4C, which had a single member parent company—DDC—and “provide[d] construction development and management services, facilities operation and management services, and environmental remediation services.” The plaintiff sued DDC, claiming that it breached the parties’ settlement agreement and asset purchase agreement.
The court recognized that, unlike the tribe, “a tribally created entity is not given a presumption of immunity until it has demonstrated that it is in fact an extension or an ‘arm of the tribe.’” After extensive discussion of the purpose and history of the corporation the federal district court determined that the DDC was an arm of the tribe and, therefore, was immune from suit. The Court placed special emphasis on the fact that DDC was created for the purpose of promoting tribal self-governance and economic development and that the Navajo Nation controls the Board and therefore has ultimate control of the corporation.
McCoy v. Salish Kootenai Coll., Inc., 785 F. App’x 414 (9th Cir. 2019): The Defendant in a civil action, the Salish and Kootenai Tribal College, claimed sovereign immunity from suit as an arm of the tribal government. The district court found immunity proper and the Ninth Circuit affirmed. The appellate court concluded that, while the fact that the College is incorporated under Montana law augers against immunity, all other factors weighed in favor of sovereign immunity because the tribe had “significant control over the College” and “the College is structured and operates for the benefit of” the tribe.
Cadet v. Snoqualmie Casino, No. 19-1953, 2020 WL 3469222 (W.D. Wash. June 25, 2020): Plaintiff brought suit against the Snoqualmie Casino, which was organized and operated under tribal laws and was “wholly owned and operated by the Tribe.” The court recognized that the tribe’s sovereign immunity would only extend to a tribal enterprise if that enterprise functioned as an arm of the tribe.
The court concluded that the Casino was an arm of the tribe and was “therefore immune from suit unless the Snoqualmie Tribal Council has expressly waived sovereign immunity.” The court came to this conclusion because “the Casino is owned and operated by the Tribe on tribal land, [] its purpose is to promote tribal prosperity by providing revenue for the Tribe, [and] the Tribe has intended to extend its sovereign immunity to its enterprises, including the Casino.”
In regard to a waiver of immunity, the Court concluded that the “waiver of sovereign immunity located within the Tort Claims Act does not unequivocally indicate that the Tribe has waived its immunity from suits filed in federal court; instead, the waiver provides a remedy to those who are harmed while on tribal grounds through the tribal court system.” Accordingly, the Casino, as an arm of the tribe, had “not unequivocally waived its sovereign immunity.”
Min Zhang v. Grand Canyon Resort Corp., No. 19-0124, 2020 WL 1000608 (C.D. Cal. Jan. 15, 2020): Plaintiff sued Hwal’bay Bay Enterprises, Inc., d.b.a. Grand Canyon Resort Corporation (“GCRC”). GCRC was a wholly owned tribal corporation “organized under the laws and constitution of the Hualapai Tribe” and it filed a motion to dismiss by asserting sovereign immunity.
The district court held that GCRC was entitled to sovereign immunity as an “arm of the tribe.” The court explained that “GCRC was created solely under the laws of the Hualapai Indian Tribe as described by the Plan.” Further, GCRC’s purpose is “creating economic development opportunities for the Hualapai Indian Tribe through various commercial activities.” Having concluded that the tribal corporation was generally able to assert immunity the district court further held that despite the presence of a “sue and be sued” clause in a prior corporate charter, there is a “strong presumption against waiver of tribal sovereign immunity.” The court reasoned that the previous charter was “not operative in the Court’s determination of GCRC’s current status as an ‘arm of the tribe’ or its subsequent waiver of sovereign immunity.”
§ 1.4 The Federal Sovereign
§ 1.4 1 Indian Country & Land Into Trust
The IRA authorizes the Secretary of the Interior to take land into trust for the benefit of an Indian tribe’s reservation.[75] In 2009, however, the U.S. Supreme Court issued a landmark ruling reversing the Interior’s prior interpretation of the IRA, 25 U.S.C. § 465, now located at 25 U.S.C. § 5108, and limiting the Secretary’s ability to take land into trust on behalf of tribes.[76]Carcieri held that the Secretary may only acquire land in trust for tribes that (1) were “under federal jurisdiction” in 1934, and (2) currently enjoy federal recognition.[77] This effectively precludes certain tribes from avoiding state tax and regulatory compliance, or conducting gaming or other economic development activities on newly acquired or reacquired lands.
Despite the Carcieri ruling, Interior seems willing to issue final decisions on fee-to-trust applications by tribes that were recognized, restored, or reaffirmed after June 1934 on the basis that the tribe may have been under the jurisdiction of the United States in 1934 even if that recognition was not formally documented.[78] Interior will continue processing applications for tribes that have enjoyed uninterrupted, formal recognition since June 1934 and for tribes that can point to a non-IRA statute granting the Secretary acquisition authority.[79] In sum, any non-Indian party looking to enter into a joint venture with a tribe to develop Indian lands not yet in trust status must pause to consider the implications of Carcieri.[80]
In response to the Carcieri decision, in 2014, the Interior Department issued a Memorandum that provided guidance on the meaning of “under federal jurisdiction.”[81] The Solicitor’s M-37029 Memorandum outlined a two-part test for interpreting the phrase “under federal jurisdiction.” The first part of this inquiry examines whether, before June 18, 1934, the federal government took an action or series of actions through a course of dealings or other relevant acts reflecting its obligation to, responsibility for, or authority over, an Indian tribe, bringing such tribe under federal jurisdiction.[82] The second prong examines whether this jurisdictional status remained intact in 1934.[83] Satisfying either prong will suffice to establish that the tribe was “under federal jurisdiction.” In a recent decision, Confederated Tribes of Grand Ronde Community of Oregon v. Jewell, the D.C. Circuit Court of Appeals upheld Interior’s application of the two-part test outlined in M-37029.[84] M-37029 appears to be a non-statutory Carcieri fix.
As if Carcieri were not complicated enough, in 2012, the U.S. Supreme Court issued its opinion in Match-E-Be-Nash-She-Wish Band of Pottawatomi Indians v. Patchak.[85] In that case, a local landowner by the name of David Patchak launched a legal challenge against the Interior Secretary’s decision to take the tribe’s land into trust for the purpose of gaming. Importantly, Patchak did not allege that he had a legal interest in the land to be taken into trust. Rather, Patchak brought an action under the APA[86] asserting that the IRA did not authorize the Department of Interior to take land into trust for the tribe. The remedy Patchak sought was the issuance of an injunction prohibiting Interior from taking the land into trust. The basis for the injunction, in Patchak’s opinion, was that the requirements of the IRA were to be satisfied per the Supreme Court’s opinion in Carcieri. Both the federal government and the tribe argued that only the Quiet Title Act (QTA)[87] could grant the waiver of sovereign immunity. Under the theory advanced by the defendants, the APA waiver of sovereign immunity was negated.
The Court determined that the QTA only applies to quiet title actions where a person claims an interest in the property that conflicts with, or is superior to, the government’s claim in the property.[88] In addition, because the exception causing the APA waiver of sovereign immunity to be negated did not apply, the Court held Patchak had standing under the APA to pursue his challenge.
The result of this decision is that any party claiming harm to property nearby proposed trust land, even damage to an “aesthetic” interest, has legal standing under the APA to bring a lawsuit. This creates considerable risk for casino developers because the statute of limitations under the APA is considerably longer than that of the QTA, creating much more time for a party to challenge Interior’s trust transaction.[89]
The Interior Department revised its land-into-trust regulations at Part 151 in response to the Patchak decision during the Obama Administration, in late 2013.[90] This “Patchak Patch” provides that if the Interior Secretary or Assistant Secretary approves a trust acquisition, the decision represents a “final agency determination” subject immediately to judicial review.[91] If a BIA official issues the decision, however, the decision is subject to administrative exhaustion requirements[92] before it becomes a “final agency action.”[93] In this instance, parties must file an appeal of the BIA official’s decision within 30 days of its issue.[94] If no appeal is filed within the 30-day administrative appeal period, the BIA official’s decision becomes a “final agency action.” In October 2017, the Trump Administration’s Interior Department announced a consultation regarding a rulemaking that would reverse the “Patchak Patch,” and impose much newer criteria for off-reservation land-into-trust applications. Assuming that rulemaking results in new Part 151 regulations, litigation will certainly follow.
A brief discussion of several of the year’s most prominent cases involving the diminishment of an Indian reservation and/or the taking of land into trust follow:[95]
** See the U.S. Supreme Court’s July 9, 2020 decision in McGirt v. Oklahoma holding that the Muscogee (Creek) Reservation was not diminished in 8.2.1.
Littlefield v. Mashpee Wampanoag Indian Tribe, 951 F.3d 30 (1st Cir. 2020): In 2015, the Bureau of Indian Affairs (“BIA”) approved the Mashpee Wampanoag Indian Tribe’s (the “Tribe”) land-into-trust application for two parcels of land in Massachusetts. The BIA concluded the Tribe was eligible to have land taken into trust under the Indian Reorganization Act. Local non-tribal residents challenged the decision. The federal district court found that the definition of Indian in the IRA is unambiguous and refers to the entire phrase “members of any recognized Indian tribe now under Federal jurisdiction,” and remanded the application to the BIA.
The First Circuit affirmed the decision, concluding that the Secretary did not have the authority to take the land into trust for the benefit of the Tribe. Using the principles of statutory interpretation, focusing on the plain meaning, the Court found that “such” refers to the entire phrase including “now under federal jurisdiction.” The Court reasoned that the text lacks a natural break or connector like “or” that would suggest that “such” refers only to a portion of the phrase. The Tribe argued that, in other cases, the Court found the word “such” to be ambiguous. But the Court refused to adopt a per se rule for the word “such” because it reasoned that ambiguity depends on context.
Mashpee Wampanoag Tribe v. Bernhardt, No. 18-2242, 2020 WL 3037245 (D.D.C. June 5, 2020): Interior approved the Mashpee Wampanoag Tribe’s land-into-trust application for two areas of land in Massachusetts based on the second definition of “Indian” in the Indian Reorganization Act (“IRA). The decision was challenged by local non-tribal residents, and the district court found that the Tribe’s members were not “Indian” under the second definition unless they also qualified under the first. The court remanded the application to the Secretary. The Secretary decided in 2018 (“2018 Decision”) that the Tribe did not qualify as “Indian” because they were not under federal jurisdiction in 1934. The Tribe challenged the 2018 Decision, arguing it was arbitrary, capricious, and an abuse of discretion and contrary to law.
The federal district court agreed with the Tribe and remanded the application to the Secretary to reassess. The Court noted that the 2018 Decision the Secretary repeatedly reasoned that specific pieces of evidence “in and of itself” did not establish federal jurisdiction. The Court found that this analysis directly contradicts the Solicitor’s M-Opinion, which states that evidence “when viewed in concert” with other probative evidence may support a finding of federal jurisdiction.
Stand Up for California! v. U.S. Dep’t of Interior, 410 F. Supp. 3d 39 (D.D.C. 2019): The Wilton Rancheria Tribe of California submitted a land-into-trust application for land in Elk Grove, California to be used for a casino. Residents of Elk Grove and an advocacy organization (collectively “Stand Up”) challenged the Bureau of Indian Affairs on five counts. The Court addressed the first two counts in a different case, finding that the Department had the authority to take the land into trust. The BIA then accepted Wilton’s application. The Court addressed the remaining three counts in this case.
A brief history of Wilton is necessary to understand the case. In 1958, under the California Rancheria Act, the government distributed rancheria lands to various tribes, including Wilton, and then terminated them. Then in 1994, Congress enacted the Federally Recognized Indian Tribe List Act (“List Act’) which repudiated those terminations and authorized the Secretary to decide whether previous federal recognition supports current recognition. In 2009, the Department and Wilton entered a stipulated judgment in court that restored Wilton as a federally recognized tribe.
The Court quickly dismissed Count III finding that the plain language of the Stipulated Judgment restored Wilton’s status to what it was before the CRA, meaning Wilton qualified as “Indian” under the Indian Reorganization Act. For Count IV, Stand Up argued that Wilton could not qualify as a “restored tribe” and Elk Grove could not qualify as a “restored land” to meet the Indian Gaming Regulatory Act (“IGRA”) “restored land” exception. The Court easily found Wilton qualified as a “restored tribe” based on its previous federal recognition, CRA termination, and Stipulated Judgment restoration. The Court also found that Elk Grove qualified as a “restored land” because it met all three criteria required in the IGRA. First, Elk Grove was in the same state as Wilton. Second, Wilton demonstrated a significant historical connection to Elk Grove by showing it was previously occupied by ancestors of Wilton members, is near historic village sites, and is within a few miles of the last reservation and a historical burial site. Third, Wilton demonstrated a temporal connection between the date of acquisition and restoration in two independently sufficient ways. First, Wilton included Elk Grove in its “first request for newly acquired lands” since restoration, and second, Wilton’s application for Elk Grove was submitted within 25 years of restoration.
Finally, Count V challenged the Department’s compliance with the National Environmental Policy and the Administrative Procedure Act. The Court found that the Department complied with the NEPA when it detailed water analysis and mitigation measures, went beyond NEPA requirements to address public safety risks for a nearby propane facility, and addressed the need for a parking structure and its environmental impacts. As for the APA, the Court noted it was suspicious that Interior made its decision within 40 hours but found no evidence of bad faith. The Court accordingly affirmed the right of Interior to take the land into trust for the benefit of the Tribe.
Cherokee Nation v. Bernhardt, No. 12-0493, 2020 WL 1429946 (N.D. Okla. Mar. 24, 2020): The Cherokee Nation of Oklahoma and Cherokee Nation Entertainment, LLC, the Nation’s gaming enterprise, challenged the Assistant Secretary of Indian Affairs of the Department of the Interior’s decision to take a little over two acres of land in Oklahoma into trust for gaming purposes for the benefit of the United Keetoowah Band of Cherokee Indians (the “UKB”).
The Indian Gaming Regulatory Act (“IGRA”) generally bans gaming on lands taken into trust unless an exception permits the land acquisition. One exception is if the tribe has no reservation and the lands are in Oklahoma “within the boundaries of the Indian tribe’s former reservation, as defined by the Secretary.” The Secretary promulgated a regulation defining “former reservation” as “lands in Oklahoma that are within the exterior boundaries of the last reservation that was established by treaty, Executive Order, or Secretarial Order for an Oklahoma tribe.” Here, the Secretary read the IGRA to give him the authority to determine the existence of a former reservation. Thus, although the Secretary had previously recognized that the same land was the former reservation of the Nation, he concluded that it was also the former reservation of the UKB.
The Court held, among other things, that the Secretary’s determination was arbitrary and capricious. The Court reasoned that the plain language of the IGRA gives the Secretary the authority to determine only the boundaries of the former reservation, not the existence of a former reservation. The Court further reasoned that, even if it accepted the Secretary’s interpretation, because no reservation had ever been established by treaty, Executive Order, or Secretarial Order for the UKB the land cannot have been its former reservation. Therefore, Court would have found that the Secretary abused his discretion because he ignored his own regulation.
Sault Ste. Marie Tribe of Chippewa Indians v. Bernhardt, No. 18-2035, 2020 WL 1065406 (D.D.C. Mar. 5, 2020): The Sault Ste. Marie Tribe of Chippewa Indians submitted a land-into-trust application to the Department of the Interior for parcels of land in Michigan to develop a casino. The basis of the application was the Michigan Indian Land Claims Settlement Act (“MILCSA”). Section 108 of this Act directs the Secretary to transfer the Tribe’s share of damages from lands stolen in the 1800s into a Self-Sufficiency Fund, notes that the Secretary has no responsibility for the use of the Funds nor does use require the Secretary’s approval, and that the Secretary shall take any land into trust that the Tribe acquires using the Fund. Section 108 also deems the Tribe’s board of directors the “trustee” of the Fund to administer it for one of the listed purposes including for “enhancement of tribal lands.” The Department denied the Tribe’s application because it found that the Tribe did not establish that the land would be used for the “enhancement of tribal lands.” The Tribe challenged the Department’s authority to decide if the land was acquired for a proper purpose.
The Court found that Congress vested the Tribe’s leaders, rather than the Department, with the power to determine whether the land was acquired for a permissible purpose under the MILCSA. The Court reasoned that the plain language of Section 108 required the Secretary to take the lands the Tribe acquired with the Fund into trust and left no room for discretion.
Independently sufficient, the Court found that the Tribe acquired the land for “enhancement of tribal lands.” The Court reasoned that the Department erroneously interpreted “enhancement” as only an increase in value of landholdings rather than an increase in value or amount. However, the Court refused to order the Department to take the Tribe’s land into trust because the Department had not yet determined whether the Tribe acquired the land with Fund income. Therefore, the Court set aside the Department’s decision and remanded it for a determination as to the income question.
§ 1.4.2 Federal Approval for Reservation Activity
Due to the unique trust status of Indian lands, contracts involving those lands are subject to various forms of federal oversight. The Secretary of the Interior must approve any contract or agreement that “encumbers Indian lands for a period of seven or more years,” unless the Secretary determines that approval is not required.[96] Federal regulations explain that “[e]ncumber means to attach a claim, lien, charge, right of entry, or liability to real property.”[97] Encumbrances may include leasehold mortgages, easements, and other contracts or agreements that, by their terms, could give to a third party “exclusive or nearly exclusive proprietary control over tribal land.”[98]
Per Section 81’s year 2000 revisions, the Interior Secretary will not approve any contract or agreement if the document does not (1) set forth the parties’ remedies in the event of a breach; (2) disclose that the tribe can assert sovereign immunity as a defense in any action brought against it; and (3) include an express waiver of tribal immunity.[99] Leaseholds for Indian lands, which typically run 25 years, also require secretarial approval.[100] Failure to secure secretarial approval could render the agreement null and void.[101] Therefore, if the transaction implicates tribal lands, counsel should analyze whether the Secretary must approve the underlying contract or lease.[102] Regardless of whether Secretary approval is necessary, all parties should be careful how they draft agreements which may encumber the land.[103] If the contract pertains to a tribal casino, the parties must also consider whether the contract should be submitted to the National Indian Gaming Commission (NIGC) for approval pursuant to the Indian Gaming Regulatory Act (IGRA).[104] Any “management agreement” for a tribal casino or “contract collateral to such agreement” requires NIGC approval to be valid and enforceable.[105] The NIGC has recently found that certain consulting, development, lease, and financing documents that confer management authority to the consultant, developer, landlord, or lender thereby constitute a management contract that is void unless approved by the NIGC.
Non-Indian contractors must also consider whether they need to obtain an Indian Traders License from the BIA and/or a tribal business license to properly do business with a tribe.[106] Federal regulations do not preclude certain tribes from imposing additional fees on non-Indian contractors.[107] Failure to obtain appropriate licenses could subject the contractor to a fine or forfeiture, if not tribal qui tam litigation.[108]
With much tribal and media fanfare, in 2012, President Obama signed into law the Helping Expedite and Advance Responsible Tribal Homeownership (HEARTH) Act.[109] As noted above, prior to the passage of this bill, under 25 U.S.C. § 415 every lease of a tribe’s lands must undergo federal review and approval by the Secretary of the Interior under a sprawling, burdensome set of regulations.[110] The HEARTH Act changes that scheme of Indian land leasing by allowing tribes to lease their own land. The Act gives tribal governments the discretion to lease restricted lands for business, agricultural, public, religious, educational, recreational, or residential purposes without the approval of the Secretary of the Interior. Tribes are able to do so with a primary term of 25 years, and up to two renewal terms of 25 years each (or a primary term of up to 75 years if the lease is for residential, recreational, religious, or educational purposes).
There are some caveats, though. First, before any tribal government can approve a lease, the Secretary must approve the tribal regulations under which those leases are executed (and mining leases will still require the Secretary’s approval). Second, before the Secretary can approve those tribal regulations, the tribe must have implemented an environmental review process—a “tribal,” or “mini” National Environmental Policy Act—that identifies and evaluates any significant effects a proposed lease may have on the environment and allows public comment on those effects. The HEARTH Act authorizes the Interior Secretary to provide a tribe, upon the tribe’s request, with technical assistance in developing this regulatory environmental review process. HEARTH Act implementing regulations went into effect in 2013.[111] As of October 2018, the BIA lists twenty-six tribes whose regulations have been approved to exercise the enhanced rights of sovereignty associated with taking control over the leasing of tribal land.[112]
The following highlights several of the more relevant cases decided in the last year.[113]
State v. Ysleta Del Sur Pueblo, 955 F. 3d 408 (5th Cir. 2020): The Attorney General, on behalf of the State of Texas, brought action against federally recognized Indian tribe, the Yselta del Sur Pueblo, seeking to enjoin the tribe from operating certain gaming activities. This case posed the question which federal law governs the legality of the Pueblo’s gaming operations—the Restoration Act (which bars gaming that violates Texas law) or the Indian Gaming Regulatory Act (which establishes Federal standards for gaming on Indian lands). The Court concluded that the Restoration Act controls. In 1987, Congress passed, and President Reagan signed, the Ysleta del Sur Pueblo and Alabama and Coushatta Indian Tribes of Texas Restoration Act. But the Pueblo’s “restoration” came with a catch: In exchange for having its federal trust status restored, the Pueblo agreed that its gaming activities would comply with Texas law. Not all tribes fall under the Restoration Act, many tribes conduct gaming operations under the less restrictive Indian Gaming Regulatory Act (IGRA).
The Fifth Circuit affirmed the district court’s conclusion that the Restoration Act governs gaming by the relevant Tribe. As held in Ysleta I, Texas gaming law “functions as surrogate federal law” on the land of Restoration Act tribes. Therefore, the Pueblo are subject to Texas’ regulations. The Restoration Act governs the legality of the Pueblo’s gaming activities and prohibits any gaming that violates Texas law.
§ 1.4.3 Labor and Employment Law & Indian Tribes
When Indian tribes act as commercial entities and hire employees, they are not subject to the same labor and employment laws as nontribal employers. For example, state labor laws and workers’ compensation statutes are inapplicable to tribal businesses.[114] Moreover, tribal employers may not be subject to certain federal labor and employment laws.[115]
Tribal employers are ordinarily exempt from antidiscrimination laws. Both Title VII of the Civil Rights Act of 1964[116] and the Americans with Disabilities Act[117] expressly exclude Indian tribes,[118] and state anti-discrimination laws usually do not apply to tribal employers.[119] In addition, tribal officials are generally immune from suits arising from alleged discriminatory behavior.[120]
The circuits remain severely split regarding the application of federal regulatory employment laws to tribal employers. The Eighth and Tenth Circuits have refused to apply to tribes such laws as the Occupational Safety and Health Act (OSHA),[121] the Employee Retirement Income Security Act (ERISA),[122] the Fair Labor Standards Act (FLSA),[123] the National Labor Relations Act (NLRA),[124] and the Age Discrimination in Employment Act (ADEA),[125] because doing so would encroach upon well-established principles of tribal sovereignty and tribal self-governance.[126]
Conversely, the Second, Seventh, and Ninth Circuits have applied OSHA and ERISA to tribes.[127] Moreover, the Seventh and Ninth Circuits lean toward application of FLSA to tribes.[128] These circuits reason that, because Indian tribes are not explicitly exempted from these statutes of general applicability, the laws accordingly govern tribal employment activity.[129] Following this reasoning, the Department of Labor has stated that the FMLA[130] applies to tribal employers.[131] However, aggrieved employees may experience difficulty enforcing federal employment rights due to the doctrine of sovereign immunity.[132] For example, the Second Circuit has held that, because Congress did not explicitly authorize suits against tribes in the language of the FMLA or the ADEA, tribal employers cannot be sued for money damages in federal court by employees under these statutes.[133]
Questions remain concerning whether federal statutes of general applicability extend beyond the labor and employment arena where they do not affirmatively contemplate whether Indian tribes govern tribal or reservation-based activities. For example, do federal franchise laws apply in Indian Country? What about the federal Copyright Act or other federal intellectual property statutes? What about Sarbanes-Oxley? While subject to the split in circuits discussed immediately above, it is unclear in which federal jurisdictions a court would hold that such federal laws apply to tribes.[134]
In the last year, federal courts have continued to decide cases involving the application of federal labor and employment rules to tribal employers. More generally, courts have grappled with how to apply statutes of general applicability to tribal sovereigns. Several of the most prominent cases from the last year are discussed below:[135]
Tsosie v. Arizona Public Service, No. SC-CV-03-15, 2020 WL 3265425 (Navajo 2020). The Arizona Public Service (“APS”) terminated Eldon Tsosie from his employment at the Four Corners Power Plant, a coal-fired generating plant located on trust land within the Navajo Reservation. APS had a lease with the Navajo Nation for the development of the plant subject to the Four Corners Generating Preference Plan for hiring Native Americans. The Preference Plan included provisions on selection, goals, training, recruiting, advertising, and dispute resolution, and was approved by the Navajo Nation Council. The Preference Plan required any employment concerns to be resolved by an “Advisory Committee” having at “least two members of the Navajo Nation government.”
Tsosie filed a Complaint with the Navajo Nation Labor Commission “claiming APS terminated his employment…in violation of the Navajo Preference in Employment Act (“NPEA”).” The NPEA requires employers provide “just cause” when terminating employees. After unsuccessful settlement negotiations, the NNLC granted APS’s Motion to Dismiss, noting the Council had the authority to approve the alternative dispute process; Four Corners Generating Preference Plan.
Tsosie appealed and the Supreme Court of the Navajo Nation relied on the “Navajo Fundamental Law” to conclude the Council had the duty and authority to approve the lease and its amendments with APS. The Supreme Court noted employment is “central to living a good life”; therefore, “the duty and authority to legislate or regulate employment relationships cannot be delegated or handed over wholesale to a non-Navajo entity.” The Court reasoned that the Council “did not waive Navajo law but approved an alternative process…in adherence with Navajo law.” Ultimately, the Court affirmed the Labor Commission’s dismissal because “the Council found a viable solution to ensure the Four Corners’ operation for jobs and economic development for the Navajo people,” in adherence to Navajo Fundamental Law.
Wilhite v. Littlelight, No. 19-0020, 2020 WL 1332231 (D. Mont. 2020): Tammy Wilhite was fired from the Awe Kualawaache Care Center where she worked as a registered nurse. The Care Center, owned by the Crow Tribe of Indians, “is a long-term nursing facility that provides 24-hour medical services exclusively to members of the Crow and Northern Cheyenne Tribes,” and operates under a “638 contract” between the Tribe and the federal government. The contract provides for tribal administration of programs previously operated by the Bureau of Indian Affairs.
A patient confided in Wilhite that he was molested while being transported, allegedly by an individual related to Defendant Catolster. Wilhite reported the incident to Catolster, but no action was taken, so Wilhite reported the incident to law enforcement. After an investigation, the Montana Department of Public Health and Human Services substantiated the allegations in a report, which was made available to Catolster. Wilhite was then terminated. Wilhite subsequently brought this suit for wrongful termination alleging that she was fired for reporting “patient abuse to law enforcement.”
Wilhite’s initial claim was dismissed on the basis of sovereign immunity, and she filed a second action under the Federal Tort Claims Act directly against the individuals involved in the decision to terminate her employment. The Defendants filed two motions to dismiss, arguing first that “Wilhite failed to state a claim upon which relief can be granted because her claim [was] barred by the [FTCA],” and, second, that the claim was “precluded by the doctrine of res judicata.”
The federal district court denied both motions. It first held that the Defendant did not follow the proper procedure for invoking immunity FTCA and there was no basis to sustain the motion to dismiss for failure to state a claim. The court then concluded that Wilhite’s first case was dismissed on the basis of sovereign immunity and so did not reach the merits required to qualify as preclusive. The court relied on the Ninth Circuit’s two-part test to determine whether a Tribal employee’s actions are covered by the FTCA, which stated “first…courts must determine whether the alleged activity is…encompassed by the relevant federal contract or agreement,” and “[s]econd, courts must decide whether the allegedly tortious action falls within the scope of the tortfeasor’s employment under state law.” Because the previous ruling did not adequately address these issues, the Defendants’ motion was denied.
Janiver v. Seminole Hard Rock Hotel Casino, No. 19-62204, 2020 WL 509997 (S.D. Fla. 2020): This claim arose from a complaint purporting to “allege a cause of action for employment discrimination based on race and national origin under Title VII.” The Plaintiff alleged that, in response to her interest in a customer service representative position with the Seminole Tribe, an employee in human resources told her she “can only work in the back to do dishes” because she was Black and from Haiti. The Plaintiff brought a suit against the Seminole Hard Rock Hotel Casino, which was removed to the District Court for the Southern District of Florida. The Defendant filed a motion to dismiss because the proper defendant was the Seminole Tribe of Florida.
The Court granted the dismissal. It held that the Seminole Tribe “is a federally recognized Indian tribe exempt from suit under Title VII” and that the Tribe did not waive immunity so there was no subject matter jurisdiction. The Court also explained that the Plaintiff “failed to allege that she properly and timely exhausted her administrative remedies prior to filing the suit,” which is required before bringing an action under Title VII, “and that Plaintiff’s Complaint otherwise failed to state an actionable claim.” In denying the Plaintiff’s Motion to Reopen the Case, the court reiterated that Title VII does not apply to Indian tribes so there is no subject matter jurisdiction.
Thurmond v. Forest County Potawatomi Community, No. 18-1047, 2020 WL 488864 (E.D. Wis. 2020): The Plaintiff filed a complaint against the Forest County Potowatomi Community and several employees of the Potowatomi Bingo Casino, alleging “the defendants discriminated against him based on his race and his verbal tic.” The defendants filed a motion to dismiss the complaint for failure to state a claim because “federal laws don’t apply to Indian tribes or their employees.”
Although it was unclear in the complaint, the court assumed that the Plaintiff was alleging either a violation of his civil rights under 42 U.S.C. § 1983, a violation of Title VII, or a violation of the Americans with Disabilities Act (the “ADA”). As to the § 1983 claim, the court noted the Plaintiff can only sue the Defendants if they were “acting under color of any statute, ordinance, regulation, custom, or usage, of any State or Territory or the District of Columbia.” The court rejected this argument because the Defendants were “a sovereign Indian tribe and employees of that tribe” and were not employees of Wisconsin, of a territory, or of the district. Furthermore, the Court recognized “an Indian tribe is not a ‘person’ subject to suit under § 1983.”
As to the Title VII claim, the court noted a person cannot sue an Indian tribe for violating Title VII, “even if the tribe discriminated against him in his employment based on his race,” because Title VII specifically says, “the term ‘employer’…does not include…an Indian tribe.” The court further noted “a supervisor does not, in his individual capacity, fall within Title VII’s definition of employer.”
Finally, as to the ADA claim, the court noted the ADA specifically excludes Indian tribes from the definition of employer, and that “individuals who do not otherwise meet the statutory definition of ‘employer’ cannot be held liable under the ADA.” As such, even if the plaintiff was discriminated against based on a disability, he “cannot state an ADA claim.”
§ 1.4.4 Federal Court Jurisdiction
Federal court jurisdiction is limited to cases that invoke a federal court’s limited subject matter jurisdiction. Such cases may involve a federal question[136] or claims that are brought involving diversity of citizenship.[137] Litigation that arises from a deal with a federally recognized tribe, or otherwise has federal overtones, does not necessarily present a federal question that will allow a federal district court to assume jurisdiction,[138] nor does the possibility that a tribe may invoke a federal statute in its defense confer federal court jurisdiction.[139] Moreover, courts have generally held that a tribe is not a citizen of any state for diversity purposes and, therefore, cannot sue or be sued in federal court based on diversity jurisdiction.[140] However courts are split on whether a business incorporated under federal statute, state law, or tribal law can qualify for diversity jurisdiction.[141] Because the potential judicial forums for commercial litigation arising out of Indian Country are likely restricted to state or tribal court, choosing federal court as the choice of venue may not make sense.
The following highlights several of the more relevant cases decided in the last year.[142]
Landreth v. United States, 797 F. App’x 521 (Fed. Cir. 2020): Plaintiff Landreth brought an action against the United States as a trustee for the Quinault Indian Nation. The Tribe had allegedly been asserting jurisdiction and control over Lake Quinault, forcing out the public owners, and restricting all uses of the lake for non-tribal members. Landreth brought claims for deprivation of property rights by the Tribe’s trespassory actions, conversion of Lake Quinault, tortious interference with property, private nuisance, violations of the U.S. Constitution, and violations of various federal and Washington state laws. The government filed a motion to dismiss for lack of subject matter jurisdiction, which the Claims Court granted.
The Federal Circuit affirmed. It held that Landreth’s complaint failed to allege a taking by the United States sufficient to confer Tucker Act jurisdiction on the Claims Court because the complaint failed to mention the Takings Clause of the Fifth Amendment. The court found that every alleged wrongful act was committed by the Tribe, not the United States, and the complaint did not allege sufficient facts to establish the responsibility of the United States for actions taken by the Tribe. While there is a “general trust relationship between the United States and the Indian people,” Landreth did not demonstrate why the United States, as trustee, should be liable for the alleged wrongful acts of the Tribe. Even if the United States was responsible for the alleged wrongful acts of the Tribe, the Federal Circuit held that the complaint failed to allege a valid takings claim under the Fifth Amendment.
Gila River Indian Cmty. v. Cranford, No. 19-0407, 2020 WL 2537435 (D. Ariz. May 12, 2020): The Gila River Indian Community (“GRIC”) alleged that the defendants unlawfully irrigated their lands with well water from the Gila River, in derogation of GRIC’s rights. GRIC’s complaint asserted four separate bases for jurisdiction, including subject-matter jurisdiction under 28 U.S.C. §§ 1362 and 1331. The defendants filed a Rule 12(b)(1) motion to dismiss for lack of jurisdiction.
The federal district court found jurisdiction to be proper. § 1362 provides that district courts have original jurisdiction over “all civil actions, brought by any Indian tribe or band with a governing body duly recognized . . . wherein the matter in controversy arises under the Constitution, laws, or treaties of the United States.” Claims brought by a tribe to protect its federally derived property rights, including “possessory rights of the tribes to tribal lands” granted and governed by federal treaties and laws, are within the scope of § 1362. The Court concluded that GRIC’s claims for water rights, rights which are held in trust by the United States and derived from federal law, are within the scope of § 1362.
The district court further held that § 1331 also conferred federal jurisdiction over the action. It reasoned that a case brought by an Indian tribe to protect its water rights would “nearly always require recourse to federal law” as “[t]ribal water rights are created by the federal government and rooted in federal law.” Because the GRIC’s rights to the land, and the water rights appurtenant to the land, were granted and governed by federal law, the Tribe’s claim raised a federal question.
Leachmand v. United States, No. 19-0082, 2020 WL 1511262 (D. Mont. Mar. 30, 2020): Members of the Fort Peck Indian Reservation brought a civil case in Fort Peck Tribal Court for breach of contract and other claims. The tribal trial court ruled in favor of the tribal members, but the Tribal Court of Appeals reversed, finding that the tribal trial court had violated the appellee’s rights to due process and equal protection.
The tribal members then filed a claim in federal court under the Federal Tort Claims Act against the United States (“Government”) because the federal Bureau of Indian Affairs funded the Fort Peck Tribal Court. The Government filed a motion to dismiss for lack of subject matter jurisdiction and the federal district court dismissed the complaint with no leave to amend.
The Court explained that, even if there was subject matter jurisdiction over the Government to hear the claims, the complaint had to be dismissed because Montana, the state in which the underlying contract dispute arose, recognized judicial immunity for members of the judiciary “for damages arising from the lawful discharge of an official duty associated with judicial actions of the court.” Thus, Montana’s judicial immunity would bar Plaintiffs from pursuing monetary damages against a federal judicial officer acting in their official capacity. Here, even if the Government set up, funds, and administers the Fort Peck Tribal Court, the Tribal Court judge was protected by judicial immunity. Given that the United States was exempt from suit under the theory of sovereign immunity and the Tribal Court judge had judicial immunity, the district court dismissed the case for lack of subject matter jurisdiction.
Cherokee Nation v. Dep’t of Interior, No. 19-2154, 2020 WL 224486 (D.D.C. Jan. 15, 2020): This case arose from the Cherokee Nation’s request for an accurate accounting of its Trust Funds held by the Department of the Interior and other federal defendants (collectively, the “Government”). The Government filed a motion to dismiss on jurisdictional grounds, arguing that sovereign immunity barred the lawsuit and that the Nation failed to set forth any relevant federal statutes for its claims. The district court denied the Government’s motion, finding the Nation had met its burden at this stage of the litigation.
The Court found that there was federal question jurisdiction under 28 U.S.C. § 1331 because district courts have original jurisdiction over civil actions arising under the Constitution, laws, or treaties of the United States. The D.C. Circuit has consistently interpreted the United States’ duties regarding Indian trust accounts “in light of the common law of trusts and the United States’ Indian policy” and that this case specifically involved trust accounting claims under statute, common law, and the Administrative Procedure Act (“APA”). The Court further recognized that § 702 of the APA waived the Government’s immunity from actions when the requested relief is nonmonetary. Accordingly, the Court found it had subject matter jurisdiction over the suit.
Ysleta Del Sur Pueblo v. City of El Paso, 433 F. Supp. 3d 1020 (W.D. Tex. 2020): The Ysleta Del Sur Pueblo (“Pueblo”), a federally recognized Indian tribe, sought judicial confirmation of the Pueblo’s title to certain real property in Texas, claiming that the 1751 Spanish Land Grant vested ownership rights in the Pueblo. Pueblo asked the Court to enter declaratory judgment that the City of El Paso had no estate, right, title, or interest in the property at issue. The City filed a motion for summary judgment, which the district court construed as a motion to dismiss for lack of subject-matter jurisdiction and a motion for summary judgment in the alternative.
Pueblo asserted that the Court had subject-matter jurisdiction under 28 U.S.C. § 1331 and under § 1362 for civil lawsuits brought by Indian tribes. The court held that § 1362 would provide a jurisdictional basis for a tribe’s claims only if the claims satisfied the “arising under” requirement of § 1331. Pueblo invoked the Treaty of Guadalupe Hidalgo for their suit, asserting that the right to the property at issue derived from the 1751 Spanish Land Grant that was allegedly “recognized by federal law, and the laws of Spain and Mexico, and preserved by the United States in the Treaty of Guadalupe Hidalgo.”
The Court ruled that the claim did not raise a federal question because (1) the cause of action was not based on federal law, but rather state law; and (2) the Pueblo’s asserted right to the property at issue was not a federally derived right with a substantial federal issue. Because an action to quiet title is rooted in state law, and the mere presence of a federal issue in a state cause of action does not automatically confer federal question jurisdiction.
Kangarlou v. Locklear, No. 18-2286, 2019 WL 5964008 (D. Nev. Nov. 13, 2019): Locklear, a member of the Lumbee Tribe of North Carolina, assaulted Kangarlou on the gaming floor of the Mirage Casino while he was attending a conference on behalf of the Lumbee Land Development, Inc. Kangarlou sued Locklear for assault and battery and sued the Lumbee Tribe (a non-federally recognized Tribe), Lumbee Land Development, Inc., and Lumbee Tribe Holdings, Inc. for negligence.
The district court held that “the presence of an unincorporated tribe destroys diversity.” Because an unincorporated Indian tribe is not a citizen of any state under 28 U.S.C. § 1332(a)(1), a tribe cannot sue or be sued in diversity “because they are not citizens of any state.” However, if an Indian tribe incorporates, it “may have state citizenship for diversity of citizenship purposes. As “the parties are not diverse within the meaning of § 1332(a)(1) because an Indian tribe is not a citizen of any state,” there is not complete diversity of the parties. Thus, because Kangarlou joined the unincorporated Lumbee Tribe in this suit, diversity was destroyed, and the complaint was dismissed with leave to amend.
Toahty v. Kimsey, No. 19-01308, 2019 WL 5104742 (D. Or. Oct. 11, 2019): Pro se plaintiff Toahty brought a case for sexual misconduct, sexual harassment, and retaliation against Kimsey, the Tribal Employment Rights Ordinance Division’s Assistant Director with the Confederated Tribes of Grande Ronde. Toahty alleges he was subject to sexual misconduct and harassment by Kimsey and that, when he reported this conduct to the T.E.R.O., he was subjected to retaliation.
The court found that there was no federal question jurisdiction, as Toahty failed to cite any federal law or constitutional provision in his complaint. Even if he was able to assert a claim for employment discrimination, “Title VII excludes Indian tribes,” and civil liability for employment discrimination does not extend to individual agents of the employer. Toahty’s complaint also failed to allege diversity of citizenship. The Tribe was not a citizen of any state, so it could not be sued in diversity. Accordingly, the court dismissed the complaint without prejudice.
§ 1.5 The State Sovereign
With billions of dollars being exchanged in Indian Country, state government is naturally looking for a piece of the action, giving rise to tax clashes between tribes and their business partners, and states and counties. These conflicts are primarily decided under the “federal preemption doctrine,” which asks whether a state’s attempted regulation or taxation of non-Indian activities in Indian Country is preempted by federal statutes or treaties, taking into account overarching notions of tribal sovereignty.[143]
Generally, state taxes apply to everyone “outside a tribe’s reservation” and are “federally preempted only where the state law is contrary to express federal law.”[144] Within Indian Country, on the other hand, “the initrequently dispositive question in Indian tax cases is who bears the legal incidence of the tax.”[145] When the legal incidence falls on tribes, tribal members, or tribal corporations,[146] “[s]tates are categorically barred” from implementing the tax.[147]
When the legal incidence falls on non-Indians, however, a more nuanced analysis applies. Although, historically, the U.S. Supreme Court asked whether any assertion of state power on Indian land would impinge on the tribal right to make its own laws and be ruled by them, in recent years, the High Court has moved away from that inherent tribal sovereignty analysis in favor of a federal preemption regime.[148] Because Congress does not often explicitly preempt state law,[149] the Supreme Court and the lower federal courts engage in a balancing act to determine whether tribal self-governance rights, bolstered by federal laws, preempt state laws.[150] This balancing act weighs a state’s interest in policing non-Indian conduct against combined federal and tribal interests in regulating affairs that arise out of tribal lands within the state’s boundaries.[151]
In New Mexico v. Mescalero Apache Tribe,[152] the Supreme Court explained that “state jurisdiction is preempted by the operation of federal law if it interferes or is incompatible with federal and tribal interests embodied in federal law, unless the state interests at stake are sufficient to justify the assertion of state authority.”[153] In Mescalero, the Court held that New Mexico could not impose its own fishing and hunting regulations on non-Indians on the reservation because of strong federal interests in “tribal self-sufficiency and economic development” and a lack of state interests.[154]
When non-Indian parties operate in Indian Country, lawyers must proactively evaluate whether, or to what extent, a state or local government’s interest in policing or taxing conduct that relates to neighboring tribal lands outweighs relevant federal and tribal interests pertaining to that same conduct arising within those lands.
The issues of preemption and infringement are regularly litigated in the federal courts. The following highlights several of the more relevant cases decided in the last year.[155]
Cayuga Nation v. Tanner, No. 14-1317, 2020 WL 1434157 (N.D.N.Y. Mar. 24, 2020): In 2003, the Cayuga Nation purchased, in fee simple by indenture deed, a parcel of land in the Village of Union Springs within the bounds of the Cayuga Historic Reservation. After the Nation began renovating the parcel to contract a gaming facility under the Indian Gaming Regulatory Act, the Village sought to apply its local laws and ordinances to the development.
In 2019, the Nation filed an amended complaint seeking declaratory and injunctive relief against the Village and its officials and argued that all local regulation was preempted by IGRA. The federal court agreed. The court reasoned that the parcel qualifies as “Indian lands” because the unrestricted language of the IGRA includes all lands within the limits of any Indian reservation. Second, in evaluating the jurisdictional requirement for IGRA Class II gaming, the court rejected the claim that Sherrill precluded the Nation from exercising any sovereignty over the parcel. The court noted that Sherill’s advice to pursue the land-into-trust process was not the exclusive means for establishing IGRA jurisdiction on repurchased historic reservation land. Instead the court concluded that an Indian Tribe is not required to exercise exclusive governmental authority to satisfy the jurisdiction requirement; some jurisdiction, even if concurrent with state and local authorities satisfies this test. Because the Nation exercised concurrent jurisdiction over the parcel the IGRA applied and preempted the Village from regulating the Tribe’s gaming activities via local laws and ordinances.
Swinomish Indian Tribal Cmty. v. BNSF Ry. Co., 951 F.3d 1142 (9th Cir. 2020): The Interstate Commerce Commission Termination Act of 1995’s preemption clause is only applicable to state laws and actions; however, it does not repeal the Indian Right of Way Act nor abrogate the Treaty of Point Elliot.
Over a century ago, a predecessor to BNSF Railway Co. built a railroad across the Swinomish Indian Tribal Community without the Tribe’s consent. Litigation ensued and resulted in a Settlement Agreement and an Easement Agreement. Subsequently, BNSF obtained a right-of way (ROW) across the reservation under the Indian Right of Way Act of 1948. The ROW incorporated the easement terms which included a daily maximum of one train in each direction with a maximum of 25 railcars and an annual reporting requirement detailing the cargo carried by the trains. However, BNSF failed to comply with these terms.
The Tribe filed suit in 2015 seeking a declaratory judgment that BNSF breached the Easement Agreement, injunctive relief limiting the train traffic in accordance with the Agreement, and damages for both trespass and breach of contract. BNSF contended that the Tribe’s claims were pre-empted by the Interstate Commerce Commission Termination Act of 1995 (ICCTA). The district court ruled against BNSF on the breach of contract claim.
After hearing BNSF’s interlocutory appeal, the Ninth Circuit held that the ICCTA does not preclude the use of injunctive relief to enforce the terms of the Easement Agreement. First, the court noted that the ICCTA only preempts “actions by states or localities” or “all state laws”. The ICCTA’s preemption applies to the regulation of railroads; however, ROW easements are a voluntary agreement and not regulation, even in a state-law context. Further, there is nothing in the legislative language or history to suggest that Congress intended the ICCTA to repeal the Indian Right of Way Act, nor to abrogate the Treaty of Point Elliot. Because it does not repeal the Indian Right of Way Act, nor abrogate the Treaty of Point Elliot, the Tribe has a right to pursue injunctive relief to enforce the terms of the Easement Agreement.
Herpel v. Cty. of Riverside, 258 Cal. Rptr. 3d 444 (Cal. App. 2020): The Agua Caliente Band of Cahuilla Indians has reservation land spread across three cities in Riverside County. Some land is owned in trust by the federal government for the benefit of the Tribe and some is owned in trust for the benefit of individual Tribe members (Allotted Land). Plaintiffs each hold a leasehold or other possessory interest in Allotted Land. Plaintiffs filed a class action suit contending that the County’s possessory interest tax is preempted by federal law. The trial court entered judgement in favor of the defendants and the plaintiffs appealed.
The Bracker interest test calls for courts to inquire into the “state, federal, and tribal interests at stake” to determine whether “in the specific context, the exercise of state authority would violate federal law.” In considering the federal interests, the court noted that the regulations governing the Long-Term Leasing Act do not signal an intent by Congress to exclude state taxation, but instead a simple purpose of removing restrictions that disadvantage tribal economic development. In evaluating the Tribe’s interest, the court noted that the tax does not fall on the Tribe and that there is no evidence to suggest that the Tribe would be negatively affected if it imposed its own tax in addition to state or local tax on parcel holders. Lastly, in evaluating the state’s interest, the court noted that the state interest in funding state services that have a substantial connection with on-reservation activity (police, fire, health and sanitation, road maintenance, etc.) is sufficient to justify the County possessory interest tax.
Video Gaming Techs., Inc. v. Rogers Cty. Bd. of Tax Roll Corr., 2019 OK 83, cert. denied, No. 19-1298, 2020 WL 6121479 (U.S. Oct. 19, 2020): Plaintiff owns Video Gaming Technologies Inc. (VGT), a non-Indian Tennessee corporation authorized to do business in Oklahoma. The Plaintiff leased electronic gaming equipment to Cherokee Nation Entertainment (CNE), a business entity of the Cherokee Nation. CNE gaming facilities are all located on tribal trust land. Plaintiff sought relief from assessment of ad valorem taxes on the leased equipment imposed by Rogers County. The district court found for the defendant, holding that Oklahoma’s tax statutes were not preempted by the IGRA. Plaintiffs appealed contending that the taxes on equipment are indeed preempted by federal law.
The Oklahoma Supreme Court noted that, because the gaming equipment is used exclusively in a tribal gaming operation, it is “inextricably intertwined” with the regulation of gaming activities, and, therefore, IGRA applies to the dispute. Next, the Court went on to apply the Bracker interest test. Evaluating federal interests, the court noted that in enacting the IGRA Congress had a strong interest in prevention of corruption through the oversight over gaming and gaming equipment. In evaluating the Tribe’s interest, the court noted that the tax burden will ultimately fall on the Nation because the County may seize property when taxes are not paid; thus, the County’s remedy for delinquent taxes would directly impact the Nation’s economic well-being. Lastly, in evaluating the state’s interest, the court noted that the County provides no evidence that the taxes fund any regulatory services or function to VGT; an interest in revenue is insufficient to justify taxation.
The Oklahoma Supreme Court ultimately concluded that the state’s interests fail the Bracker test; because the IGRA’s comprehensive regulations occupy the field of ad valorem taxes imposed on gaming equipment used exclusively in tribal gaming, the present taxation of gaming equipment is preempted. The Supreme Court denied cert. on October 19, 2020 over a dissent from denial of certiorari by Justice Thomas. (See discussion of the denial of cert. in §8.2.2 above).
New York v. Mountain Tobacco Co., 942 F.3d 536 (2d Cir. 2019): Mountain Tobacco Company (MTC) shipped unstamped and untaxed cigarettes from the Yakama Indian Reservation in Washington State to Indian Reservations in New York State. New York brought suit to enjoin MTC from making these shipments, claiming that they violated state and federal law. The district court granted partial summary judgment for the State on claims that MTC violated state laws on cigarette sales, enjoined future violations, and ruled that the injunction is not a violation of the Dormant Commerce Clause. MTC appealed arguing that New York’s enforcement violates the Dormant Commerce Clause and that the injunction violates the Indian Commerce Clause and the Yakama Treaty of 1859. The State cross-appealed claiming that the cigarette shipments were interstate commerce under Prevent All Cigarette Trafficking Act (PACT) and that MTC does not qualify for the “an Indian in Indian country” exception under the Contraband Cigarette Trafficking Act (CCTA).
The Second Circuit Court of Appeals ruled that there was no violation of the Dormant Commerce Clause because a lack of universal enforcement across in-state and out-of-state entities “does not bespeak discrimination.” Next, the court held that the state tax was not a violation of the Indian Commerce Clause because the tax falls on non-Indian consumers and New York’s stamping regime does not place an undue burden on MTC. Despite these initial findings the Court ultimately held that the imposition of the State tax was preempted by the CCTA. MTC is a business organized under Yamaka law, located on the Yakima reservation, and owned by a Yakima tribal member. It is exempt from the CCTA under the “Indian in Indian Country” exception. While the term “Indian” has not been defined by the CCTA, the court “decline[d] to interpret § 2346(b)(1) to mean that an “Indian” is not a “person,”” In turn, “person” has been defined to include corporations; therefore, MTC fits within this interpretation of the exception.
§ 1.6 Conclusion
Economic growth and development throughout Indian Country have spurred many businesses to engage in business dealings with tribes and tribal entities. Confusion may arise during these transactions because of the unique sovereign and jurisdictional characteristics attendant to business transactions in Indian Country. As a result, these transactions have prompted increased litigation in tribal and nontribal forums. Accordingly, counsel assisting in these transactions, or any subsequent litigation, should conduct certain due diligence with respect to the pertinent tribal organizational documents and governing laws that may collectively dictate and control the business relationship.
To maximize the client’s chances of a successful partnership with tribes and tribal entities, counsel should ensure that the transactional documents contain clear and unambiguous contractual provisions that address all rights, obligations, and remedies of the parties. Therefore, even if the deal fails, careful negotiation and drafting, and, in turn, thoughtful procedural and jurisdictional litigation practice, will allow the parties to more expeditiously litigate the merits of any dispute, without jurisdictional confusion. As business between tribes and nontribal parties continues to grow, ensuring that both sides of the transaction fully understand and respect the deal will lead to a long-lasting and beneficial business relationship for all.
* Grant Christensen is an Associate Professor of Law at the University of North Dakota School, the director of the law school’s Indian Law Certificate program, an Affiliated Associate Professor of American Indian Studies, and an Associate Justice on the Standing Rock Sioux Tribe’s Supreme Court. He is also one of the ABA Business Law Section’s Business Law Fellows for the 2018-2020 term. In addition to his J.D., Grant also holds an LL.M. in Indigenous Peoples Law and Policy from the University of Arizona and was a Fulbright Scholar. Before arriving at North Dakota, he taught Federal Indian Law at the University of Oregon as a Visiting Professor and at the University of Toledo as a Lecturer. Grant is the co-chair of the Tribal Court Litigation Subcommittee.
† Ryan D. Dreveskracht is an attorney with Galanda Broadman PLLC. Ryan practices out of the firm’s Seattle office, focusing on representing businesses and tribal governments in complex litigation. He is also devoted to defending individuals’ constitutional rights and handles civil rights and intentional tort cases.
** Heidi McNeil Staudenmaier is a Senior Partner with Snell & Wilmer LLP in Phoenix, Arizona, where her practice emphasizes Gaming Law, Native American Law, and Business Litigation. She has been recognized in Best Lawyers in America for many years and was named Best Lawyers “Phoenix Native American Law Lawyer of the Year” for 2015 & 2017 and “Phoenix Gaming Law Lawyer of the Year” for 2011, 2016, 2018 & 2020. Heidi is listed in Southwest Super Lawyers, Chambers Global and Chambers USA (Leading Lawyers for Business) for Native American Law and Gaming/Licensing. She is a member of the ABA Business Law Section’s Executive Council, Past Chair of the Business and Corporate Litigation Committee, an active member of the Gaming Law Committee, Past Editor-in-Chief of Business Law Today, Past Editor of the “Annual Review of Recent Developments in Business & Corporate Litigation,” and a former Section Fellow. Heidi received the prestigious Business Law Section Jean Allard Glass Cutter Award in 2019. Also, in 2019, she was inducted into the Maricopa County Bar Association Hall of Fame, named among the “Women Achievers of Arizona”, honored as Greater Phoenix Chamber Athena Finalist, and received the University of Iowa College of Law Alumni Service Award. In addition, she has been recognized among the AZ Business Leaders 2020 and 2021.
[1] The Honorable Sandra Day O’Connor, Lessons from the Third Sovereign: Indian Tribal Courts, 33 TULSA L.J. 1 (1997).
[2] Jack F. Williams, Integrating American Indian Law into the Commercial Law and Bankruptcy Curriculum, 37 TULSA L. REV. 557, 560 (2001). See also Frank Pommersheim, What Must Be Done to Achieve the Vision of the Twenty-First Century Tribal Judiciary, 7 Kan. J.L. & Pub. Pol’y 8, 11-12 (1997).
[3] Frank Pommersheim, What Must Be Done to Achieve the Vision of the Twenty-First Century Tribal Judiciary, 7 Kan. J.L. & Pub. Pol’y 8, 17 (1997).
[4]Worcester v. Georgia, 31 U.S. (1 Pet.) 515, 559 (1832).
[12] B.J. Jones, Role of Indian Tribal Courts in the Justice System, NATIVE AMERICAN MONOGRAPH SERIES, Mar. 2000, at 6, http://www.icctc.org/Tribal%20Courts.pdf (last visited Oct. 13, 2019).
[13]Id.; Steven J. Gunn, Compacts, Confederacies, and Comity: Intertribal Enforcement of Tribal Court Orders, 34 N.M. L. REV. 297, 306 (2004).
[14] Kristen Carpenter and Eli Wald, Lawyering for Groups: The Case of American Indian Tribal Attorneys, 81 FORDHAM L. REV. 3085 (2013).
[15]SeeMontana v. United States, 450 U.S. 544, 566 (1981) (“Indian tribes retain inherent sovereign power to exercise some forms of civil jurisdiction over non-Indians on their reservations . . . .” (emphasis added)); Means v. Navajo Nation, 432 F.3d 924, 930 (9th Cir. 2005) (holding that the tribe had jurisdiction over defendant because he was an Indian by political affiliation).
[16] Indian Country includes: (1) all land within the limits of any Indian reservation, (2) “dependent Indian communities” within the borders of the United States, and (3) all Indian allotments, including rights-of-way. 28 U.S.C. § 1151 (2000). “Although [that] definition by its terms relates only to . . . criminal jurisdiction . . . it also generally applies to questions of civil jurisdiction. . . .” Alaska v. Native Vill. of Venetie Tribal Gov’t, 522 U.S. 520, 527 (1998).
[17] “The ownership status of land . . . is only one factor to consider in determining whether [tribal courts have jurisdiction over non-members]. It may sometimes be a dispositive factor.” Nevada v. Hicks, 533 U.S. 353, 360 (2001) (emphasis added).
[18]Water Wheel Camp Recreational Area, Inc. v. LaRance, 642 F.3d 802 (9th Cir. 2011); see also Iowa Mut. Ins. Co. v. LaPlante, 480 U.S. 9, 14 (1987) (“We have repeatedly recognized the Federal Government’s long-standing policy of encouraging tribal self-government. . . . This policy reflects the fact that Indian tribes retain ‘attributes of sovereignty over both their members and their territory . . . .’”) (quotingUnited States v. Mazurie, 419 U.S. 544, 557 (1975)).
[19]Lesperance v. Sault Ste. Marie Tribe of Chippewa Indians, No. 2:16-cv-232, 2017 U.S. Dist. LEXIS 64193 (W.D. Mich. Apr. 27, 2017) (a non-Indian sued the tribe in tribal court but provided notice in a letter to a customer representative and not to the tribal Secretary as required under the tribe’s waiver authority. The tribal trial court and appellate court upheld dismissal and the federal district court affirmed.).
[20]Water Wheel, 642 F.3d 802; Washington v. Confederated Tribes of the Colville Indian Reservation, 447 U.S. 134 (1980) (power to tax transactions on trust lands). Indian land in this context includes land owned by the tribe or its members as well as land owned in fee by the United States but held in trust for the benefit of the tribe or its members. Notably, the land beneath a navigable waterway is not “Indian land,” Montana v. United States, 450 U.S. 544 (1981); neither is land owned by the United States but with a right of way granted to a state for the purposes of the construction and use of a state highway, Strate v. A-1 Contractors, 520 U.S. 438 (1997).
[21]Montana v. United States, 450 U.S. 544 (1981).
[23]Plains Commerce, 554 U.S. 316 (2008). Although Montana originally pertained to civil jurisdiction over non-Indians on non-Indian fee lands within reservation boundaries (450 U.S. at 564), the Ninth Circuit Court of Appeals has previously maintained “that the general rule of Montana applies to both Indian and non-Indian lands.” Ford Motor Company v. Todeecheene, 394 F.3d 1170, 1178-79 (9th Cir. 2005), overruled on other grounds, 488 F.3d 1215 (9th Cir. 2007). More recently, however, the Ninth Circuit has indicated a reversion to its original rule. SeeWater Wheel, 642 F.3d 802.
[25]Id. It appears, however, that courts have become more sympathetic to the second exception as of late. See, e.g., Knighton v. Cedarville Rancheria of N. Paiute Indians, 922 F.3d 892, 905 (9th Cir.), cert. denied, 140 S. Ct. 513 (2019); Norton v. Ute Indian Tribe of the Uintah & Ouray Reservation, 862 F.3d 1236, 1246 (10th Cir. 2017).
[26] Charlene Smith helped to research and summarize the cases in this section. Charlene is a rising third year law student at the University of Southern California Gould School of Law and expects to graduate in May 2021.
[27] Exhaustion is not always required. SeeNat’l Farmers Union Ins. Co. v. Crow Tribe of Indians, 471 U.S. 845, 857 n.21 (1985) (“We do not suggest that exhaustion would be required where an assertion of tribal jurisdiction is motivated by a desire to harass or is conducted in bad faith, or where the action is patently violative of express jurisdictional prohibitions, or where exhaustion would be futile because of the lack of an adequate opportunity to challenge the court’s jurisdiction.”).
[28]Id. at 857. (“Until petitioners have exhausted the remedies available to them in the Tribal Court system . . . it would be premature for a federal court to consider any relief.”); Progressive Advanced Ins. Co. v. Worker, No. CV-16-08107-PCT-DJH, 2017 U.S. Dist. LEXIS 19283 (D. Ariz. February 8, 2017) (Judge Humetewa writes: “Progressive issued an insurance policy that listed a tribal member as a named insured and covered vehicles that were kept on tribal lands . . . however Progressive never mailed anything to an address on tribal lands. To the extent that factor is dispositive, it may be that the tribal court lacks jurisdiction. But this is a question that must be answered first by the tribal courts of the Navajo Nation.”).
[29]Whitetail v. Spirit Lake Tribal Ct., Civ. No. 07-0042, 2007 U.S. Dist. LEXIS 87312, at *4-*5 (N.D. Nov. 28, 2007). The doctrine applies even to federal habeas corpus actions filed under 25 U.S.C. § 1303. See, e.g., Valenzuela v. Silversmith, No. 11-2212, 2012 WL 5507249 (10th Cir. Nov. 14, 2012).
[30]SeeRincon Mushroom, 490 Fed. Appx. 11, 13 (9th Cir. 2012) (“[H]old[ing] that the district court abused its discretion in dismissing the case rather than staying it.”); but seeProgressive Advanced Ins. Co. v. Worker, No. CV-16-08107-PCT-DJH, 2017 U.S. Dist. LEXIS 19283 (D. Ariz. February 8, 2017) (dismissing the case); Window Rock Unified School District v. Reeves, 2017 U.S. App. LEXIS 14254 (9th Cir. August 3, 2017) (same).
[32]Iowa Mut. Ins. Co. v. LaPlante, 480 U.S. 9, 19 (1987) (“If the Tribal Appeals Court upholds the lower court’s determination that the tribal courts have jurisdiction, petitioner may challenge that ruling in the District Court.”).
[33]SeeFord Motor Co. v. Todecheene, 474 F.3d 1196, 1197 (9th Cir. 2007), amended and superseded by 488 F.3d 1215, 1216 (9th Cir. 2007); Duncan Energy Co., Inc. v. Three Affiliated Tribes of the Fort Berthold Reservation, 27 F.3d 1294, 1300 (8th Cir. 1993); Plains Commerce Bank, 128 S. Ct. at 2726. It is unclear whether state courts must likewise abstain from hearing a matter arising on tribal lands until the tribal court has determined the scope of its own jurisdiction and entered a final ruling. In Drumm v. Brown, 245 Conn. 657, 716 A.2d 50 (Conn. 1998), the Connecticut Supreme Court held that “[o]ur analysis, which is based primarily on the three United States Supreme Court exhaustion cases, persuades us that the courts of this state must apply the exhaustion of tribal remedies doctrine.” 245 Conn. at 659. However, the Drumm court found that exhaustion was not required in the absence of a pending action in tribal court. Id. at 684.
[34]Nat’l Farmers Union, 471 U.S. at 857; see, e.g., Evans v. Shoshone-Bannock Land Use Policy Comm’n, 4:12-CV-417-BLW, 2012 WL 6651194 (D. Idaho Dec. 20, 2012) (requiring plaintiff to exhaust its tribal court remedies).
[35]See, e.g., Bruce H. Lien Co. v. Three Affiliated Tribes, 93 F.3d 1412, 1421 (8th Cir. 1996).
[37]See id. at 17 (“At a minimum, exhaustion of tribal remedies means that tribal appellate courts must have the opportunity to review the determinations of the lower tribal courts.”); see alsoWhitetail v. Spirit Lake Tribal Ct., No. 07-0042, 2007 U.S. Dist. LEXIS 87312, at *4 (D.N.D. Nov. 28, 2007) (declining review of the case because the plaintiff had failed to exhaust his tribal court remedies).
[38]See Nat’l Farmers Union, 471 U.S. at 853 (reasoning that “a federal court may determine under § 1331 whether a tribal court has exceeded the lawful limits of its jurisdiction”).
[40]Id. (“Unless a federal court determines that the Tribal Court lacked jurisdiction . . . proper deference to the tribal court system precludes relitigation of issues raised . . . and resolved in the Tribal Courts.”). A thorough analysis of post-judgment proceedings is beyond the scope of this chapter, but there is case law on the issue. See, e.g., AT&T Corp. v. Coeur d’Alene Tribe, 295 F.3d 899, 903-904 (9th Cir. 2002); Burrell v. Armijo, 456 F.3d 1159, 1168 (10th Cir. 2006), cert.denied, 549 U.S. 1167 (2007); Brenner v. Bendigo, No. 13-0005, 2013 WL 5652457 (D.S.D. Oct. 15, 2013); Bank of America, N.A. v. Bills, No. 00-0450, 2008 WL 682399, at *5 (D. Nev. Mar. 6, 2008); First Specialty Ins. Corp. v. Confederated Tribes of Grand Ronde Community of Oregon, No. 07-0005, 2007 WL 3283699, at *4 (D. Or. Nov. 2, 2007); U.S. ex rel. Auginaush v. Medure, No. 12-0256, 2012 WL 5990274 (Minn. Ct. App. Dec. 3, 2012).
[42]Nevada v. Hicks, 533 U.S. 353, 369 (2001); Strate v. A-1 Contractors, 520 U.S. 438, 459 n.14 (1997).
[43]El Paso Natural Gas v. Neztsosie, 526 U.S. 473 (1999).
[44] Megan Carrasco helped to collect and summarize the cases in this section. Megan is a rising third year law student at the Sandra Day O’Connor College of Law at Arizona State University. She expects to graduate in May 2021.
[46]SeeSanta Clara Pueblo v. Martinez, 436 U.S. 49, 57-58 (1978).
[47] Tribal immunity can be abolished via federal statute. Alvarado v. Table Mountain Rancheria, 509 F.3d 1008, 1015-16 (9th Cir. 2007) (“[The] cornerstone of federal subject matter jurisdiction is statutory authorization.”); E.F.W. v. St. Stephen’s Indian High School, 264 F.3d 1297, 1302 (10th Cir. 2001) (“Tribal sovereign immunity is a matter of subject matter jurisdiction.”); McClendon v. United States, 885 F.2d 627, 629 (9th Cir. 1989) (“The issue of sovereign immunity is jurisdictional in nature.”). Tribal immunity can be voluntarily waived. Kiowa Tribe of Okla. v. Mfg. Techs., 523 U.S. 751, 755-56 (1998); Filer v. Tohono O’odham Nation Gaming Enters., 129 P.3d 78, 83 (Ariz. Ct. App. 2006) (applying for a liquor license did not waive the tribe’s sovereign immunity); Seminole Tribe of Fla. v. McCor, 903 So. 2d 353, 359-60 (Fla. Dist. Ct. App. 2005) (purchasing liability insurance is not a clear waiver of a tribe’s sovereign immunity); Furry v. Miccosukee Tribe of Indians of Fla., 685 F.3d 1224, 1234 (11th Cir. 2012) cert. denied, 133 S. Ct. 663, 184 L. Ed. 2d 462 (U.S. 2012) (tribe did not waive its immunity from private tort actions by applying for a state liquor license).
[48]Plains Commerce Bank v. Long Family Land & Cattle, 554 U.S. 316 (2008).
[50]Kiowa Tribe v. Mfg. Tech., Inc., 523 U.S. 751, 760 (1998). Constitution provides a basis for suits to enforce state election and campaign finance laws). The U.S. Supreme Court has yet to take a position on this matter.
[51]Santa Clara Pueblo v. Martinez, 436 U.S. 49, 58 (1978).
[52]Id.; United States v. Oregon, 657 F.2d 1009, 1013 (9th Cir. 1981); Filer, 129 P.3d at 86; Bellue v. Puyallup Tribe of Indians, No. 94-3045 (Puyallup 1994); Colville Tribal Enter. v. Orr, 5 CCAR 1 (Colville Confed. 1998).
[53]Miccosukee Tribe of Indians v. Tein, 2017 Fla. App. LEXIS 11442 (Fla. App. August 9, 2017) (even evidence of vexatious and bad faith litigation did not amount to a waiver of immunity, and “even where the results are deeply troubling, unjust, unfair, and inequitable”).
[54]In re Greektown Holdings, LLC, No. 12-12340, 2012 WL 4484933 (E.D. Mich. Sept. 27, 2012), aff’d, 728 F.3d 567 (6th Cir. 2013) (holding that for Congress to waive the tribe’s immunity the waiver must be “express, unequivocal, unmistakable, unambiguous, clearly evident in statutory language, and allow the Court to conclude with perfect confidence that Congress intended to waive sovereign immunity”). See alsoDemontiney v. United States ex rel. Bureau of Indian Affairs, 255 F.3d 801, 811 (9th Cir. 2001); Sanchez v. Santa Ana Golf Club, Inc., 104 P.3d 548, 551 (N.M. Ct. App. 2004) (reasoning that ambiguity within an immunity waiver should be interpreted in favor of the tribe).
[55]Contour Spa at the Hard Rock, Inc. v. Seminole Tribe of Fla., 692 F.3d 1200, 1206 (11th Cir. 2012) cert. denied, 133 S. Ct. 843 (2013) (Indian tribe’s removal of action to federal court did not waive its sovereign immunity). But seeGuidiville Rancheria of California v. United States, 2017 U.S. App. LEXIS 14394 (9th Cir. August 4, 2017) (holding that by raising the issue of attorney’s fees was sufficient to constitute a waiver its right to claim sovereign immunity on the issue of attorney’s fees when defendant subsequently claimed for fees against the tribe).
[56]Santa Clara Pueblo v. Martinez, 436 U.S. 49, 58 (1978) (internal quotation marks and citations omitted); see alsoGilbertson v. Quinault Indian Nation, 495 F. App’x 779 (9th Cir. 2012) (language in the Quinault Indian Nation’s employee handbook indicating that employees were protected by Title VII was not a sufficiently clear waiver of the Nation’s sovereign immunity).
[57]E.g., Memphis Biofuels, L.L.C. v. Chickasaw Nation Indus., Inc., 585 F.3d 917 (6th Cir. 2009) (holding that the presence of a sue-and-be-sued clause in the charter of a tribal corporation, alone, was “insufficient” to waive the corporation’s immunity because it made approval by the corporation’s board of directors a prerequisite to legal action by the corporation); accord Ninigret Dev. Corp v. Narragansett Indian Wetuomuck Hous. Auth, 201 F.3d 21, 30 (1st Cir. 2000) (holding that “the enactment of such an ordinance . . . does not waive a tribe’s sovereign immunity [where the ordinance] authorize[d] the [tribal corporation] to shed its immunity ‘by contract’” because “these words would be utter surplusage if the enactment of the ordinance itself served to perfect the waiver”); cf.Rosebud Sioux Tribe v. Val-U Constr. Co., 50 F.3d 560, 562 (8th Cir. 1995) (holding that the mere presence of an arbitration provision in the agreement represented a waiver of immunity from a judgment being enforced in federal court).
[58]C & L Enter., Inc. v. Citizen Band Potawatomi Indian Tribe of Okla., 532 U.S. 411 (2001).
[59]Id. at 418; seeTrump Hotels and Casino Resorts Dev. Co. v. Rosow, No. X03CV034000160S, 2005 Conn. Super. LEXIS 1224, at *41 (Conn. Super. Ct. May 2, 2005) (concluding that the tribe “clearly and unequivocally waived sovereign immunity” in its contract).
[62]Calvello v. Yankton Sioux Tribe, 584 N.W.2d 108, 114 (S.D. 1998) (holding that chairman of tribal business committee did not have authority to waive immunity); see alsoSandlerin v. Seminole Tribe of Fla., 243 F.3d 1282, 1286-87 (11th Cir. 2001) (reasoning that the tribal chief did not have authority to waive the tribe’s immunity through contract where the tribal code provided procedure for effecting a waiver); Chance v. Coquille Indian Tribe, 963 P.2d 638, 639 (Or. 1998) (reasoning that the tribal corporation president did not have authority to bind the corporation to a contract waiving tribal immunity); Harris v. Lake of the Torches Resort and Casino, 363 Wis. 2d 656 (2015) (holding that a third-party workers compensation administrator lacked the authority to waive the tribe’s immunity). But seeRush Creek Solutions, Inc. v. Ute Mountain Ute Tribe, 107 P.3d 402, 407 (Colo. App. 2004) (holding that the tribal chief financial officer had apparent authority to waive immunity when the tribal law was silent).
[63] John Habib helped to research and summarize the cases in this section. John is a rising third-year law student at the Sandra Day O’Connor College of Law, Arizona State University, and expects to graduate in May 2021.
[72]Native American Distrib. v. Seneca-Cayuga Tobacco Co., 546 F.3d 1288, 1295 (10th Cir. 2008) (holding that, because the tribal enterprise was not a corporation with a “sue-and-be-sued clause,” the tribal enterprise was immune from suit, as it did not explicitly waive its sovereign immunity). C.f. Grand Canyon Skywalk Dev. LLC v. Cieslak, 2015 U.S. Dist. LEXIS 73186 (D. Nev. June 5, 2015) (holding that, while sovereign immunity may protect the tribal corporation, it does not extend to an employee of the tribal corporation to allow the employee to refuse to comply with a federal subpoena).
[73]SeeSeaport Loan Products et al. v. Lower Brule Community Development Enterprise LLC, 2013 NY slip op. 651492/12 [Sup Ct. NY County 2013] (concluding that an independent, state-incorporated, for-profit tribal enterprise that was principally operating in the financial services markets, with separate assets, liabilities, purposes, and goals could not claim immunity); Arrow Midstream Holdings v. 3 Bears Construction LLC, 873 N.W.2d 16 (N.D. 2015) (holding that a corporation wholly owned by tribal members but incorporated under state law was a non-member entity for the purposes of litigation and therefore subject to state jurisdiction).
[74] Jada Allender helped to research and summarize the cases in this section. Jada is a rising third year law student at the Sandra Day O’Connor College of Law, Arizona State University, and expects to graduate in May 2021.
[75] 25 U.S.C. § 463 (2000); seeTOMAC v. Norton, 433 F.3d 852, 866-67 (D.C. Cir. 2006) (upholding Congress’s delegation of power to the Secretary to acquire land in trust for the tribe under § 1300j-5).
[78] Record of Decision, Trust Acquisition of, and Reservation Proclamation for the 151.87-acre Cowlitz Parcel in Clark County, Washington, for the Cowlitz Indian Tribe (Dec. 2010), http://www.bia.gov/cs/ groups/mywcsp/documents/text/idc012719.pdf. The Cowlitz Indian Tribe was not federally recognized until 2002, but, in 2010, the BIA nonetheless approved a fee-to-trust application, determining that the tribe was “under Federal Jurisdiction” in 1934, even though the federal government did not believe so at that time. Id. The D.C. District Court upheld the BIA’s Record of Decision, Confederated Tribes of Grand Ronde Cmty. of Or. v. Jewell, 75 F. Supp. 3d 387 (D.D.C. 2014) and the D.C. Circuit upheld the District Court, Confederated Tribes of Grand Ronde Cmty. of Or. v. Jewell, 830 F.3d 552 (D.C. Cir. 2016); see also Record of Decision, Trust Acquisition and Reservation Proclamation for 151 Acres in the City of Taunton, Massachusetts, and 170 Acres in the Town of Mashpee, Massachusetts, for the Mashpee Wampanoag Tribe (Sept. 2015), http://www.indianaffairs.gov/cs/groups/public/documents/text/idc1-031709.pdf. Although the Interior Department did not federally acknowledge the Mashpee Wampanoag Tribe until 2007, Interior applied M-37029 Memorandum’s two-part test to determine that the Tribe was “under federal jurisdiction” in 1934, which provided the legal basis for the trust acquisition outlined in the 2015 Record of Decision and circumvented the Tribe’s Carcieri issues. However, the District Court of Massachusetts rejected the Secretary’s interpretation and has returned the decision to take land into trust on behalf of the Mashpee to the Secretary of Interior. Littlefield v. U.S. Dept. of Interior, 2016 U.S. Dist. LEXIS 98732 (D. Mass. July 28, 2016).
[80]See, e.g., Stand Up for California! v. U.S. Dept. of Interior, No. 12-2039, (D.D.C. Sept. 6, 2016) (challenging the Department’s fee-to-trust decision for the benefit of the North Fork Rancheria of Mono Indians on the basis that the tribe wasn’t a “federally recognized tribe under jurisdiction” in 1934 as required under Carcieri).
[81] Memorandum from Hilary C. Tompkins, U.S. Dep’t of the Interior, Office of the Solicitor, to Sally Jewell, Secretary of the Interior, U.S. Dep’t of the Interior (Mar. 12, 2014) (hereinafter “M-37029 Memorandum”).
[84]Confederated Tribes of Grand Ronde Cmty. of Or. v. Jewell, 850 F.3d 552 (D.C. Cir. 2016); see alsoStand Up for California! v. U.S. Dept. of Interior, No. 12-2039, (D.D.C. Sept. 6, 2016); Citizens for a Better Way v. U.S. Dep’t of the Interior, No. 12-3021, ECF No. 168 (E.D. Cal. Sept. 24, 2015); No Casino in Plymouth v. Jewell, No. 12-1748, ECF No. 100 (E.D. Cal. Sept. 30, 2015); Cnty. of Amador v. Dep’t of Interior, No. 12-1710, ECF No. 95 (E.D. Cal. Sept. 30, 2015).
[85]Match-E-Be-Nash-She-Wish Band of Pottawatomi Indians v. Patchak, 132 S.Ct. 2199 (2012).
[88] The decision thus did not upset the rule that the “QTA provides the exclusive remedy for claims involving adverse title disputes with the government.” McMaster v. United States, 731 F.3d 881, 899 (9th Cir. 2013).
[89] The statute of limitations under the APA is six years. See, e.g., Cachil Dehe Band of Wintun Indians of Colusa Indian Cmty. v. Salazar, No. 12-3021, 2013 WL 417813, at *4 (E.D. Cal. Jan. 30, 2013) (holding that under Patchak, “federal district courts do have the power to strip the federal government of title to land taken into trust for an Indian tribe under the APA so long as the claimant does not assert an interest in the land.”).
[90] Land Acquisitions: Appeals of Land Acquisitions, 78 Fed. Reg. 67,928, 67,929 (Nov. 13, 2013) (codified at 25 C.F.R. pt. 151).
[95] Delilah Cassidy helped to research and summarize the cases in this section. Delilah is a 2021 Juris Doctor and Master of Sports Law and Business candidate at Arizona State University, Sandra Day O’Connor College of Law.
[96] 25 U.S.C. § 81 (2000) (Section 81). For a list of contracts that are exempt from secretarial approval, see 25 C.F.R. § 84.004 (2008).
[102] The approval process for alternative energy projects on tribal lands has been particularly burdensome. See Ryan Dreveskracht, The Road to Alternative Energy in Indian Country: Is It a Dead End?, 19 INDIAN L. NEWSL. 3 (2011). For a jurisdictional analysis of the complications created by real property transactions in Indian Country see Grant Christensen, Creating Brightline Rules for Tribal Court Jurisdiction Over Non-Indians: The Case of Trespass to Real Property, 35 AM. INDIAN L. REV. 527 (2011).
[103]Outsource Servs. Mgmt. v. Nooksack Bus. Corp., No. 74764-9-I, 2017 Wash. App. LEXIS 709 (Wash. App. April 3, 2017) (tribal business defaulted on a $15 million loan secured by future profits generated from tribal land on which the tribe intended to build a casino. When the tribe subsequently used the land—not for a casino but for other revenue raising operations—the creditor sought those profits to satisfy the loan obligation. The tribe claimed that the Creditor’s attempt would unlawfully encumber their lands in violation of 25 U.S.C. 81. The court disagreed, holding that “[t]he pledged security is not a legal interest in the land itself. Nor does [creditor]’s right interfere with the tribe’s exclusive proprietary control over the land” and that “[b]ecause the tribe retains complete control over the casino building and property and can use the facilities for any purpose, there is no encumbrance for purposes of Section 81, and thus the agreements did not require preapproval.”).
[104] 25 U.S.C. §§ 2701-21 (1988). The jurisdictional and regulatory powers of the NIGC have received criticism in several court decisions. In October 2006, the U.S. Court of Appeals for the District of Columbia Circuit ruled that the IGRA did not confer authority upon the NIGC to promulgate operational control regulations for Class III gaming operations. SeeColo. River Indian Tribes v. Nat’l Indian Gaming Comm’n, 466 F.3d 134, 140 (D.C. Cir. 2006) and Colo. River Indian Tribes v. Nat’l Indian Gaming Comm’n, 383 F. Supp. 2d 123, 137 (D.D.C. 2005). The Colorado River Indian Tribes cases are significant because some Indian tribes have interpreted the trial court’s decision to mean that the NIGC has no regulatory authority whatsoever over Class III gaming. Indeed, in the wake of the decision, several tribes advised the NIGC that they believe the decision strips the NIGC of all regulatory power over Class III gaming and therefore will not permit any NIGC auditors or other oversight into their casinos. As a result, the NIGC filed a petition for a panel rehearing in late December 2006. This petition was denied per curiam on Dec. 27, 2007. Colo. River Indian Tribes, 466 F.3d 134 (denying the motion for rehearing).
[105] 25 U.S.C. § 2711; First Am. Kickapoo Oper. v. Multimedia Games, Inc., 412 F.3d 1166, 1172 (10th Cir. 2005); United States v. President, 451 F.3d 44, 50 n.5 (2d Cir. 2006).
[106] 25 U.S.C. § 264 (1882); 25 C.F.R. §§ 140-41 (1996). “Trading” is broadly defined as “buying, selling, bartering, renting, leasing, permitting and any other transaction involving the acquisition of property or services.” 25 C.F.R. § 140.5(a)(6) (1984). For an example of tribal business license requirements, see NAVAJO NATION CODE, 5 N.N.C. § 401, et seq. (2005).
[108]See 25 C.F.R. § 140.3. Dahlstrom v. Sauk-Suiattle Indian Tribe, NO. C16-0052JLR, 2017 U.S. Dist. LEXIS 40654 (W.D. Wash. March 21, 2017) (a former employee brought a qui tam action against the tribe and against a medical clinic for filing false claims through the Indian Health Service (IHS)). The court barred the action against the tribe; “Like a state, a Native American tribe ‘is a sovereign that does not fall within the definition of a ‘person’ under the FCA.’” However, the court held that the medical clinic was not “an arm of the tribe” and so it was ineligible to claim sovereign immunity.
[110] Any failure of a federal agency to complete its obligations in relation to Indian lands can be catastrophic to businesses operating under federal permits. See, e.g., Tribe v. U.S. Forest Serv., No. 13-0348, 2013 WL 5212317 (D. Idaho Sept. 12, 2013).
[112] United States Department of Interior, HEARTH ACT of 2012, https://www.bia.gov/bia/ots/hearth (last visited Oct. 28, 2018).
[113] Kaitlyn Salmans helped to research and summarize the cases in this section. Kaitlyn is a rising third year law student at Moritz College of Law, Ohio State University, and expects to graduate in May 2021.
[114]See, e.g., Middletown Rancheria of Pomo Indians v. Workers’ Comp. Appeals Bd., 71 Cal. Rptr. 2d 105, 114-15 (Cal. Ct. App. 1998) (holding that the Workers’ Compensation Board has no jurisdiction over tribe); Tibbets v. Leech Lake Reservation Bus. Comm’n, 397 N.W.2d 883, 890 (Minn. 1986) (holding Minnesota workers’ compensation law inapplicable to tribal employer); see generallyNew Mexico v. Mescalero Apache Tribe, 462 U.S. 324, 332-33 (1983) (discussing applicability of state laws to tribes).
[115]Seegenerally Steven G. Biddle, Indian Law Theme Issue: Labor and Employment Issues for Tribal Employers, 34 ARIZ. ATT’Y 16 (1998) (discussing the applicability of federal labor and employment laws to tribal employers); but seeState ex rel. Indus. Comm’n v. Indian Country Enters., Inc., 944 P.2d 117 (Idaho 1997) (applying 40 U.S.C. § 290 to require the application of state workers’ compensation laws to tribal companies incorporated under state law); State ex rel. Workforce Safety & Ins. v. J.F.K. Raingutters, 733 N.W.2d 248, 253-54 (N.D. 2007) (same); Martinez v. Cities of Gold Casino, Pojoaque Pueblo, and Food Industries Self-Insurance Fund, No. 28,762, slip op. at ¶ 27 (N.M. Ct. App. filed Apr. 24, 2009) (holding that a tribal corporation waived immunity from claims brought under the Workers’ Compensation Act by voluntarily complying with other provisions of the act and submitting to the jurisdiction of the Workers’ Compensation Administration).
[116] 42 U.S.C. §§ 2000e-2000e-17 (1991). Bruguier v. Lac du Flambeau Band of Lake Superior Chippewa Indians, 237 F. Supp. 3d 867 (W.D. Wis. 2017) (“Title VII expressly does not authorize suits against tribes; “the term employer . . . does not include . . . an Indian tribe . . . .”).
[118]Id. §§ 2000e(b)(1), 12111(5). Additionally, discrimination based on tribal affiliation is often not considered unlawful national origin discrimination. See, e.g., E.E.O.C. v. Peabody W. Coal Co., No. 12-17780, 2014 WL 6463162 (9th Cir. Nov. 19, 2014) (discrimination based on tribal affiliation as it relates to lease agreements containing a Navajo reference in hiring provision does not constitute unlawful national origin discrimination but is a political classification and, thus, not within the scope of Title VII of the Civil Rights Act). See alsoMorton v. Mancari, 417 U.S. 535 (1974) (holding that the United States Department of Interior may affirmatively hire and promote American Indians because the preference is based on a political classification (membership in a federally recognized tribe) and not a racial classification and is, therefore, subject only to rational basis scrutiny to avoid constitutional challenge).
[119]See, e.g., ARIZ. REV. STAT. ANN. § 41-1464 (2005) (exempting tribes from Arizona’s discrimination laws). Even if a state’s antidiscrimination laws do not provide an express exemption, the doctrine of sovereign immunity will ordinarily operate to achieve the same effect. SeeSanchez v. Santa Ana Golf Club, Inc., 104 P.3d 548, 554 (N.M. Ct. App. 2004) (affirming dismissal of employee’s state law discrimination claim based on tribal employer’s sovereign immunity); see alsoAroostook Band of Micmacs v. Ryan, 404 F.3d 48, 67-68 (1st Cir. 2005) (discussing the probable inapplicability of state antidiscrimination laws to a tribal employer).
[120]SeeHardin v. White Mountain Apache Tribe, 779 F.2d 476, 479 (9th Cir. 1985) (extending the tribe’s sovereign immunity to tribal officials acting in a representative capacity).
[122]Id. §§ 1001-61. Congress amended ERISA in 2006 to apply Indian tribal commercial enterprises, but tribal governments remain exempt. 29 U.S.C. §§ 1002(32) (as amended by Pension Protection Act of 2006, 29 U.S.C. § 1002(32)).
[126]NLRB v. Pueblo of San Juan, 276 F.3d 1186, 1200 (10th Cir. 2002) (holding NLRA inapplicable to tribes); EEOC v. Fond du Lac Heavy Equip. & Const. Co., 986 F.2d 246, 248 (8th Cir. 1993) (refusing to apply the ADEA to an Indian employed by the tribe); Donovan v. Navajo Forest Prods. Indus., 692 F.2d 709, 712 (10th Cir. 1982) (holding OSHA inapplicable to the tribe partly because enforcement “would dilute the principles of tribal sovereignty and self-government recognized in the treaty”).
[127]Menominee Tribal Enter. v. Solis, 601 F.3d 669 (7th Cir. 2010) (applying OSHA); Lumber Indus. Pension Fund v. Warm Springs Forest Prods. Indus., 939 F.2d 683, 683 (9th Cir. 1991) (applying ERISA); U.S. Dep’t of Labor v. OSHA Rev. Comm’n, 935 F.2d 182, 182 (9th Cir. 1991) (applying OSHA); Smart v. State Farm Ins., 868 F.2d 929, 935 (7th Cir. 1989) (stating the “argument that ERISA will interfere with the tribe’s right of self-government is over-broad,” and applying ERISA); Donovan v. Coeur d’Alene Tribal Farm, 751 F.2d 1113, 1116-17 (9th Cir. 1985) (right of self-government is too broad to defeat applicability of OSHA); see alsoReich v. Mashantucket Sand & Gravel, 95 F.3d 174 (2d Cir. 1996) (following Ninth and Seventh Circuits to apply OSHA).
[128]SeeReich v. Great Lakes Indian Fish and Wildlife Comm’n, 4 F.3d 490, 493-94 (7th Cir. 1993) (holding that the tribe’s law enforcement officers were exempt from FLSA, but noting that not all employees of tribes are exempt); Solis v. Matheson, 563 F.3d 425, 434-35 (9th Cir. 2009) (applying FLSA to retail business on tribal land because business did not involve tribal self-governance and was not protected by treaty rights).
[129]Reich, 4 F.3d at 493-94; Lumber Indus. Pension Fund, 939 F.2d at 683; U.S. Dept. of Labor, 935 F.2d at 182; Smart, 868 F.2d at 935; Donovan, 751 F.2d at 1113; see alsoMashantucket Sand & Gravel, 95 F.3d at 174.
[134]Cf.Multimedia Games, Inc. v. WLGC Acquisition Corp., 214 F. Supp. 2d 1131, 1131 (N.D. Okla. 2001) (holding that the federal Copyright Act of 1976 was inapplicable to tribes).
[135] Chase Colwell helped to research and summarize the cases in this section. Chase is a rising third year law student at the Sandra Day O’Connor College of Law, Arizona State University, and expects to graduate in May 2021.
[136] 28 U.S.C. § 1331 (“Federal Question: The district courts shall have original jurisdiction of all civil actions arising under the Constitution, laws, or treaties of the United States.”).
[137]Id. § 1332 (“Diversity of Citizenship: The district courts shall have original jurisdiction of all civil actions where the matter in controversy exceeds the sum or value of $75,000, exclusive of interest and costs, and is between—(1) citizens of different states . . . .”).
[138]SeePeabody Coal Co. v. Navajo Nation, 373 F.3d 945, 945 (9th Cir. 2004) (dismissing a complaint against the Navajo Nation that sought enforcement of an arbitration agreement for lack of federal question jurisdiction); accord,TTEA v. Ysleta Del Sur Pueblo, 181 F.3d 676, 681 (5th Cir. 1999) (“The federal courts do not have jurisdiction to entertain routine contract actions involving Indian tribes.”); Gila River Indian Cmty. v. Henningson, Durham & Richardson, 626 F.2d 708, 714-15 (9th Cir. 1980) (finding “no reason to extend the reach of the federal common law to cover all contracts entered into by Indian tribes”). See alsoBurlington N. & Santa Fe Ry. Co. v. Vaughn, 509 F.3d 1085, 1089 (9th Cir. 2007) (holding that a federal court may review a denial of sovereign immunity by interlocutory appeal).
[139]SeeYsleta Del Sur Pueblo, 181 F.3d at 681 (holding that “an anticipatory federal defense is insufficient for federal jurisdiction”).
[140]SeePayne v. Miss. Band of Choctaw Indians, 159 F. Supp. 3d 724, 726-27 (S.D. Miss. 2015); Am. Vantage Cos. v. Table Mountain Rancheria, 292 F.3d 1091, 1095 (9th Cir. 2002); Akins v. Penobscot Nation, 130 F.3d 482, 485 (1st Cir. 1997); Romanella v. Hayward, 114 F.3d 15, 16 (2d Cir. 1997); Gaines v. Ski Apache, 8 F.3d 726, 728-29 (10th Cir. 1993); Oneida Indian Nation v. Cnty. of Oneida, 464 F.2d 916, 923 (2d Cir. 1972), rev’d and remanded on other grounds, 414 U.S. 661 (1974); Standing Rock Sioux Indian Tribe v. Dorgan, 505 F.2d 1135, 1040-41 (8th Cir. 1974); Tenney v. Iowa Tribe of Kan., 243 F. Supp. 2d 1196, 1198 (D. Kan. 2003); Victor v. Grand Casino-Coushatta, No. 02-2348, 2003 U.S. Dist. LEXIS 24770, at *4 (D. La. Jan. 21, 2003); Worrall v. Mashantucket Pequot Gaming Enter., 131 F. Supp. 2d 328, 329-30 (D. Conn. 2001); Barker-Hatch v. Viejas Group Baron Long Capitan Grande Band of Digueno Mission Indians of the Viejas Group Reservation, 83 F. Supp. 2d 1155, 1157 (D. Cal. 2000); Abdo v. Fort Randall Casino, 957 F. Supp. 1111, 1112 (D.S.D. 1997); Calvello v. Yankton Sioux Tribe, 899 F. Supp. 431, 435 (D.S.D. 1995); Whiteco Metrocom Div. v. Yankton Sioux Tribe, 902 F. Supp. 199, 201 (D.S.D. 1995); Weeder v. Omaha Tribe of Neb., 864 F. Supp. 889, 898-99 (N.D. Iowa 1994); GNS, Inc. v. Winnebago Tribe, 866 F. Supp. 1185, 1191 (D. Iowa 1994). But seeCook, 548 F.3d at 723 (holding that, for diversity purposes, a tribal corporation is “a citizen of the state where it has its principal place of business”). Cf.R.J. Williams Co. v. Fort Belknap Hous. Auth., 719 F.2d 979, 982 (9th Cir. 1983) (stating that the tribal corporation had its principal place of business in Montana); R.C. Hedreen Co. v. Crow Tribal Hous. Auth., 521 F. Supp. 599, 602-03 (D. Mont. 1981) (stating that a tribal corporation had its principal place of business in Montana and “[a]ccordingly, it is a citizen of the state for purposes of diversity jurisdiction”); Parker Drilling Co. v. Metlakatla Indian Cmty., 451 F. Supp. 1127, 1138 (D. Alaska 1978) (“As [the tribal corporation’s] only major business activities, and situs, are located in Alaska, it is an Alaskan corporation for diversity purposes.”).
[141]See Inglish Interests LLC v. Seminole Tribe of Florida, 2011 U.S. Dist. LEXIS 6123 (M.D. Fla. January 21, 2011) (describing this split).
[142] Caitlin White helped to research and summarize the cases in this section. Caitlin is a rising third year law student at the Sandra Day O’Connor College of Law at Arizona State University and expects to graduate in May 2021.
[143]White Mountain Apache Tribe v. Bracker, 448 U.S. 136, 143 (1980).
[144]Mescalero Apache Tribe v. Jones, 411 U.S. 145, 148-49 (1973); Cabazon Band of Mission Indians v. Smith, 388 F.3d 691, 694-95 (9th Cir. 2004).
[145]Wagnon v. Prairie Band Potawatomi Nation, 546 U.S. 95, 101 (2005).
[146] There has been some question as to what exactly constitutes a tribally owned corporation. The general rule is that “[a] subdivision of tribal government or a corporation attached to a tribe may be so closely allied with and dependent upon the tribe that it is effectively an arm of the tribe. It is then actually a part of the tribe per se” and is nontaxable. Uniband, Inc. v. C.I.R., 140 T.C. 230, 252 (U.S. Tax Ct. 2013) (quotation omitted). Although preemption of state taxes “is most assured for tribal corporations organized pursuant to federal or tribal law,” Cohen’s Handbook of Federal Indian Law § 8.06 (2012 ed.), “the mere organization of such an entity under state law does not preclude its characterization as a tribal organization as well.” Duke v. Absentee Shawnee Tribe of Okla. Housing Auth., 199 F.3d 1123, 1125 (10th Cir. 1999).
[147]Wagnon v. Prairie Band Potawatomi Nation, 546 U.S. 95, 101 (2005); see also Bercier v. Kiga, 103 P.3d 232, 236 (Wash. Ct. App. 2004) (“[T]he State may not tax Indians or Indian tribes in Indian country . . . .”) (citing Wash. Admin. Code § 458-20-192(5)); Pourier v. S. D. Dept. of Revenue, 658 N.W.2d 395, 403 (S.D. 2003), aff’d in relevant part and rev’d in part on other grounds on reh’g, 674 N.W.2d 314 (S.D. 2004) (“If the legal incidence of a tax falls upon a Tribe or its members . . . the tax is unenforceable.”). See also Seminole Tribe of Florida v. Stranburg, 799 F.3d 1324, 1345-46 (11th Cir. 2015) (reaffirming the legal incidence test but determining that a gross receipts tax more properly fell on utility companies instead of the tribe and, therefore, the tax was not preempted).
[148]SeeMcClanahan v. Ariz. State Tax Comm’n, 411 U.S. 164, 172-73 (1973).
[149]Williams v. Lee, 358 U.S. 217, 220 (1959); but see 25 C.F.R. § 162.415(c) (“Any permanent improvements” on business leased Indian land “shall not be subject to any fee, tax, assessment, levy, or other such charge imposed by any State or political subdivision of a State, without regard to ownership of those improvements.”). See alsoCalifornia v. Cabazon Band of Mission Indians, 480 U.S. 202, 216 (1987) (“Decision in this case turns on whether state authority is pre-empted by the operation of federal law; and “[state] jurisdiction is pre-empted . . . if it interferes or is incompatible with federal and tribal interests reflected in federal law, unless the state interests at stake are sufficient to justify the assertion of state authority.”).
[151]Id. at 144; see alsoAroostook Band of Micmacs v. Ryan, No. 03-0024, 2007 WL 2816183, at *4, *9-11 (D. Me. Sept. 27, 2007) (discussing whether federal law or state law affects the Aroostook Band, even though the tribe is exempt from state civil and criminal laws).
[152]New Mexico v. Mescalero Apache Tribe, 462 U.S. 324 (1983).
[155] Martyna Sawicka helped to research and summarize the cases in this section. Martyna is a rising second year law student at the University of Arizona James E. Rogers College of Law and expects to graduate in May 2022.
Sellers in merger and acquisition (M&A) deals almost always run the risk of breaching a representation or warranty in the agreement. Such a breach (often unintentional) is almost an inevitable hazard that every seller must contemplate.[1] This consideration often leads sellers to invoke (and buyers to accept) certain well-established conventions to partially reduce the negative consequences to sellers of such breaches. Buyers and sellers generally accomplish this by incorporating limitations to the sellers’ indemnity liability into the indemnification provisions, such as:
small deductibles (“baskets” and “thresholds”),
de minimis minimum claims,
maximum liability amounts (“caps”), and
time limitations (“survival periods”) which shrink the period of time after the closing during which the buyer can make claims to be indemnified.
Deductibles, baskets, and thresholds tend to minimize or at least defer disputes over small amounts of alleged damages (the proverbial “nickels and dimes”) arising from breaches of representations, and can be regarded as fostering peace between buyer and seller. Survival periods (usually years shorter than applicable statutes of limitations) bring closure and finality in the near term. Caps reflect the confidence and optimism of buyers and sellers in the extensive and rigorous pre-closing due diligence and disclosure processes and in the historic operating results of the target enterprise. Caps also provide assurance that – even if this confidence is misplaced – the seller, under the usual benign circumstances, will not need to disgorge huge portions of the total purchase price. Caps on recovery for breaches of representations therefore contribute to certainty, finality and peace of mind at least to the seller.
The risk to the buyer is reduced by the typical provisions in that if the buyer can establish that it has been deliberately misled or defrauded by the seller, all the various limitations discussed become inapplicable. Baskets, survival periods and caps are so routine as to be almost universal; the only questions are how big the baskets, how low the caps, and how long the survival periods. Such well-established limitations on sellers’ indemnification liability have the salutary effects of peace, certainty, finality and closure – worthy goals in business transactions.
Although not nearly as broadly accepted to be considered a tradition-bound convention such as a basket, cap or survival period,[2] sellers often argue (on the basis of “fairness”) that the amount of indemnification sellers should be required to pay the buyers in a breach of representation context should be further limited and that the payment should be reduced to the extent the buyer or target can (for tax purposes) deduct the outlay needed to rectify the loss or damage occasioned by or underlying the breach as an expense, whether by settling or paying the undisclosed liability or rectifying the misrepresented negative condition (such outlays referred to herein as a “Rectifying Expenditure(s)”). To do otherwise, the sellers’ argument goes, would enable the buyer to reap a “windfall” consisting of not only the full recovery of actual damages but also the value of the buyer’s tax benefit for the item for which indemnification is sought.[3] This argument might be referred to as the tax benefit offset (“TBO”) argument.
2. Defeating a Proposed TBO
Preeminent M&A lawyer James C. Freund stated in his famous book Anatomy of a Merger, published in 1975, that he never developed a cogent rebuttal to the seller’s argument in favor of the TBO. Mr. Freund’s proposed response in a hypothetical negotiation with seller’s counsel was to acknowledge that the seller’s point was not unreasonable or uncommon, but then to convince the sellers’ attorney that it would be too difficult and time-consuming to figure out the net effect of the tax saving, particularly when different fiscal years could be involved. Mr. Freund, undoubtedly a persuasive negotiator, states that most sellers yield the point.[4]
The experience of many other M&A negotiators in recent times do not bear out Mr. Freund’s confidence and good fortune in making the troublesome pro-seller TBO provision go away. More than 40 years after Mr. Freund’s statements, TBO provisions are found in many acquisition documents governing deals between large publicly-held buyers in multimillion dollar transactions in which the sellers and buyers are usually represented by prestigious and extremely well-qualified law firms. Studies of deal documents ABA Studies published by the American Bar Association Business Law Section M&A Market Trends Subcommittee of the Mergers & Acquisitions Committee (the “ABA M&A Committee”), reported the percentage of deal documents studied that contained TBO provisions. The percentages varied from a high of 53% in 2011 to a low 27% in 2019, the most recent year in which the study was conducted. In that most recent study, which was published by the ABA M&A Committee in December, 2019 (the “Latest ABA Study”), of the 151 deals in 2018 and early 2019 covered, 41 deal documents included TBO provisions.[5]
Despite the prevalence of TBO provisions in modern M&A deal documentation, there are questions as to whether they are correctly conceived and effectively implemented. The purpose of this article is to examine the foundations (more correctly the lack of foundation) of the TBO provisions, examine the objections to such provisions, and hopefully discredit the TBO concept to the point of eradication in many or most taxable M&A deals.
A. Common Sense Objection
The authors suggest that, rather than being solicitous towards the seller advocate for the TBO gambit as Freund recommended, an incredulous response to and a summary dismissal of such an audacious theory would be more appropriate. If a TBO argument had been made by a defendant in a tort-based property damage claim, plaintiff’s reaction could be expected to be disbelief and firm rejection. If a defendant negligently or deliberately caused damage to a business owner’s truck, would a defendant successfully claim that the repair or replacement might be tax deductible to some extent and therefore the damages to be paid by the defendant should be reduced by the value of the benefit of any deduction or tax saving available to the plaintiff? In a breach of contract action brought by a business owner plaintiff for whom a defendant performed a contract in a faulty manner requiring rework or repair, could the defendant make a successful TBO argument? Legal intuition based on common sense would say absolutely not. The TBO gambit smacks of the apocryphal case of the man who murdered his parents seeking clemency because he is an orphan.
B. Lack of Legal Precedent Objection
Not only does the TBO gambit fail the “red face test” on first impression, it also fails to find any real historical legal support. Perhaps because of the sheer novelty and audacity of the TBO argument, little direct discussion of reduction of damages based on alleged tax benefit to a plaintiff has been found. However, several cases have indirectly addressed arguments by plaintiffs who have sought to increase damage award based on tax disadvantages suffered by plaintiffs who urged that the award of only pre-tax damages would not make the plaintiff whole. For example, in Sears v. Atchison Santa Fe Ry Co.,[6] employee plaintiffs were awarded over 15 years of back pay in a lump sum which would have been taxed in the year of receipt at a much higher rate than if taxed annually in increments over the period of employment. The court increased the ultimate award to “make the plaintiffs whole” in respect of the after-tax differential. However, even in these cases dealing with awards to plaintiffs, courts have been reluctant to venture into the tax area where complexity and variability of tax reporting positions and expert opinions abound.[7]
Randall v. Loftsgaarden is one of the few cases where a defendant sought to have damages reduced by the tax benefits received by the plaintiffs. The case involved the sale of tax-shelter investments by defendants to plaintiffs in violation of the federal Securities Act of 1933 and Securities Exchange Act of 1934.[8] In Randall v. Loftsgaarden, the Supreme Court held that the tax benefits resulting from the problematic tax shelter investments sold to the plaintiffs should not reduce the award to the plaintiffs. Another case, Hanover Shoe Inc. v United States Machinery Corp. (393 U.S. 481 (1968)[9] is particularly illuminating as it relates to the defendant’s use of the TBO argument. This was an anti-trust case where the defendant sought to reduce the amount recoverable by the plaintiff by calculating the plaintiff’s lost profits (the measure of damages in such anti-trust cases) on an after-tax basis. Plaintiff Hanover Shoe Inc. complained that the defendant only allowed the plaintiff to rent machinery instead of selling machines to plaintiff in violation of the anti-trust laws, causing the plaintiff to earn less profits because the rental arrangements were more costly to the plaintiff than an outright purchase of the machines. Defendant contended that the annual amount of lost profits should be reduced by the increased taxes that would have been payable by plaintiff on those lost profits, i.e., the profits should be calculated on an after-tax basis. Plaintiff responded that the defendant’s approach would result in double deduction for taxation on plaintiff: it had already been taxed on the profits actually earned and would be taxed again when the treble damages award was received. The Supreme Court rejected the defendant’s argument, and decided in favor of the plaintiff. The Supreme Court also noted the immense difficulty of attempting the recalculation of profits and taxes over a long period of time.[10]
Despite the absence of any jurisprudence supporting the TBO theory, and the likely judicial distaste for the concept, fairness requires the acknowledgement that the well-established notions of baskets, caps, survival periods also find no support in jurisprudence.
C. Complexity, Uncertainty and Unworkability Objection
Any indemnification regime which enables a seller to take account of the supposed actual tax benefits to the buyer leaves open the question as to how far the seller may venture in reviewing and evaluating the buyer’s federal and state income tax returns and the reporting positions buyer has taken. Such an inquiry and review would naturally open up the buyer’s tax positions, (perhaps very aggressive) tax reporting positions and tax strategy to discovery, and ultimately to disclosure. Opening the door of the inner sanctum to a hostile party and perhaps public record seems unwise at best.
There can be great uncertainty in calculating the value of a purported tax benefit to a buyer. Do tax rules limiting use of net operating loss carry-overs and built-in losses apply?[11] Taxation is a very complex area in which a variety of competing or conflicting reasonable tax reporting positions can be taken and where the opinions of learned tax experts can differ on many issues. Different reporting positions could lead to different outcomes and different tax-effected indemnification amounts. Who decides? Reporting can be challenged by the Internal Revenue Service long after the indemnification process has run its course. What happens then? Also, if the buyer was required to adopt a reporting position espoused by the seller, will the seller be willing or able to defend or to compensate the buyer if that position is successfully challenged by the IRS? Such uncertainty underscores the unworkability of the TBO mechanism.
The tax department of a buyer seeking to deal with a TBO provision would be required to continuously keep track of the effect and value of the impact of its reporting positions regarding Rectifying Expenditures as compared to the effect and value of a possible different reporting position (or range of reporting positions) as if the Rectifying Expenditure had not been made. In effect, the tax department would have to run a separate set of tax books on a hypothetical basis. Such double tax books requirement would be required for as long as the TBO’s specified period for recognizing receipt of tax benefits.
D. Tax Accounting and Reporting Objection
i. General Discussion
There are two basic types of taxable acquisitions: asset deals and stock deals.
The first type of taxable transaction, collectively referred to as “Asset Deals,” involves:
an acquisition by the buyer of the assets of a target company,
an acquisition by the buyer of the stock of a target company accounted for as an acquisition of assets pursuant to an election under section 338(h)(10) of the Internal Revenue Code , or
a forward triangular merger of a subsidiary of the buyer and the target in which the target company is merged out of existence and which is accounted for as a purchase of assets of the target.
The use of limited liability companies (“LLCs”) as business entities has increased in recent years, and a correspondingly increasing number of targets doing business as LLCs have appeared in M&A transactions. LLCs generally use a pass-through entity status for tax purposes, unless they are covered by an election to be treated as an association taxable as a corporation. In the case of an LLC as selling or target entity, the result of the purchase of all of the ownership interests in the entity is generally treated the same as a purchase of the assets of the entity for tax purposes. Revenue Ruling 99-6, Situation 2, provides that the purchase of all of the equity or membership interests in a target LLC by a buyer is treated the same as the sale by the former owners of all of the assets of the entity to the buyer — equivalent to a 338(h)(10) election for LLCs.[12]
The second type of taxable transaction involves a purchase by the buyer of the stock of the target company (without a section 338(h)(10) election) or a reverse triangular merger of a subsidiary of the buyer and the target in which the target company is the survivor (collectively, “Stock Deals”).
ii. General Tax Accounting Rules
A pre-closing event or negative condition that would constitute a breach of a representation by the seller may in real terms constitute an unfavorable occurrence for the buyer. But that does not mean that a buyer’s outlay to address the event or negative condition, in and of itself, will generate an expense that can currently be deducted by the buyer for federal income tax purposes. Certain post-closing expenditures, i.e. Rectifying Expenditures, by the buyer or a buyer subsidiary that are incurred to correct negative events or conditions that occurred prior to the closing, such as the misrepresented quantity or usable condition of inventory or machinery and equipment, would probably have to be capitalized by the buyer and would therefore not be immediately deductible. Accordingly, those Rectifying Expenditures would not give rise to an immediate “tax benefit” that could be viewed as a potential tax “windfall” which is the very basis of the “fairness” argument.
Further, even if the rectification of the misrepresented pre-closing event or condition does give rise to an otherwise legitimate deductible expense, it does not necessarily follow that the expense would be deductible by the buyer (or the target in the case of a Stock Deal). For an expense to be deductible as a trade or business expense by a taxpayer it must be an ordinary and necessary expense of that taxpayer’s trade or business. If the expense was incurred in some other taxpayer’s (i.e., the seller) trade or business it will generally not be deductible by a different taxpayer (e.g., the buyer) but may continue to be deductible by the first taxpayer (i.e., the seller).[13] Also, for an expense in respect of a liability to be deductible by an accrual basis taxpayer generally all the events needed to establish liability must have occurred, the liability must be fixed and determinable, and economic performance (which generally means payment by the taxpayer) must have occurred with respect to the expenditure by the end of year in which the deduction would be claimed (or in certain cases shortly after the end of that year). If the buyer merely pays a liability properly attributable to the seller that does not provide any assurance that the buyer will be entitled to a deduction for that expense.[14]
The task then is to apply these general tax accounting rules to the types of taxable transactions described above: Asset Deals and Stock Deals.
iii. Asset Deals
Where the buyer or the buyer’s subsidiary takes title to the assets of the purchased business and there is a breach of a seller’s representation to the buyer and as a result the buyer becomes subject to a liability or negative condition, the question is whether the Rectifying Expenditure in undoing the damage occasioned by such liability or negative condition is properly deductible by either the buyer or the seller. For an expenditure to be deductible by a taxpayer under the accrual method of accounting, it must meet three conditions:
1) it must be an ordinary and necessary expense of the taxpayer’s trade or business;
2) the liability must be fixed and determinable; and
3) economic performance (which generally means payment) by the taxpayer must have occurred with respect to the expenditure.
All three conditions must generally be met before the end of the taxable period of the taxpayer claiming the deduction. If the misrepresentation by the seller concerns a liability or negative condition that was not fixed and determinable on or prior to the closing, even if it could not have been deducted by the seller prior to the closing, the Rectifying Expenditure by the buyer in respect of the liability or condition does not necessarily convert to one that could be deducted as an expense by the buyer. In such a case the Rectifying Expenditure is really more akin to a liability that the buyer assumed as part of the purchase and should more properly be treated as part of the purchase price. Under existing authority it is generally accepted that any liability – even a contingent liability – that is assumed by the buyer in the purchase of the assets of a business must be capitalized into the cost of the acquisition and that liability may not be deducted by the buyer.[15] If a liability was a contingent liability at the closing and did not become fixed and determinable until after the closing, that liability could still not be deducted by the buyer.[16] The fact that the buyer will be precluded from claiming a deduction for an assumed liability will be the result whether the assumed liability is fixed and determinable or is contingent, whether it is identified or not identified, or whether the liability is known or unknown at the time it is assumed.[17]
Thus, in an Asset Deal, there is no merit from a tax point of view to a seller’s argument that a buyer will have a potential tax windfall from a Rectifying Expenditure that should be reflected as a reduction of seller’s indemnity payment. Asset Deals do not give rise to a viable tax benefit offset (referred to hereinafter as “Viable TBO”)
iv. Stock Deals
1. Free-Standing and Not Pass-Through
In a taxable Stock Deal, the target company remains in existence as a separate entity following the closing and if it is an accrual basis taxpayer, it should generally retain the ability to deduct a Rectifying Expenditure that was necessitated by and arose from the circumstances underlying a breach of representation. This is the case whether the liability was a fixed and determinable liability that was properly accrued prior to the closing or was a contingent liability that was properly accrued after the closing. A Stock Deal does not involve the disqualifying element of a “new” or different taxpayer trying to claim a deduction that is attributable to another taxpayer’s trade or business, which was the critical problem in an Asset Deal. Thus, in taxable Stock Deals there might be a potentially Viable TBO.
However, if the target company was a member of the seller’s affiliated group and was included on the consolidated return filed by that group prior to the Stock Deal, the target company may still be precluded from deducting after the closing a Rectifying Expenditure. Preclusion would be the result if the deduction was or should have been properly accrued for tax purposes prior to the closing. If that deduction was or should have been properly accrued for tax purposes prior to the closing it should be claimed on a consolidated return for that prior period and it should not be available to the target company following the closing. As in the case of an Asset Deal, there is no prospect for a Viable TBO if target was not a free-standing taxpayer.[18]
The result would be similar if the target prior to the closing was a corporation covered by an S election (or if it was a pass-through entity not covered by an election to be treated as an association taxable as a corporation). Under the S corporation rules, the income items and deductions of an S corporation that appear on its return for a particular year pass through to the stockholders of the corporation at that time and would not thereafter appear on any subsequent return filed by the corporation.[19] In other words, deductions that were or should have been properly accrued prior to the closing may not be available to the target company after the closing if the target company was covered by a consolidated return through the closing or if it was covered by an S election through the closing. The result is similar if the target was a limited liability company or other entity which is subject to “pass through” taxation. These Stock Deals involving pass-through targets do not present the possibility for a Viable TBO.
It may be observed that such Stock Deals where the target has been in a consolidated group or the target is a pass-through have a disqualifying feature that is shared with Asset Deals: the presence of an additional or different taxpayer entity (the consolidated group or the owners of the pass-through) which is entitled to claim the deduction.
2. Code Sections 382 and 383
Even if the target was a C corporation through the closing and was not included on a consolidated return covering the seller’s affiliated group (i.e., it was free-standing), the target’s ability to claim a tax-saving deduction could be also reduced or eliminated by operation of the net operating loss carryover and the built-in loss rules of section 382 and section 383 of the Internal Revenue Code (“Built-in Loss Rules”). These rules restrict the ability of a target corporation, in any year after there has been a prohibited change in the ownership of the target, to utilize net operating losses and built-in losses that were in place at the time of the change in ownership. A prohibited change in ownership will generally occur if over any three-year period there is a shift in the ownership of more than 50% of the outstanding stock of the target corporation, and the Section 382 rules apply once that threshold has been exceeded.
The Built-in Loss Rules in general restrict – on an annual basis after the prohibited change in ownership (i.e., the closing) – the target’s ability to utilize those net operating loss carryovers and built-in losses that were in place at the closing to the value of the target at the time of the change in ownership times the long term tax-exempt interest rate.[20] In December of 2020 the long term tax exempt rate was 0.99%.[21] Using that rate, if a target was acquired in December of 2020 for $5,000,000, the annual limitation on utilizing those losses constituting Rectifying Expenditures would only be $49,500.
The authors believe (admittedly without the support of empirical data) that the vast majority of merger and acquisitions that take place each year in the United States, and certainly almost all of the deals covered by the Latest ABA Study, involve the single year transfer of more than 50% ownership of target enterprises. Accordingly, the Built-in Loss Rules would minimize the potential tax benefits alleged by sellers to be available to most buyers of C corporation targets depending on the value of the target at the time of the closing.
3. Summary of Stock Deal Issues
In short, the argument that a foundational “windfall” would give rise to a Viable TBO (even if it was available) would only be available to a buyer or a buyer subsidiary in a taxable Stock Deal if the target meets two conditions:
(1) the target had been prior to the closing a “free standing” individually taxed entity (i.e., not part of seller’s consolidated group); and
(2) the target is a C corporation (or an LLC covered by an election to be treated as an association taxable as a corporation and not covered by an S election).
If the target does not meet that two-part test, then the Rectifying Expenditure as to the buyer will be treated as part of the purchase price or it will be treated as an expense properly allocated to another taxpayer.And even if the target is a free-standing C corporation, any deduction opportunity would also be severely limited by the Built-in Loss Rules discussed above. If the target was an S corporation or other pass-through entity such as a limited liability company (which is taxed as a partnership) or a partnership, any deduction constituting a Rectifying Expenditure which is actually attributable to a period prior to the closing would be allocated to the equity owners of that entity and would not be available to buyer. Thus, in the case of taxable Stock Deals the potential of a tax benefit windfall to the buyer would not materialize. Overall, a Viable TBO mechanism which is intended to achieve the “fairness” arguably sought by sellers would fail.
3. How Are Actual Deals Being Done?
A. Overview
In the several ABA Studies published by the ABA M&A Committee over the past decade, TBO provisions in deal documents appeared in many instances although there has been a clear declining trend since 2011 when TBO provisions appeared in a slight majority of deals studied. As mentioned earlier, 41 of the 151 deals covered by the Latest ABA Study in 2019 contained pro-seller TBO provisions – just over 27%. Of those 41 deals, 3 were tax free reorganizations in which TBO provisions could be viable from a tax point of view, but which would nevertheless be subject to the other objections outlined earlier in this article including the Built-in Loss Rules which severely restrict tax savings that an indemnifying seller would seek to exploit. Of the remaining 38 deals, 10 were Asset Deals for tax purposes which as argued above do not present Viable TBO situations. All the remaining 28 deals were Stock Deals which included potentially Viable TBO provisions, but only if the target were free-standing and taxed as a C corporation.
B. Language
Given the inherent complexity of taxation in general, it could reasonably be expected that contractual provisions regarding TBO would likewise tend to be extensive and complex. In fact, the TBO provisions in the documents in question in the Latest ABA Study were brief and relatively simple. There follow several representative examples of TBO provisions which run the gamut from simple to detailed to very detailed.
Simple “The amount of any and all Losses shall be determined net of …any Tax benefits realizable by or accruing to the Purchaser Indemnitees with respect to such Losses.”
Simple “Without limiting the effect of any other limitation contained in this Section … for purposes of computing the amount of any Damages incurred by the Indemnified Party under this Section … there shall be deducted an amount equal to the amount of any Tax benefit actually realized within two (2) years of such Damages in connection with such Damages, as determined on a ‘with and without’ basis.”
Conceptual “The amount of indemnification claims hereunder will be net of any tax benefits realized within three (3) taxable years by the Indemnified Party in connection with such claims.”
More detailed “The amount of any Buyer Indemnified Losses shall be reduced by the amount of any Tax Benefit directly or indirectly available to the Buyer Indemnitee relating thereto. For purposes of this Section …a ‘Tax benefit’ shall mean a reduction in the Buyer Indemnitee’s Tax (calculated net of any Tax detriment resulting from the receipt of any indemnification payment, including the present value of any Tax detriment resulting from the loss of any depreciation and amortization deductions over time, calculated using a discount rate of 3.5%) arising out of any Damages that create a Tax deduction, credit or other tax benefit.”
Very detailed Indemnity payment regarding Losses “shall be reduced to reflect any Tax Benefit actually realized in the year in which the indemnity payment is required to be made or in any prior year by Buyer …. Tax Benefit means any deduction, amortization, amortization, exclusion from income or other allowance that actually reduces in cash the of Tax that Buyer … would have been required to pay (or actually increased the amount of the Tax refund to which Buyer… would have been entitled in the absence of the item giving rise to the claim….For purposes of this section … Buyer …. shall be deemed to use all other deductions, amortizations exclusions from income or other allowances …prior to the use of ‘Tax Benefits’….”
C. Calculation of Tax Benefit Amount
All of the TBO provisions require a calculation of the amount of the tax benefit offset. Those provisions effectively call for subtracting the amount of actual tax paid by the buyer from the amount of tax which would have been paid without including the tax-reducing item (sometimes referred to as the “with and without” method). A variation on the with and without method seen in a few of the deals studied calls for subtracting the amount of actual tax paid by the buyer from the amount that would have been paid if the tax-reducing item is the last item included (sometimes referred to as the “last in” method). It is unclear whether there is any real difference in result under the two methods.
D. When Must Tax Saving Be Actually Realized by Buyer?
Most of the 28 Stock Deals studied specify a period of time during which the tax benefit or savings must be actually received or realized by the buyer in order to reduce an indemnity payment. Where a time period is specified, it is usually expressed in tax years measured from the date of incurrence of the damages underlying the breach of representation. Additional periods of one, two or even three years are specified. It should be noted that the limiting effects of the Built-in Loss Rules (currently about 1% per year) combined with the specified short periods which tax savings must be realized by the buyer in Viable TBO provisions greatly reduces to minimal percentages any possible reduction of sellers’ indemnity obligation.
E. Mandate on Buyer to Seek Tax Benefits; Mitigation
Most of the TBO provisions refer to tax savings or tax benefits “actually” received or realized (some say “in cash”) by the buyer. None of the TBO provisions expressly compel the buyer to seek tax savings or benefits.
Even the stand-alone express general mitigation obligation contractually imposed on buyers (found in 18 of the 28 Stock Deals with TBO provisions) do not obligate the buyer to seek tax benefits. Those stand-alone general mitigation provisions do not mention tax issues at all. Furthermore, almost all such mitigation provisions address the “gross” losses or damages, but not the “net” indemnification payment. Such contractual mitigation provisions do not by their terms extend to the attainment of tax advantages favoring the seller.
It is worth noting that another pro-seller provision analogous to TBO often seen in M&A documentation reduces the indemnity payment a seller must pay by any insurance recovery received or receivable by the buyer on account of the circumstances underlying the breach of representation. Such insurance provisions are found in all 28 Stock Deals in the Latest ABA Study. Unlike the silence of the language of TBO provisions, the insurance offset provisions frequently do expressly require the seller to seek recovery under available insurance. The implication would be that such an affirmative duty would not apply in the case of TBO when the two offset provisions appear in the same document.
F. What Role Does Seller Have in Buyer’s Tax Strategy?
None of the 28 Stock Deals with potentially Viable TBO provisions give seller any a priori role in the preparation of the buyer’s tax returns or the selection of the buyer’s tax reporting strategy. It appears, appropriately so, that in the first instance the buyer has total control of its tax reporting and filing. However, there should clearly be litigable potential for the seller to inquire as to the existence of tax savings even in the absence of contractual provisions to that effect. In a dispute over indemnification and TBO there could be significant risk to buyer that a court would grant a seller some right of discovery taking into account mitigation obligations, either common law or contractual.
G. Lack of Buyer Protection
None of the 28 Stock Deals in question contained any provisions that would protect an indemnified buyer if TBO issues were in play. There were no provisions protecting the confidentiality of buyer’s tax reporting. Further, there was no express provision leaving all tax reporting decisions to the exclusive discretion of the buyer. It is left unsaid what happens if the buyer is forced to litigate an indemnity claim. If the buyer’s indemnity claim resulted in litigation it would expose the buyer’s tax returns and its reporting positions to scrutiny and disclosure. The buyer could also be forced to show that it has not been unreasonable in declining to adopt tax positions advocated by the seller. Would the buyer’s tax returns and the testimony of its tax advisors be part of the public record in the case or could they be sealed? Would the buyer be forced to adopt tax positions advocated by the seller and adopted by the court even though buyer’s tax advisors recommended against adopting those positions? What assurance would the buyer have that the seller would be willing or able to defend a buyer which adopted those seller-friendly positions if a taxing authority later questioned those positions? Such critical questions are not addressed whatsoever in any of the TBO provisions in any of the deals in question. The risks and uncertainties could very well chill the inclination of buyers to seek redress through indemnification for obvious breaches of representations.
H. Procedural Shortcomings
What is missing from all the TBO provisions in all 41 deals covered in the Latest ABA Study is any treatment of the mechanics of implementing an adjustment of the payment under a TBO scheme other than in many of the deals which require buyer to refund a portion of a tax saving subsequent to receiving an unadjusted indemnity payment. Since there is no express requirement that the buyer seek tax benefit or tax savings, and since any tax benefit or tax saving would ordinarily occur well after the buyer successfully sought an unadjusted indemnification payment from the seller it would seem that it is up to the seller to proactively monitor the activity of the buyer and query the buyer about tax benefits subsequent to the indemnity payment. Perhaps there is an implied duty (good faith and fair dealing) on the part of the buyer to keep the seller informed, but no explicit provision to that effect is found in any of the documents. In any event, the absence of treatment of the mechanics suggests that the sellers who extract a TBO provision from the buyer are not trying very hard to provide for a truly functioning and effective provision that will provide a possible advantage. It may be that sellers are satisfied with extracting from buyers a provision that might inhibit a buyer from seeking redress through indemnification than in actually seeking workable reduced indemnification liability.
I. Do the 28 Stock Deals Pass the Free-Standing C Corp Test?
The ultimate test of the viability of TBO provisions in a Stock Deal is whether the target company is a free-standing taxpayer and is treated for tax purposes as a C corporation. The authors are not aware of any publicly available databases that would answer either of those questions. However, in some cases the documents themselves contain indications of status in whereas clauses, representations and warranties, and certain other provisions. On that basis the authors conclude that all 10 Asset Deals and at least 5 of the Stock Deals would actually fail the free-standing C corporation test.[22] Accordingly, in 18% of all Stock Deals in the Latest ABA Study the TBO provisions are just not viable from a tax point of view.
4. Conclusion
Earlier in this article it is suggested that the traditional limitations on indemnification payments such as baskets, caps and short survival periods foster peace, clarity, finality and closure between buyer and seller. That is not true of TBO provisions. TBO provisions actually greatly prolong the period of hostility between buyer and seller, and give rise to numerous additional issues and grounds for dispute. It appears obvious that many M&A practitioners do not understand the tax law and the practical consequences (especially to the buyer) in negotiating TBO provisions in deal documents. Seller-side practitioners can be excused for blindly advocating for TBO provisions along with all other obstacles to indemnification by buyer. The same can’t be said for buyers. The acceptance by buyers of such TBO provisions, without at the least insisting on measures to protect the buyer, suggests a lack of vigilance or failure to perceive the dangers.
When approximately 36% of all of the deals in the Latest ABA Study cannot possibly have the desired result under applicable tax law, and when the remaining 64% can only have an absurdly small percentage desired result under applicable tax law (i.e., the Built-in Loss Rules), it is time that the TBO concept is abandoned in all M&A transactions. It is the view of the authors, for all the reasons set forth in this article, that TBO provisions do not belong in M&A transactions.
[1] John F. Corrigan is a sole practitioner at John F. Corrigan Law. P.C. in Providence, Rhode Island. E. Hans Lundsten is of counsel at Adler Pollock & Sheehan P.C. in Providence, Rhode Island. The views expressed are solely those of the authors and do not necessarily represent the views of their respective firms or clients.
[2] Teams of experienced M&A lawyers, as members of the American Bar Association Business Law Section’s Mergers & Acquisition Committee (the “ABA M&A Committee”), have been studying the deal terms and conditions that have repeatedly been the subject of intense negotiations in merger and acquisition documentation for over a decade. This group—the Mergers & Acquisitions Market Trends Subcommittee—has conducted studies of critical deal terms found in acquisitions of private companies by public companies that are disclosed by the public companies as part of their reporting obligations under the Securities Exchange Act of 1934 (referred to in this article as “ABA Studies”). The ABA Studies are only available to members of the ABA M&A Committee.
The most recent Study, released in December 2019, covered transactions for which definitive deal documents were executed or completed in 2018 and the first quarter of 2019 that involved private targets being acquired by public reporting companies (this most recent study is referred to in this article as the “Latest ABA Study”). In the Latest ABA Study only 41 out of 151 deal documents contained TBO provisions.
[3] This Article will not cover acquisitions that are structured as tax-free reorganizations under one of the categories of transactions described in Section 368(a) of the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”) because the general accounting rules (discussed, infra, under the caption “General Tax and Accounting Rules”) that apply to assumed liabilities and that could preclude a buyer or the target company from deducting an assumed liability by statute do not apply to transactions that qualify as a tax-free reorganization under Section 381(c) of the Internal Revenue Code and the buyer or the target company acquired in the transaction should be entitled to claim the deduction. VCA Corp. v. U.S., 566 F2d. 1192 (Fed. C. 1977); Rev. Rul. 83-73, 1983-1 C.B. 84. Therefore, a tax windfall to a buyer is quite possible in a tax-free reorganization, although since the buyer does not get a basis step-up for the acquired assets in a tax-free reorganization any arguable inequity the seller faces if it does not share the supposed tax “windfall” accruing to the buyer is probably offset because the buyer has forgone the tax benefit of the basis step-up in the acquisition.
[4] James Freund, Anatomy of a Merger (1975), pp 376-8.
[12] Section 1.708-1(b)(1), Income Tax Regulations and Rev. Rul. 99-6, Situation 2, 1999-6 I.R.B.6 (2/8/99).
[13]Welch v. Helvering, 290 U.S. 111, 113 (1933); Deputy v. DuPont, 308 U.S. 488, 494 (1940).
[14] 188 BNA Daily Report for Executives J-1, 2003, Treatment of Contingent Liabilities in an Acquisition Evolving (2003).
[15] Federal Tax Coordinator, Second Edition PL-5404, Successor’s Contingent Liabilities – Reorganization Expenses as Capital Expenditures (2012).
[16] The Federal Tax Coordinator article described supra note 17 above, provides that while some of the decisions, including the Seventh Circuit in its opinion in Illinois Tool Works, infra note 19, have observed that it might be possible in some situations for the assumption of a contingent liability by the buyer as part of an acquisition to give raise to a deduction (and not have to be capitalized) none of the decided cases have allowed a deduction for an assumed liability and none of them have described those situations where an assumed liability would be give raise to a deduction.
[17]Holdcroft Transp. Co. v. Comm., 153 F2d 323 (C.A. 8, 1946); Pacific Transport Company v. Comm., 483 F2d 209 (C.A. 9, 1973), cert. denied, 415 U.S. 948 (1974); Illinois Tool Works v. Comm., 117 T.C. 39 (2001,) aff’d 355 F.2d 997 (C.A. 7, 2004).
[18] Section 1.1502-21(b)(2)(ii), Income Tax Regulations.
[19] Section 1366(a) of the Internal Revenue Code.
[22] Many of the deal documents contained provisions which were ambiguous or which referred to schedules which were not available for review. In the absence of incontrovertible evidence that the target was not a free-standing C corporation, the authors gave the deal the benefit of the doubt and assumed the provision was a Viable TBO provision.
Financial institutions face significant risks from enforcement actions by prudential regulators as well as agencies charged with protecting consumers, investors, or the public at large, such as the Consumer Financial Protection Bureau (CFPB), Securities and Exchange Commission (SEC), and Department of Justice (DOJ). I recently published an article about what steps in-house counsel can take to mitigate those risks for their financial institution clients. This article has a different perspective. Rather than focusing on threats to the institution, it focuses on threats to in-house counsel in their personal capacity. At the outset, it is important to recognize that enforcement actions against in-house counsel are extremely rare. They are not, however, non-existent.
This article draws in part on an unpublished analysis prepared by one of my partners at Williams & Connolly that examines non-insider trading SEC action and DOJ criminal prosecutions against corporate in-house counsel over the past two decades. The analysis focuses on threats that in-house counsel may face personally from government agencies, and what lessons can be drawn from prior enforcement actions and criminal prosecutions against individuals. While not all of the lessons are drawn from actions involving in-house counsel specifically at financial institutions, the lessons are equally applicable to them.
Common Factors in Actions Involving In-House Counsel
Factor #1 – The top lawyer is nearly always the target, either in their own right or to undermine an ‘advice of counsel’ defense for other top executives
When the SEC or DOJ takes action against in-house lawyers, they almost always focus on the General Counsel or Chief Legal Officer. There are two overarching reasons for this. First, the top lawyer indisputably had the power and the mandate to address issues, and—rightly or wrongly—the failure to do so is often laid at the feet of the General Counsel or Chief Legal Officer. Another reason why General Counsel or Chief Legal Officers may find themselves in the crosshairs, particularly in criminal actions, may be to undermine the advice of counsel defense for other executives. When the government threatens civil or criminal claims against in-house lawyers, self-preservation instincts may surface. It is not uncommon for lawyers to disavow or distance themselves from certain positions being advanced by other targets of the investigation as a way to protect themselves.
Factor #2 – Big losses to the institution bring unwanted scrutiny to in-house counsel
Another common factor in SEC enforcement actions and criminal prosecutions against in-house counsel is when the institution itself suffers substantial losses. The bigger the failure of the institution, the greater the risk of exposure for the in-house counsel. When the institution is handed a large judgment or damning indictment, there is incredible pressure from consumers, politicians, and the media to hold someone accountable and actions may be second-guessed with the benefit of hindsight. The in-house counsel often becomes the scapegoat.
Factor #3 – In-house lawyers can insulate themselves by consulting outside counsel
Inside lawyers who relied upon outside lawyers are rarely, if ever, the targets of SEC enforcement actions or criminal prosecutions. The advice of counsel defense is a real deterrent to prosecution or enforcement. But to mount a viable defense, the consultation with outside counsel must be meaningful and – ideally – documented. Outside counsel needs to be apprised of the material facts and their advice should be memorialized contemporaneously; by extension, in-house counsel should act in a manner that is consistent with outside counsel’s advice to clearly demonstrate reliance on the advice.
Factor #4 – Complex or debatable problems are rarely a basis for individual enforcement action or prosecution, whereas perjury or obstruction are much easier cases
Enforcement lawyers and prosecutors prefer to pursue cases where there is a clear legal violation. SEC enforcement counsel and prosecutors will vigorously pursue claims of perjury or obstruction against in-house counsel because these actions tend to be straightforward and easy to prove. SEC enforcement proceedings against in-house counsel most commonly arise from disclosures, particularly omissions in disclosures. Self-dealing or other actions to line one’s pockets is not necessary for the SEC to bring an enforcement action. By contrast, when the violation itself is unclear or complicated, there is less risk to in-house counsel even if the SEC or DOJ decides to pursue an action against the institution. It is much easier to fault somebody when the violation is unambiguous. A corollary to this is that mere knowledge of conduct later deemed to be criminal is usually not enough to warrant prosecution against an in-house lawyer, unless the conduct was so egregious as to be unambiguously improper.
Factor #5 – Generalist lawyers cannot insulate themselves from liability by claiming ignorance
Do not get in over your head. In-house lawyers are expected to have the knowledge and experience necessary to discharge the responsibilities of their role. It is not uncommon for in-house lawyers in smaller institutions to wear several hats, such as also serving in a compliance function (or at least overseeing the compliance function). No matter how many hats they wear, in-house counsel will be held responsible for shortcomings, particularly when those shortcomings impact consumers or the institution in a material way. Neither the SEC nor DOJ are moved by arguments that the individual charged with these roles lacked the sophistication to discharge those responsibilities.
Practical Tips for In-House Counsel at Financial Institutions
These observations lead to some practical tips for in-house counsel for minimizing the enforcement profile of their institution and, by extension, themselves.
Ensure that your institution’s risk management function is well-resourced and appropriately staffed with competent personnel. An enforcement action is almost always far more costly (both as a matter of reputation and penalty) than maintaining a well-functioning compliance team. These staffing and resource investments can pay big dividends in terms of smooth regulatory relationships and the early identification and remediation of problems.
Establish and maintain a close working relationship with the Chief Risk Officer. Most institutions have three lines of defense (line of business, compliance, and audit) and the Chief Risk Officer should have clear visibility into each one. The Chief Risk Officer ideally should be not only a peer, but also a partner for in-house counsel.
Make sure that your institution is taking proactive steps to identify and address issues as they arise. Problems that fester or recur are more likely to provoke regulatory attention on in-house counsel’s action (or perceived inaction). Being proactive will help establish that in-house counsel (and the institution as a whole) exercised appropriate business judgment.
Be on high alert if your institution’s CAMELS ratings start to slip, as this may signal deeper issues with institutional controls or management. This also signals greater regulatory scrutiny, particularly when a bank or credit union is operating under a consent order or memorandum of understanding, and an increased likelihood of second-guessing.
When faced with particularly thorny questions: (1) consult with outside counsel; (2) make sure that their advice is memorialized in an appropriate fashion; and then (3) act on that advice. While there will invariably be a marginal cost associated with engaging outside counsel, the long-term benefits are almost always worth it.
There is a veritable alphabet-soup of scenarios which financial institution in-house counsel hope not to encounter: CID, OOI, PWL, NORA, 15-Day Letter.[1] When a bank or credit union receives a Civil Investigative Demand (CID), an Order of Investigation (OOI), a Preliminary Warning Letter (PWL), a Notice of Opportunity to Respond and Advise (NORA), or a 15-Day Letter, the institution knows one thing for sure: it is in the crosshairs of a potential enforcement action by a prudential regulator or the Consumer Financial Protection Bureau.
This article identifies lessons that in-house counsel at banks and credit unions may find helpful as they advise their own institutions. The lessons are drawn from my own experiences representing financial institutions – their directors and officers – under investigation or in enforcement litigation, and augmented by a review of other publicly filed actions and consent orders.
Enforcement Actions by Prudential Regulators
Prudential regulators such as the Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), National Credit Union Administration (NCUA), and Federal Reserve pursue formal enforcement actions when they believe that there have been violations of laws, rules, or regulations, unsafe or unsound banking practices, breaches of fiduciary duty, or violations of final orders or conditions imposed in writing or written agreements. The enforcement actions may seek anything from cease-and-desist orders to civil money penalties.
Banks or credit unions that find themselves the target of enforcement investigations rarely litigate against their prudential regulators, absent overreach in the agency’s jurisdiction or demand. The supervisory relationship is usually too important to risk long-term damage, and the restrictions on an institution’s ability to pursue business opportunities without supervisory approval are usually too stifling to be tolerated for long.
Individual executives are sometimes in a better position to fight. Not only do they not have the same institutional concerns, they usually can draw on a directors and officers liability (D&O) insurance policy or have their fees indemnified and possibly advanced by the institution. Moreover, they are often motivated to clear their reputation and avoid draconian sanctions, such as civil money penalties and/or removal and prohibition from the banking industry.
Here are three key takeaways based on my work handling enforcement actions by prudential regulators. These lessons might have forestalled or avoided the enforcement action altogether had they been part of the institution’s policies or performed at the outset.
Lesson #1 – An ineffective risk management function is a recipe for trouble
A common denominator in many enforcement actions is the lack of an effective risk management function with sufficient authority and voice within the bank to elevate concerns and drive changes. Sometimes risk management failures manifest themselves in the failure to comply with existing consent orders, resulting in repeat violations that are invariably dealt with far more harshly than the original violation. There are numerous examples where financial institutions failed to comply with existing consent orders that mandated changes to Bank Secrecy Act/Anti-Money Laundering (BSA/AML) practices, only to see recurring violations and correspondingly more draconian penalties.
Other enforcement actions are premised on inattention to governance and compliance mechanisms. This inattention can manifest in many ways, such as taking reactive approaches that depend on third parties – customers, credit reporting agencies, examiners – to identify problems; failing to investigate and address what in retrospect may be viewed as red flags; and providing superficial responses that fail to fix root causes. These shortcomings may be attributed to competing management priorities, or an inexperienced or ineffective risk management team. Institutions that have the most significant compliance violations tend to have risk management departments that are under-staffed, under-resourced, and under-appreciated. Whatever the underlying cause, regulators (with the benefit of hindsight) are predisposed to pursue enforcement actions if an institution is perceived as having a substandard risk management function.
The lesson here is that every financial institution should place a premium on having an effective and formidable risk management function. Risk management should have the resources and ability to evaluate internal and external complaints or reports of misconduct, investigate and report suspicious banking activity, conduct risk-based assessments of operations, assess compensation systems, detect and investigate outliers, consider feedback given by departing employees, and adhere to a transparent and well-documented disciplinary system.
Lesson #2 – Avoid high-risk products or services unless your institution has the requisite competence and expertise
Another common feature of investigations and enforcement actions is that they involve high-risk products, services, or customers. There have been a number of enforcement actions around flawed or deficient BSA/AML compliance and monitoring processes emanating from high-risk customers. For instance, third-party payment processors may pose heightened risk to financial institutions if they service merchants or businesses that regulators deem to be (potentially) fraudulent, predatory, or unsavory, such as telemarketers or internet gaming providers. Financial institutions that cater to digital asset customers such as cryptocurrency exchanges and other crypto-related businesses run the risk that prudential regulators may find their Customer Due Diligence (CDD) processes inadequate for the risk posed by these customers. Likewise, partnering with Fintech companies poses its own set of risks, as the financial institutional may be held accountable for the actions or omissions of the third-party company, which may be more focused on growth and product development than customer service and compliance without adequate oversight and controls.
Financial institutions whose CAMELS ratings are less than satisfactory should be particularly wary of banking high-risk customers, products, or services. Examiners rarely look fondly on this, and commonly criticize these practices and fault institutional management for the high-risk customer’s shortcomings when there is any problem. For those financial institutions that are considering banking with higher risk customers or partnering with Fintech companies, it is advisable to keep an open line of communication with prudential regulators – this proactive step helps avoid surprises and demonstrates an ability to handle the relationship. It is imperative to develop and periodically update an overarching banking strategy that has been approved by the Board and shared with regulators and to have a sophisticated and experienced BSA/AML officer charged with making sure that the strategy is followed. Institutions should also have the technology and resources to develop and apply enhanced due diligence procedures to high-risk customers, both at the outset and throughout the course of the relationship, and have a demonstrated track record of compliance.
Lesson #3 – Individuals may be held accountable for systemic shortcomings in institutional safety and soundness
Individual enforcement actions typically are predicated on breaches of the duty of loyalty and outright violations of law, and mostly focus on deception, obstruction, or self-dealing. Such misconduct presents a straightforward case for proving that institution-affiliate parties (IAPs) breached their fiduciary duties. By contrast, prudential regulators rarely pursue enforcement actions against individuals based solely on safety and soundness, as it can be difficult to blame any single individual for such a collective lapse.
However, regulators have come under increased criticism and scrutiny over the past decade for not holding individuals accountable for bank failures and other systemic risk management shortcomings. For example, in 2014 the Office of Inspector General analyzed bank enforcement actions and recommended that enforcement counsel pursue more cases against IAPs on safety and soundness violations. More recently, politicians and the media have exerted pressure on regulators to hold individuals accountable for institutional misconduct, particularly when that misconduct occurred on a systemic basis or affected large numbers of customers. As a result, there has been an uptick in enforcement actions against individuals premised on significant safety and soundness failures. It is no longer enough to simply avoid engaging in personal dishonesty or self-dealing to stay out of enforcement’s crosshairs. It is more likely now than ever that IAPs will be held personally accountable for institutional shortcomings if the problems are considered to be widespread or egregious.
A corollary of this observation is that in-house counsel are no longer exempt from being held responsible for institutional problems. It used to be that in-house lawyers were fairly insulated from enforcement actions unless they engaged in deception, obstruction, or some form of self-dealing. Now, however, there are signs of an emerging willingness to hold in-house lawyers accountable when the institution engages in unsafe and unsound practices for an extended period of time. This is not a strict liability regime; rather, enforcement counsel appear inclined to hold in-house counsel responsible when they believe (with the benefit of hindsight) that in-house counsel’s contemporaneous actions or inaction to address systemic problems were unreasonable, reckless, or grossly negligent.
What does this mean as a practical matter? To put it simply, if you see something, say (or do) something. The best way to inoculate yourself and to protect your institution is to act. In-house counsel should not ignore so-called red flags or other signs that there may be unsafe or unsound conduct. This is especially true for systemic issues rather than isolated problems. Warning signs can emanate from many different sources – for example, internal ethics complaints by employees, customer complaints, exit interviews with departing employees, or outlier analyses of the performance of employees or agents. The critical question is whether in-house counsel monitors how the warnings are being handled and takes affirmative and effective action if problematic trends persist. Ignoring systemic problems is a recipe for trouble; likewise, ineffective actions by counsel may not be enough to stave off an enforcement action, particularly if counsel does not take steps to elevate their concerns to others who can take effective action.
This is not to say that a General Counsel must operate as a de facto Chief Risk Officer. Most institutions of sufficient size separate those roles and establish independent reporting structures, and in-house counsel are permitted to rely on others (until it is no longer reasonable to do so). But it does put a premium on in-house counsel keeping abreast of systemic problems identified by the Risk Management function and assessing whether appropriate action is being taken. When problems persist and in-house counsel fails to follow up or take meaningful steps to ensure that those problems are being addressed in an effective manner, the risk of enforcement action for both the institution and the individual rises significantly.
It also means that in-house counsel should carefully review the scope and coverage provided by their D&O insurance policy, including whether there is Side A coverage that is exclusively available to D&Os. These policies can be critical to the defense of directors and officers, particularly in the unfortunate circumstance where the institution itself has been placed into receivership. While D&Os with larger insurance policies may be a more attractive target, I have yet to meet a client who wishes their D&O coverage was less. Indeed, more often than not the converse is true, and the individual clients wish their coverage was greater. Although it may feel remote and unnecessary at the time, having a substantial D&O policy is an important factor in being able to mount an effective legal defense.
Enforcement Actions by the CFPB
The Consumer Financial Protection Bureau (CFPB) presents a different regulatory challenge for financial institutions whose assets exceed the $10 billion jurisdictional threshold. Unlike prudential regulators whose primary mission is to ensure institutional safety and soundness, the CFPB’s mandate is to an institution’s consumers and not the institution itself.
The CFPB is charged with enforcing 18 different consumer protection statutes and armed with expansive unfair, deceptive, or abusive acts or practices (UDAAP) power under Title X of the Dodd Frank Wall Street Reform and Consumer Protection Act. Historically, the CFPB has wielded its power aggressively. The Bureau is known for taking enforcement positions that push the envelope. And while that posture was modulated to a degree during the Trump administration, the pendulum appears to be swinging back to a more aggressive enforcement posture, with particular emphasis on pursuing fair lending violations and abusive acts or practices.
While the key takeaways for dealing with prudential regulators continue to apply, there are other lessons that are unique to the CFPB’s enforcement investigations and actions. Prioritizing a strong Compliance Management System under the direction of qualified and capable Risk Management personnel will always be the most important thing a financial institution can do to stay on the good side of regulators. Institutions with a strong risk management function are more likely to spot issues and address them promptly, and therefore will have greater credibility with prudential and CFPB examiners alike. But what else should an institution do to better position itself with regard to the CFPB?
Lesson #1 – Approach supervisory responses, even Supplemental Information Requests and PARR letters, from an advocate’s perspective
Often the decision whether to refer a matter inside the CFPB from Supervision to Enforcement is a judgment call. In my experience, once a matter gets referred to Enforcement, it tends to take on a life of its own. That is not to say that every investigation inevitably ends with an enforcement action, but most of them do. That reality means that financial institutions should put a premium on their supervisory responses. The deadlines for providing responses are often short, particularly for Supplemental Information Requests. But institutions with the foresight to involve in-house counsel and – when appropriate – outside counsel, can improve the quality of their responses and frame them in ways that provide important context and ultimately make them more persuasive. This does not guarantee that an institution can avoid a referral to Enforcement, but it can make the difference in a close case. And even if there is a referral to Enforcement, having involved litigation counsel at the Supervisory stage ensures that the counsel is up-to-speed and ready to handle the matter from the outset.
Lesson #2 – It is never too late to fix things, even after an investigation starts
Sometimes financial institutions fall short despite their best efforts. Mistakes happen, or sophisticated databases do not function as expected, and consumers may be negatively impacted. Institutions that identify these problems, promptly take corrective action, and voluntarily disclose the issue almost always find themselves in a better overall position when dealing with the CFPB than those that do not. For starters, sometimes the Bureau will decline to take enforcement action if it believes that the institution was forthcoming, has a strong compliance management function, and took appropriate action to notify and remediate affected consumers. But even when the Bureau does elect to bring an enforcement action, it will often acknowledge the voluntary corrective actions that were taken and negotiate a reduced penalty below what it otherwise might have demanded.
Even when an institution does not identify the problem until after an investigation has begun, it still is not too late. Investigations rarely move quickly; they are most often measured in years rather than months. Financial institutions that take effective action early in an investigation to address deficiencies may come out ahead. If the institution implements new and effective controls to address the issue, they can then point to those changes to demonstrate their responsiveness to supervision, the important role played by management in driving these changes, and the effectiveness of the controls.
It is often quite compelling to have the institution’s own personnel showcase their work. For example, it may make sense to arrange for an in-person demonstration of newly developed controls, and to have employees show how it functions and how its use now prevents the problem at the heart of the investigation from recurring. When done correctly – i.e., with personnel who have the qualifications, credibility, and presentation skills needed to communicate their message – this sort of show-and-tell can reassure CFPB enforcement personnel that they do not need to make an example of the institution.
Lesson #3 – Sometimes it pays to litigate
Given the Bureau’s tendency to take aggressive positions, it is sometimes difficult to reach a reasonable settlement with the CFPB in a pre-litigation posture. There are institutional reasons why the Bureau tends to be more aggressive in enforcement actions. First, it is still a relatively new agency and is trying to cement its reputation as a tough and effective consumer advocate. The more wins it can get under its belt, and the more significant they are, the more fearsome it becomes. Second, the Bureau cannot possibly file enforcement actions against everyone who violates any of the 18 federal consumer protection laws under its purview. So it magnifies its leverage by pursuing high-profile entities – including financial institutions – to set examples for the rest of the industry, and then using those investigations and actions as templates to target others. Third, to borrow a baseball analogy, in its early years the Bureau preferred swinging for the fences to adopting a more conservative strategy premised on hitting singles or doubles. Early on, the CFPB pursued litigation on the periphery of its authority, such as around indirect auto lending, or controversial interpretations, such as around the proper interpretation of RESPA or Regulation E, rather than consistently tackling acts or practices more at the heart of its authority. This approach sparked substantial criticism of the CFPB’s “regulation by enforcement” approach. And fourth, the Bureau is trying to establish the parameters of its authority and therefore is incentivized to take more expansive and aggressive positions in order to do so.
Despite these dynamics, it is common to resolve enforcement actions without litigation. To their credit, CFPB enforcement counsel usually engages in substantive discussions about the merits of their claims. This process usually begins in earnest with a NORA response, but often continues after enforcement counsel obtains authority to sue. When they are fact- and principles-based, these discussions can lead both parties to modify their positions and reach an acceptable resolution. When this happens, the CFPB typically will include additional factual recitals requested by the institution to add context or emphasize voluntary remedial measures.
There are times, however, when management and the board of directors view the Bureau’s demands as too extreme or unreasonable. Perhaps the CFPB predicates its demand on agreeing to certain conditions, such as the amount of restitution or civil money penalty, or frames the facts in the proposed consent order in a way that the institution feels is misleading or inaccurate, or is pursuing claims that exceed its authority. In those circumstances, institutions are left with a stark choice: they can take the offer on the table, or they can choose to litigate. In those situations, financial institutions sometimes achieve substantially better outcomes when they choose to litigate the enforcement action.
I co-authored an article on this topic: Sometimes It Pays to Litigate Against the CFPB, Law360, Oct. 13, 2017. Although published over three years ago, the central premise of this article – that defendants threatened with CFPB enforcement actions should carefully weigh the merits of their legal and factual defenses and not assume that settlement will result in the best outcome – remains true today. This is not to say that institutions should litigate simply for the sake of litigation. To the contrary, if the institution lacks a compelling defense, then it may be best to accept the offer on the table. But when there are unsettled legal questions and a factual narrative that diverges from the CFPB’s telling, then litigation can pay off.
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The benefits of avoiding damaging and expensive enforcement actions and reputational hits are incalculable. Financial institutions that internalize these lessons and devote the necessary resources to establishing a culture and system that prioritizes compliance will come out ahead in the long run. But even sophisticated financial institutions make mistakes, and when that happens it is important to remember that there are still things that can be done to improve your position with regulators and the overall outcome of any enforcement actions.
[1] Ryan Scarborough is a partner at Williams & Connolly LLP. He litigates enforcement actions brought by prudential regulators targeted at financial institutions, their directors and officers, and other institution affiliated parties, as well as consumer protection actions brought by the CFPB, securities actions brought by the SEC, and investigations by the DOJ.
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