Public listings through reverse mergers with special purpose acquisition companies (SPACs), commonly referred to as “backdoor listings,” have returned to the capital markets spotlight and are being utilized at record-breaking levels as an expedited alternative to traditional initial public offerings (IPOs).[1] Often referred to as “blank check companies,” SPACs are publicly traded shell corporations that raise capital through an IPO of the SPAC (a SPAC IPO) in order to subsequently acquire and take public a separate privately held target company in what is commonly referred to as either a SPAC merger, a “De-SPAC” transaction or an initial business combination transaction (a SPAC IBC).[2]  The volume of SPAC IPOs and related SPAC IBCs (collectively, SPAC transactions) skyrocketed in 2020 as a result of COVID-19 pandemic-related financial market uncertainty, as well as sponsor, investor and target company appetite for liquidity and exit opportunities.[3] Technology is considered to be the dominant sector for SPAC transactions,[4] and an increasing number of SPACs are being formed to combine specifically with target companies in the financial services technology (Fintech) sector. This article provides a brief overview of the rise of SPAC transactions in the Fintech sector in 2020.

SPAC IPOs Targeting Fintech Companies 

The SPAC Sponsor View

Fintech-focused SPAC sponsors view the Fintech sector as ripe for SPAC business combinations as a result of the “deep supply”[5] of privately held Fintech targets that are well positioned to be taken public, as well as the increased demand for Fintech-related products and services that has resulted from the COVID-19 pandemic.[6] Recognition of the Fintech sector’s potential from a public market standpoint resulted in the launch of over 30 Fintech-focused SPAC IPOs in 2020,[7] with the majority initiated during the second half of the year. Among the largest Fintech-focused SPAC IPOs of 2020 were Foley Trasimene Acquisition Corp. II’s $1.4 billion IPO,[8] FTAC Olympus Acquisition Corp.’s $750 million IPO,[9] Dragoneer Growth Opportunities Corp.’s $690 million IPO,[10] and Far Peak Acquisition Corporation’s $550 million IPO.[11] Other 2020 Fintech-related SPAC IPOs of note include SVF Investment Corp.’s planned $525 million IPO,[12] FinTech Acquisition Corp. V’s $250 million IPO,[13] and Dutch Star Companies Two B.V.’s €110 million IPO.[14]

The Fintech Target Company View

From the Fintech target company’s perspective, going public via a SPAC business combination offers a number of advantages over a traditional IPO, including a faster listing process thanks to the avoidance of lengthy roadshows with prospective investors; certainty over valuation thanks to the target company’s ability to predetermine its valuation in direct negotiation with the SPAC sponsor prior to listing; contractual flexibility thanks to the ability of the target company to directly negotiate SPAC merger agreement terms with the SPAC sponsor; and an opportunity to enter the public markets in partnership with a SPAC management team that is composed of seasoned Fintech investors and well-known financial services industry professionals who can enhance the target company’s value and overall business prospects. Examples of prominent financial services industry professionals who form part of recently launched Fintech SPAC management teams include Douglas L. Braunstein, former CFO of JPMorgan Chase, who currently serves as President and Chairman of the Board of Hudson Executive Investment Corp.;[15] Betsy Z. Cohen, former CEO of The Bancorp, Inc., who currently serves as Chairman of the Board of Fintech Acquisition Corps. IV and V;[16] Robert E. Diamond Jr., former CEO of Barclays, who currently serves as Chairman of the Board of Concord Acquisition Corp.;[17] and Xavier Rolet, former CEO of the London Stock Exchange, who currently serves as a Director of Golden Falcon Acquisition Corp.[18] For these reasons, SPAC transactions are an appealing proposition to Fintech companies looking to go public in a challenging market environment.

Distinguishing Characteristics of Fintech SPACs

Fintech-focused SPACs come in a variety of shapes and sizes, with some focused on acquiring target companies active in specific Fintech product or geographic markets, while others focus on targets whose enterprise value falls within a specified range. Motive Capital Corp., for example, is focused on Fintech targets active in the “Banking & Payments, Capital Markets, Data & Analytics, Insurance and Investment Management”[19] Fintech subsectors, while others, such as North Mountain Merger Corp., take a more wide-ranging approach that includes target companies in the “financial technology segment of the broader financial services industry.”[20] Other Fintech SPACs, such as Far Peak Acquisition Corporation[21] and Ribbit LEAP, Ltd.,[22] include crypto-assets and cryptocurrency-related services within the scope of their Fintech target company search, while others do not.

From a geographic standpoint, some Fintech SPACs will consider targets located in multiple continents, while others focus more narrowly on a particular region. Golden Falcon Acquisition Corp., for example, is focused on Fintech and other technology targets headquartered in “Europe, Israel, the Middle East or North America,”[23] while byNordic Acquisition Corporation is focused on Fintech targets in Northern Europe, specifically “the Nordic and Scandinavian countries, the Baltic states, UK and Ireland, Germany, France and the Benelux countries.”[24] 

From a valuation standpoint, some Fintech SPACs limit their search to targets within a specified valuation range, while others do not specify a particular range. VPC Impact Acquisition Holdings, for example, is focused on Fintech targets with an enterprise value of approximately $800 million to $2 billion,[25] while Fusion Acquisition Corp. is focused on Fintech targets with an enterprise value of approximately $750 million to $3 billion.[26]

Fintech Sector SPAC IBCs

San Francisco-based Fintech investment bank FT Partners has described 2020 as the “most active year ever” for SPAC IBCs in the Fintech sector.[27] Over 15 Fintech SPAC IBCs were announced in 2020,[28] among the largest of which were United Wholesale Mortgage’s combination with Gores Holdings IV Inc. at a $16.1 billion valuation in September 2020, which is considered to be the largest SPAC merger of all time;[29] MultiPlan’s combination with Churchill Capital Corp III at an $11 billion valuation in July 2020;[30] and Paysafe’s combination with Foley Trasimene Acquisition Corp. II at a $9 billion valuation in December 2020.[31] Other Fintech SPAC IBCs of note include Opendoor’s combination with Social Capital Hedosophia Holdings Corp. II at a $4.8 billion valuation in September 2020;[32] Paya Inc.’s combination with FinTech Acquisition Corp III at a $1.3 billion valuation in August 2020;[33] Triterras Fintech’s combination with Netfin Acquisition Corp. at a $674 million valuation in July 2020;[34] and Katapult’s planned combination with FinServ Acquisition Corp. at a $1 billion valuation as announced in December 2020.[35]  Given the number of Fintech SPACs launched in 2020 that are actively searching for Fintech acquisition targets, additional Fintech SPAC IBC deals are expected in 2021.[36] 

Conclusion

Although some analysts view the SPAC market as having potentially “reached its limit,”[37] particularly in light of growing concern over SPAC transaction-related litigation risk[38] and the resultant increase in SPAC Director & Officer insurance policy premiums,[39] others are bullish and predict that the boom in SPAC transactions will not only continue in 2021,[40] but will also expand internationally into non-U.S markets,[41]most notably in Europe.[42] SPAC transactions in the Fintech sector, in particular, are likely to persist at a steady pace in 2021 given the sector’s strong revenue and growth projections,[43] as well as continued demand for Fintech products and services in response to ongoing COVID-19 pandemic-related challenges.[44] As such, SPAC-focused capital markets and M&A attorneys should pay close attention to developments in this space.   

DISCLAIMER

The views and opinions expressed in this article are those of the author alone and do not necessarily reflect the views of the American Bar Association. The material in this article has been prepared for informational purposes only and is not intended to serve as legal advice or investment advice.

[1] Q2 2020 PitchBook Analyst Note: SPACs Resurface in a Volatile Market, PitchBook, May 4, 2020. Available at https://pitchbook.com/news/reports/q2-2020-pitchbook-analyst-note-spacs-resurface-in-a-volatile-market.  See also Q3 2020 PitchBook Analyst Note: The 2020 SPAC Frenzy, PitchBook, August 31, 2020. Available at: https://pitchbook.com/news/reports/q3-2020-pitchbook-analyst-note-the-2020-spac-frenzy.  See also The Resurgence of SPACs: Observations and Considerations, Harvard Law School Forum on Corporate Governance, August 22, 2020. Available at: https://corpgov.law.harvard.edu/2020/08/22/the-resurgence-of-spacs-observations-and-considerations/.   

[2] Update on Special Purpose Acquisition Companies, Harvard Law School Forum on Corporate Governance, August 17, 2020. Available at: https://corpgov.law.harvard.edu/2020/08/17/update-on-special-purpose-acquisition-companies/.

[3] SIFMA Insights, Spotlight: 2020, the Year of the SPAC: Explaining SPACs and Analyzing Issuance Trends, SIFMA, August 2020. Available at: https://www.sifma.org/wp-content/uploads/2020/08/SIFMA-Insights-Spotlight-SPACs.pdf.  See also SPAC Transactions — Considerations for Target-Company CFOs, Cooley & Deloitte, October 2, 2020. Available at: https://www.cooley.com/news/insight/2020/2020-10-02-spac-transactions-considerations-for-targetcompany-cfos.

[4] Source: Dealogic Insights, 2020.

[5] VPC Impact Acquisition Holdings, Prospectus, September 22, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1820302/000119312520253319/d10733d424b4.htm.

[6]Q3 2020 Emerging Tech Research: Fintech, PitchBook, November 3, 2020. Available at: https://pitchbook.com/news/reports/q3-2020-emerging-tech-research-fintech.

[7] Sources: Nasdaq, SPAC Alpha, SPAC Research and Renaissance Capital. 

[8] Foley Trasimene Acquisition Corp. II Closes Partial Exercise of IPO Over-Allotment Option, BusinessWire, August 26, 2020. Available at: https://www.businesswire.com/news/home/20200826005729/en/Foley-Trasimene-Acquisition-Corp.-II-Closes-Partial-Exercise-of-IPO-Over-Allotment-Option.

[9] Fintech-focused SPAC FTAC Olympus Acquisition closes IPO, S&P Global Market Intelligence, August 31, 2020. Available at: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/fintech-focused-spac-ftac-olympus-acquisition-closes-ipo-60136338.

[10] Dragoneer Growth Opportunities Corp. Announces Pricing of $600,000,000 Initial Public Offering, BusinessWire, August 13, 2020. Available at: https://www.businesswire.com/news/home/20200813005845/en/Dragoneer-Growth-Opportunities-Corp.-Announces-Pricing-of-600000000-Initial-Public-Offering.

[11] Former NYSE President’s second SPAC Far Peak Acquisition prices $550 million IPO at $10, Renaissance Capital, December 3, 2020. Available at: https://www.renaissancecapital.com/IPO-Center/News/73715/Former-NYSE-Presidents-second-SPAC-Far-Peak-Acquisition-prices-$550-million.

[12] SVF Investment Corp., Form S-1 Registration Statement, December 21, 2020. Available at:

https://www.sec.gov/Archives/edgar/data/1828478/000119312520323022/d50198ds1.htm. See also SoftBank Jumps on the SPAC Bandwagon, Wall Street Journal, December 22, 2020.  Available at: https://www.wsj.com/articles/softbank-jumps-on-the-spac-bandwagon-11608634587

[13] FinTech Acquisition Corp. V, Prospectus, December 3, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1829328/000121390020041405/f424b41220_fintechacqv.htm.  See also FinTech Acquisition Corp. V Announces Completion of $250,000,000 Initial Public Offering, Including Exercise of Over-Allotment Option, GlobeNewswire, December 8, 2020.  Available at: https://www.globenewswire.com/news-release/2020/12/09/2141839/0/en/FinTech-Acquisition-Corp-V-Announces-Completion-of-250-000-000-Initial-Public-Offering-Including-Exercise-of-Over-Allotment-Option.html

[14] Dutch Star Companies Two B.V., Prospectus, November 16, 2020. Available at: https://www.dutchstarcompanies.com/download/951766/prospectus-dutchstarcompaniestwo.pdf.

[15] Hudson Executive Investment Corp., Prospectus, June 10, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1803901/000119312520165740/d846732d424b4.htm.

[16] FinTech Acquisition Corp. V, Prospectus, December 3, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1829328/000121390020041405/f424b41220_fintechacqv.htm. FinTech Acquisition Corp. IV, Prospectus, September 24, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1777835/000121390020028485/f424b4_fintechacqcorp4.htm.

[17] Concord Acquisition Corp, Prospectus, December 7, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1824301/000121390020041867/f424b4_concordacquicorp.htm.

[18] Golden Falcon Acquisition Corp., Prospectus, December 1, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1823896/000119312520307287/d167933ds1.htm.

[19] Motive Capital Corp, Amendment No. 1 to Form S-1, December 8, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1827821/000110465920133130/tm2032742-6_s1.htm.

[20] North Mountain Merger Corp., Prospectus, September 18, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1819157/000114036120020889/nt10014112x7_424b4.htm.

[21] Far Peak Acquisition Corp, Prospectus, December 3, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1829426/000119312520309439/d26326d424b4.htm.

[22] Ribbit LEAP, Ltd., Prospectus, September 14, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1818346/000104746920004858/a2242371z424b4.htm.

[23] Golden Falcon Acquisition Corp., Form S-1, December 1, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1823896/000119312520307287/d167933ds1.htm.

[24] byNordic Acquisition Corporation, Form S-1, August 28, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1801417/000121390020024311/fs12020_bynordicacq.htm.

[25] VPC Impact Acquisition Holdings, Prospectus, September 24, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1820302/000119312520253319/d10733d424b4.htm.

[26] Fusion Acquisition Corp., Prospectus, June 29, 2020. Available at: https://www.sec.gov/Archives/edgar/data/1807846/000121390020016189/f424b4062820_fusion.htm.

[27]CEO Monthly Market Update & Analysis, FT Partners, December 2020. Available at: https://www.ftpartners.com/fintech-research/monthly-sector-reports.

[28] Source: FT Partners.

[29] United Wholesale Mortgage Goes Public in Biggest SPAC Deal Ever, Wall Street Journal September 23, 2020. Available at: https://www.wsj.com/articles/united-wholesale-mortgage-to-go-public-via-merger-with-gores-spac-11600828200.

[30] MultiPlan to Go Public in Merger with Churchill Capital Entity, Wall Street Journal, July 12, 2020. Available at: https://www.wsj.com/articles/multiplan-to-go-public-in-merger-with-churchill-capital-entity-11594593000.

[31] Foley Trasimene Acquisition Corp. II and Paysafe, A Leading Global Payments Provider Focused on Digital Commerce and iGaming, Announce Merger, Paysafe Group, December 7, 2020. Available at: https://www.paysafe.com/us-en/paysafegroup/news/detail/foley-trasimene-acquisition-corp-ii-and-paysafe-a-leading-global-payments-provider-focused-on-digital-commerce-and-igaming-announce-merger/.

[32] Home Buyer Opendoor Is Going Public in $4.8 Billion Merger, Forbes, September 15, 2020. Available at: https://www.forbes.com/sites/noahkirsch/2020/09/15/home-buyer-opendoor-is-officially-going-public-in-48-billion-deal/?sh=3c4dd507134f.

[33] Paya and FinTech III Announce Merger Agreement, BusinessWire, August 3, 2020. Available at: https://www.businesswire.com/news/home/20200803005351/en.

[34] Singapore’s Triterras Fintech plans listing, Netfin Acquisition merger, S&P Global Market Intelligence, July 29, 2020. Available at: https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/singapore-s-triterras-fintech-plans-listing-netfin-acquisition-merger-59651728.

[35] Fintech Katapult to go public through merger with SPAC FinServ, that values company at $1 billion, MarketWatch, December 18, 2020. Available at: https://www.marketwatch.com/story/fintech-katapult-to-go-public-through-merger-with-spac-finserv-that-values-company-at-1-billion-2020-12-18.

[36] See also An Avalanche of SPAC M&A Deals Predicted for Q1 of 2021: Lawsuits Certain to Follow, Woodruff Sawyer, January 3, 2021. Available at: https://woodruffsawyer.com/mergers-acquisitions/avalanche-spac-ma-deals-predicted-q1-2021/.

[37] ANALYSIS: Investor Hunger for SPACs Is Hitting Limits . . . for Now, Bloomberg Law, November 16, 2020. Available at: https://news.bloomberglaw.com/securities-law/analysis-investor-hunger-for-spacs-is-hitting-limits-for-now.  See also Q4 2020 PitchBook Analyst Note: 2021 US Venture Capital Outlook, PitchBook, December 11, 2020. Available at: https://pitchbook.com/news/reports/q4-2020-pitchbook-analyst-note-2021-us-venture-capital-outlook.

[38]Alert Memorandum: SPAC Sponsors Beware: The Rising Threat of Securities Liability, Cleary Gottlieb Steen & Hamilton LLP, October 21, 2020. Available at:

https://www.clearygottlieb.com/-/media/files/alert-memos-2020/spac-sponsors-beware–the-rising-threat-of-securities-liability.pdf. See also Litigation Risk in the SPAC World, Quinn Emanuel Urquhart & Sullivan LLP, 2020. Available at: https://www.quinnemanuel.com/the-firm/publications/litigation-risk-in-the-spac-world/.

[39] How SPAC Exuberance Led to a Perfect Storm in D&O Insurance, Woodruff Sawyer, November 24, 2020. Available at:

https://woodruffsawyer.com/mergers-acquisitions/spac-exuberance-perfect-storm-do-insurance/. See also How Much Is That D&O Premium? Eye-Popping D&O Price Increases Confound SPAC Sponsors, Woodruff Sawyer, October 21, 2020. Available at: https://woodruffsawyer.com/mergers-acquisitions/do-price-increases-confound-spac-sponsors/.  

[40] 219 ‘blank-check’ companies raised $73 billion in 2020, outpacing traditional IPOs to make this the year of the SPAC, according to Goldman Sachs, Business Insider, December 18, 2020. Available at: https://markets.businessinsider.com/news/stocks/spacs-raised-73-billion-more-than-traditional-ipos-blank-checks-2020-12-1029906693.

[41] Dealbook Newsletter: The Year in Deals Can Be Summed Up in 4 Letters, New York Times, December 19, 2020. Available at: https://www.nytimes.com/2020/12/19/business/dealbook/deals-mergers-acquisitions-2020.html.

[42] SPACs Cross the Atlantic, Baker McKenzie, December 21, 2020. Available at: https://www.bakermckenzie.com/en/insight/publications/2020/12/spacs-cross-the-atlantic.

[43] Fitch Ratings 2021 Outlook: North America & Europe FinTech, Fitch Ratings, December 3, 2020. Available at: https://www.fitchratings.com/research/corporate-finance/fitch-ratings-2021-outlook-north-america-europe-fintech-03-12-2020. See also The Fintech Industry in 2021, American Banker, December 17, 2020.  Available at: https://www.americanbanker.com/leaders/the-fintech-industry-in-2021.

[44] PitchBook Analyst Note: 2021 Emerging Technology Outlook, PitchBook, December 16, 2020. Available at: https://pitchbook.com/news/reports/q4-2020-pitchbook-analyst-note-2021-emerging-technology-outlook.  See also How US customers’ attitudes to fintech are shifting during the pandemic, McKinsey & Company, December 17, 2020.  Available at: https://www.mckinsey.com/industries/financial-services/our-insights/how-us-customers-attitudes-to-fintech-are-shifting-during-the-pandemic.

Recent events have spurred a social justice movement that has called for companies to commit to inclusion and diversity, specifically in the composition of their boards of directors.*  In light of the foregoing, on December 1, 2020, Nasdaq filed a proposal with the U.S. Securities and Exchange Commission (“SEC”) that, if approved by the SEC, would condition a company’s continued listing on Nasdaq’s U.S. exchange on the satisfaction of certain board diversity and disclosure requirements.  In proposing this rule, Nasdaq conducted its own internal study on the diversity of Nasdaq-listed companies, including a review of more than two dozen third-party studies on the effects of board diversity.  Nasdaq concluded that a positive correlation exists between diverse boards and improved corporate governance and financial performance. 

Nasdaq’s proposed rule would impose two action items for companies listed on Nasdaq’s U.S exchange.  First, the proposed rule would require Nasdaq-listed companies to disclose standardized statistical information on the diversity of each company’s board of directors through each director’s optional self-identification of certain diversity characteristics—such as race/ethnicity, gender, and LGBTQ+ status.[1]  Companies listed on Nasdaq’s U.S. exchange will have one year after the SEC approves the proposed rule to comply with this disclosure requirement.  Second, Nasdaq’s proposed rule would require each Nasdaq-listed company to either (i) have at least one director who self-identifies as a woman, without regard to such director’s designated sex at birth, and have at least one director who self-identifies as either LGBTQ+ or a racial or ethnic minority consistent with the categories established by the Equal Employment Opportunity Commission, or (ii) explain why the composition of its board does not comply with the diversity requirements listed in (i).[2]  That explanation would also need to be included on the company’s website and in its proxy statement or information statement for its annual meeting of stockholders.  Nasdaq will phase in the application of this portion of its proposed rule. Within two calendar years following SEC approval of the proposed rule, Nasdaq-listed companies must have at least one Diverse (defined in the proposed rule to include those who self-identify as a woman, LGBTQ+, or a racial or ethnic minority) director (or explain and disclose why such company does not have a Diverse director); and within four[3] calendar years following SEC approval of the proposed rule the companies must have at least two Diverse directors (or explain and disclose why such company does not have two Diverse directors).  Additionally, any newly listed company on Nasdaq’s U.S exchange that was not subject to a similar requirement from another national securities exchange will have one year from the date of listing (following the transition periods mentioned above) to satisfy these board diversity requirements. 

If a company listed on Nasdaq’s U.S. exchange fails to comply with either the board composition statistical disclosure or the Diverse board member requirement of the proposed rule, the company will be notified that it has until the later of its next annual stockholders’ meeting or 180 days from the time the deficiency occurred to provide a plan to regain compliance with the proposed rule or face potential delisting from Nasdaq.  Nasdaq’s proposed rule would generally apply to all companies listed on Nasdaq’s U.S. exchange; however, certain companies are exempt from the proposed rule and certain companies, including Foreign Issuers[4] and Smaller Reporting Companies[5] as defined in the Securities Exchange Act of 1934, have certain modifications to the proposed rule that apply to them.  In an attempt to assist companies in complying with Nasdaq’s diversity rule, Nasdaq will provide companies with free access to a network of diverse, board-ready candidates, a tool to support board evaluation and refreshment, and a designated email address for companies and their counsel to pose questions to Nasdaq regarding application of the rule.

In Nasdaq’s press release announcing its intent to file the proposed rule, Nasdaq identified a key goal of “provid[ing] stakeholders with a better understanding of the company’s current board composition and enhanc[ing] investor confidence that all listed companies [on Nasdaq’s U.S. exchange] are considering diversity in the context of selecting directors.”[6]  Proxy advisory firms, such as Glass Lewis or Institutional Shareholder Services (“ISS”), are among such stakeholders that will monitor the diversity of companies’ boards.  Notably, these firms have already begun to include certain diversity benchmarks in how they will recommend stockholders vote in the election of directors.  For example, Glass Lewis will, effective for stockholder meetings held after January 1, 2022, generally recommend against the nominating committee chair of a board that has fewer than two female directors and, beginning in 2021, will assess companies’ disclosures regarding diversity.[7]  Currently, ISS will generally recommend against the nominating committee chair or other relevant directors for boards that do not include a woman.  Commencing with stockholder meetings held after February 1, 2022, ISS will generally recommend against the nominating committee chair or other relevant directors for boards that do not include at least one ethnic or racially diverse member.[8] 

Nasdaq’s proposal follows on the heels of at least 12 state legislatures, in addition to the U.S. Congress, that have enacted or are considering enacting legislation relating to board diversity.[9]  The state-based board diversity requirements that have received the most attention are those enacted in California in September 2018,[10] which are focused on gender diversity, and September 2020,[11] which are focused on racial diversity and LGBTQ+ inclusion. These requirements are applicable to corporations with principal executive offices in California.  California’s statutory board diversity requirements are substantially similar to Nasdaq’s proposal in that both effectively require affected companies (i) to make certain disclosures regarding the diversity of their boards of directors, and (ii) to have at least one director who self-identifies as a woman in addition to at least one director who self-identifies as an underrepresented minority (with the Nasdaq proposed rule and the California statute both including racial/ethnic minorities and those who identify as LGBTQ+[12]).  California’s statute, however, provides for a proportionate structure to the mandated minimum amount of diverse directors, requiring an increased minimum number of directors who identify as a woman, as well as an increased minimum number of directors who identify as an underrepresented minority, based on the size of the corporation’s board of directors.[13]  Additionally, California’s statute is more rigorous than Nasdaq’s proposed rule in that it mandates compliance with its board diversity requirements (and imposes penalties for non-compliance with the mandates), while Nasdaq’s proposed rule is structured as a “comply or explain” rule.  Nasdaq acknowledged that it considered adopting a mandatory regime, but ultimately determined the “comply or explain” model would encourage companies to take action while providing them sufficient flexibility to maintain decision-making authority over their board’s composition.  Nevertheless, companies that fail to comply with Nasdaq’s “comply or explain” rule are subject to delisting from Nasdaq’s U.S. exchange. 

In light of Nasdaq’s proposed rule and similar legislative initiatives, as well as the trend toward increased diversity and inclusion in corporate boardrooms and research on the effects of diversity on governance, corporations and their boards should continue to evaluate the diversity of their current boards of directors on an ongoing basis.

See Nasdaq’s proposed rule regarding diversity requirements here.

* John Mark Zeberkiewicz is a director and Ryan A. Salem is an associate at Richards, Layton & Finger, P.A. in Wilmington, Delaware.  The opinions expressed in this article are those of the authors and not necessarily of Richards, Layton & Finger, P.A. or its clients.

[1] See Nasdaq Proposed Rule 5606 (Board Diversity Disclosure).

[2] See Nasdaq Proposed Rule 5605(f)(2) (Board Diversity Representation).

[3] Companies listed on The Nasdaq Capital Market will be given five calendar years following SEC approval of the proposed rule to have two Diverse directors.

[4] 17 CFR § 240.3b-4.

[5] 17 CFR § 240.12b-2.

[6] Press Release, Nasdaq, Nasdaq to Advance Diversity Through New Proposed Listing Requirements, https://www.nasdaq.com/press-release/nasdaq-to-advance-diversity-through-new-proposed-listing-requirements-2020-12-01.

[7] An Overview of the Glass Lewis Approach to Proxy Advice, Glass Lewis, https://www.glasslewis.com/wp-content/uploads/2020/11/US-Voting-Guidelines-GL.pdf?hsCtaTracking=7c712e31-24fb-4a3a-b396-9e8568fa0685%7C86255695-f1f4-47cb-8dc0-e919a9a5cf5b.

[8] Proxy Voting Guidelines Benchmark Policy Recommendations, Institutional S’holder Servs. (Nov. 19, 2020), https://www.issgovernance.com/file/policy/latest/americas/US-Voting-Guidelines.pdf.

[9] Michael Hatcher & Weldon Latham, States are Leading the Charge to Corporate Boards: Diversify!, Harvard Law Sch. Forum on Corp. Governance (May 12, 2020), https://corpgov.law.harvard.edu/2020/05/12/states-are-leading-the-charge-to-corporate-boards-diversify/#:~:text=In%20September%202018%2C%20California%20Governor,executive%20office%E2%80%9D%20in%20the%20state.

[10] Cal. Corp. Code § 301.3.

[11] Cal. Corp. Code § 301.4.

[12] Nasdaq’s proposed rule goes slightly further in its definition of LGBTQ+ by expanding it to include those in the queer community, while California’s statute is limited to those identifying as gay, lesbian, bisexual, or transgender.

[13] If the corporation has at least five directors, the board must be comprised of at least two women and two underrepresented minorities.  The board must be comprised of one additional director who identifies as a woman when the board consists of six or more directors, and the board must be comprised of one additional director who identifies as an underrepresented minority when the board consists of nine or more directors.

Restaurants and retail stores often face a large number of tort claims seeking relatively small amounts in damages, e.g., the twisted ankle allegedly caused by the wet spot on the floor, or the burned hand caused by the waiter missing the cup when pouring the coffee. Retail establishments and restaurants frequently choose to have some form of self-insurance rather than pay the high premiums that would be charged by an insurance company for insuring a large number of small claims. They buy insurance to cover only larger claims. How tort claims are treated in a retail bankruptcy case depends on the type of coverage the debtor has purchased. This article will discuss the various forms of coverage available and how the form of coverage impacts the treatment of the claims.

I. Distinctions Among Types of Policies

The handling of tort claims against a bankrupt insured impacts three parties—the claimant, the insured debtor, and the insurance company. A debtor may take different positions on how claims should be handled based on whether the debtor’s insurance policy is a guaranteed-cost or a loss-sensitive one, and whether the policy is subject to a deductible or only covers claims above the debtor’s self-insured retention. The insurance company’s position varies based on the same factors, as well as whether it has adequate security for the insured’s obligation to reimburse deductibles. The claimant’s position is always the same—somebody, and it does not matter who, should pay the full amount of the asserted claim.

To understand why the parties take the positions they do, one must appreciate the differences among the various types of policies a debtor may have.

A. Guaranteed-Cost Versus Loss-Sensitive Policies

The amounts owed to an insurer by its insured depend on whether the policies are guaranteed-cost or loss-sensitive ones. Under a standard guaranteed-cost policy, the premium payable by an insured does not vary based on the losses asserted under a policy. As the name implies, however, the amount owed for loss-sensitive policies depends on the losses experienced under the policies.

Loss-sensitive policies can be structured in a variety of ways. Typically, loss-sensitive policies are subject to a large deductible. The insured is required to reimburse the insurance company for losses that are within the deductible amount. The insured may also be required to reimburse the insurer for some or all of the defense costs that it incurs. Insurance companies often hold collateral securing the debtor’s obligation to reimburse it for deductible losses and defense costs.

B. Deductibles Versus Self-Insured Retentions

The coverage available for claims depends on whether the policy provides coverage over a self-insured retention (SIR) or is a deductible policy. A company can decide to elect to be self-insured or can achieve the same economic result by purchasing a large-deductible policy. Courts often fail to distinguish between a “deductible” and a “SIR,” using the terms interchangeably. There is, however, an important distinction between the two. Under a primary liability policy that is subject to a deductible, insurance coverage starts at the first dollar of loss. With a deductible policy, the deductible endorsement to the policy provides that the insured agrees to reimburse the insurer for all losses (i.e., claim payments) and expenses up to the deductible limits. This language makes it clear that the insurer is required to pay the claimant and look to its insured for reimbursement.

Most people do not understand that the deductibles for third-party liability policies work in this fashion. When most people think of a deductible, they think of the deductible on their automobile policy. For first-party coverage, such as automobile physical damage coverage or property damage insurance, the insurance company typically pays the loss less the applicable deductible. For example, if the car suffers $2,000 of damage and the deductible under the policy is $500, the body shop will receive payment of $1,500 from the insurance company, and the insured party will pay the balance. By contrast, with third-party coverages, such as general liability and workers’ compensation policies, the injured party’s claim is entitled to payment in full, including the deductible amount, by the insurance company. The insurance company is then reimbursed by its insured for the deductible.

Policies subject to a SIR provide that the insurance company is obligated to pay only the portion of the damages in excess of the SIR. Generally, if an insurance policy provides for a SIR, there is no coverage until the loss exceeds the SIR. The insurance company has no obligation to pay anything to the claimant for claims within the SIR. Rather, those claims are paid by the insured. Most retail establishments choose to buy policies with a SIR to avoid having to post collateral with the insurer securing their reimbursement claim under a deductible policy.

Insurance policies sometimes do not make a clear distinction between a deductible and a SIR. Deductible endorsements to policies sometimes use wording similar to the language used in SIR policies, providing that the carrier’s obligation to pay damages applies only to the damages in excess of the deductible and further providing that the carrier will not advance any amounts included within the deductible. Although labeled “deductible endorsements,” these endorsements seem to be more like SIRs.

II. Effect of Policy Type on Parties

These different types of policies have no economic impact on the claimant, the insured, or the insurance carrier so long as the insured remains out of bankruptcy. The differences are critical to all parties, however, if the insured becomes a debtor in a bankruptcy case. The distinctions will be explored by using an example and outlining the various results for the parties based on the type of policy. The example presumes that the injured party has a prepetition claim with a jury value of $75,000 and a settlement value of $35,000. It also presumes that the policy deductible or SIR is $25,000. Deductibles and SIRs are, however, often significantly higher and sometime equal or exceed $1,000,000. For simplicity sake, the following discussion ignores the costs of defending the claim, which are typically included within, and reduce the amount of, the deductible or the SIR.

A. Guaranteed-Cost Policies

With a guaranteed-cost policy, prior to bankruptcy, the insurance company pays the settlement amount or the judgment in full, as well as all defense costs. After a bankruptcy filing by the insured, the claimant will argue that the discharge injunction imposed by Bankruptcy Code § 524(a)(2) does not block payment of the discharged debt by the insurer. The insurer, for obvious reasons, would like to argue that it does. The debtor may side with the claimant, wanting the insurer to defend and pay the claim in order to eliminate the unsecured claim against the bankruptcy estate. The debtor may, on the other hand, argue that the discharge injunction applies so that the debtor does not need to spend time participating in the defense of the claim. The debtor may also be concerned that the entry of a tort judgment against it will drive up its future insurance premiums. If the discharge injunction protects the insurer, the claimant will receive nothing from the insurance company. If it does not, the insurance company must pay the covered claim. Almost all courts have held that the discharge does not protect the insurance carrier and that the covered claim must be paid in full. Under the example, therefore, the injured party would receive payment in full from the insurance company.

B. Deductible Policies

Assume the same facts, but also assume the policy is subject to a $25,000 deductible. Prior to bankruptcy, the claimant would be paid its $75,000 judgment in full. The insured would bear $25,000 of the cost of the judgment either by paying the claimant directly itself or by reimbursing the insurance company for the claim payment. The insurance company would bear the remaining $50,000 cost of the judgment.

After the bankruptcy, with a deductible policy, the economic result should be the same for the claimant but would be different for the debtor and its carrier. The insurance company would pay the judgment in full and be left to recover the $25,000 deductible from the insured debtor, hoping that it has adequate collateral for what would otherwise be an unsecured reimbursement claim. From the debtor’s perspective, there might simply be a change in who holds the unsecured claim—the tort claimant or the insurance company seeking reimbursement. If the insurance company holds collateral, however, instead of having an unsecured tort claim against it, it would have a secured reimbursement claim against the debtor. That is why debtors sometimes insist that the claimant waive the right to collect the amount of its claim falling within the deductible before the debtor will agree to lift the stay/waive the discharge injunction to let the claimant proceed. Insurers argue correctly that such a requirement is an unauthorized modification of the policy. Furthermore, the claimant’s waiver of its claim within the amount of the deductible does not waive the insurer’s right to reimbursement of defense costs within the deductible.

C. Self-Insured Retentions

Economically, the same result occurs prebankruptcy for an excess policy with an SIR of $25,000 as that for a $25,000 deductible policy. The judgment would cost the insured $25,000 and the insurance company $50,000, and the claimant would be paid in full.

If the insurance company has issued an insurance policy with a $25,000 SIR, the post-discharge economic result depends on how the applicable court rules on several legal issues. If the insurance company has to drop down, i.e., pay the full amount of the judgment, the insurer bears the entire economic risk of the bankruptcy. The claimant is paid in full because the insurer must pay the entire $75,000 judgment, including the $25,000 SIR. If the debtor’s failure to pay the SIR allows the insurer to deny all coverage, the claimant bears the risk and receives nothing from the insurance carrier. The claimant is left with a $75,000 unsecured claim against the estate, which may have little to no value.

Most courts do not require the insurance company to drop down and pay claims within the SIR. They do (with some exceptions depending on the law of the applicable state), however, require the insurer to pay losses within its layer. This results in the claimant bearing some, but not all, of the insolvency risk. Using our example, the claimant would be left with a $25,000 unsecured claim against the estate for the unfunded SIR, but would be paid $50,000 of its judgment by the insurance carrier. Our example presumes what would be a relatively large claim against a restaurant or store; however, most garden variety slip-and-fall claims have a claim value well within the SIR, leaving the claimant with an unsecured claim against the bankruptcy estate.

If the claim has anything more than minimal value, the claimant may still be paid in part by the insurance carrier. Even if the court rules that the carrier is not required to drop down, as a practical matter the carrier often decides to pay the costs of defending the claim, rather than face the risk of the entry of a default judgment that pierces its layer. Furthermore, given that most claims are settled and not litigated, the insurance company often effectively steps down to pay a portion of the claim within the SIR. If, due to the insured’s failure to meet its contractual obligations to pay all losses and costs within the SIR, an insurance carrier is forced to pay the costs of defense or a settlement within the SIR, the insurance company may have claim against the insured debtor, which may or may not be secured depending on whether the insurer holds collateral and can apply it to its claim.

Our example can illustrate this point. If, prior to bankruptcy, plaintiff’s counsel would settle the claim for $35,000, plaintiff’s counsel will undoubtedly demand more than $35,000 after the bankruptcy filing. Prior to bankruptcy, a $35,000 settlement results in the plaintiff receiving just that, with the insured paying $25,000 of the settlement and the insurance company paying the remaining $10,000. Postpetition, if the claim is settled for $35,000, the plaintiff would have an unsecured claim of $25,000 against the bankruptcy estate—an amount equal to the SIR. The claimant would probably (in most cases, with justification) place little value on that claim. The insurance company would pay the claimant only $10,000—the amount of the settlement above the SIR.

To be absolutely sure of receiving the same economic equivalent of a prebankruptcy settlement of $35,000, the plaintiff would have to settle the claim for $60,000. With a $60,000 settlement, the plaintiff would have a $25,000 potentially valueless unsecured claim against the estate and would receive a $35,000 payment from the insurance company.

The settlement value would likely be somewhere in between the prebankruptcy amount of $35,000 and the absolute economic equivalent amount of $60,000. The parties might agree to a settlement amount of $45,000, consisting of a $25,000 unsecured claim in the bankruptcy case and a $20,000 check from the insurance company. Under such a settlement, the plaintiff would potentially receive more than it would be able to collect on a judgment obtained at trial because collection of any judgment obtained at trial would be reduced by the $25,000 SIR.

The insurer would settle at that amount to cut off future defense costs and eliminate the possibility of a large, adverse judgment at trial. The payment by the insurer of $20,000, however, would be twice the $10,000 that it would have paid under a prepetition settlement of $35,000. The insurer, therefore, would be effectively paying claims within the $25,000 SIR. As a result of this rather practical need to drop down, the insolvency of its insured drives up the settlement costs for the carrier.

The same is true when the court requires the claimant to waive its claim amount to the extent that it falls within the deductible. If the claimant cannot recover anything of its claim amount under the deductible, the claimant will ask for a larger settlement payment from the insurer’s layer (i.e., the amount above the deductible). Given that the insurer arguably pays nothing within the deductible, however, the insurer might be left without a reimbursement claim against the debtor for the settlement amount. It would, however, still have a claim for the costs of defense.

III. Other Sources of Recovery

In its bankruptcy case, a debtor may ask for, and receive, permission to pay self-insured claims. Restaurants and retail establishments depend on their reputation within the community. One of the typical “first-day motions” in a retail bankruptcy case is a motion seeking leave to pay “customer claims,” such as honoring gift certificates. A patron’s tort claims against the restaurant is probably covered by such a motion, allowing the restaurant to pay the claim if it elects to do so. In addition, any settlement might be allowed under a debtor’s de minimis claims settlements motion. A restaurant or retailer may well decide it is worth paying the minimal doctor’s bill relating to a fall on the premises rather than suffer the adverse publicity for failing to do so. For the same reason, a purchaser of such debtor’s assets may decide to pay at least a portion of the debtor’s tort claims, notwithstanding the order authorizing the purchase “free and clear” of all claims. Depending on the facts giving rise to the claim, the claimant may have a claim against the landlord (or may assert one even if there is not much justification for doing so). The landlord, or the landlord’s insurance carrier, may be another source of recovery for injured customers.

Broad, all-encompassing (and sometimes painful) discovery is a uniquely American staple of litigation. Although it is a matter of perspective, avoiding this discovery may be a selling point for international companies both to resolve their disputes through arbitration and to locate that arbitration outside the United States.

Of course, arbitration does not absolve all discovery responsibilities. Beyond the discovery permitted under the applicable institutional or tribunal rules, global entities can also obtain discovery from individuals and companies within the United States’ borders through 28 U.S.C. § 1782 (“Section 1782”), which allows a party arbitrating before a “foreign or international tribunal” to bypass traditional procedural burdens of the Hague Convention and obtain discovery of witnesses and documents located in the United States by petitioning a federal district court. No other country has similar legislation, which essentially allows a wholesale bypass of the Hague Convention.

Those engaged in private arbitration proceedings abroad may want to use Section 1782 to obtain discovery in the United States. Who can use this statute turns on how a “foreign or international tribunal” is defined. In the 2004 decision Intel Corp. v. Advanced Micro Devices, Inc., the Supreme Court held the term “tribunal” in Section 1782 “includes investigating magistrates, administrative and arbitral tribunals, and quasi-judicial agencies, as well as conventional civil, commercial, criminal, and administrative courts.”[1] In Intel, the Supreme Court ruled that the Commission of the European Communities (which is considered a judicial arm of the European Union) was a “foreign or international tribunal” under Section 1782.

Since Intel was a case about a foreign governmental tribunal in the European Union, the decision arguably left open whether Section 1782 could be as broad in private arbitration proceedings. Circuit courts have split over whether parties to these private international arbitrations may use Section 1782 to their advantage. Interestingly, the Fourth Circuit and the Seventh Circuit have split over discovery requested in the same private commercial arbitration in the United Kingdom. Now, one of the parties to that case has asked the Supreme Court for a definitive answer.

The case petitioned to the Supreme Court involves the Boeing 787 Dreamliner aircraft. In 2016, an aircraft engine tail pipe fire occurred during a test at a Boeing facility in South Carolina. Rolls-Royce, who manufactured the engine installed on the Boeing aircraft, claimed the fire’s proximate cause was an engine valve supplied by Servotronics. After settling its more than $12 million claim with Boeing, Rolls-Royce sought indemnity from Servotronics, who refused. Rolls-Royce then commenced arbitration against Servotronics under the rules of the Chartered Institute of Arbitrators (“CIArb”) in Birmingham, England. During the arbitration, Servotronics contended it had not received critical documents from Rolls-Royce and Boeing. To resolve these discovery issues, Servotronics filed ex parte applications with two U.S. district courts for leave to serve subpoenas. In response, Servotronics has received conflicting messages from two U.S. appellate courts in its quest to use Section 1782 for discovery in the private U.K. arbitration.

The Fourth Circuit Endorsed Servotronics’ Use of Section 1782 for the Private Commercial Arbitration

Servotronics first filed an ex parte application in the U.S. District Court in South Carolina, requesting that the court issue subpoenas for the chair of Boeing’s Incident Review Board (which investigated the fire) and two employees involved in troubleshooting the engine issues. The South Carolina federal district court declined to apply Section 1782, finding the CIArb was not a “tribunal” under the statute.[2]

On appeal, the Fourth Circuit reversed, holding that Section 1782 can be used in a private “foreign or international” arbitration.[3] The Fourth Circuit concluded “[t]he current version of the statute, as amended in 1964, thus manifests Congress’ policy to increase international cooperation by providing U.S. assistance in resolving disputes before not only foreign courts but before all foreign and international tribunals.”[4] Importantly, the Fourth Circuit held CIArb was “acting within the authority of the state” because the arbitration is subject to the U.K. government’s sanctions, regulations, and oversight.[5]

The Seventh Circuit Blocked Servotronics’ Use of Section 1782 for the Private Commercial Arbitration

Servotronics next filed an ex parte application in the U.S. District Court for the Northern District of Illinois requesting that the court issue a subpoena to compel Boeing to produce documents for use in the CIArb arbitration. The Illinois federal district court granted Boeing and Rolls-Royce’s motion to quash Servotronics’ application.[6]

The Seventh Circuit affirmed the district court’s decision, and in doing so concluded the polar opposite of its colleagues in the Fourth Circuit.[7] The court observed that the word “tribunal” is not defined in the statute, and turning to statutory interpretation, held that dictionary definitions do not resolve whether private commercial arbitration panels are included in the term “tribunal.”[8] The Seventh Circuit then compared Section 1782’s use of the phrase “foreign and international tribunal” to the phrase’s use in Sections 1696 and 1781 (governing service-of-process assistance and letters rogatory, respectively).[9] The Seventh Circuit concluded that the phrase “foreign or international tribunal” refers to state-sponsored tribunals only—not private commercial arbitration panels.[10]

In reaching its decision, the Seventh Circuit also cautioned against an interpretation of Section 1782 that would provide more than what is permitted under the Federal Arbitration Act (“FAA”).[11] The FAA permits the arbitration panel (but not litigants) to summon witnesses before the panel to testify at arbitration hearings and to petition federal district courts to enforce those summons.[12] By contrast, the Seventh Circuit notes, Section 1782 allows both the panel and litigants to obtain discovery orders from federal district courts. “If [Section] 1782(a) were construed to permit federal courts to provide discovery assistance in private foreign arbitrations, then litigants in foreign arbitrations would have access to much more expansive discovery than litigants in domestic arbitrations.” The Seventh Circuit warned, “[i]t’s hard to conjure a rationale for giving parties to private foreign arbitrations such broad access to federal-court discovery assistance in the United States while precluding such discovery assistance for litigants in domestic arbitrations.”[13]

Servotronics Petitions the Supreme Court to Bridge the Divide

On December 7, Servotronics appealed the Seventh Circuit’s decision to the Supreme Court.[14] Servotronics cited its Fourth and Seventh Circuit decisions and pointed to other circuit court decisions exacerbating the inconsistent application of Section 1782.[15] The Second and Fifth Circuits have agreed with the Seventh Circuit, holding that an arbitration proceeding must be public or governmental to be a “tribunal” for purposes of Section 1782.[16] By contrast, the Sixth Circuit has agreed with the Fourth Circuit, holding that a private arbitration panel constitutes a tribunal for the purpose of Section 1782.[17] Additional appeals are pending in the Third and Ninth Circuits, meaning the potential for an increased split in the near future.[18] The First, Eighth, Tenth, Eleventh, and D.C. Circuits have yet to address the issue.

Implications of a Potential Supreme Court Endorsement of Section 1782’s Use in Private International Arbitration

Whether the Supreme Court grants certiorari remains to be seen. If the Supreme Court ultimately agrees with Servotronic’s interpretation, however, there are at least three broad implications for the private arbitration landscape.

• First, a Supreme Court endorsement is likely to open the door to private litigants’ increased use of Section 1782 to shoehorn broad discovery—generally (previously) unavailable outside the United States—into private international arbitration proceedings. As the law stands now, global companies who want to do business in the United States can often avoid the local discovery tools and procedures by demanding their contracts stipulate to binding arbitration outside the United States. A Supreme Court ruling in favor of Servotronics could broaden the available discovery tools.
• Second, beyond the increased scope of discovery, there are confidentiality concerns. Private commercial arbitrations remain a popular dispute resolution process for global companies in part because the process, documents, arguments, and outcome of the arbitration all remain confidential. Increased Section 1782 applications (that, by definition, involve public court filings) could bring unwanted publicity to high-stakes arbitration proceedings, which could put confidentiality agreements at risk and potentially destroy a key incentive for companies to pursue binding arbitration at all.
• Third, private arbitration tribunals may view the Supreme Court’s support for an expansive use of Section 1782 as an encroachment on the tribunals’ arbitral autonomy. Arbitral tribunals exercise broad power to resolve disputes when the parties have agreed to arbitrate, and, although not universal, many tribunals are accustomed to courts deferring to them if the tribunal is able to grant effective relief.[19] A broader use of Section 1782, endorsed by the Supreme Court, may be viewed as impeding the tribunals’ autonomy in dispute resolution. Parties to private commercial arbitrations abroad would then need to carefully consider strategically how their chosen tribunal will view a Section 1782 application.

If the Supreme Court grants certiorari, argument would likely occur in Fall 2021.

[1] Intel Corp. v. Advanced Micro Devices, Inc., 542 U.S. 241, 258 (2004).

[2] In re Servotronics, Inc., No. 2:18-MC-00364-DCN, 2018 WL 5810109, at *1 (D.S.C. Nov. 6, 2018).

[3] Servotronics, Inc. v. Boeing Co., 954 F.3d 209, 216 (4th Cir. 2020).

[4] Id. at 213.

[5] Id. at 214.

[6] In re Servotronics, Inc., No. 18-cv-7187, 2019 WL 9698535, at *1 (N.D. Ill. April 22, 2019).

[7] Servotronics, Inc. v. Rolls-Royce, 975 F.3d 689 (7th Cir. 2020).

[8] Id. at 693.

[9] Id. at 695.

[10] Id.

[11] Id.

[12] The breadth of the authority granted by the FAA’s Section 7 is the subject of its own circuit court split. In 2019, the Eleventh Circuit joined the Second, Third, Fourth, and Ninth Circuits in holding that while Section 7 allows arbitrators to compel non-party witnesses to attend arbitration hearings and bring documents with them, Section 7 does not permit subpoenas for pre-hearing depositions or documents. Managed Care Advisory Group, LLC v. Cigna Healthcare, Inc., 939 F.3d 1145, 1159 (11th Cir. 2019); see also Hay Group, Inc. v. E.B.S. Acquisition Corp., 360 F.3d 404, 407 (3d Cir. 2004) (then-Judge Alito holding that the plain language of Section 7 “unambiguously restricts an arbitrator’s subpoena power to situations in which the non-party has been called to appear in the physical presence of the arbitrator and to hand over the documents at that time.”).

[13] Id. at 695.

[14] Servotronics, Inc. v. Rolls-Royce PLC, et al., No. 20-_____ (Dec. 7, 2020). Servotronic’s petition to the Supreme Court is available at https://www.supremecourt.gov/DocketPDF/20/20-794/162881/20201207153530435_Petition.pdf. A response is due January 11, 2021.

[15] Servotronics, 975 F.3d at 695.

[16] NBC v. Bear Stearns, Inc., 165 F.3d 184 (2d Cir. 1999); Republic of Kazakhstan v. Biedermann International, 168 F.3d 880 (5th Cir. 1999).

[17] In re Application to Obtain Discovery for Use in Foreign Proceedings, 939 F.3d 710, 723 (6th Cir. 2019).

[18] In re EWE Gassepeicher GMBH, No. 19-mc-109-RGA, 2020 WL 1272612 (D. Del. March 17, 2020), appeal docketed, No. 20-1830 (3d Cir. April 24, 2020); HRC-Hainan Holding Co. LLC v. Yihan Hu, No. 19-mc-80277-TSH, 2020 WL 906719 (N.D. Cal. Feb. 25, 2020), appeal docketed sub nom., In re HRC-Hainan Holding Co. LLC, No. 20-15371 (9th Cir. March 4, 2020).

[19] See, e.g., Gerald Metals SA v Timis & Ors [2016] EWHC 2327 (Ch), in which the U.K. Commercial Court deferred to the London Court of International Arbitration’s ability to grant effective emergency relief under Article 9B, holding that under English law, the Court would only act if the arbitral tribunal has no power or is unable to act effectively.

Alternative investments are back in the news. The Massachusetts Securities Division has announced an investigation of broker-dealers selling oil and gas and car dealership limited partnerships, and has issued subpoenas to sixty-three firms selling the private placements.[1],[2] The Financial Industry Regulatory Authority (FINRA) and Securities and Exchange Commission (SEC) have announced similar inquiries, which are still underway.[3] In May 2020, the Massachusetts Securities Division filed formal charges against GPB Capital Holdings, LLC. GPB, a complex network of car dealerships, waste carting, and oil and gas limited partnerships, is alleged to have raised $1.5 billion based on false and misleading offering statements.[4]

A federal class action in Texas, Kinnie Ma Individual Retirement Account v. Ascendant Capital LLC., alleges that seventy-five broker-dealers facilitated the sale of financially troubled and insufficiently vetted limited partnerships that invested in oil and gas and car dealerships.[5] In addition to the class action, hundreds of individual FINRA arbitration claims have been filed, and it would appear that more are forthcoming.

These developments bring to mind earlier enforcement actions, in the wake of the financial crisis and Great Recession of 2008–2009, which challenged investor exposure to alternative investments and sought to impose concentration limits on such investments for retail investors.

GPB can rightfully be called a major event in the broker-dealer world due to the sheer number of broker-dealers involved. It may also, however, present an opportunity to test some novel legal theories, some of which will be discussed in this article. As explained in detail below, the Uniform Limited Offering Exemption (ULOE), approved by the North American Securities Administrators Association (NASAA) in 1983 and adopted, in varying formats, by eleven U.S. states, provides a presumption of suitability for portfolio allocations of up to 10 percent of alternative investments, such as nontraded real estate investment trusts (REITs) and limited partnerships. The ULOE has not been extensively tested by the courts or arbitration panels. While NASAA has more recently proposed a 10 percent concentration limit for nontraded REITs, that proposal has not been fully adopted.

The Great Recession

The financial crisis of 2008 and the ensuing Great Recession brought unprecedented and unwelcome attention to nontraditional investments, such as nontraded REITS, tenant-in-common investments, oil and gas limited partnerships, and similar alternative investments. With the crash of the real estate markets, investors concentrated in securitized (and nonsecuritized) real estate investments found themselves strapped for cash, as numerous limited partnerships and Regulation D offerings failed or struggled, along with broad swaths of the overall economy. As Warren Buffet famously quipped, “It’s only when the tide goes out that you see who’s been swimming naked.”[6]

Regulators, quick to pounce, prosecuted the issuers and sellers of nontraditional alternative investments. Federal and state regulators brought numerous enforcement actions against issuers of syndicated real estate and other alternatives, along with the broker-dealers who marketed and recommended them.

State Concentration Limits

In the wake of the 2008–2009 financial crisis, many states implemented concentration limits on alternative investments, which they defined as nontraded REITS, limited partnerships, and other alternatives to the traditional baskets of publicly traded stocks, bonds, and money market investments.[7] Alternative investments include structured products, nontraded REITS, limited partnerships, Regulation D offerings, and the like. In order to manage risk and comply with state regulations, many independent broker-dealers have modified their written supervisory procedures to impose concentration guidelines of their own—typically, between 10 and 20 percent of an investor’s net worth, depending on such factors as overall net worth, trading experience, sophistication, and age.[8] NASAA, an association of state blue sky securities regulators, proposed a rule in 2016 that would cap the exposure of nonaccredited investors at 10 percent of liquid net worth.[9] According to NASAA, its proposal “would add a uniform concentration limit of ten percent (10%) of an individual’s liquid net worth, applicable to their aggregate investment in a REIT, its affiliates, and other nontraded REITs, as defined therein.”[10]

While alternative investments are often disparaged, they have some distinct features that make them attractive. For one, alternative investments typically do not correlate with the stock market, which offers investors downside protection in a falling market.[11] And while publicly traded REITs provide a measure of liquidity, they tend to rise and fall with the vagaries of the market. Alternative investments clearly offer investors diversification that standard equities do not, but how much is too much when it comes to concentration levels in alternative investments?

Uniform Limited Offering Exemption

While the trend over the past ten years has clearly been in favor of imposing concentration limits, the converse question is worth considering. In other words, if a recommendation of over, say, 10 percent of an investor’s portfolio in alternative products is presumed unsuitable, is the converse true? Is an investment of 10 percent or less of the same customer’s net worth in an alternative investment presumed to be suitable? This question is posed in Securities Regulation by Professors Coffee, Sale, and Henderson.[12] John Coffee and his co-authors discuss the Uniform Limited Offering exemption, adopted by NASAA in 1983 under the authority of §19 (d) of the 1933 Securities Act, which was intended to create an exemption from state registration and qualification for certain specified private offerings.[13] While the ULOE references some of the terms and standards in SEC Regulation D,[14] it also contains a suitability standard.[15] According to Coffee and his colleagues, “Even more importantly, [the ULOE] includes a suitability standard for sales to non-accredited investors, which requires that the investment be suitable for the purchaser upon the basis of the facts, if any, disclosed by the purchaser as to other security holdings and as to his financial situation and needs.”[16] The ULOE “then adds a presumption that if the investment does not exceed 10% of the investors’ net worth, it is presumed to be suitable.”[17]

The text of the ULOE provides the following: “For the purpose of this condition only, it may be presumed that if the investment does not exceed 10% of the investors’ net worth, it is suitable.”[18] The ULOE applies to any offer or sale of securities sold under Reg. D Rule 506 (§ 505 having been repealed subsequent to issuance of the ULOE), “including any offer or sale made exempt by application of Rule 508(a).” Thus, thirty-seven years ago, NASAA suggested that at least for some Regulation D issues, a recommendation of no more than 10 percent of an investor’s net worth would be presumed suitable.[19] And while in 2016 NASAA proposed imposing a concentration limit of 10 percent on nontraded REITs, that proposal has yet to pass.

Eleven states have adopted the suitability presumption in the NASAA ULOE. For example, Alabama and Indiana provide a presumption of suitability if an alternative investment does not exceed a specified minority presumption of the investor’s net worth.[20] For Alabama, suitability is presumed if alternatives do not exceed 20 percent of the investor’s net worth; in Indiana, the presumption applies for a recommendation of no more than 10 percent.[21] Tennessee agrees that, for an alternative investment, “It may be presumed that if the investment does not exceed 10% of the sum of the purchasers’ net worth, the investment is suitable.”[22] Louisiana provides that “it may be presumed that if the investment does not exceed 25% of the investor’s net worth, it is suitable.” These various state regulations survived the 2008–2009 financial crisis and the ensuing Great Recession, and, while they harken to an earlier era, they seem to bespeak a more balanced view of customers’ investment portfolios. Thus, at least in some states (by our count eleven), while an overconcentration in alternative securities might be deemed unsuitable, alternatives are presumed to be suitable in smaller doses.[23]

This allocation approach is consistent with the philosophy that suitability must be viewed on balance as a whole and not in isolation. This viewpoint is also consistent with the teaching of the FINRA suitability rule, Rule 2111, which provides that suitability should include an assessment of the customers’ other securities holdings (quantitative suitability), net worth and income, along with other traditional factors such as customers’ risk tolerance and investment objectives.[24]

Moreover, the presumed suitability of relatively modest concentrations is consistent with the teachings of new Regulation Best Interest (Reg. BI), which imposes a three-tiered approach to suitability.[25] Under Reg. BI, a registered representative should consider three aspects of suitability. First, is the investment suitable for anyone? Second, is the investment suitable for this investor? Third, the registered representative must determine whether the recommended quantity is suitable for the customer in question.[26]

This is not to suggest that the presumed suitability of smaller holdings, under 10 percent concentration levels, can be bootstrapped into a substitute for the suitability of a product that is not suitable for anyone or not suitable for this specific customer under any circumstances under Reg. BI. A product that was never suitable for any investor cannot be sanitized by a presumed statutory concentration level. Moreover, there probably are some products that, while objectively suitable, will likely be viewed as unsuitable for particular investors based on the product’s complexity.[27] However, regulators, particularly those in jurisdictions that have been aggressive in securities enforcement, should be mindful of these concentration presumptions in their prosecutions. Moreover, firms that have complied with their state’s concentration guidelines might make the argument that an overall view of a balanced portfolio is more appropriate than the cherry-picking approach favored by some regulators and claimants’ lawyers. If alternative investments, generally, are viewed as a legitimate tool for diversifying a client’s portfolio, it would appear to be unfair to punish an advisor for a small portion of a portfolio that did not produce that same rate of return as equities in a rising market, for example.

The ULOE and Preemption

Any discussion of state blue sky laws should also include a mention of federal preemption. Federal preemption of securities regulation is far from complete, and many blue sky laws, some of which antedated the Securities Act of 1933, exist side by side with their federal counterparts.[28] Yet there are areas of both express and implied preemption. Under the Supremacy Clause of the Constitution, federal law displaces state law where (1) Congress expressly preempts state law; (2) Congress has established a comprehensive regulatory scheme in the area, effectively removing the entire field from the state realm; or (3) state law directly conflicts with federal law or interferes with the achievement of federal objectives.[29]

The National Securities Markets Improvement Act of 1996 (NSMIA) precludes state regulation of enumerated federally regulated securities, including some Regulation D exempt offerings.[30] NSMIA, while permitting state fraud claims, bars state regulation of covered securities, including both listed securities and some transactions exempt from registration.

The Securities Litigation Uniform Standards Act (SLUSA) preempts covered class actions based on state law that alleges a misrepresentation or omission of material fact in connection with the purchase or sale of a covered security, which generally means a listed security.[31] The Supreme Court declined to extend the reach of SLUSA in Chadbourne & Parke LLP v. Troice.[32] The plaintiffs in Troice did not purchase covered securities from the defendants. Rather, they purchased bogus certificates of deposit from fraudster Alan Stanford, which they alleged were going to be used in the future to purchase covered securities on their behalf. Thus, in that case, the victims did not allege that they themselves directly purchased covered securities. Rather, they alleged that they purchased CDs that would be used indirectly in the future to purchase securities. This, the Supreme Court held, was more in line with traditional garden-variety state court fraud, which was traditionally relegated to state court enforcement actions. The Court did not seek to “limit the scope of protection under state laws that seek to provide remedies for victims of garden variety fraud.”[33] The Court reasoned that the intent of Congress was to “protect securities issuers, as well as investment advisors, accountants and brokers who help them sell financial products, from abusive class action cases.”[34] The Court sought to strike a balance between providing relief for federally registered brokers and investment advisors, on the one hand, and allowing traditional state claims on the other, noting that the majority opinion “preserved the ability for investors to obtain relief under state laws when the fraud bears so remote a connection to the national securities market that no person actually believes he was taking an ownership position in that market.”[35]

In Temple v. Gorman, a Florida district court held that state law claims for selling unregistered Regulation D securities are preempted by NSMIA.[36] According to the Temple court:

Regardless of whether the private placement actually complied with the substantive requirements of Regulation D or Rule 506, the securities sold to Plaintiffs are federal “covered securities” because they were sold pursuant to those rules. As a result, FLA. STAT. § 517.07 does not require registration of such securities. Furthermore, any attempt by Florida to require registration of such securities or securities transaction would be preempted by NSMIA. Congress expressed its intent in NSMIA that federal regulations alone should govern the registration of national securities offerings. Where a Form D was filed with the SEC for a transaction that purported to merit an exemption from federal registration pursuant to Regulation D, Florida law could not require duplicative registration or a transactional exemption from registration.[37]

Thus, the Temple court dismissed state law claims on federal preemption grounds, suggesting that future state law claims alleging sale of unregistered securities might face significant headwinds. Other district courts have agreed, noting that “Defendants’ state law failure-to-register claim is preempted because [issuer] Pinnacle purported to sell its stock under the Rule 506 exemption.”[38]

Subsequent decisions have distinguished Temple or questioned its reasoning. For example, the Sixth Circuit Court of Appeals has held that “offerings must actually qualify for a valid federal securities registration exemption in order to enjoy NSMIA preemption.”[39] The Court of Appeals in Brown v. Earthboard Sports USA, Inc. reasoned that NSMIA did not expressly preempt state claims against imperfectly registered exempt securities and concluded that “NSMIA preempts state securities registration laws with respect only to those offerings that actually qualify as ‘covered securities’ according to the regulations that the SEC has promulgated.”[40]

Would application of the ULOE be preempted by federal law? The answer to this question, as is often the case with securities law, depends on the surrounding facts and circumstances. For example, a respondent in a state court regulatory prosecution by local blue sky regulators would presumably be able to avail itself of that state’s version of the ULOE exemption. Thus a hypothetical Tennessee broker-dealer facing regulatory sanctions in a suitability prosecution by the Tennessee State Securities Division would be able to assert the presumption of suitability in that state’s version of the ULOE. On the other hand, the same broker-dealer might face a chillier reception when trying to assert a state statute as a defense to a federal enforcement action brought by the SEC in federal court or before an administrative law judge alleging a violation of federal law.

Closer questions are presented by a regulatory action brought by a self-regulatory organization, such as FINRA, for violation of an SRO rule, especially the suitability provisions of FINRA Rule 2111.[41] FINRA rules approved by the SEC might be candidates for preemption. On the other hand, a private arbitration brought by an individual investor should be defensible by reference to the ULOE, especially if the statement of claim alleges violations of state law.

Conclusion

The Uniform Limited Offering Exemption, approved by the North American Securities Administrators Association in 1983 and adopted, in varying formats, by eleven U.S. states, provides a presumption of suitability for portfolio allocations of up to 10 percent of alternative investments, such as nontraded REITs and limited partnerships. Although the ULOE could be viewed, at least by some investor advocates, as a holdover from the deregulation ethos of the Reagan era, it remains on the books in several jurisdictions (and of the NASAA) and could be used as a defense to a claim of unsuitable recommendations in violation of state blue sky laws. While NASAA has proposed a 10 percent concentration limit for nontraded REITs, that proposal has not been fully adopted.

Whether an individual state’s ULOE rule is preempted by federal law is likely to depend on the nature of the proceeding and the plaintiff bringing the claim. An individual investor bringing a claim alleging a violation of state law, in FINRA or state court, is more susceptible to a defense based on the ULOE than, say, a federal regulatory agency bringing an enforcement action in federal court.

[1] Robert J. Usinger is a graduate of Brooklyn Law School and a claims professional specializing in financial institutions claims. Robert has also worked as a coverage attorney, with a focus on professional liability matters. Barry R. Temkin is a partner at Mound Cotton Wollan & Greengrass LLP and an adjunct professor at Fordham University School of Law, where he teaches broker-dealer regulation. The views expressed in this article are the authors alone and not those of Fordham or Mound Cotton. Arie Smith, an associate at Mound Cotton, contributed to the research and writing of this article.

[2] See Massachusetts Securities Division v. GPB Capital Holdings, LLC, May 2020, https://www.sec.state.ma.us/sct/current/sctgpb/2020-5-27-MSD-GPB-Complaint-E-2018-0100.pdf; Massachusetts Securities Division Newsletter, December 2018, http://www.sec.state.ma.us/sct/sctpdf/newsletters/Securities-newsletter-Dec-2018.pdf.

[3] See Investment News, November 27, 2019, https://www.investmentnews.com/gpb-announces-another-delay-in-release-of-audited-financials-170779.

[4] Massachusetts Securities Division v. GPB Capital Holdings LLC, May 2020, https://www.sec.state.ma.us/sct/current/sctgpb/2020-5-27-MSD-GPB-Complaint-E-2018-0100.pdf.

[5] See Investment News, November 6, 2019, https://www.investmentnews.com/lawsuit-claims-gpb-a-ponzi-riven-with-conflicts-and-self-dealing-170607.

[6] Letter from Warren Buffett to Berkshire Hathaway Shareholders, March 1, 1993, Annual Meeting.

[7] See, e.g., Mass. Securities Division v. Securities America, https://www.sec.state.ma.us/sct/archived/sctfive/SecuritiesAmericaSignedConsentOrder.pdf (10% Concentration limit); In Re LPL Financial, https://securitiesarbitration.com/wp-content/uploads/lpl-financial-complaint.pdf.

[8] See, e.g., Mass. Securities Division v. Securities America, https://www.sec.state.ma.us/sct/archived/sctfive/SecuritiesAmericaSignedConsentOrder.pdf (10% Concentration limit).

[9] See IPA Letter to NASAA, September 12, 2016, https://www.nasaa.org/wp-content/uploads/2016/10/IPA-Comment-letter-Regarding-Proposed-Amendment-to-the-NASAA-Statement-o….pdf.

[10] NOTICE OF REQUEST FOR PUBLIC COMMENT REGARDING A PROPOSED AMENDMENT TO THE NASAA STATEMENT OF POLICY REGARDING REAL ESTATE INVESTMENT TRUSTS, http://nasaa.cdn.s3.amazonaws.com/wp-content/uploads/2016/07/Notice-for-Public-Comment-REIT-Concentration-Limit-07272016.pdf.

[11] See IPA Letter to NASAA, September 12, 2016, https://www.nasaa.org/wp-content/uploads/2016/10/IPA-Comment-letter-Regarding-Proposed-Amendment-to-the-NASAA-Statement-o….pdf.

[12] John Coffee, Hillary Sale, and M. Todd Henderson, Securities Regulation (13th ed., 2013 at 395).

[13] Section 19 (d) of the 1933 Act provides for cooperation, information sharing and an annual conference between the SEC and state securities regulators. 15 USC 77 (s); Uniform Limited Offering Exemption.

[14] 17 CFR §200.501 et seq.

[15] Uniform Limited Offering Exemption Rule 1, D (1).

[16] Coffee, Sale, and Henderson at p. 395.

[17] See Coffee, Sale, and Henderson, Id.

[18] Uniform Limited Offering Exemption Rule 1 D (1).

[19] Uniform Limited Offering Exemption Rule 1, D (1).

[20] Indiana Uniform Limited Offering Exemption 710 IAC 4-2-4; Alabama Limited Offering Exemption 830-X-6-.11.

[21] Alabama Rule 830—X-6-.11; Indiana Regulation Section 710 IAC 4-2-4.

[22] Tenn. Comp. R. & Regs. 0780-04-02-.08(2)(e).

[23] Peter M. Fass and Derek A. Wittner, Appendix 9C. Blue Sky Limited Offering Exemptions, Blue Sky Prac (June 1, 2019).

[24] See FINRA Rule 2111, https://www.finra.org/rules-guidance/rulebooks/finra-rules/2111; FINRA Notices to Members 03-07, 03-71, 05-26, 05-50, and 05-59; FINRA Regulatory Notices 09-31, 09-73, 10-09, 10-22, 10-51, and 12-03.

[25] 17 CFR 240.15I-1.

[26] Regulation Best Interest, 17 CFR § 240.15; Barry R. Temkin and Melissa Tarentino, New regulation BI Become Effective for Broker-Dealer, New York Law Journal (September 25, 2019).

[27] Robert J. Usinger and Todd D. Kremin, How to Sell Complex Financial Products in a Hostile Environment, INVESTMENT NEWS (September 11, 2012).

[28] Section 19 (d) of the 1933 Act assumes the presence of blue sky regulation, and provides for cooperation, information sharing, and an annual conference between the SEC and state securities regulators. 15 USC Section 77s.

[29] Fidelity Federal Savings and Loan Association v. de la Cuesta, 458 U.S. 141, 102 S.Ct. 3014, 73 L.Ed.2d 664 (1982).

[30] 15 U.S.C.A. Section 77r; Thomas Lee Hazen, Treatise of the Law of Securities Regulation (5th Ed. 2005), Section 8.1 [3] at 251; Myers v. Merrill Lynch & Co., 1999 WL 606082 (N.D. Cal. 1999).

[31] 15 USC § 78 (bb)(f)(1). R.W. Grand Lodge of Free and Accepted Masons of PA v. Meridian Capital Partners, Inc., 634 Fed. Appx. 4, at *8-9 (2d Cir. 2015); see also, Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71 (2006).

[32] Chadbourne & Parke LLP v. Troice, 571 U.S. 377, 134 S. Ct. 1038 (2014).

[33] 134 S.Ct. at 1069.

[34] Id. at 1068 (emphasis added).

[35] Id. at 1070.

[36] Temple v. Gorman, 201 F. Supp. 2d 1238 (S.D. Fla.) 2002.

[37] Temple v. Gorman, 201 F. Supp. 2d at 1244. Accord, Pinnacle Communications Int. v. American Fam. Mortg., 417 F. Supp. 2d 1073 (D. Minn. 2006) (“When an offering purports to be exempt under federal Regulation D, any allegation of improper registration is covered exclusively by federal law.”). But see Brown v. Earthboard Sports USA, Inc., 481 F. 3d 901, 910 (6th Cir. 2007) (only registered Regulation D securities preempt state law claims) and Ciuffitelli for Trustee of Ciuffitelli Revocable Trust v. Deloitte & Touche LLP, 2017 WL 2927481 (D. OR. 2017) (“The court concludes NSMIA preemption is limited to securities that actually qualify as covered securities under federal law.”)

[38] Pinnacle Communications Int. v. American Fam. Mortg., 417 F. Supp. 2d 1073 (D. Minn. 2006)

[39] Brown v. Earthboard Sports USA, Inc., 481 F. 3d 901, 910 (6th Cir. 2007).

[40] Brown v. Earthboard Sports USA, Inc., 481 F. 3d at 912.

[41] FINRA Rule 2111, https://w”ww.finra.org/rules-guidance/rulebooks/finra-rules/2111.

The Business Law Section mourns with profound sadness the passing of former Senator Paul Sarbanes. As chairman of the Senate’s Committee on Banking, Housing and Urban Affairs, and the author, together with Representative Michael Oxley, of the landmark Sarbanes-Oxley Act of 2002, Senator Sarbanes was truly the investors’ friend. The Sarbanes-Oxley Act significantly reformed corporate accountability by enhancing the independence and responsibilities of public company audit committees, and  by creating the Public Company Accounting Oversight Board (PCAOB), which was charged with the robust oversight of accounting firms that audit public company and broker-dealer financial statements.  The changes effected by the Sarbanes-Oxley Act were seismic, and many, such as the whistleblower provisions and the requirement for assessments and audits of internal control over financial reporting, were initially viewed as significant challenges by the business community. However, from the vantage of 18 years since the enactment of the Sarbanes-Oxley Act, it is clear that Senator Sarbanes’ prescience and wisdom have not only significantly improved the quality of disclosures to investors, but have impelled public companies to implement internal corporate controls and financial risk assessment procedures that increase the ability of companies to identify and remediate weaknesses before they take on entity-level significance.

We mourn the passing of Senator Sarbanes not only because of his seminal contributions to investor protection, but for far more. His voice was one of civility and reason, and he was never hesitant to work across the aisle to achieve a common goal. His manner was understated, but his impact was considerable.  In our contemporary political landscape, voices like that of Senator Sarbanes are very much missed. To his family and friends, we extend our deepest sympathy.

This article provides an overview of the practicalities of conducting a mediation session by Zoom.

1. Practice, then just do it.

Anyone can do it!  That’s the moral of this story.

A mediation is scheduled for mid-March of 2020.  A week beforehand, having participated in several pandemic-prompted Zoom meetings by then, I announce that the session will be held by Zoom, to maintain distance.  To my surprise, everyone agrees. 

Truth be told, this is terrifying.  Knowing nothing about managing Zoom technology, and sitting in my basement with a laptop and no tech support, I’m on my own.  So my wife, Marilyn, gets on her laptop upstairs, and we practice . . . and practice some more.

Then, counsel for one party guesses that help is needed and offers a practice run—and it is most helpful!

Finally, the mediation session arrives—and Zoom works like a charm.  We start in a joint session, then move each party’s team into separate Zoom rooms—there are eleven separate computers logged in.  Not unlike traditional mediation sessions, we all reconvene in a joint session, and re-separate to the individual Zoom rooms, and continue to switch back and forth between them.

Everyone is forgiving and offers assistance on technical issues—but we make it through, and the case settles!

If it can work for me, anyone can do it! 

2. Joint sessions work particularly well over Zoom.

As a specific example, let’s examine proceedings under the new Small Business Reorganization Act—which is part of Chapter 11 of the Bankruptcy Code and known as “Subchapter V.” Subchapter V requires appointment of a bankruptcy trustee and creates a new trustee duty: to “facilitate the development of a consensual plan of reorganization” (11 U.S.C. § 1183(b)(7)).

This new duty creates a mediator-like role for the trustee.  It isn’t an entirely neutral role because of the trustee’s other duties, such as investigating the debtor’s conduct, opposing debtor’s discharge, weighing-in on plan confirmation and asset sale issues, and enforcing payment obligations.[1]  But, facilitating a consensual result is certainly on the mediator-like spectrum of ADR.

A Zoom facilitation meeting is one step in satisfying this duty.  Here’s how it works, with confidentiality limited to what Rule 408 provides—normal confidentiality rules for mediation can’t apply because of the trustee’s various duties.  [For a discussion of Rule 408 in mediation, see attached Exhibit A.]  Immediately following the § 341 meeting, the debtor, debtor’s attorney, creditors, creditor attorneys, and Subchapter V trustee get together for a Zoom meeting with this agenda:

• Debtor explains the intended action and terms of a proposed plan;
• Creditors explain their views and suggestions thereon; and
• Discussions occur toward reaching agreements.

In a facilitation meeting like this, everyone needs to hear what is being discussed.  So, a joint session works best—bouncing back and forth among caucused parties would not work here.

These facilitation meetings, in joint session, can be helpful.  I remember going into one such meeting thinking, “There is no way to achieve a consensual plan, based on what’s in the schedules.”  But, lo and behold, the explanation by debtor’s counsel under the first agenda item presented a perfectly plausible strategy.  And all creditors were immediately on board—they had a lot of questions and were skeptical of debtor’s ability to pull the strategy off, but they were most definitely cheering for the debtor to make it work.

It’s the joint session that makes a facilitation meeting’s three-part agenda successful.  And the Zoom-created social distance between participants even helps reduce any discomfort that may exist between disputing parties.   

3. Related processes demonstrate that Zoom mediation is here to stay.

Depositions and bench trials with warm-body testimony are also happening by Zoom—everywhere.  And like mediations and facilitations, the Zoom technology is working well there too.  Here are a couple examples.

a. Deposition

A deposition occurs with the witness, attorneys, parties and court reporter in far flung locations.  There are twenty exhibits, with advance copies delivered to everyone by email.

Then, after the witness is sworn and testimony is moving forward, the attorney taking the deposition pulls up one of the exhibits on the Zoom share screen and uses the cursor to highlight a sentence in the exhibit for discussion.  After reviewing pertinent portions of that exhibit, the attorney moves through the exhibits, one by one, in a similar manner.

This works well—and the savings in travel time and costs are significant.

It’s my new favorite way of taking a deposition.

b. Bench Trial

Imagine a judge sitting in a courtroom in one city, attorneys sitting in their offices in three other locations across the country, and the witness sitting in an attorney’s office in an entirely different location.  Zoom pulls them all together for a bench trial—as if they were all together in the same room.

There are some quirks like dealing with a glitch or two in technology, and what qualifies as “unavailable” under Rule 804 for hearsay purposes?  [For a discussion of Rule 804, see attached Exhibit B.]

But the Zoom process works well.  And savings in travel time and costs, alone, can be huge.

It’s my new favorite way of doing a bench trial.

Conclusion

Zoom has revolutionized our world, in this distancing-focused environment.

Legal processes, including mediation, are the beneficiaries of such change.  And what we are finding is this: the change is incredibly positive and is, therefore, here to stay.

As silver linings go, Zoom mediations seem to be one.

Exhibit A

MEDIATION CONFIDENTIALITY: FEDERAL EVIDENCE RULE 408 LEAKS LIKE A SIEVE

Hypothetical:  A Chapter 11 Debtor successfully mediates confirmation disputes with a half-dozen creditors.  Now, a hold-out creditor moves for discovery of the mediation communications in an effort to torpedo plan confirmation.

The mediating parties come to realize that their Bankruptcy Court has no local rule requiring mediation confidentiality.  And, of course, there is no Federal bankruptcy rule on mediation confidentiality, either.

Uh, oh!

So, the mediating parties set their sights on the Federal rule of evidence that protects confidentiality of settlement negotiations.  Hopefully, they think, Fed. R. Evid. 408 (“Rule 408”) will stand in the gap for arguing that their mediation communications are privileged.

Rule 408

Rule 408 prohibits admissibility of the following types of evidence to prove or disprove the validity or amount of a disputed claim or to impeach:

1. 1. Promising, or offering to settle; and
2. Conduct or a statement made during compromise negotiations about the claim.

The two ideas behind Rule 408, according to its official Notes, are:

• Irrelevance: settlement negotiations may be motivated by a desire for peace or by a multitude of other reasons that have nothing to do with the merits of the case; and
• Policy: confidentiality promotes a policy of favoring the settlement of disputes.

Unfortunately, the evidence protection afforded by Rule 408 leaks like a sieve.  Here are some reasons why:

Sieve-like Exceptions

1. Enumerated Exceptions. Rule 408 allows the court to admit settlement-related evidence “for another purpose.” Examples provided in the rule include proving a witness’s bias or prejudice or negating a contention of undue delay.
2. Judicial Exceptions. Settlement discussions have been admitted to:

• Establish that the threshold amount-in-controversy exists for Federal diversity jurisdiction;
• Determine when a statute of limitations began to run;
• Determine the reasonableness of an attorney fee award; and
• Determine whether a settlement agreement has been performed or breached.

3. Discovery Leaks. Sieve-like leaks in the Rule 408 privilege are even more pronounced in the context of discovery.

Fed. R. Civ. P. 26(b) authorizes discovery of any nonprivileged matter that is relevant to any party’s claim or defense.  Rule 26(b) is incorporated into bankruptcy contexts by Fed. R. Bankr. P. 7026 & 9014(c).

Based on such discovery-rule language, and since Rule 408 “does not provide a blanket ban” on admissibility, “most courts reject a discovery privilege for settlement-related materials.”[2]

So, the following advice is important: “it is wise to assume that settlement-related evidence will be discoverable”[3] (emphasis added).

Conclusion

Put another way, Rule 408 is a rule that limits admission of evidence—it is NOT a rule that limits discovery of information.  Accordingly, it is unwise to rely on Rule 408 for maintaining the confidentiality of mediation information.  

Exhibit B

“UNAVAILABLE” WITNESS (UNDER HEARSAY RULES) IN A ZOOM TRIAL?

Many bench trials are occurring these days via Zoom and similar platforms (I’ll refer to all such platforms, collectively, as “Zoom”).

But Zoom trials raise interesting—and solvable—issues.  For example, witness availability is a crucial factor in hearsay provisions of the Federal Rules of Evidence.  So, what qualifies as witness “unavailability” in a Zoom trial?

1. Hearsay Rules

a. Availability—Irrelevant

Rule 803 says, “The following are not excluded by the rule against hearsay, regardless of whether the declarant is available as a witness.” (emphasis added)  Rule 803 identifies 24 such hearsay exceptions, including:

• present sense impression,
• excited utterance,
• then-existing mental, emotional, or physical condition,
• statement made for medical diagnosis or treatment,
• recorded recollection,
• records of a regularly conducted activity,
• public records,
• certificates of marriage, baptism, and similar ceremonies,

b. Unavailability—Required

Rule 804(b) says, “The following are not excluded by the rule against hearsay if the declarant is unavailable as a witness.” (emphasis added) Rule 804(b) identifies five such hearsay exceptions:

• former testimony,
• statement under belief of imminent death,
• statement against interest,
• statement of personal or family history, and
• statement offered against a party that wrongfully caused the declarant’s unavailability.

c. Unavailability—Criteria

Rule 804(a) says, “A declarant is considered to be unavailable as a witness if the declarant” (emphasis added) fits into one of the Rule 804(a) identified categories of unavailability:

• the witness is exempted from testifying because a privilege applies,
• the witness refuses to testify despite a court order to do so,
• the witness does not remember the subject matter,
• the witness cannot be present or testify because of death, infirmity, or physical or mental illness, or
• the witness is absent and cannot be compelled to attend or testify.

None of these criteria apply when a party, in an effort to prevent a witness from testifying, causes the witness to be unavailable.

2. Zoom and Availability.

Zoom raises a new set of issues centering on this question: How do hearsay rules on an “unavailable” witness work in a Zoom trial? 

Examples of such issues are these:

1. How can a witness be compelled “by process or other reasonable means” (Rule 804(a)(5)) to attend and testify in a Zoom trial?
2. What would a subpoena say to compel the attendance of a witness at a Zoom trial?
3. When a witness from New Mexico is subpoenaed to testify at a Zoom trial before a court in New Hampshire, can the New Hampshire court issue the subpoena?
4. What happens when the witness attempts to attend a Zoom trial but can’t get the technology to work?

Such issues will, undoubtedly, be easily and quickly solved.  But until the solutions are identified, witness availability will provide one more set of uncertainties and headaches that a litigator must manage in trial preparations. 

Conclusion

Zoom is revolutionizing litigation processes. 

One fallout from Zoom changes involves the in-person testimony of a witness at trial—and associated evidence rules on witness availability.  I’m sure that solutions to such issues will be simple and easily achieved, but it will be interesting to see the solutions that courts develop. 

[1] A Subchapter V trustee’s statutory duties are described in 11 U.S.C. § 1183(b) like this:

(b) Duties.—The trustee shall—(1) perform the duties specified in paragraphs (2), (5), (6), (7), and (9) of section 704(a) of this title; (2) perform the duties specified in paragraphs (3), (4), and (7) of section 1106(a) of this title, if the court, for cause and on request of a party in interest, the trustee, or the United States trustee, so orders; (3)appear and be heard at the status conference under section 1188 of this title and any hearing that concerns—(A) the value of property subject to a lien; (B) confirmation of a plan filed under this subchapter; (C) modification of the plan after confirmation; or (D) the sale of property of the estate; (4) ensure that the debtor commences making timely payments required by a plan confirmed under this subchapter; (5) if the debtor ceases to be a debtor in possession, perform the duties specified in section 704(a)(8) and paragraphs (1), (2), and (6) of section 1106(a) of this title, including operating the business of the debtor; (6) if there is a claim for a domestic support obligation with respect to the debtor, perform the duties specified in section 704(c) of this title; and (7) facilitate the development of a consensual plan of reorganization.

[2] Gerald E. Burns, Admissibility of Settlement-Related Evidence at Trial, American Bar Association, July 31, 2013. 

[3] Id.

Constitutional authority begins with the Constitution itself. The Constitution vests the federal judicial power in Article III courts. Article III judges are distinguished by two characteristics: they hold their offices during good behavior and receive compensation that will not be diminished while in office. Bankruptcy judges are not Article III judges. The authority to establish bankruptcy courts is instead found in Article I of the Constitution, which gives Congress the power “[t]o establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.”

Today, the Bankruptcy Code, found in title 11 of the United States Code, contains nearly all the applicable uniform federal bankruptcy law. But district courts, not bankruptcy courts, have original and exclusive jurisdiction of all cases under title 11. District courts have the option, however, to provide that those cases will be referred to the bankruptcy judges for their districts. District courts also have the option to refer proceedings to the bankruptcy judges for their districts if the proceedings fit into one of three categories: (1) arising under title 11, (2) arising in a case under title 11, or (3) related to a case under title 11. If the proceedings fit into one of the first two categories, they are “core” proceedings; therefore, bankruptcy judges may hear and determine them. But if the proceedings are only related to a case under title 11, bankruptcy judges are limited to hearing them and submitting proposed findings of fact and conclusions of law to the district court.

Sometimes there are challenges as to whether Congress has passed a law that exceeds its constitutional authority. These challenges may arise in the bankruptcy context. One recent example is a challenge to a bankruptcy judge’s authority under 28 U.S.C. § 157(b)(2)(C). That provision provides bankruptcy judges with authority to hear and determine “counterclaims by the estate against persons filing claims against the estate” because they are—as described above—“core” proceedings. In Stern v. Marshall, the Supreme Court of the United States addressed this provision. In that case, Vickie Lynn Marshall filed for bankruptcy, her deceased husband’s son filed a claim against her, and then she filed a counterclaim for tortious interference against him. Although the Supreme Court found that the bankruptcy court had statutory authority to hear and determine the claim, it held that the bankruptcy had no constitutional authority to do so. That constitutional authority, the Supreme Court held, belonged to Article III courts.

Restructuring of the Debtor-Creditor Relationship

The test for whether a bankruptcy judge has constitutional authority to hear and determine a proceeding is whether it is integral to the restructuring of the debtor-creditor relationship. Stern v. Marshall, 564 U.S. 462, 497 (2011) (“We explained [in Langenkamp] that a preferential transfer claim can be heard in bankruptcy when the allegedly favored creditor has filed a claim, because then ‘the ensuing preference action by the trustee become[s] integral to the restructuring of the debtor-creditor relationship.’” (citing Langenkamp v. Culp, 498 U.S. 42, 44 (1990) (per curiam)); Langenkamp, 498 U.S. at 44 (“In other words, the creditor’s claim and the ensuing preference action by the trustee become integral to the restructuring of the debtor-creditor relationship through the bankruptcy court’s equity jurisdiction. . . . As such, there is no Seventh Amendment right to a jury trial.” (citing Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 57–58 (1989)); Granfinanciera, 492 U.S. at 58–59 (“Because petitioners here, like the petitioner in Schoenthal, have not filed claims against the estate, respondent’s fraudulent conveyance action does not arise ‘as part of the process of allowance and disallowance of claims.’ Nor is that action integral to the restructuring of debtor-creditor relations. Congress therefore cannot divest petitioners of their Seventh Amendment right to a trial by jury.” (emphasis added)); N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 71 (1982) (plurality opinion) (“[T]he restructuring of debtor-creditor relations, which is at the core of the federal bankruptcy power, must be distinguished from the adjudication of state-created private rights, such as the right to recover contract damages that is at issue in this case.”).

Proceedings that are integral to the restructuring of the debtor-creditor relationship may be limited to proceedings to collect a debtor’s property, resolve claims by creditors, order the distribution of assets in the estate, and ultimately discharge the debts. This explanation is qualified by may be because the Supreme Court has yet to provide a complete list of proceedings that are integral to the restructuring of the debtor-creditor relationship. But this explanation is consistent with the Supreme Court’s decisions on the constitutional authority of bankruptcy courts (or bankruptcy referees in Katchen).

Integral to the Restructuring:

• In Katchen v. Landy, 382 U.S. 323 (1966), the Court held that a bankruptcy referee (similar to a bankruptcy court today) had constitutional authority to hear and determine a proceeding to resolve claims by creditors. The bankruptcy trustee brought a voidable preference claim against a creditor who had filed a proof of claim in the bankruptcy proceeding. The referee could not rule on the creditor’s proof of claim without first resolving the voidable preference issue.
• In Langenkamp v. Culp, 498 U.S. 42 (1990) (per curiam), the Court held that a bankruptcy court had constitutional authority to hear and determine a proceeding to resolve claims by creditors. The bankruptcy trustee brought a preferential transfer claim against an allegedly favored creditor who had filed a claim.

Not Integral to the Restructuring:

• In Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982) (plurality opinion), the Court held that a bankruptcy court could not hear and determine a reorganizing debtor’s suit against a third party seeking damages for alleged breaches of contract and warranty, as well as for alleged misrepresentation, coercion, and duress.
• In Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989), the Court held that a bankruptcy court could not hear and determine a fraudulent conveyance action filed by a bankruptcy trustee on behalf of a bankruptcy estate against a non-creditor.
• In Stern v. Marshall, 564 U.S. 462 (2011), the Court held that a bankruptcy court could not hear and determine a debtor’s counterclaim for tortious interference.

A recent dissent by Chief Justice John Roberts, the author of the majority opinion in Stern, provides another piece of the what-is-integral-to-the-restructuring puzzle. In Wellness International Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015), the Chief Justice dissented because the majority decided the case on broad grounds where narrower would have done. One paragraph of his opinion is key. He explains that the bankruptcy court’s constitutional authority to adjudicate is based on historical practice—specifically the practice when the founders drafted the Constitution in 1787. At that time, “English statutes had long empowered nonjudicial bankruptcy ‘commissioners’ to collect a debtor’s property, resolve claims by creditors, order the distribution of assets in the estate, and ultimately discharge the debts.” Wellness, 135 S. Ct. at 1951 (Roberts, C.J., dissenting) (citing 2 W. Blackstone, Commentaries *471–88).

This view of the constitutional authority of bankruptcy courts is also consistent with the Supreme Court’s view of the constitutional authority of Article III courts. Article III judges are responsible for deciding suits that are “made of ‘the stuff of the traditional actions at common law tried by the courts at Westminster in 1789,’ . . . and [are] brought within the bounds of federal jurisdiction.” Stern v. Marshall, 564 U.S. 462, 484 (2011) (citing N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 90 (1982) (Rehnquist, J., concurring in judgment)). In the same vein, bankruptcy judges would be responsible for deciding suits that are made of the stuff that English bankruptcy commissioners decided in 1789. But the Supreme Court has yet to decide how far the constitutional authority of bankruptcy courts to adjudicate might extend beyond the power that English bankruptcy commissioners had in 1789.

Consent to Adjudication

In Wellness International Network, Ltd. v. Sharif, 135 S. Ct. 1932 (2015), the Supreme Court held that a bankruptcy judge can adjudicate claims for which litigants are constitutionally entitled to adjudication by an Article III judge if one condition is met: the parties knowingly and voluntarily consent to adjudication by that bankruptcy judge. In other words, bankruptcy litigants can waive the right to Article III adjudication of Stern claims. Stern claims are those that the bankruptcy courts have statutory but not constitutional authority to hear and determine. In Wellness, the Supreme Court also emphasized that such consent need not be express; it can be implied. But such consent must still be knowing and voluntary.

Public Rights Doctrine

The Supreme Court first described the public rights doctrine in Murray’s Lessee v. Hoboken Land & Improvement Co., 59 U.S. 272 (1856). In essence, that doctrine provides non-Article III courts with a constitutional basis to resolve matters that involve public rights. Bankruptcy courts are non-Article III courts. The Supreme Court has addressed the application of the public rights doctrine in the bankruptcy context, but it has yet to hold that the public rights doctrine provides bankruptcy courts with constitutional authority to hear and determine proceedings. See Stern v. Marshall, 564 U.S. 462, 493 (2011) (“Vickie’s counterclaim—like the fraudulent conveyance claim at issue in Granfinanciera—does not fall within any of the varied formulations of the public rights exception in this Court’s cases.”); N. Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 71 (1982) (plurality opinion) (“Finally, the substantive legal rights at issue in the present action cannot be deemed ‘public rights.’”).

Nonconsensual Third-Party Releases in Chapter 11 Plans

Chapter 11 debtors sometimes file a plan of reorganization with third-party releases. These provisions may release the claims of creditors against third parties. If a creditor votes against the plan, the third-party releases are termed nonconsensual. The courts of appeals are split as to whether circumstances exist when a bankruptcy court may confirm a chapter 11 plan with nonconsensual third-party releases. See Collier Bankruptcy Practice Guide ¶ 84.02[1][c][v] (citing decisions from the First, Second, Fourth, Fifth, Sixth, Seventh, Ninth, Tenth, Eleventh, and D.C. circuits).

The Third Circuit recently addressed whether a bankruptcy court had constitutional authority to confirm a Chapter 11 plan with certain nonconsensual third-party releases. In In re Millennium Lab Holdings II, LLC, 945 F.3d 126 (3d Cir. 2019), the court held that the bankruptcy court had such authority.

In that case, Millennium provided laboratory-based diagnostic services. In 2015, the U.S. Department of Justice filed a complaint against Millennium, and then the Centers for Medicare and Medicaid Services notified Millennium that its Medicare privileges were being revoked. Millennium then reached an agreement in principle with the DOJ and CMS, but it did not have enough money to make the required settlement payment. Adding to its liquidity problems, Millennium had entered into a $1.825 billion credit agreement one year earlier.

To settle with the government, Millennium had to negotiate a transaction with its lenders. After negotiations, Millennium, its equity holders, and an ad hoc group of lenders entered into a restructuring support agreement. As part of the agreement, Millennium’s equity holders transferred 100% of the equity interests in Millennium to the company’s lenders. In exchange, some equity holders and various others received broad releases: the releases covered all claims arising from conduct before the agreement (including anything related to the above credit agreement).

After entering into the agreement, the parties failed to reorganize Millennium out of court. Next, Millennium filed its petition for bankruptcy. Millennium submitted a prepackaged plan of reorganization, which reflected the terms of the agreement. But a variety of funds and accounts, collectively referred to as Voya, objected to confirmation of the plan. Voya asserted it had significant legal claims against Millennium and its equity holders—claims that would be released by confirmation of the plan. In sum, Voya argued that the bankruptcy court lacked constitutional authority to confirm the plan with the specific releases. On appeal, the Third Circuit held that the bankruptcy court had constitutional authority to confirm the plan.

At first blush, the constitutional authority of a bankruptcy court in this context is difficult to determine. To begin with, the Supreme Court has provided few examples of what a bankruptcy court is authorized to determine under the Constitution. In Katchen, a bankruptcy referee (similar to a bankruptcy court today) could determine a proceeding in which a bankruptcy trustee brought a voidable preference claim against a creditor who had filed a claim. In Langenkamp, a bankruptcy court could determine a proceeding in which a bankruptcy trustee brought a preferential transfer claim against an allegedly favored creditor who had filed a claim. That’s about it. The Supreme Court has provided more examples of what the bankruptcy court is not constitutionally authorized to determine.

Relying on Supreme Court precedents, however, the Third Circuit in Millennium concluded that the bankruptcy court had constitutional authority to determine the proceeding at issue. And the court limited its holding to the “specific, exceptional facts of this case.” These are the specific, exceptional facts that the court identified:

• The released parties were not willing to make their contributions under the plan without the releases and the enforcement of such releases through the plan’s injunction provisions.
• Without the contributions of the released parties, the debtors would have been unable to satisfy their obligations under the settlement with the government, no chapter 11 plan would have been feasible, and the debtors likely would have shut down upon revocation of their Medicare enrollment and billing privileges.
• The record made abundantly clear that the release provisions were agreed to only after extensive, arm’s length negotiations.

The court found that, under these facts, the release provisions were integral to the restructuring of the creditor-debtor relationship. For that reason, the court concluded that the bankruptcy court had constitutional authority to confirm the chapter 11 plan with those releases.

On March 18, 2020, Voya filed a petition for a writ of certiorari. Voya argued that the Millennium decision has created a circuit split concerning the proper test for determining the scope of a bankruptcy court’s constitutional authority to enter final judgment under Stern. Voya also argued that recent decisions of the Supreme Court have undermined the legal basis for the equitable mootness doctrine. On May 26, 2020, the Supreme Court denied Voya’s petition.

Conclusion

A bankruptcy judge has constitutional authority to hear and determine a proceeding if it is integral to the restructuring of the debtor-creditor relationship. When the founders drafted the Constitution, empowering Congress to establish uniform laws on bankruptcy, the bankruptcy power in England was exercised by bankruptcy commissioners. In 1787, those bankruptcy commissioners collected a debtor’s property, resolved claims by creditors, ordered the distribution of assets in the estate, and ultimately discharged the debts. The Supreme Court has yet to explain how far the constitutional authority of bankruptcy courts to hear and determine proceedings might extend beyond proceedings of that kind. In Millennium, the Third Circuit recently held that—under specific, exceptional facts—a bankruptcy court had constitutional authority to confirm a chapter 11 plan with nonconsensual third-party releases.