This two-part series of articles has been abridged and adapted from the chapter “Analysis of Cost Behavior” by Elizabeth A. Eccher, Jeffrey H. Kinrich, and James H. Rosberg, in the book Lost Profits Damages: Principles, Methods, and Applications, edited by Everett P. Harry III and Jeffrey H. Kinrich (Valuation Products and Services, 2017).

In Part One of this series, we discussed concepts relevant to calculating avoided costs, a key step in calculating lost profits. In this article, we illustrate the use of these concepts in determining avoided costs.

Identifying the Cost Objects Comprising Lost Sales

The analysis of avoided costs logically follows, and depends on, an analysis of lost sales revenue, which is in turn a function of the quantity of products or services that were not sold and the price that would have been received if the sales had occurred. Therefore, for each cost object comprising the lost sales, the cost analysis requires consideration of the following questions:

• How many units of each product or service would have been sold?
• Over what time period(s) would the sales have occurred?
• At what prices would sales have occurred?

The total amount of any costs that are determined to be variable—and hence potentially avoided—will depend directly on the quantity of product that would have been manufactured and sold. In addition, because fixed costs may be fixed only with respect to a relevant range of time and activity, it is important to know whether the quantity of lost sales falls within or outside of that range. As discussed further below, the price of a lost sale may be relevant for certain incremental marketing costs, such as sales commissions.

Identifying Resources Involved in Producing the Product or Service

As discussed in Part 1, costs arise through the consumption of resources. Therefore, the analyst should gain an understanding of the resources and activities required to make the lost sales products or services. To gain this understanding, the analyst should consider the following:

• Are direct materials required?

These may include raw materials, such as steel or silicon, as well as components, such as batteries or circuit boards. Direct materials almost always result in variable, and thus incremental or avoidable, costs.

• Is direct labor required?

Labor costs depend on the nature of the contracts between employer and employees, which may affect the variability of these costs.

• Are productive assets (i.e., capital investments) used in the production process?

Machinery use, for example, can give rise to indirect costs, such as set-up, calibration, operating supplies, and routine maintenance. Similarly, the use of a factory or other building can give rise to indirect costs related to ongoing maintenance and other operating overhead costs, such as for electricity, other utilities, and security.

Identifying the Resources Involved in Selling and Delivering the Product or Service

In addition to production costs, the company may incur costs related to delivering and selling the product or service in question, as well as costs related to future obligations resulting from a sale. The following considerations will be relevant to this assessment:

• How are sales generated? Is there a direct sales force that receives a sales commission?
• Does the seller bear the cost of transporting the products to buyers? If so, the behavior of transportation/delivery costs should be analyzed.
• Is the product or service covered by a warranty or other contract that will give rise to expected costs in the future? Warranties obligate the seller to guarantee certain aspects of product performance after delivery.
• Is additional capital required to produce a good or service and, if so, at what cost? For example, the company may have accounts receivable or may purchase and hold relevant inventory. Whether the funds are provided by the company or sourced externally, the company is incurring a cost by using funds from which it could otherwise earn a return on investment.

Identifying the Cost Data Available for Analysis

For financial reporting under generally accepted accounting principles (GAAP), firms must calculate the cost of products they produce or purchase and transfer those costs from an inventory account to an expense called cost of goods sold (COGS) as the products are sold. COGS often include, however, both direct costs that can be traced to products and indirect costs, such as warehousing or depreciation costs, that may be unlikely to change as sales volume increases, at least within a relevant range. Nevertheless, the unit costs calculated under GAAP can provide a useful starting point, particularly if the underlying financial records allow the analyst to disaggregate unit costs into components (such as materials, labor, and various types of overhead) that can be further analyzed.

Beyond the cost systems used for financial reporting, firms sometimes maintain internal records and systems to support their own cost-management efforts.

Developing Hypotheses about Likely Cost Behaviors

When developing hypotheses about cost behavior, the central question is: What incremental costs must be incurred to develop, produce, and sell the good or service within the relevant time frame and range? In some cases, strong hypotheses about cost behavior exist at the outset of the analysis.

As mentioned in Part 1, though, expected cost behavior may not be as clear-cut for other resources. Consider direct labor costs in automobile manufacturing. Unlike direct materials, labor is not usually purchased by the unit (e.g., by the hour or even by the day). Rather, employees often have labor contracts that limit the firm’s ability to terminate employment over short periods. Thus, labor is one example of a cost for which it is important for an analyst to carefully assess cost behavior in order to determine whether the cost can be expected to vary (or not) with incremental sales volumes over specific periods.

Testing the Hypotheses

Two of the most common methods used to test cost behavior and estimate avoided costs are account analysis and regression analysis. We discuss and illustrate each in turn.

Account Analysis

Account analysis (sometimes called the direct assignment method) is a simple but often valuable method for identifying fixed and variable costs. The analyst reviews the historical income statements or a detailed general ledger and judges whether costs reflected in each account are fixed or variable based on experience, observation of the accounts’ behavior, review of the business’s contracts, and consultation with other sources of expertise. This background provides valuable information about how costs relate to activities and how both activities and costs behave with respect to changes in production or sales volumes.

Although account analysis can be a useful tool for analyzing cost behavior, accounting data are often “messy” due to changes in accounting practices over time, the presence of amortized or allocated costs, and end-of-quarter or end-of-year adjustments, among other issues. These data problems can lead to nonsensical results; thus, it is often informative to combine account analysis with other tools, such as regression analysis.

Regression Analysis

Regression analysis is a generally accepted statistical method used to measure the degree and nature of association between a dependent variable (the variable the analyst seeks to explain) and one or more independent variables (the variables hypothesized to cause the behavior of the dependent variable). That is, the analyst seeks to measure the association of the rate of change of a dependent variable with the rate of change of independent variables.

In the context of lost-profits analysis, costs are typically the dependent variable, whereas measures of activity (such as inputs to or from manufacturing processes or units sold) are typically among the independent variables. Analysts might use regression analysis when they have data for a dozen or more time periods for two or more particular costs or volumes and want to find a relation that can predict one value given the others.

Although the mathematics behind regression analysis may be complex, it is a powerful tool with which to measure the extent of the correlation between dependent and independent variables.

Developing Conclusions, Subjecting Them to “Sanity Checks,” and Revising

A common refrain in scientific analyses is that “correlation is not causation.” Regression analysis may yield spurious results, such as finding a statistically significant relationship between cost and sales (or production) that does not reflect a causal relationship, or failing to find a statistical relationship when a causal relationship does exist. Moreover, regression analysis may fail to identify an actual incremental cost when measures of cost are not recorded when they are incurred. For example, depreciation of capital equipment is typically recorded according to a preset formula, not according to the intensity of use of the machinery. Therefore, a regression analysis of depreciation cost will typically not find a statistically significant relationship with production even if machinery does wear out in proportion to its usage.

Given the potential for spurious results, the analyst must confirm any cost estimate, statistical or otherwise, as reasonable. Accepted testing methods include:

• Comparing the results of more than one estimation method. If the results are reasonable, both methods should yield approximately the same results; if results differ, reasonable explanations should exist for any discrepancy.
• Comparing the results to actual experience. For example, compare estimated costs at historical volumes to actual historical costs. Compare results at an assumed but for volume with historical results (at some other date) for roughly the same volume. The results need not be identical, but differences should be reasonable.
• Comparing the results to independent cost estimates. The company may have forecast costs as part of a business plan before the alleged misconduct. Industry statistics can also provide a useful baseline.
• Considering the intrinsic reasonableness of the results. Do costs increase with volume? Do they behave appropriately compared to changes in production capacity? In short, do the results make sense?
• Considering the insights and experience of company management, industry analysts, and experts on the particular production process.

Conclusion

Cost estimation is an important part of a lost-profits analysis. By understanding cost behaviors and using the tools of cost accounting, statistics, economics, and industrial engineering, the analyst can produce defensible estimates of incremental costs. If the tools are applied by rote or without sufficient consideration of the context, the results of the analysis will not be reliable.

Read Part One of this series.

Elizabeth A. Eccher is a principal in the Chicago office of Analysis Group, Inc.; Jeffrey H. Kinrich is a managing principal in the company’s Los Angeles office; and James H. Rosberg is a vice president in the San Francisco office.

This two-part series of articles has been abridged and adapted from the chapter “Analysis of Cost Behavior,” by Elizabeth A. Eccher, Jeffrey H. Kinrich, and James H. Rosberg, in the book Lost Profits Damages: Principles, Methods, and Applications, edited by Everett P. Harry III and Jeffrey H. Kinrich (Valuation Products and Services, 2017).

In many lawsuits, a plaintiff may recover damages for lost profits. For a given time period, profit equals the difference between sales revenues and the costs or expenses required to generate those revenues. When revenues are (wrongfully) diminished, costs are often reduced as well. Therefore, computing lost profits requires computing not only lost sales revenues, but also the resulting avoided costs that would have been required to generate those sales (also referred to as saved expenses or incremental costs). Think of it as a simple equation:

Lost Profits = Lost Revenues – Avoided Costs

Although proper calculation of avoided costs is thus essential to calculating lost profits, it is not as straightforward as it may seem, and it often becomes a point of contention between damages experts. The higher the costs that can be attributed to a sale, the lower the profit from that sale. This can lead to disagreements between a defendant’s expert and a plaintiff’s regarding both the nature of the costs associated with lost sales and the amount of those costs.

In what follows, we lay out the basic concepts behind avoided costs and offer analytical guidelines as to their proper calculation.

Fundamental Cost Concepts

We begin with costs themselves, which are measures of resources used or foregone to achieve a particular objective. A cost object is something that a cost measures—it could be a physical object, a service, or an activity.

An example of a physical product that is a cost object is a bicycle. Costs associated with manufacturing and selling the bicycle would arise from acquisition or production of the bicycle’s components, labor used to assemble the components into a bicycle, distribution of the bicycle to retailers, and so on.

An example of a service that is a cost object is the customization of a database software package. Here, the relevant costs could include those associated with sales and marketing, developers’ time to do the required development work, and ongoing development to maintain and update the program.

An understanding of the different ways to classify costs is essential for an accurate calculation of avoided costs. We describe some of the basic distinctions below.

Variable, Fixed, and Semi-variable Costs

The first important dimension to consider is whether costs are variable or fixed. Variable costs vary with respect to changes in the underlying activity or volume/quantity. In the bicycle example, if each bicycle requires two pedals, and the company purchases each pedal for $3, the pedal cost is a variable cost of $6 per bicycle. This cost is variable because the total cost varies in constant proportion to the number of bicycles produced.

Fixed costs, by contrast, do not change in response to changes in the volume of activity over a specified time period or range of volume. Consider rent for factory space under a lease that requires a monthly payment of $2,000. Although the company’s production volume may fluctuate from one month to another, the rent remains a constant fixed cost of $2,000 per month.

Fixed costs, however, may not always remain fixed. A lease may expire, causing the rent to increase or decrease. Over a long enough period of time and a large enough change in volume, nearly every cost becomes variable. Thus, fixed costs are typically fixed for a limited period (e.g., the monthly rent can increase or decrease after the lease expires), and only over a relevant range of activity (e.g., a large change in production volume may require a change in production facilities or equipment).

Therefore, in assessing whether a cost is fixed, a critical consideration is “fixed with respect to a particular period and a relevant range of activity.” Costs that are fixed over a certain range but change outside that range are sometimes referred to as step costs.

Finally, the term semi-variable costs refers to those costs that have both a fixed and a variable component, for example a telephone service contract that charges an “access” cost of $10 per month that includes 300 minutes of connection time plus a usage cost of $0.05 for each minute beyond 300.

Direct and Indirect Costs

Another important distinction is between direct and indirect costs. Direct costs are those that can be traced in an economically feasible or cost-effective way to a particular cost object, whereas indirect costs cannot. Typically, companies record indirect costs in cost pools and then make allocations from these pools to calculate the full cost of a product or service.

Continuing with our bicycle example, the direct costs for the product include the pedals and other components that are purchased from outside vendors. The cost of each pedal is directly traceable to the cost object (the bicycle). By contrast, consider a production supervisor whose job entails oversight of a number of projects, one of which involves bicycles. The supervisor’s salary is an indirect cost that cannot be traced directly to the cost object (the bicycle) in a straightforward way. Such indirect costs have become a greater proportion of total product costs in recent years, making their analysis and estimation increasingly important.

Analysis of Cost Behavior

Why are these distinctions important? Why should they matter for the project of determining lost profits?

The answer is that, as a general rule, fixed costs should not be deducted from lost sales during the lost profits calculation. In a simplified case, only variable costs that change according to the volume of lost sales should be taken into account. Similarly, indirect costs that cannot be traced to the lost sales of a particular cost object should be excluded from the avoided costs calculation; only direct costs and those indirect costs that can be traced to lost sales of a particular cost object should be included as saved expenses. This is because, in many cases, traceable costs tend to behave as variable costs, whereas untraceable costs tend to behave as fixed costs.

To take a rather basic example, think of our bicycle manufacturer, which claims it has lost sales of a specific number of bicycles due to a competitor’s allegedly illegal actions. If the company does not purchase the pedals that would have gone into the manufacture of those bicycles, the cost of those pedals is a direct (traceable to the cost object of the bicycle) variable (with the number of bicycles that were not sold) cost, and hence an avoidable cost. By contrast, the rent on production space, which would have to be paid regardless of the disruption, is a fixed cost that is not avoidable. A portion of a production supervisor’s salary that cannot be traced to bicycle production in a straightforward way is an indirect cost that also may not be relevant for the saved expenses calculation.

Although this may sound straightforward, these distinctions are rarely so clear-cut when it comes to multifaceted, real-world businesses. In particular, the line between fixed and variable costs may prove especially complex in certain cases. Consider a business that has suffered a disruption and wants to argue that it would have significantly ramped up its production volume (and hence its profits) but for the disruption.

In this scenario, certain costs that would have been considered as fixed in the existing circumstances should be considered as variable in the “but for” world; examples could include increased rent for a larger factory space, or additional labor costs to meet the new production demands. These costs should now be considered step costs because the alteration in range has made a portion of the costs variable instead of fixed; this portion should now be considered as part of the avoided costs calculation.

The broader point is that the calculation of avoided costs is a complex task that requires a set of sophisticated tools in order to produce a plausible assessment in litigation.

Analyzing Avoided Costs: A Step-by-Step Methodology

As we have seen, a key cost question in a lost-profits analysis is: What incremental costs would the plaintiff have incurred to realize the additional sales revenues but for the unjust disruption to the business? The following steps are helpful in making this calculation:

1. identify the cost objects (i.e., the products or services) comprising the lost sales;
2. identify the resources involved in producing the product or service;
3. identify the resources involved in selling and delivering the product or service;
4. identify the cost data that are available for analysis;
5. develop hypotheses about cost behaviors using the data and knowledge gathered from the steps above,;
6. test these hypotheses; and
7. develop conclusions, subject them to “sanity” checks, and revise conclusions as necessary.

We discuss and illustrate each step in Part Two of this series.

Elizabeth A. Eccher is a principal in the Chicago office of Analysis Group, Inc.; Jeffrey H. Kinrich is a managing principal in the company’s Los Angeles office; and James H. Rosberg is a vice president in the San Francisco office.

In the bankruptcy case of In re Fisher, 584 B.R. 185, 199–200 (N.D. Ohio Bankr. 2018), the United States Bankruptcy Court for the Northern District of Ohio disallowed a lender’s proof of claim on a mortgage based on “the well-settled law in Ohio that the same statute of limitations governs enforcement of a note and a mortgage.” At least one other district court in Ohio has since followed Fisher’s lead, relying on the same supposedly “well-settled law in Ohio” to cancel a lender’s mortgage and hold the lender liable under the FDCPA for seeking to collect time-barred debt. Baker v. Nationstar, No. 2:15-cv-2917, 2018 U.S. Dist. LEXIS 121686 *31, *35–*39, 2018 WL 3496383 (S.D. Ohio July 20, 2018).

The bankruptcy court in Fisher and the district court following Fisher both openly rejected multiple opinions from Ohio’s Eighth District Court of Appeals applying a longer statutory limitations period to foreclosure actions than actions seeking judgment on the note. See id. at *30–*35; Fisher, 584 B.R. at 199. They also contradict the Ohio Supreme Court’s century-old ruling in Fisher v. Mossman, 11 Ohio St. 42, 45–46 (1860), which held that an expired statute of limitations barring judgment on a mortgage’s underlying debt did not similarly bar an action to foreclose the mortgage.

This tale of two Fishers tells the story of how Ohio’s statute of limitations jurisprudence evolved from an accepted legal proposition derived from one Fisher opinion to “well-settled law” stating the complete opposite in another Fisher opinion. It is the best of legal analysis and the worst of legal analysis . . . .

The Holden Reset

In 2016, the Ohio Supreme Court reaffirmed several longstanding doctrines governing mortgage foreclosure in Ohio, reminding that lenders “may elect among separate and independent remedies to collect the debt secured by a mortgage.” Deutche Bank Nat’l Trust Co. v. Holden, 2016-Ohio-4603, ¶ 21 (2016). As the Holden court explained, these remedies include: (1) a personal judgment against the borrower to recover the amount due on the note; (2) an action “in ejectment” to take possession of the property and apply income derived from the property to the loan, returning the property to the borrower once the loan is paid; and (3) an action to foreclose the mortgage, which cuts off the borrower’s redemption rights and sells the property to satisfy the debt. Id. ¶¶ 21–24.

Thus, under Ohio law, actions for personal judgment on the note and actions to enforce the mortgage, whether by ejectment or foreclosure, “are separate and distinct remedies.” Id. ¶ 25 (internal quotations omitted). The court confirmed that, “[b]ased on the distinction between these causes of action . . . the bar of the note or other instrument secured by mortgage does not necessarily bar an action on the mortgage.” Id. (internal quotations omitted). Holden discussed these well-accepted principles in the context of loans discharged in bankruptcy, but nowhere did it limit them to only the bankruptcy context.

After the Ohio Supreme Court issued its Holden decision, Ohio’s Eighth District Court of Appeals recognized that Holden “casts serious doubt” on Ohio cases that applied the six-year statute of limitations on notes to foreclosure actions. Walker, 2017-Ohio-535, ¶ 19. Accordingly, it held that a lender may still seek to enforce the obligations in a mortgage even when it is barred from seeking judgment on the note. Id. at ¶ 23. See also U.S. Bank N.A. v. Robinson, 2017 Ohio 5585, ¶ 11 (8th Dist.).

Nevertheless, despite the Eighth District’s clear application of Ohio law as expressed by the Ohio Supreme Court in Holden, the United States Bankruptcy Court for the Northern District of Ohio and the United States District Court for the Southern District of Ohio both rejected the Eighth District’s opinions. See Baker, 2018 U.S. Dist. LEXIS 121686, *30–*38; Fisher 584 B.R. 197–201.

In Fisher, the bankruptcy court focused on the Ohio Supreme Court’s statement in Kerr v. Ledecker, 51 Ohio St. 240, 254 (1894), that “when a note is secured by mortgage, the statute of limitations as to both is the same.” See Fisher, 584 B.R. at 200. Noting that Holden cited Kerr favorably, the bankruptcy court determined that the same statute of limitations governs actions for personal judgment on the note and actions to foreclose the mortgage. Id. In Baker, the district court picked up where Fisher left off, finding that Holden never intended to overrule Kerr. See Baker, 2018 U.S. Dist. LEXIS 121686, *33–*34. The district court therefore felt that because Kerr remained good law, the Eighth District’s opinions in Walker and Robinson are not. Id.

The problem with the federal courts’ analyses in Fisher and Baker is not that they are wrong about Kerr remaining good law, but that they are wrong about the law according to Kerr.

Reading Kerr in Context

The Ohio Supreme Court in Kerr did not rule as a matter of law that the statute of limitations for actions seeking judgment on the note always applied to actions seeking to foreclose the mortgage. Rather, it explained as a matter of fact that the statutes then in effect were the same. See Kerr, 51 Ohio St. at 254.

In Kerr, the lender brought a foreclosure action against a borrower. The borrower argued that Ohio’s 15-year statute of limitations on specialties and written contracts barred the foreclosure. The trial court rejected the defense, finding that Ohio’s 21-year statute of limitations governing actions to recover real property applied. The Ohio Supreme Court reversed. Id. at 247–55.

Noting that an action to foreclose a mortgage does not seek title or possession of the property but instead seeks to cut off the borrower’s right of redemption and sell the property, the court held that an action to foreclose a mortgage is a specialty governed by Ohio’s statute of limitations on specialties. Id. at 251–53. The court distinguished this from an action in ejectment, which seeks to dispossess the borrower until the mortgage is paid and is governed by Ohio’s statute of limitations on recovering possession of property. Id. at 250.

In ruling, the court in Kerr discussed its prior decision in Fisher v. Mossman, 11 Ohio St. 42 (1860), confirming that Fisher “correctly holds that the bar of the note, or other instrument secured by mortgage, does not necessarily bar an action on the mortgage.” Id. at 253. In Fisher, the lender sought to foreclose against purchasers from a judicial sale held on judgment liens inferior to its mortgage. The purchasers argued that the lender could not foreclose his mortgage due to a statutory bar preventing him from enforcing the underlying debt, and the trial court agreed. The Ohio Supreme Court reversed. Fisher, 11 Ohio St. at 47.

Acknowledging that the lender could not enforce the underlying obligation due to the expired limitations period, the court in Fisher nevertheless held: “[D]oes it follow that because an action on the notes secured by the mortgage is barred by the statute [of limitations], that therefore the remedy in equity on the mortgage is also lost? We think not.” Id. at 45. Rather, the court confirmed, “where a security for a debt is a lien on property, personal or real, that lien is not impaired in consequence of the debt being barred by the statute of limitations.” Id. at 46 (internal quotations omitted).

Kerr relied on its earlier holding in Fisher to determine that different statutes of limitations apply to the different causes of action founded on notes and mortgages. See Kerr, 51 Ohio St. at 253–54. Kerr also clarified the impact its ruling would have in situations where the statute of limitations for the underlying debt differed from the mortgage securing the debt. Id. at 254. Using actions on an account as an example, the court found that “[a] mortgage may be made to secure an account, and an action on account may be barred in six years, while an action on the mortgage would not be barred short of fifteen years.” Id.

Concerning the account scenario, the Kerr court explained further:

The payment of the account would extinguish the right of action on the mortgage, and in an action for the foreclosure of the mortgage after action on the account is barred, the presumption of payment of the account arising from the lapse of time, might be used as an item of evidence to prove payment, but such presumption would not be conclusive and might be overcome by satisfactory proof showing that in fact such account remains unpaid. In such case the lapse of six years is not the equivalent of payment. The condition of the mortgage is for payment of the account, and not for its bar by the statute of limitations.

Id. at 254 (emphasis in original).

Translating this from 19th century judge to 21st century lawyer, the court explained that if the borrower paid the account, then the lender could not foreclose the mortgage securing the account. Id. If the lender sought to foreclose the mortgage after the account’s six-year statute of limitations expired, then the lender’s failure to sue on the account could establish a presumption that the borrower paid the account—a presumption the lender could overcome with evidence showing the account remained unpaid. Id. Nevertheless, the expired limitations period barring an action on the account is not the same as payment, and the lender could still foreclose the mortgage if it demonstrated the account remained unpaid. Id.

In the context of this discussion, the Kerr court then stated:

But when a note [as opposed to an account] is secured by mortgage, the statute of limitations as to both is the same; and therefore the mortgage will be available as a security to the note in an action for foreclosure and sale until the note shall be either paid or barred by statute; but in such case an action for foreclosure and sale cannot be maintained on the mortgage after an action on the note shall be barred by the statute of limitations.

Id. at 254–55 (emphasis in original).

Read in this context, Kerr plainly did not issue a new rule that the statute of limitations for actions to enforce a note is always the same as the statute of limitations for actions to foreclose a mortgage. Id. It instead contrasted the situation where the mortgage secured a note as opposed to where the mortgage secured an account, and it recognized the factual reality that—as Ohio law existed at the time—the same 15-year statute of limitations governed actions to enforce notes and actions to foreclose mortgages, as opposed to the different statute of limitations that governed actions on accounts. Id.

Indeed, a rule that the limitations period to enforce the note is always the same as the limitations period to foreclose the mortgage would have directly conflicted with Kerr’s opposite conclusion in the two immediately preceding paragraphs on accounts. Id. It would also have conflicted with the court’s previous holding in Fisher—which Kerr cited with approval and confirmed was correct—where the court expressly held that “[it does not] follow that because an action on the notes secured by the mortgage is barred by the statute [of limitations], that therefore the remedy in equity on the mortgage is also lost.” Fisher, 11 Ohio St. at 45.

The Ohio Supreme Court later confirmed this analysis and harmonized Kerr with prior rulings that recognized the oft-stated proposition that the mortgage “is a mere incident to the debt.” Bradfield v. Hale, 67 Ohio St. 316, 321–25 (1902). In Bradfield, the lender brought an ejectment action more than 15 years after the underlying debt secured by the mortgage became due. The trial court refused to allow the mortgage into evidence on statute of limitations grounds, and the appellate court reversed. The Ohio Supreme Court affirmed the reversal. Id. at 323–25.

Determining that the 15-year statute of limitations barring the mortgage foreclosure action did not also bar the ejectment action, the court indicated that it fully covered the same question in Williams v. Englebrecht, 37 Ohio St. 383, 386–88 (1881), where the court held that the illegality of promissory notes secured by a mortgage did not constitute a defense to an ejectment action on the mortgage even though it could be used as a defense against the notes. See Bradfield, 67 Ohio St. at 323–24.

In other words, Bradfield confirmed that a defense against foreclosing the mortgage does not necessarily constitute a defense against ejectment based on the mortgage, just as a defense against enforcing the note does not necessarily constitute a defense against enforcing the mortgage. See id. at 324. This makes sense because all three are separate and distinct actions with separate and distinct remedies. See, e.g., Holden, 2016-Ohio-4603, ¶¶ 21–25.

Applying the Old Rules Today

These early Ohio Supreme Court rulings perfectly align with Holden and the Eighth District’s decisions in Walker and Robinson, as well as with commonly recognized legal principles in Ohio.

Under Ohio law, a statute of limitations—like a bankruptcy discharge—creates an affirmative defense to a complaint. See Ohio Civ. R. 8(C). In the context of promissory notes, the statute’s lapse acts as a procedural bar to obtaining a personal judgment against the borrower on the note, but the underlying debt continues to exist. See, e.g., Summers v. Connolly, 159 Ohio St. 396, 402 (1953). However, these defenses against an action on the note do not transfer to an action on the mortgage. See, e.g., Bradfield, 67 Ohio St. at 321–25; Williams, 37 Ohio St. at 386–88.

Relatedly, a statutory bar to obtaining judgment on the note does not destroy the underlying obligation. See, e.g., Summers, 159 Ohio St. at 402. The debt continues to exist, and the mortgage continues to secure the debt. This is why lenders can still foreclose even after borrowers discharge their debt in bankruptcy. See, e.g., Blue View Corp. v. Gordon, 2007-Ohio-5433, ¶¶ 19–23 (8th Dist. 2007).

If the lender can prove it is entitled to enforce the note, then it can prove that the borrower owes the lender money. See, e.g., Fannie Mae v. Hicks, 2015-Ohio-1955, ¶¶ 31–32 (8th Dist. 2015). If the borrower proves some valid defense to the lender’s action on the note, then the defense prevents judgment on the note. However, the borrower’s obligation to repay the money still exists, and the mortgage—an incident to that obligation—also still exists.

Once the lender proves that the borrower owes it a debt, the lender can enforce the mortgage securing that debt. See, e.g., Hicks, 2015-Ohio-1955, ¶¶ 31–32; Blue View Corp., 2007-Ohio-5433, ¶¶ 19–23. As the Ohio Supreme Court expressly recognized in Holden: “There is a significant difference between being a party that cannot obtain judgment on the note and being a party that is not entitled to enforce the note.” Holden, 2016-Ohio-4603, (internal quotations omitted). Expiration of the note’s statute of limitations prevents the lender from obtaining judgment on the note; it does not prevent the lender from proving it is entitled to enforce the note.

Explaining Ejectment

The different treatment of statutes of limitations for ejectment and foreclosure also makes sense under current Ohio law.

Under Ohio law, ejectment and foreclosure arise from property rights given in the mortgage. See, e.g., id. ¶¶ 23–24. A mortgage is effectively a conditional deed conveying a property interest that the borrower can redeem by paying back the loan. Id. ¶ 23. When the borrower defaults on the mortgage, title to the property as between the borrower and the lender automatically transfers to the lender, and only the borrower’s equitable right to redeem remains with the borrower. Id.

In a foreclosure action, the lender seeks to cut off the borrower’s redemption rights and sell the property to satisfy the debt. See id. ¶ 24. In an ejectment action, the lender seeks to take possession of the property until the profits pay off the loan, or until the borrower redeems. Id. ¶ 23. In the statute of limitations context, the lender has eight years (previously 15 years before 2012 statutory amendments) to cut off the borrower’s redemption rights and have the property sold in foreclosure, but the lender has 21 years to take possession through ejectment. See O.R.C. §§ 2305.04, 2305.06.

In other words, even if the lender fails to timely foreclose, it can still take possession of the property. See, e.g., Bradfield, 67 Ohio St. at 324–25. It just cannot cut off the borrower’s redemption rights or sell the property, meaning the property will eventually return to the borrower once the loan is paid. The inability to obtain a personal judgment on the note does not impact either of these rights under the mortgage. See id. at 323–25; Kerr, 51 Ohio St. at 253–55; Fisher, 11 Ohio St. at 45–46.

A “Well-Settled Law” Is Born

So how did Ohio get from Fisher’s 1860 Ohio Supreme Court ruling that the statute of limitations barring the underlying debt does not impair mortgage rights to Fisher’s 2018 bankruptcy court ruling that it does? Like most things, the devil is in the details.

In Fisher 1860, the lender could not collect the underlying debt due to a four-year statutory bar involving probate administration. Fisher, 11 Ohio St. 45–46. The Ohio Supreme Court determined that the four-year limitations period did not also bar an action to foreclose the mortgage, and it specifically said it saw no reason the analysis would change for nonprobate statutes. Id. at 45. Later, in Bradfield, the court similarly held that expiration of the limitations period governing foreclosure did not also bar an action in ejectment. Bradfield, 67 Ohio St. at 323–25.

In between these two rulings came Kerr, which confirmed that the six-year statute of limitations on actions to collect an account would not bar an action foreclosing a mortgage securing the account. Kerr, 51 Ohio St. at 254. This analysis perfectly aligned with the court’s earlier analysis from Fisher 1860 and its later analysis in Bradfield. Nevertheless, the line from Kerr destined to ring through the ages was its recognition that “when a note is secured by mortgage, the statute of limitations as to both is the same.” Id. (emphasis in original).

Importantly, Kerr’s description of the statutes of limitations governing notes and foreclosure actions was true when made in 1894, and it stayed true for over 100 years afterward. Then, in 1994, Ohio amended its Uniform Commercial Code to create a six-year statute of limitations for promissory notes. See O.R.C. § 1303.16(A) (eff. Aug. 19, 1994). This changed the applicable statute of limitations on the note from the then-15-year period governing written contracts to the newly enacted six-year period governing negotiable instruments. See O.R.C. §§ 1303.16(A), 2305.06. The statute governing specialties like mortgage foreclosures remained the same. See O.R.C. § 2305.06.

About 10 years after the amendments to Ohio’s U.C.C., the Twelfth District Court of Appeals declared that, “it has long been settled in this state that when a debt that is secured by a mortgage is barred by the statute of limitations, the mortgage securing the debt is also barred.” Barnets, Inc. v. Johnson, 2005-Ohio-682, ¶ 16 (12th Dist.). In Barnets, the lender sought to foreclose a mortgage securing an account despite expiration of the six-year statute of limitations governing actions on the account. The Twelfth District reversed the trial court’s order of foreclosure, holding that the expired limitations period on the account also barred the mortgage foreclosure action. Id. ¶ 18.

Confusingly, Barnets specifically discussed Kerr while simultaneously contradicting Kerr’s detailed explanation for how an expired statute of limitations on an account would impact an action to foreclose the mortgage. The Ohio Supreme Court in Kerr clearly explained that expiration of the statute of limitations on an account would not prevent the foreclosure of a mortgage securing the account. Kerr, 51 Ohio St. at 254. The appellate court in Barnets held the opposite. Barnets, 2005-Ohio-682, ¶ 18.

Further clouding its analysis, the Barnets court went on to “parenthetically” note that “in most instances, the debt secured by the mortgage will often be a promissory note, which, as a written contract, has a 15-year statute of limitation.” Id. ¶ 18. Oddly, this clarification was as incorrect as it was unnecessary because the Ohio legislature had already amended the applicable U.C.C. provision governing notes a decade earlier. See R.C. § 1303.16(A).

In short, the court in Barnets made a mistake. It misread Kerr, and its misreading birthed a previously nonexistent legal rule that eventually grew into “well-settled law in Ohio” that was neither well settled nor the law in Ohio.

The End of the Tale

A careful examination of the underlying cases shows that the Ohio Supreme Court never intended to create a hard and fast rule that the same statute of limitations governing actions on the note also governs actions to foreclose the mortgage. In fact, it appears the court intended the opposite.

As one Ohio trial court explained: “[T]he previously ‘well settled proposition’ [that when a debt . . . secured by a mortgage is barred by the statute of limitations, the mortgage securing the debt is also barred] was derived from the fact that prior to 1994, the same statute of limitations applied to notes and mortgages.” Deutsche Bank Nat’l Trust Co. v. Kalista, Case No. CV-2016-03-1477, 2017 Ohio Misc. LEXIS 6506 *12 (Summit C’ty Common Pleas Sept. 27, 2017) (internal quotation omitted). “Therefore, while there has been some confusion on this issue, Holden and Walker are consistent with long-standing Ohio law.” Id. at *13.

Yet according to at least two federal courts in Ohio, a statutory bar preventing judgment on the note will also bar foreclosure of the mortgage. See Baker, 2018 U.S. Dist. LEXIS 121686, *30–*38; Fisher 584 B.R. 197–201. In fact, according to one of these courts, seeking to foreclose the mortgage under the statute of limitations applicable in state court could even subject a lender to liability under the FDCPA in federal court. See Baker, 2018 U.S. Dist. LEXIS 121686, *35–*39.

Hopefully, as the tale of two Fishers draws to a close, federal courts interpreting Ohio law will correct course and begin to apply the proper statute of limitations to mortgage foreclosure actions. The current confusion on this issue deserves a far, far better rest than it has ever known.

Introduction

The U.S. Constitution vests Congress with enumerated “legislative Powers,”[1] confers upon the President “the executive Power,”[2] and endows the federal courts with “the judicial Power of the United States.”[3] The “standing” doctrine, including a related body of judicial principles as precedent, has developed over many years in defining the test for cases to be heard before the federal judiciary.

The Supreme Court’s 2016 ruling in Spokeo v. Robins, although designed to clarify the “injury-in-fact” principle of Article III standing, has in fact yielded a line of Article III analysis that deviates from the traditional principles of the standing doctrine and arguably bestows judicial power to Congress. In applying such analysis, courts authorize Congress to elevate intangible harms to the status of legally cognizable injuries. This analysis effectively appoints Congress as the arbiter of standing—an authority held by the courts under its judicial power.

This case note explores the interplay between statutory damages for procedural violations by creditors and the principles of Article III standing. There is an inherent tension between the “injury-in-fact” requirement for standing and statutory damages for mere procedural violations (without further harm to the petitioner) as awarded by statutes such as the Fair Credit Reporting Act.

This case note also examines how post-Spokeo cases, specifically Hagy v. Demers & Adams, LLC, acknowledged standing and granted statutory damages for a procedural violation in the face of Spokeo, and explores additional factors beyond standing that may impact debtors’ access to statutory damages for procedural violations.

1. Hagy Facts and Procedural Background

In 2002, the Hagys financed the purchase of a mobile home and related real estate.[4] In 2010, they subsequently defaulted on their loan obligations.[5] The law firm defendants, Demers & Adams, LLC, filed a foreclosure action against the Hagys on behalf of the loan servicer.[6] On June 8, 2010, the loan servicer’s attorney, David Demers, sent the Hagys a letter that accompanied a warranty deed in lieu of foreclosure.[7] The June 8th letter advised the Hagys that Demers & Adams, LLC had been retained to represent the loan servicer in regards to the delinquent account, and that in return for the Hagy’s execution of the deed in lieu, the loan servicer would waive any deficiency balance.[8]

Plaintiffs James and Patricia Hagy executed the deed in lieu of foreclosure in exchange for the deficiency waivers.[9] On behalf of his law firm, Mr. Demers sent a letter on June 30th to the Hagy’s attorney confirming receipt of the executed deed and stating that there would be no additional attempts to collect the deficiency balance.[10] Thereafter, the foreclosure complaint against plaintiffs was dismissed; however, the loan servicer began contacting the Hagys by telephone for the collection of the deficiency.[11]

Hagy sued the loan servicer, one of its employees, the loan servicer’s law firm, Demers & Adams, LLC, and Mr. Demers in federal court alleging that the phone calls and letters violated the Fair Debt Collection Practices Act (FDCPA) and Ohio Consumer Sales Practices Act (OCSPA).[12]

The loan servicer and its employee/phone callers resolved the dispute using previously agreed upon arbitration rights.[13] The cause of action against Demers and his law firm alleging that the June 8th letter violated the FDCPA was denied due to the applicable statute of limitations.[14] The issue of whether the June 30th letter violated the FDCPA remained, and both plaintiffs and defendants moved for summary judgment.[15]

The district court in Hagy granted summary judgment and awarded statutory damages to plaintiffs. The court held that the letter from Demers and his law firm violated the FDCPA and OCSPA (which incorporates the FDCPA disclosure requirement) because it was a letter from a debt collector that did not make that disclosure as required.[16]

Defendants appealed the decision and alleged that the court did not have jurisdiction because plaintiffs did not have standing to bring suit.[17] During the appeal process, Demers asked the district court to reconsider its decision in light of the U.S. Supreme Court’s ruling in Spokeo, once again claiming that plaintiffs lacked standing to bring federal suit.[18] The district court rejected the argument.[19]

On appeal, the Sixth Circuit reversed the district court’s decision and dismissed the case for lack of jurisdiction, relying heavily on the U.S. Supreme Court’s analysis in Spokeo.[20]

2. Standing Analysis under Spokeo

Spokeo is a search engine that reports online information about people whose names are searched. In this case, the search engine reported some inaccurate information about Thomas Robins and he sued, claiming a violation of his statutory rights under the Fair Credit Reporting Act (FCRA).[21] He cited the section that obligates consumer reporting agencies to ensure their reports are accurate.[22] The FCRA provides for statutory damages if its provisions are violated.[23]

The issue for the Supreme Court was whether Robins had adequately pleaded an “injury-in-fact” that satisfied the standing requirements under Article III.[24] The court ruled that in order to establish an injury-in-fact, plaintiff must show that he or she suffered “an invasion of a legally protected interest” that is “concrete and particularized” and “actual or imminent,” and not “conjectural or hypothetical.”[25]

The court further explained the “concrete” prong by stating that a plaintiff cannot allege a “bare procedural violation, divorced from any concrete harm, and satisfy the injury-in-fact requirement of Article III.”[26] To show that an injury is concrete, it must be “de facto,” meaning that it must actually exist—it must be real and not abstract.[27] For these reasons, the court vacated the Ninth Circuit’s decision and held that Robins met the Article III standing requirements.[28]

3. How the District Court in Hagy Granted Standing in the Face of Spokeo’s Concreteness Analysis

A. Spokeo’s Analysis Is Conflicting, Causing the District Court and Other Courts to Follow an Article III Analysis that Grants Judicial Powers to Congress

There are principles in the Spokeo ruling that are conflicting and confusing for courts to interpret. On the one hand, Spokeo held that standing requires an actual injury that is not hypothetical and that is not a “bare procedural violation, divorced from any concrete harm.”[29] On the other hand, Spokeo held that intangible harm in the form of a violation of a procedural right granted statutorily can be sufficient in some circumstances to constitute an injury-in-fact, and a plaintiff need not allege any additional harm beyond the one Congress identified.[30]

The inconsistency arising from Spokeo is that intangible harm deriving from a procedural violation, without any additional harm, is in fact conjectural, hypothetical, and a bare procedural violation. The district court in Hagy, like other courts facing interpretation of Spokeo, found itself wedged between two conflicting prongs of Spokeo’s Article III analysis. Spokeo forces courts to decide between following the “Congressionally created harm” prong or holding true to the traditional standing principles of the “no bare procedural violation” prong—two diametrically opposed lines of analyses.

The district court in Hagy is not the only post-Spokeo court following the Congressional-harm prong.[31] For example, the post-Spokeo case Church v. Accretive Health, Inc. held that “an injury-in-fact . . . may exist solely by virtue of statutes creating legal rights, the invasion of which creates standing . . . .”[32] The court held in applying Spokeo that “while this injury may not have resulted in tangible economic or physical harm that courts often expect, the Supreme Court [in Spokeo] has made it clear that an injury need not be tangible to be concrete.”[33] The Supreme Court further acknowledged in Spokeo that Congress may elevate intangible harms to the status of legally cognizable “concrete” injuries.[34]

The introduction of Congressionally created intangible harms as “concrete injuries” deviates from the original core principles of Article III standing, which require actual, nonhypothetical injuries and which preclude bare procedural violations as sufficient grounds for standing. Under the Congressionally created harm line of analysis, Congress can effectively create causes of action with statutorily mandated damages for plaintiffs who have incurred no substantive, actual injury.

Actual harm means actual harm—not some intangible harm fantasized by Congress. Under the Congressionally created harm analysis, plaintiffs can point to Congress and say, “I’m harmed because Congress says so,” regardless of the actual injury limitations of Article III. There is reason for concern when Congressional power overrides established Constitutional principles. As the Sixth Circuit noted in Hagy, “Congressional leeway cannot mean judicial abdication. Broad though Congress’s power may be to define and create injuries, they cannot override constitutional limits” and “Congress . . . may not simply enact an injury into existence, using its lawmaking power to transform something that is not remotely harmful into something that is.”[36]

B. The District Court in Hagy Followed What the Supreme Court Said, and Ignored What the Supreme Court Did, in Spokeo

Although the Supreme Court stated in Spokeo that no additional harm may be necessary in the case of a procedural violation of a Congressionally created right,[37] a close examination of Spokeo reveals that the court did in fact look for additional harm. After the court acknowledged that “a plaintiff . . . need not allege any additional harm beyond the one Congress has identified,” the court recognized that a violation of one of FCRA’s procedural requirements may in fact result in no harm.[38]

In furtherance of this analysis, the Supreme Court considered a hypothetical in which Spokeo disseminates an incorrect zip code.[39] The court found it “difficult to imagine” how this, without more, could create concrete harm.[40] This analysis establishes the important Spokeo principal (which appears to be ignored in post-Spokeo cases) under the Congressionally created harm line of analysis that if the procedural violation is likely to or could possibly result in no harm, then the existence of a concrete harm is unlikely and “difficult to imagine.”[41]

The district court in Hagy ignored this important component of the Congressionally created harm analysis and focused narrowly on what Spokeo said in a vacuum (i.e., that a violation of a procedural right without any additional harm can constitute an injury-in-fact), and not what the Supreme Court did in Spokeo (i.e., consider whether the procedural violation could possibly result in no harm).

The district court in Hagy never considered the question of whether the failure to disclose the fact that the June 30th letter was from a debt collector could result in no harm to the Hagys.[42] In reality, had the court so considered, it likely would have concluded that such a failure very well could have resulted in no harm to the Hagys.

The June 30th letter simply confirmed receipt of the executed deed and stated that there would be no additional attempts to collect the deficiency balance.[43] The letter was not an attempt to collect a debt.[44] It summarized a mutually agreed upon resolution to the debt—a letter that the Hagys surely considered favorable as evidence that the debt collection activities would cease.[45] Thus, defendants’ failure to disclose their status as debt collectors posed absolutely no risk of harm to the Hagys because it was not drafted for the purpose of collecting a debt, but rather confirmed the great news that debt collection activities would cease due to settlement. If the Hagy court had followed Spokeo’s consideration of whether the violation could possibly result in no harm, standing would have likely been denied.

C. The District Court in Hagy Followed a More Speculative View of the Definition of “Concrete”

The district court in Hagy relied on Macy v. GC Services Limited Partnership, a pre-Spokeo case, in addition to post-Spokeo cases[46] to support applying a more speculative definition of “concrete.”[47]

In Macy, the Eastern District of Kentucky held that “the concreteness requirement may be satisfied by the risk of real harm.”[48] Further, the court acknowledged that in cases involving alleged procedural violations, the court must determine whether the particular procedural violations alleged in the case entail a degree of risk sufficient to meet the concreteness requirement.[49]

In Macy, the plaintiffs alleged that defendant violated the FDCPA by sending debt collection letters that did not inform them that defendant was only obligated to provide additional debt and creditor information if plaintiffs disputed their debts in writing.[50] The court held that the possibility that the failure to provide such warnings might lead a least sophisticated debtor to waive certain statutory rights met the concreteness standard.[51]

The “possibility” that there “might” be harm is completely contrary to traditional Article III principles holding that the injury must be “actual or imminent” and not “conjectural or hypothetical.” It is surprising that the district court in Hagy relied on such a speculative, pre-Spokeo analysis that exemplifies the type of conjectural harm Spokeo rejects as sufficient to grant standing.

4. How Arbitration Provisions in Consumer Contracts Impact Harmed Consumers’ Accessibility to Statutory Damages

There is a notable trend in the United States toward including binding arbitration provisions in consumer contracts.[52] Such binding arbitration provisions leave consumers who believe they are entitled to statutory damages, regardless of the amount of actual harm, with significantly fewer avenues to seek damages.

In AT&T Mobility L.L.C. v. Concepcion, the Supreme Court reaffirmed the supremacy of the Federal Arbitration Act and the validity of contractual binding arbitration clauses in agreements between businesses and their customers.[53] The Supreme Court strongly reaffirmed this decision in DirecTV, Inc. v. Imburgia in an opinion stating, “The Federal Arbitration Act is the law of the United States, and Concepcion is an authoritative interpretation of the Act. Consequently, the judges of every state must follow it.”[54]

The Consumer Financial Protection Bureau, now known as the Bureau for Consumer Financial Protection, issued its binding arbitration rule on September 18, 2017, with a March 19, 2018 mandatory compliance date. Although it continued to allow arbitration of disputes between consumer financial service providers and their customers, it required that such provisions be limited in scope to allow class-action lawsuits. That rule was invalidated by Congress under the Congressional Review Act by H.J. Res. 111, which passed the House and the Senate (with the vice president casting the tie-breaking vote) and was signed by the president on November 1, 2017. Consequently, the rule limiting the scope of arbitration provisions to enable class-action lawsuits is not effective, and the Bureau for Consumer Financial Protection is precluded from again issuing a similar rule.

As a result, cases are often subject to commonly used binding arbitration clauses in disputes between consumers and financial service providers and, depending upon the scope of the arbitration clause, the consumers’ available options for resolution are often limited to third-party service providers of the lender, such as collection attorneys, collection agencies, and servicers retained by the lender.

As courts continue to keep the window of litigation open for consumers experiencing harm—even intangible, Congressionally created, procedural harm—arbitration provisions play a key role as a countervailing force limiting litigation and other avenues for seeking recourse and statutory damages. Sophisticated lenders are incentivized to close the litigation window as much as possible through broad, one-sided arbitration provisions.

5. Complex and Inconsistent Statutory Requirements May Play a Role in Courts Defaulting Toward Granting Statutory Damages

Numerous federal statutes, other than the FDCPA at issue in Hagy, provide for statutory damages. Such statutes include the Fair and Accurate Credit Transactions Act provisions as added to the Fair Credit Reporting Act in 2003 ($1,000),[55] the Telephone Consumer Protection Act ($500),[56] and the Truth in Lending Act ($5,000).[57]

However, the FDCPA violations create perhaps the most fertile ground for statutory damages claims because of its hyper-technical and inconsistent requirements applicable to communications by debt collectors to debtors. For example, the federal courts of appeal are split as to whether section 1692g(a)(3) requires that a dispute over the validity of a debt by a consumer be in writing.[58]

Some courts have held that the debtor may dispute the debt orally and do not require the debt collector to advise the debtor that the dispute must be in writing to be valid. There is also disagreement even within a circuit regarding whether the debt collector is required to disclose that the balance may increase and whether such disclosure can be general or specific.[59]

The courts have also rejected the use of safe-harbor language[60] and federal courts have also been inconsistent on whether the FDCPA bars the collection of time-barred debt if the debt collector does not threaten legal action.[61]

The bottom line is that the statutory damage provisions of the FDCPA and the uncertainty and judicial inconsistency for complying with such law can create numerous instances in which alleged technical violations, typically with no debtor harm, are successfully used to claim a right to statutory damages. Simply put, it is easier and convenient for courts to grant statutory damages where there might be some level of statutory noncompliance where the statute is ambiguous.

6. A Consideration of the Implications of State Constitutions and Due Process on Statutory Damages for Procedural Violations

Although the “case or controversy” requirement applies to actions in federal court related to enforcement of state law requirements and limitations,[62] there is also the issue, under state constitutions, of whether there is a similar “case or controversy” prerequisite to standing under state constitutions. As stated in Asarco, Inc. v. Kadish, “[T]he constraints of Article III do not apply to state courts, and accordingly the state courts are not bound by the limitations of a case or controversy or other federal rules of justiciability even when they address issues of federal law.”[63] Many state constitutions lack the Article 3 standing requirements, arguably providing an easier litigation venue for procedural violations with statutory damages.[64]

The due process requirements of the 5th and 14th amendments may play a role by limiting otherwise “grossly excessive” damages in individual and class-action cases. Although the application of this limitation will typically not apply to individual or class-action awards for statutory damages, but rather to punitive awards, one can speculate that a future Spokeo 2.0 case will consider whether a litigant’s claim for statutory damages where little or no actual harm exists is “grossly excessive” in violation of due process.[65]

Conclusion

The Hagy district court and the Hagy circuit court decisions illustrate the inherent conflict in the Spokeo decision regarding whether mere Congressionally created, intangible harm or true “actual harm” is required for Article III standing. This conflict is now playing out in federal courts across the United States and may have to be ultimately resolved by the U.S. Supreme Court in a future “son of Spokeo” case. Further, it remains to be seen whether plaintiffs will increase reliance on state courts and state credit reporting and debt collection laws to avoid the Article III analysis altogether, and whether statutory damages may be limited or denied based upon a due process analysis.

[1]              U.S. Const. art. I § 1.

[2]              U.S. Const. art. II § 1, cl. 1.

[3]              U.S. Const. art. III § 1.

[4]              Hagy v. Demers & Adams, LLC, 882 F.3d 616, 618 (6th Cir. 2018).

[5]              Id.

[6]              Hagy v. Demers & Adams, LLC, No. 2:11-cv-530, 2013 WL 434053, at *1 (S.D. Ohio Feb. 5, 2013).

[7]              Id.

[8]              Id.

[9]              Id.

[10]             Id.

[11]             Id. at *2.

[12]             Id.

[13]             Hagy v. Demers & Adams, LLC, No. 2:11-cv-530, 2017 WL 1134408, at *1 (S.D. Ohio Mar. 27, 2017).

[14]             Hagy, 2013 WL 434053, at *2.

[15]             Id.

[16]             Hagy, 2017 WL 1134408, at *1.

[17]             Hagy, 882 F.3d at 620.

[18]             Id.

[19]             Id.

[20]             See id. at 623.

[21]             Spokeo v. Robins, 136 S. Ct. 1540, 1542 (2016).

[22]             See id.

[23]             See id. at 1545.

[24]             Id. at 1544.

[25]             Id. at 1547.

[26]             Id. at 1548.

[27]             Id.

[28]             Id. at 1545.

[29]             Id. at 1549 (citing Summers v. Earth Island Inst., 555 U.S. 488, 496 (2009)).

[30]             Id. (citing Federal Election Comm’n v. Akins, 524 U.S. 11, 20-25 (1998)).

[31]             See, e.g., Church v. Accretive Health, Inc., 654 F. App’x 990, 994 (11th Cir. 2016) (“through the FDCPA, Congress has created a new right—the right to receive the required disclosures in communications governed by the FDCPA—and a new injury—not receiving such disclosures.”); Linehan v. AllianceOne Receivables Mgmt., No. C15-1012-JCC, 2016 WL 4765839, at *8 (W.D. Wash. Sept. 13, 2016) (“The goal of the FDCPA is to protect consumers from certain harmful practices; it logically follows that those practices would themselves constitute a concrete injury.”); Daubert v. Nra Grp., LLC, No. 3:15-CV-00718, 2016 WL 4245560, at *4 (M.D. Pa. Aug. 11, 2016) (“Plaintiff’s injury is also the unlawful disclosure of legally protected information . . . . Both history and the judgment of Congress demonstrate that the unlawful disclosure of legally protected information is a concrete harm that is sufficient to confer standing.”); Dickens v. GC Servs. Ltd. P’ship, No. 8:16-cv-803-T-30TGW, 2016 WL3917530, at *2 (M.D. Fla. July 20, 2016) (“Congress, through the FDCPA, entitles the plaintiff to certain information, and thus an alleged invasion of this right is not hypothetical or uncertain.”).

[32]             Church, 654 F. App’x at 993 (2016) (citing Havens Realty Corp. v. Coleman, 455 U.S. 363, 373 (1982)).

[33]             Id. at 995.

[34]             Spokeo, 136 S. Ct. at 1549.

[35]             Hagy, 882 F.3d at 623.

[36]             Id. at 622.

[37]             Spokeo, 136 S. Ct. at 1549 (citing Federal Election Comm’n, 524 U.S. 11 at 20–25).

[38]             Id. at 1549–50.

[39]             Id. at 1550.

[40]             Id.

[41]             See id.

[42]             See generally Hagy, 2017 WL 1134408, at *1.

[43]             Hagy, 2013 WL 434053, at *1.

[44]             See id.

[45]             Id.

[46]             See, e.g., Anda v. Roosen Varchetti & Oliver, PLLC, No. 1:14-CV-295, 2016 WL 7157414 (W.D. Mich. Oct. 31, 2016); Church, 654 F. App’x at 994; Sayles v. Advanced Recovery Systems, 206 F. Supp. 3d 1210, 1212 (S.D. Miss. 2016); Dickens, 2016 WL 3917530, at *2.

[47]             See Hagy, 2017 WL 11344008, at *3.

[48]             Macy v. GC Services Limited P’ship, No. 3:15-cv-819-DJH, 2016 WL 5661525, at *2 (E.D. Ky. Sept. 29, 2016) (citing Spokeo, 136 S. Ct. 1540) (citing Clapper v. Amnesty Int’l USA, 133 S. Ct. 1138 (2013)).

[49]             Id. at *2 (citing Spokeo, 136 S. Ct. at 1550).

[50]             See id. at *1.

[51]             Hagy, 2017 WL 11344008, at *3 (citing id. at *4).

[52]             Consumers Want the Right to Resolve Bank Disputes in Court (2016), http://www.pewtrusts.org/-/media/assets/2016/08/consumerswanttherighttoresolvebankdisputesincourt.pdf.

[53]             563 U.S. 333, 333, 131 S. Ct. 1740, 179 L.Ed.2d 742 (2011).

[54]             136 S. Ct. 463, 468, 193 L.Ed.2d 365 (2015).

[55]             15 U.S.C. § 1681n(a) (2008).

[56]             47 U.S.C. § 227(b)(3)(B) (2018).

[57]             15 U.S.C. § 1640(a)(2)(A) (2010).

[58]             Hooks v. Forman, Holt, Eliades & Ravin, LLC, 717 F.3d 282 (2d Cir. 2013); Graziano v. Harrison, 950 F.2d 107 (3d Cir. 1991); Clark v. Absolute Collection Serv., Inc., 741 F.3d 487 (4th Cir. 2014); Camacho v. Bridgeport Financial, Inc., 430 F.3d 1078 (9th Cir. 2005).

[59]             Miller v. McCalla, Raymer, Padrick, Cobb, Nichols & Clark, L.L.C., 214 F.3d 872 (7th Cir. 2000); Avila v. Riexinger & Associates, 817 F.3d 72 (2d Cir. 2016); Carlin v. Davidson Fink, 285 F.3d 207 (2d Cir. 2017); Taylor v. Financial Recovery Services, 886 F.3d (2d Cir. 2018).

[60]             Boucher v. Finance System of Green Bay, Inc., 880 F.3d 362 (7th Cir. 2018).

[61]             McMahon v. LVNV Funding, LLC, 744 F.3d 1010 (7th Cir. 2014); Huertas v. Galaxy Asset Mgmt., 641 F.3d 28 (3d Cir. 2011); Freyermuth v. Credit Bureau Servs, Inc., 248 F.3d 767 (8th Cir. 2001).

[62]             DaimlerChrysler Corp. v. Cuno, 547 U.S. 332, 126 S. Ct. 1854 (2006).

[63]             490 U.S. 605, 617 (1989).

[64]             William A. Fletcher, The “Case or Controversy” Requirement in State Court Adjudication of Federal Questions, 78 Cal. L. Rev. 263 (1990).

[65]             See generally Sheila B. Scheuerman, Due Process Forgotten: The Problem of Statutory Damages and Class Actions, 74 Mo. L. Rev. 103 (2009).

The potential impact of cyber crime among financial institutions, and especially community banks, is considerable. Unless proactive steps are taken to implement cybersecurity programs, community banks will continue to be at risk. Increasingly sophisticated attacks exposing software and systems vulnerabilities have become commonplace for financial institutions focused on other, more traditional areas of compliance, such as mortgage and consumer lending and deposits. As a result of the number and sophistication of cyber attacks, a top-down approach to cyber security, a culture of compliance, and a culture of information security at financial institutions are all necessary to combat the evolving threat landscape.

There are effective processes and procedures that community banks can establish to manage cybersecurity risks. A helpful starting point for any financial institution is to conduct a comprehensive risk assessment that identifies categories of risk that apply to people, processes, systems, and vendor activities. These risk assessments should be based on the financial institutions’ products and services as well as the cybersecurity risks from the software and systems maintained, and should be reviewed and updated on a periodic basis. Significantly, the Federal Financial Institutions Examination Council (FFIEC) released a Cybersecurity Assessment Tool in 2015 that has been used by many financial institutions when working through such risk assessments. Finally, although these risk assessments could be conducted internally, they are generally assisted by outside advisors with specific expertise in identifying cybersecurity vulnerabilities.

Once the risk assessment is finalized and potential vulnerabilities are identified, financial institutions should be planning for the unfortunate inevitability of attacks on their people and systems. Many common attacks begin with simple phishing attacks but have included more sophisticated “spear-phishing” attacks tailored to the particular recipient or group of recipients at a financial institution. In addition to these types of traditional attacks targeting individual employees or vendors, malware, ransomware, and distributed denial-of-service attacks on institutions’ systems have become unfortunate realities. Adding insult to injury, many of these system-wide attacks have involved ransom requests to be paid in cryptocurrency—namely, Bitcoin—with which community banks are not yet generally involved.

In addition to training employees, executives, and board members to help prevent attacks where possible, financial institutions should have robust, written response plans developed and readily available to quickly and efficiently handle an attack. The response plan should include a step-by-step plan of action specifying the actions to be taken by institution employees, vendors, and other key stakeholders to determine the facts and circumstances of the breach or intrusion, which will quickly inform management on the proper course of action for notifying law enforcement, regulatory agencies, and customers, if applicable.

In addition to traditional regulatory expectations around risk management, information security, and training, financial institutions are expected to ensure that third-party relationships account for cybersecurity and other risks. Vendor management has become a hot topic at countless industry events as financial institutions work to conduct the proper level of due diligence on vendors and craft adequate policies, procedures, and especially contracts that establish and outline the relationship between the financial institution and the vendor.

Financial institutions begin the due diligence of vendors by understanding the vendor’s background and leadership, whether they have had prior regulatory or litigation proceedings, their use of subcontractors, and their compliance training. This can be effectively accomplished through the use of a comprehensive due diligence questionnaire sent to the vendor.

To effectively manage vendor risk, many financial institutions have created vendor databases in which due diligence information, risk ratings, and monitoring information are collected and stored. The database could also include current and past versions of contracts as well as exceptions to vendor policies and procedures. By constantly maintaining and updating records, financial institutions can further minimize cybersecurity risks.

As mentioned above, the contractual arrangements with vendors play a critical role in combating cybersecurity threats. Agreements with third parties providing services for the bank often contain provisions regarding what specific services are to be performed, the compensation structure, confidentiality, information security, representations and warranties, liability and indemnification, and auto-renewal and termination. These written agreements form the basis of the relationship and allow financial institutions to circle back to determine whether there are deviations and exceptions from standard agreements, or whether a contract must be updated to comply with new regulatory schemes and frameworks. Many of these arrangements with critical vendors also include provisions requiring evidence of regular audits and reporting by the vendor to the financial institution for ongoing maintenance of the relationship.

Boards of directors also have the ability to be key players in the relationship between banks and third parties and in fact should be engaged throughout the process of approving the use of such third parties. The board generally is responsible for ensuring that an effective process managing vendor risk is established and consistent with the institution’s goals, organizational objectives, and risk appetite. In addition, they serve an accountability function by ensuring that management takes appropriate actions to address dips in performance, changing risks, or material issues.

Insurance, and potentially a supplemental cyberinsurance policy, is another important factor influencing financial institutions’ cybersecurity preparedness. It is vital for institutions to assess whether they have adequate insurance and, even more critically, what that insurance actually covers. At the same time, when selecting an insurance policy, institutions should carefully consider the representations made to insurance companies. If contractual conditions are not fulfilled or representations are inaccurate, insurers will attempt to rescind coverage or deny claims in the event of a cyber incident.

With the attention to cyber security and the pressure on financial institutions to protect systems and customer information, these are just a few considerations to combat, prepare for, and respond to a cyber incident.

Joseph E. Silvia is senior counsel in the Chicago office of Chapman and Cutler LLP where he focuses his practice on representing financial institutions, financial technology companies, and marketplace lenders on corporate, transactional, and regulatory matters. Carla Potter is an associate in the Toronto office of Cassels Brock where she is a member of the Financial Services Group.

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Failure is not an option—at least not until it happens. Starting a venture with the attitude that failure is not an option may reflect the American spirit, but the reality is that attitude alone does not control the fate of the venture—even if it did, events can change attitude, precipitating the decline of a once-promising idea. Market or other forces often affect whether a venture fails or succeeds, and failure is a definite possibility for most ventures. Advisors working with venturers in their euphoric, optimistic days of formation must maintain a realistic perspective and help them draft provisions of their entity documents that effectively address the possibility of failure. For instance, the preference for particular contribution-default remedies can change as a venture’s promise and condition change. Consider how the members’ preference for interest dilution and damages can change as the fortunes of a venture change. Recognizing such preferences should affect the venturers’ decisions as their advisors help them draft the entity documents. A recent case from the Delaware Superior Court and earlier cases from the Kansas Court of Appeals help illustrate the legal repercussions of drafting contribution-default remedies for LLC or limited partnership ventures that fail. The cases all considered contribution-default remedies in LLC operating agreements, but the principles should apply to limited partnership agreements as well.

The operating agreement in Canyon Creek Development, LLC v. Fox, 46 Kan. App. 2d 370, 263 P.3d 799 (2011), allowed a majority in interest of the members (i.e., those holding more than 50 percent of the ownership interests (percentage interests) in the LLC) to issue a capital call. The majority in interest (following a contribution to service the LLC’s debt, which was excepted from the Majority-in-Interest capital call rule) did issue such a call, and Fox, one of the members, defaulted on his obligation to contribute additional capital. The LLC’s operating agreement provided that if a member defaulted on a contribution obligation, the other members had the right, but not the obligation, to cover the defaulted amount. The agreement further provided that in the event that a member covered a defaulting member’s default amount, the percentage interests of the members would be adjusted to reflect each member’s contribution as a percentage of total contributions.

The contributing members, having obtained a majority interest in the LLC through additional contributions, appointed themselves managers and caused the LLC to sue Fox for, among other things, breach of the operating agreement, claiming that the LLC was entitled to damages for his failure to satisfy his additional contribution obligation. Fox argued that the dilution in his interest in the LLC that he suffered consequent to his default was the contractually agreed-upon remedy. He further claimed there could not be in substitution or addition a suit for damages (in effect specific performance). The court recognized that Kansas state law provides:

• an operating agreement may specify the penalties or consequences to members who fail to comply with the terms and conditions of the operating agreement (KSA § 17-7691);
• that a member who fails to make a required contribution is obligated, at the option of the LLC, to contribute cash equal to the value of the agreed obligation (KSA § 17-76-100(a));
• that reduction in membership interest was an acceptable penalty for defaulting on a contribution obligation (KSA § 17-76-100(c)); and
• a catch-all providing that the rules of law and equity apply, if not otherwise provided in the act (KSA § 17-76-135).

The court was satisfied that the interest-dilution provision was clearly stated and that the operating agreement did not provide for any additional remedies. It noted that a remedy such as damages is so fundamental that failure to mention it in an operating agreement is an expression of clear intent that damages cannot be assessed against a member who defaults on a contribution obligation absent such a stated remedy.

By contrast, although the operating agreement under consideration in Skyscapes of Castle Pines, LLC v. Fischer, 337 P.3d 72 (Kan. App. 2014) (slip opinion), provided an interest-dilution remedy for contribution-defaults, the court found that was not the exclusive contribution-default remedy in the agreement. This case involved a real estate venture that collapsed along with the real estate market generally in the late 2000s. When one member refused to make contributions required by a managers-initiated capital call, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), the LLC sued the defaulting member. The court found that the Skyscapes operating agreement did not make interest-dilution the sole remedy for contribution-defaults. In fact, the court stated that interest dilution does not extinguish the defaulting member’s personal liability. This operating agreement specifically provided that the rights and remedies of the parties under the agreement are not mutually exclusive and preserved equitable remedies. The court noted that money damages (a remedy at law) might be inadequate in some instances and that nothing in the operating agreement was intended to limit any rights at law or by statute or otherwise for breach of a provision.

The Skyscapes court recognized that the situation under which default occurs could affect parties’ preferences for different remedies. In the situation Skyscape faced, the court observed that in the circumstance of a failing venture, the participants would have strong economic incentive to avoid complying with a capital call, and interest-dilution as a remedy would be singularly ineffective. The contributing members would not “be too happy about making up the delinquency and, thereby, garnering a greater interest in what had turned into a losing proposition.” The preferable remedy for the other members and the entity would be suing to collect from the defaulting member the assessed but delinquent contribution. Based upon that reasoning, the court concluded that it “seems unlikely the operating agreement would have been written to limit the participants’ remedies that way.”

The Skyscapes court distinguished the Skyscapes operating agreement from the Canyon Creek operating agreement in holding that the defaulting member was personally liable to make the additional capital contribution. Although both agreements included interest-dilution remedies, the Skyscapes agreement did not make that the exclusive remedy. The Skyscapes preservation of remedies and other provisions provided other remedies that the entity could seek against a member who failed to satisfy contribution obligations.

The operating agreement in Vinton v. Grayson, 189 A.3d 695, 2018 WL 2993550 (Super. Ct. Del. June 13, 2018), granted Vinton, the manager, sole authority to make capital calls in good faith. Any member who failed to make an additional contribution within 45 days after the notice of the capital call automatically transferred 50 percent of the member’s units to the contributing members. A noncontributing member forfeited the remaining 50 percent of the member’s units by failing to make the contribution within 180 days after the first notice of the capital call. The operating agreement also provided: “The rights and remedies provided by this Agreement are given in addition to any other rights and remedies a Member may have by law, statute, ordinance or otherwise.” Given that the Kansas and Delaware statutes were similar, the Delaware court considered both the Canyon Creek and the Skyscapes rulings in its decision. It found that the preservation-of-remedies clause in the instant agreement approximated the provision in the Skyscapes agreement. Furthermore, the court noted that for the mandatory interest-transfer (and dilution) provision to be the exclusive remedy, the court would expect to see an explicit statement to that effect.

The lesson to be drawn from these three cases is that an LLC operating agreement or limited partnership agreement (entity agreement) may provide that interest-dilution (or readjustment-of-interests including forfeiture) is the exclusive remedy if a member defaults on a contribution obligation. What is less clear is whether an entity agreement must expressly provide that interest-dilution is the exclusive remedy, or whether failure to provide for any other remedy is sufficient to create exclusivity. The court in Canyon Creek found that the absence of a provision for other remedies made interest-dilution the sole remedy. The court in Vinton suggested that the absence of a statement that interest-dilution is the exclusive remedy, combined with other language preserving other options, indicated that the LLC could pursue a damages remedy. The court in Vinton also relied upon a preservation-of-remedies clause in the operating agreement to hold that the LLC had a cause of action for damages against the defaulting member. Absent such a preservation-of-remedies provision, perhaps the Vinton court, like the Canyon Creek court, would have found that interest-dilution was the exclusive remedy.

The combination of these cases provides a road map for either making interest-dilution the exclusive contribution-default remedy, or preserving damages as a remedy. To make interest-dilution the exclusive remedy, the entity agreement should provide for that remedy, should state that it is the exclusive remedy for failure to meet a contribution obligation, and either not include a preservation-of-remedies clause or, if one is included for other purposes, exclude from its scope contribution default. To provide for interest-dilution or damages as a remedy, an entity agreement should state that interest-dilution is not the exclusive remedy. The entity agreement may accomplish that with a preservation-of-remedies provision, but an express statement avoids ambiguity.

Drafting an entity agreement to establish interest-dilution as the exclusive contribution-default remedy or as one of multiple contribution-default remedies is only part of the challenge attorneys face in advising clients with respect to this issue. Clients may also seek advice about whether interest-dilution should be the exclusive remedy. The court in Skyscapes recognized that nondefaulting members will be disappointed if the LLC is unable to recover damages from a defaulting member of a failing LLC, and that interest-dilution would be singularly ineffective in such circumstances. The defaulting member would, of course, be relieved to know that the agreement did not require throwing good money after bad. If every member defaults, all might avoid the good-money-after-bad situation. Parties have the freedom to contract and determine which contribution-default remedies to include in their entity agreements. The difficulty they face is making that choice upon formation of the entity or as part of an amendment to an existing entity agreement.

At the time of formation, parties should be optimistic about a venture’s prospects. In that state of mind, the members may think about how they will deal with a weak member—one who is unable to meet a capital-call obligation. The optimism bias that infects all the members will blind them from seeing the possibility that one of them might be the member facing financial hardship and the inability to meet a capital-call obligation in the future. Thus, the members will be open to a contribution-default remedy that will be painful to the defaulting member. Under the influence of their optimism bias, they may believe that at the time of the future capital call, the entity will be increasing in value, and interest-dilution will be a painful and suitable remedy against the defaulting member. Thus, they will prefer interest-dilution with an eye toward upside potential.

Attorneys should remind the venturers that it is possible for the entity to lose money. If the venture is in a loss situation with doubtful future prospects, then perhaps no member will want to be liable to make any additional capital contributions. Attorneys should help members consider whether they want to be liable to make additional capital contributions to a failing entity. At the start of a venture, the members would not foresee the venture failing, but they should be able to appreciate that they would not want to throw good money after bad and would want a mechanism in place that would limit their liability for making additional contributions to a failing entity. Thus, contrary to the Skyscapes court’s view that the members will not be too happy if interest-dilution is the exclusive contribution-default remedy, one could understand why, at the time of formation, the members would agree to interest-dilution as the exclusive remedy. The Skyscapes court may have been presumptuous in focusing solely on the state of mind of the members when the entity was failing. Their preference most likely would have been quite different at the time of formation.

One must also question the contributing members’ motive in bringing a claim for damages instead of opting for interest-dilution. Making interest-dilution the sole remedy could be a form of Ulysses pact. The members in both Skyscapes and Vinton opted to bring damages claims against the defaulting members instead of applying interest-dilution. Those members may be kicking themselves now. The value of real estate in many markets across the country has increased in value significantly since the financial crisis. Members who contributed to a losing venture during the crisis and awaited the market upswing should have profited significantly from an interest-dilution remedy. As the market rebounded, the contributors owned property that they acquired at a low price. In the midst of a crisis, they may not realize that interest-dilution will be their best alternative. If they recognize this possibility at formation, they can include interest-dilution as the sole contribution-default remedy to ensure that they benefit from the cheap membership interests instead of seeking damages from defaulting members.

Members may have additional interests to address in choosing default remedies. If only certain members are personally guaranteeing the bank debt, they are especially incentivized to have the entity collect contributions and apply them to pay down the bank debt. Even if all of the members have guaranteed an entity liability, as appeared to be the case in Skyscapes, the contributing members would most likely prefer that the defaulting member be obligated to make the additional contribution to avoid legal action from the lender. The preference could be practical or perceptional. As a practical matter, the contributing members may have deeper pockets, and if the guarantors are jointly and severally liable on the guarantee, the lender could collect the entire balance from them. From a perception standpoint, the contributing members may prefer not to be named in legal action by the lender. Their concern may be multidimensional. As members of the entity, their identities may not be publicly known. Legal action by the lender to collect on the guarantee would publicize their identities. A public legal battle about an unpaid debt could also harm the reputations of the members and make them less attractive as investors in other deals. Consequently, the existence of guarantees on an entity’s liability may incentivize contributing members to have the entity proceed against the defaulting member under a breach-of-agreement theory.

A challenge members will face with interest-dilution remedies in failing LLCs or partnerships is computing the interest adjustments when at least one member defaults and at least one other member acts on a capital call. The dilution denominator will affect the adjustments and in some situations could make the computations of adjustments challenging. Examples of contribution-denominated adjustments and value-denominated adjustments illustrate the challenge of adjusting interests in loss LLCs or partnerships that have negative value. The agreements in Canyon Creek and Skyscapes, see Brief of Appellee, 2014 WL 2113037 (Kan. App. Apr. 7, 2014), provided for contribution-denominated adjustments, computing a member’s percentage interests by dividing the member’s total contributions by the total contributions to the entity. Thus, if a member has contributed $250,000 to an LLC, and the total contributions to the LLC equal $1,250,000, the member will have a 20-percent interest in the LLC ($250,000 ÷ $1,250,000). If that same member contributes another $500,000 to the LLC and no other member makes a contribution, the member’s percentage interest will become about 43 percent ($750,000 total member contributions ÷ $1,750,000 total contributions to entity). The value of the entity does not affect a member’s interest if percentage interests are contribution-denominated. Although contribution-denominated interest adjustments raise interesting and challenging tax and financial questions (e.g., is there a taxable capital shift if value differs from contributions, and does the contributor pay a premium or receive a discount on the additional interests acquired?), they are easy to compute.

Value-denominated interest adjustments, on the other hand, use the members’ share of the value of the entity’s assets to determine their percentage interest. For instance, if a member has a 20-percent interest in an LLC that has assets valued at $1,500,000, the member’s share of that value would be $300,000. If the member makes a $500,000 contribution, and no other member makes a contribution, the value of the LLC’s assets will increase to $2,000,000. The value of the member’s share in those assets will be the member’s $300,000 precontribution value plus the member’s $500,000 contribution, or $800,000. Thus, the member’s post-contribution interest will be 40 percent ($800,000 member’s precontribution value + additional member contribution ÷ $2,000,000 entity precontribution value + additional member contribution). Determining the value of an entity’s assets could be difficult, but once the members know that value, they can easily determine their interests in the entity using value-denominated adjustments.

Computing value-denominated adjustments becomes more challenging if an entity has negative value. To illustrate, an LLC might burn through all member capital contributions and borrow $1,000,000 to fund operations. After that money is spent, the entity would owe $1,000,000 and have no assets, so its value would be negative $1,000,000. Assume a member makes a capital contribution of $500,000, no other member makes a contribution, and the operating agreement provides for interest-dilution as a remedy in such situations. If the LLC provides for contribution-denominated adjustments, then computing the adjustment will be straightforward, even though the entity has negative value.

The contributing member may, however, be disappointed to find that the contribution, which provides the entity its only capital, might have nominal effect on the interest adjustment. If the operating agreement provides for value-denominated adjustments, then computing the adjustments will be a challenge. If, prior to the contribution the contributing member’s percentage interest was 20 percent, then the value of that interest would be negative $200,000. Following the contribution, the LLC’s value would be negative $500,000. The member’s share of that value depends upon the member’s percentage interest, and the member’s percentage interest depends upon the effect that the member’s contribution has on the value of the LLC and the value of the member’s interest. The contribution would appear to change the value of the member’s interest from negative $200,000 to positive $300,000, and change the value of the entity from negative $1,000,000 to negative $500,000. Imagining how a member’s interest in an entity could be positive while the entity’s value is negative is a challenge. Computing the members’ interest in the entity following the contribution to a negative-value entity is also a challenge. Given that math does not appear to provide an obvious answer, members should consider how they will address interest adjustments in entities that have negative value if they do not provide for damages as a remedy.

Last, consideration must be given to the capacity to enforce whatever rights remedy may be provided for in a particular entity agreement. In both Canyon Creek and Skyscapes, the manager-managed LLC was the plaintiff against the defaulting member. In contrast, Vinton was brought by the members who had satisfied their respective contribution obligations against the member who had not; the LLC itself does not appear to have been a party to the action. This raises the question of standing. The operating agreement is a contract to which each of the members and the LLC are parties. See, e.g., Elf Atochem N. Am., Inc. v. Jaffari, 727 A.2d 286, 287 (Del. 1999). There is no dispute that the obligation to contribute capital is for the LLC’s benefit; members do not contribute capital to other members. For example, section 18-502 of the Delaware LLC Act refers to how a member “is obligated to a [LLC]” and the “right of specific performance that the [LLC] may have against such [defaulting] member.” The defendant, Grayson, argued in the Vinton case that only the LLC, and not the other members, could bring an action to enforce his capital contribution obligation. Applying the “Rights and Remedies Cumulative” provision of the operating agreement at issue in the Vinton case, namely:

[t]he rights and remedies provided by this Agreement are given in addition to any other rights and remedies any Member may have by law, statute, ordinance or otherwise. All such rights and remedies are intended to be cumulative and the use of any one right or remedy by any Member shall not preclude or waive such Member’s right to sue any or all other rights or remedies[,]

the court held, “Here, as signatories to the Route 9 Agreement, each of the Member Plaintiffs has standing to sue Grayson for his breach.”

Reasonable minds may differ as to whether the Vinton court properly characterized the claims as direct. Regardless, the decision is the decision. Going forward, drafters must consider and address who does (and does not) have standing to enforce (and collect upon) defaulted capital-contribution obligations.

An LLC’s management structure may also affect whether the entity makes a capital call and whether it brings a cause of action against the defaulting members. In Canyon Creek, the contributing members obtained control of the entity following their contributions and the resulting interest adjustment. If they had successfully caused the LLC to obtain an award for damages, presumably Fox’s contribution would have realigned the members’ interests to the predefault percentages. At those percentages, the contributing members would not have a controlling interest. If the interest adjustment is retroactive, the members would not have had authority to issue the capital call. That dynamic creates interesting management considerations. Can members use contribution-default remedies to obtain temporary control, only to use that authority to obtain a contribution that effectively causes the contributing members to cede control? Such dynamics may affect whether contributing members bring a direct action against the defaulting member or cause the entity to bring the action.

Contribution-default remedies appear in most entity agreements and partnership agreements. The three cases discussed in this article consider the enforceability of contribution-default remedies in ventures that were losing money and appear to have had negative value. The issues raised in such situations may differ from issues that arise in ventures that have positive, increasing value. This article scratches the surface of legal, financial, and tax issues that contribution-default remedies raise. The questions raised but unanswered in this article are some of many that warrant detailed consideration. Advisors must begin to carefully account for these and other questions, and commentators should continue to research and explore the nuances of these provisions.

The prescription opioid epidemic ravaging the country claims almost 100 lives daily with an accompanying annual cost upward of $500 billion dollars. Current estimates suggest nearly two million Americans are dependent on or abuse prescription opioids. 

As would be expected with what has been described as a “national health emergency,” there is no lack of finger-pointing (but substantially less discussion of who should take responsibility for adequately addressing it). The usual suspects are the pharmaceutical companies who promote highly addictive opioid painkillers through aggressive marketing programs, the healthcare providers who prescribe them–at times just to placate patients–and the distribution channel of pharmacies that make them available 24/7. 

There is, however, a fourth player in the opioid epidemic drama that, until recently, hadn’t been the subject of very much attention. It now finds itself under much closer scrutiny for its role in allegedly getting and keeping patients addicted to opioid painkillers while not doing enough to help fix a problem it is accused of helping create and perpetuate. 

Who is this player?  It is the payors–the private and public insurance companies and programs that cover the vast majority of Americans. These include the well-known commercial companies as well as government programs such as Medicare, Medicaid and the collection of State and local health insurance programs.

Fueling the Epidemic

Various studies, most recently one by the Johns Hopkins University Bloomberg School of Public Health, strongly suggest that payors have not done enough to combat the opioid epidemic. The Johns Hopkins study, for example, concluded that major insurer coverage policies for drugs to treat lower back pain–one of the more common types of chronic, non-cancer pain for which prescription opioids have been overused–“missed important opportunities” to steer patients toward safer and more effective treatments than prescription opioids. (These studies collectively go on to also say that providers continue  to play a role, albeit at times unwittingly, in expanding the epidemic rather than working to reduce it).   

While there are a variety of payor policies and actions blamed for the ongoing increase in prescription opioid use (and abuse), they fall into three basic areas.

Prescription Opioids are Too Price Accessible

In an open market, there is usually a direct relationship between price and demand. This is perhaps nowhere more evident than with prescription opioid painkillers. The logic is simple:  if opioid-based medicines cost less than safer alternatives, including non-narcotic medicines, then prescribers and consumers will opt for the addictive opioids rather than less addictive medicines.

This economic reality has been consistently borne out by researchers. The Johns Hopkins study showed that both public and commercial insurance plans tend to make covered opioids available relatively cheaply to patients. How cheaply?  The median commercial plan, for example, places 74 percent of opioid painkillers in Tier 1, the lowest cost category, and the median commercial co-pay for Tier 1 opioids was just $10 for a month’s supply.

In stark contrast, studies show that only one-third of the more than 40 million people covered by Medicare have access to an available painkiller skin patch that contains much less potent opioids as its key active ingredient. Other plans simply do not cover non-addictive alternatives to opioids or have co-pays that are higher than those for opioids. Many plans also require pre-authorization for the safer, alternative painkillers.

As Rep. Elijah Cummings, the ranking member of the House Committee on Oversight and Government Reform, has said, the insurance industry has, in effect, created incentives that may steer patients to the very drugs that are fueling the opioid crisis.

The government has had to intervene to curb the increased consumption of opioids that has accompanied these lower prices. In 2016, Massachusetts set a seven-day limit on initial opioid prescriptions.^[1] North Carolina imposed a five-day limitation on opioid prescriptions which went into effect on January 1, 2018.^[2] The Florida Agency for Health Care Administration limits narcotics prescriptions in the Medicaid program to a maximum seven-day supply.^[3]

Other states have even imposed a limitation on the prescribed dosage amount. Maryland has limited opioid prescriptions to the lowest effective dose in a quantity no greater than what is needed for the expected level of pain.^[4] Arizona is proposing legislation that would cap maximum prescription dosages and set a five- or fourteen-day limitation on prescriptions.^[5]

Prescribers are Rewarded  for  Putting or Keeping Patients on Opioids

A previous article discussed how the U.S. Government, through its Medicare program, may also be contributing to the opioid epidemic by including pain questions on patient satisfaction surveys. The Centers for Medicare and Medicaid Services (CMS) have used the Hospital Consumer Assessment of Healthcare Providers and Systems (HCAHPS) survey, a set of 32 questions administered to a random sample of hospital patients about their experience of care, since 2008.^[6] The results of these surveys are posted on CMS’s “Hospital Compare” website.^[7] Now, as part of the Affordable Care Act’s Hospital Value-Based Purchasing Program, CMS is withholding 1 percent of Medicare payments—30 percent of which is tied to HCAHPS scores—to fund the incentives of the program.^[8] The belief is that these surveys pressure doctors to prescribe unnecessary opioids in hopes of getting a better score on patient surveys. As various studies have shown, opioid use has been associated with higher patient satisfaction scores.^[9]

It is easy to spot the conflict here. Tying money to great reviews can easily lead to undue pressure on doctors to prescribe opioids to make a patient happy in order to get a good score. Perhaps the biggest area affected by patient satisfaction surveys has been the emergency room. Several studies suggest that ER doctors have drastically changed their practice in order to avoid negative patient satisfaction reports.^[10] Prescribing painkillers, even when not entirely necessary, is often necessary to get paid by Uncle Sam.

Two surveys of more than 800 emergency physicians by Emergency Physicians Monthly and the South Carolina Medical Association reported that more than 50 percent of the ER docs routinely ordered tests and procedures, prescribed medications, and even admitted patients to the hospital unnecessarily. Why? Because patient satisfaction affects their bottom line.

Compounding the problem are savvy patients aware of how the system now works. One physician wrote that drug seekers “are well aware of the patient satisfaction scores and how they can use these threats and complaints to obtain narcotics.”

Lax Application of Utility Management Protocols

Another factor identified by the Johns Hopkins study is that many insurers failed to apply evidence-based “utilization management” rules to discourage opioid overuse and encourage safer and more effective alternatives. What’s more, many of the utilization management rules in place were applied as often to non-opioids as opioids.

While utilization management takes various forms depending on the clinical setting and payor policies, the most common are quantity limits, step therapy and prior authorization. Here are some of the ways that not correctly applying these rules exacerbates the opioid crisis:

• Quantity Limits. While the S. Centers for Disease Control and Prevention Guideline for Prescribing Opioids for Chronic Pain is for a short-term supply, many insurance policies allow for 30-day supplies. The danger here is that duration of early prescriptions is associated with a patient converting to chronic use.
• Step Therapy. This is a strategy that makes riskier opioids the “last resort” for pain management after other, non-narcotic medications have failed to provide pain relief. By permitting opioids to be a “first step,” the risk of addiction and/or chronic use increases. Unfortunately, fewer than 10 percent of government and commercial plans require step therapy for opioids.
• Prior Authorization. The idea is that requiring a provider to get in touch with the insurer before prescribing an opioid will help reduce the number of prescriptions or encourage quantity control or step therapy. The reality is that only a minority of plans require this.

Only recently has the Centers for Medicare & Medicaid Services (CMS) urged state Medicaid agencies to require quantity limits, step therapy or prior authorization to limit access to particular opioids. ^[11] On February 1, 2018, CMS issued a Draft Call Letter announcing that it is considering new strategies to reduce opioid overutilization under Medicare Part D, including limiting initial prescription fills for treatment of acute pain with or without a daily maximum dose.^[12]

The Way Forward

Providers have a stake in working with payors–commercial and public–as well as with distribution channels to continue to develop integrated solutions to the opioid crisis. Aside from the human toll on their communities, they also are not immune to the economic costs. Studies have clearly shown that the epidemic is increasing hospitalizations and that is hits emergency rooms especially hard.

Some estimates put the average cost of treating an overdose patient in the intensive care unit at almost $100,000. If a majority–or even a minority–of these patients are underinsured or uninsured, the resulting uncompensated care costs can easily cripple a provider that is already operating on a razor-thin margin.

Nonetheless, there are opportunities for healthcare providers to contribute to fighting the opioid crisis. They can support initiatives being undertaken by such groups as America’s Health Insurance Plans that seek to combat opioid abuse. They also can develop, implement and maximize the value of programs designed to identify potential opioid abusers and limit the prescribing of opioid painkillers. Finally, they can negotiate contracts with payors that require prompt authorization and fair reimbursement for non-opioid alternatives where indicated. 

^[1] H.4056, 2016 Leg., 189^th Sess. (Ma. 2016).

^[2] H.B. 243, 2017 Gen. Assemb., 175^th Sess. (N.C. 2017).

^[3] Christin Sexton, Florida Medicaid program limits opioid prescriptions, Palmbeachpost.com (February 20, 2018), available at https://www.palmbeachpost.com/news/state–regional-govt–politics/florida-medicaid-program-limits-opioid-prescriptions/xaRsMNmfOBpGs7574oRpdN/

^[4] Maryland Prescriber Limits Act of 2017

^[5] Arizona plan to combat opioids would limit dosages, amount, U.S. News (Jan. 19, 2018), available at https://www.usnews.com/news/best-states/arizona/articles/2018-01-19/arizona-plan-to-combat-opioids-would-limit-dosages-amounts

^[6] Centers for Medicare and Medicaid Services. Survey of patients’ experiences (HCAHPS). http://www.medicare.gov/hospitalcompare/Data/Overview.html. Accessed September 3, 2018.

^[7] Centers for Medicare and Medicaid Services. Official hospital compare data archive. https://data.medicare.gov/data/archives/hospital-compare. Accessed September 3, 2018.

^[8] Hospital Consumer Assessment of Healthcare Providers and Systems. HCAHPS fact sheet. November 2017. https://www.hcahpsonline.org/globalassets/hcahps/facts/hcahps_fact_sheet_november_2017.pdf. Accessed September 4, 2018.

^[9] Sara Heath, Opioid Use Associated with Higher Patient Satisfaction Scores, Patient Engagement Hit, available at https://patientengagementhit.com/news/opioid-use-associated-with-higher-patient-satisfaction-scores. Accessed September 3, 2018.

^[10] See for example, Kelly, S., Johnson, G.T., and Harbison, R.D. “Pressured to prescribe”: the impact of economic and regulatory factors on South-Eastern ED physicians when managing the drug seeking patient. J Emerg. Trauma Shock. 2016; 9: 58–63

^[11] U.S. Dep’t of Health and Human Servs., CMCS Informational Bulletin, Best Practices for Addressing Prescription Opioid Overdoses, Misuse, and Addiction (Jan. 28, 2016), available at https://www.medicaid.gov/federal-policy-guidance/downloads/CIB-02-02-16.pdf. Accessed September 3, 2018.

^[12] CMS, Fact Sheet, 2019 Medicare Advantage and Part D Advance Notice Part II and Draft Call Letter, Feb. 1, 2018, available at https://www.cms.gov/newsroom/mediareleasedatabase/fact-sheets/2018-fact-sheets-items/2018-02-01.html. Accessed September 3, 2018.

Joy Stephenson-Laws