In Janus v. AFSCME Council 31, 138 S. Ct. 2448 (2018), the United States Supreme Court recently held that legislation requiring public-sector employees in units represented by public-sector unions to pay “fair share fees” (sometimes referred to as “agency fees”) violates the First Amendment because it compels individuals to subsidize the speech of other private parties. Writing for the majority, Justice Samuel Alito stated, “Neither an agency fee nor any other payment to the union may be deducted from a nonmember’s wages, nor may any other attempt be made to collect such a payment, unless the employee affirmatively consents to pay [the union].” The immediate impact of Janus is that public-sector employees cannot be required to pay for any union activity without their clear and affirmative consent. This article explores the practical considerations of Janus and provides a framework for public employers to follow prospectively.

Life Before Janus

Janus’s roots date back to the Court’s 1977 decision in Abood v. Detroit Board of Education, 97 S. Ct. 1782 (1977), which evaluated the legality of a Michigan statute permitting unions and public-sector employers to agree to an “agency shop” arrangement. In an agency shop, the union is designated as the exclusive representative of all the unit employees, even those who do not join. Individuals who opt out of membership are still required to pay a service fee to the union. The Abood Court held that the payment of some fee by nonmembers was necessary to maintain labor peace as envisioned by federal labor laws and to avoid the risk of “free riders”—employees receiving the benefit of union protections at the expense of dues-paying members. On the other hand, the Abood Court recognized that the First Amendment prohibits the government from forcing contributions for political purposes. The resulting compromise was the so-called fair share fee—a percentage of union dues calculated by subtracting any portion the union expends on political or ideological activities from what the union allocates toward negotiating terms of employment on behalf of employees. Some viewed this percentage as difficult to quantify, and it left a significant gray area as to what exactly qualified as representation versus political/ideological activities. (Since 1977, the Supreme Court had tiptoed around the continuing validity of Abood. In 2012, in Knox v. SEIU, 132 S. Ct. 2277 (2012), Justice Alito noted in dicta that the constitutional justification for public-sector agency fees was “something of an anomaly.” Two years later, in Harris v. Quinn, 134 S. Ct. 2618 (2014), Justice Alito again criticized Abood.)

The Janus Decision

Mark Janus, a child-support specialist for the Illinois Department of Healthcare and Family Services, refused to join the AFSCME Council because he opposed the union’s public-policy positions as well as its stance toward collective bargaining which, in his view, did not recognize Illinois’ fiscal crises. Nevertheless, as permitted by Abood, the AFSCME Council required Janus to pay a fair share fee to the union—over 70 percent of total membership dues. As a result, Janus filed a complaint to challenge the constitutionality of such fees.

When the case reached the Supreme Court, the majority ruled that the First Amendment protected Janus from being mandated to pay such fees, effectively overruling Abood. The Court explained that Abood was based on the faulty assumption that “designation of a union as the exclusive representative of all the employees in a unit and the exaction of agency fees are inextricably linked[.]” Janus, 138 S. Ct. at 2465. In the end, the majority found fair share fees to be unconstitutional because they compel nonmembers to subsidize private speech on matters of substantial public concern.

Janus’s Impact

Practically, public-sector unions across the country anticipate that a significant number of nonmembers will cease their financial support and that current members may resign their membership to take advantage of newly discovered disposable income. To counteract such defections, unions representing public-sector employees are likely to invest in campaigns designed to educate both members and nonmembers about the value of union representation and the negative implications of a free-rider system. The efficacy of these campaigns in light of Janus is an open question.

Several states with high percentages of union density (especially in the public sector) anticipated the outcome in Janus and proactively adopted legislation. For example, in New York and New Jersey, new legislation gives unions access to new employees’ personal contact information. These states also allow unions the right to meet with new hires during work hours. Further, the New York legislation makes clear that unions cannot be forced to provide full membership benefits to nonmembers. In California, Governor Brown signed Senate Bill 866 regulating how public employers and unions manage membership dues and fees, and how public employers communicate with employees about their rights relating to union membership. Specifically, the California law requires public employers to refer employees with questions or requests concerning fees or dues to the union. It also mandates that dues or fees be deducted from payroll once the union notifies the employer of an employee’s valid authorization.

Other states may consider a more tailored alternative to agency fees, which would prevent free ridership while imposing a lesser burden on First Amendment rights. (See, e.g., Cal. Govt. Code Ann. § 3546.3 (West 2010); cf. Ill. Comp. Stat., ch. 5, § 315/6(g) (2016). These California and Illinois statutes allow public employees with religious objections to opt out of agency fees while permitting the union to charge those employees for particular services.) Such laws could provide that, if an employee with an objection to paying an agency fee “requests the [union] to use the grievance procedure or arbitration procedure on the employee’s behalf, the [union] is authorized to charge the employee for the reasonable cost of using such procedure.” Janus, 138 S. Ct. at 2469, n.6.

Practical Guidance

The Janus mandate is clear: public-sector unions cannot demand fair share fees, and public-sector employers cannot collect such fees absent clear and affirmative consent. However, the practical impact of Janus raises a myriad of questions that public employers must address now. For example, how should employers communicate the impact of Janus to employees? What type of consent is required to withhold dues or fees from employees? Can a public employer seek indemnity from the union for any claims made by employees as a result of the payroll deductions? Is there a duty to bargain over the impact of Janus? How these questions are answered will vary by locality.

Public employers may wish to affirmatively communicate with employees about the impact of Janus. However, before doing so, public employers should become familiar with recently enacted legislation that may govern such communications. For example, the California law discussed above places restrictions on “mass communications” to employees. Any mass communication sent to employees or applicants concerning their rights to join or support an employee organization, or refrain from joining or supporting an employee organization, require the employer to meet and confer with the union.

In order to prepare for a possible influx of employees seeking to cease financially supporting a union, public employers should also review applicable collective bargaining agreements and dues authorization forms on file. If such authorizations exist, employers may wish to question whether the authorizations are “clear and affirmative” as required by Janus, 138 S. Ct. at 2486. If authorizations are missing, employers may consider reaching out to the union to verify that a valid authorization exists, but again, state statutes may be implicated when an employer seeks to verify dues authorization information. For example, under the new California law, a public employer must rely on the information provided by the union concerning such authorizations. As a counterbalance, California public-sector unions must indemnify the employer for any claims made by employees that payroll deductions were improperly made. Similar indemnity legislation may follow in other states.

Since agency fee provisions are but one part of an overall collective bargaining agreement, public employers must carefully review such agreements for any contract language that requires agency (or service fee) deductions because Janus now renders such language unlawful. This issue is further complicated if the applicable collective bargaining agreement does not contain a severability clause. Additionally, depending upon the jurisdiction, unions may seek to negotiate over the “impact” of Janus. Many states’ public-sector labor laws require “impact bargaining,” referring to negotiations over the impact of management rights decisions on union employees. However, public employers may argue that negotiations are not required because this issue does not directly relate to employees’ terms and conditions of employment but rather is an intra-union matter.

Conclusion

Although the full impact of the Janus decision will play out over the course of years, public employers must grapple with the immediate impact of Janus and resulting legislation today. These practical considerations are intended to serve as a general guide to public employers to minimize disruption in the workplace during the post-Janus transition.

On August 17, 2018, the SEC adopted final amendments relating to an ambitious housekeeping effort, “Disclosure Update and Simplification,” a component of the SEC’s disclosure effectiveness project. The final amendments address certain disclosure requirements that have become redundant, duplicative, overlapping, outdated, or superseded in light of other SEC disclosure requirements, US GAAP or “changes in the information environment.” The “demonstration version” of the final amendments provides a blacklined version displaying the changes. The final rules become effective 30 days after publication in the Federal Register, and the staff has indicated that it will review the impact of the amendments within five years thereafter.

The final amendments eliminate entirely a number of provisions that are completely duplicative, as well as a variety of references to obsolete terms such as “pooling-of-interests accounting” and “extraordinary items.” In another nod to modernity, the SEC removed the requirement to identify the SEC’s Public Reference Room and disclose its physical location and phone number; instead, the SEC will retain the requirement to disclose the SEC’s internet address and require all issuers to disclose their internet addresses if they have one. SEC disclosure requirements that overlap with GAAP, IFRS, or other SEC disclosure requirements have, in some instances, been deleted and, in other instances, where the requirement involved incremental material information, been integrated into other requirements. In some cases where the disclosure requirements overlap with GAAP but require material incremental information, the SEC retained the requirement, but referred the items to FASB for potential incorporation into GAAP in the future.

For the most part, the changes are not particularly earth-shaking; however, where the amendments result in relocation of disclosure into the financial statements, the effect can be burdensome in that it subjects the new disclosure to audit or interim review and audit of internal control over financial reporting, which could create potential verification and auditability issues. In addition, XBRL tagging requirements apply to information in the financial statements. Moreover, because the safe harbor for forward-looking information under the Private Securities Litigation Reform Act of 1995 does not apply to financial statements, potential liability concerns are introduced. In this regard, relocation of disclosure into the financial statements, together with the absence of the PSLRA safe harbor protection, may make issuers warier about supplementing required disclosures in the financial statements with forward-looking information. However, the SEC noted that it did not adopt any requirements to disclose forward-looking information in the financial statements, and further observed that issuers retain the option of providing forward-looking information outside of the financial statements (and, in some cases, are required to provide that information). Of course, relocating disclosures outside the financial statements will have the opposite effect, no longer subjecting the information to requirements for audit, review, or XBRL and providing the potential for PSLRA protection. Other changes may simply affect the relative prominence of the disclosure or impose or remove a bright-line disclosure threshold.

Some Notable Changes

To convey the flavor of the changes, below are selected changes affecting Regulation S-K. Note, however, that many of the changes effected by the amendments relate to Regulation S-X and the financial statements.

Item 101—Description of Business

Segments and geographic information. In light of existing GAAP and Item 303(b) disclosure requirements, the amendments eliminate the mandates in Item 101 to provide segment financial information and financial information by geographic area. The current rule explicitly permits issuers to avoid duplication by cross-referencing to the applicable notes to the financial statements, and that is how most companies have historically addressed this requirement. Now, companies will not have to bother with that cross-reference.

Foreign operations. Similarly, the SEC eliminated the requirements to disclose under Item 101 material risks associated with an issuer’s foreign operations and any segment’s dependence on foreign operations. Those matters, the SEC concluded, are more appropriately disclosed under “Risk Factors” and, where appropriate, in MD&A. To make that point explicit, the SEC has added a specific reference to “geographic areas” to the MD&A requirement to disclose trends and uncertainties by segment.

R&D. Similarly, because the information is comparable to information already required by GAAP, the SEC has eliminated the mandate to disclose under Item 101 the amount spent on R&D activities for all years presented.

Major customers; product revenue. However, the SEC elected to retain some of the overlapping provisions that require disclosure of information incremental to GAAP and to instead refer them to FASB for potential incorporation into GAAP. For example, both GAAP and Item 101 require disclosures about major customers: Regulation S-K requires disclosure if loss of one or a few customers would have a material adverse effect on a segment, while GAAP requires certain disclosures for each customer that accounts for 10 percent or more of total revenue. In addition, Regulation S-K requires disclosure of the name of any customer that represents 10 percent or more of revenues and the loss of which would have a material adverse effect, while  GAAP does not. Similarly, both GAAP and Regulation S-K require disclosure regarding revenue from products and services; however, the Regulation S-K mandate has a 10-percent threshold, while GAAP requires disclosure for each product or service, or group of similar products and services, unless impracticable. Depending on FASB’s decision regarding integration of this information into the applicable GAAP requirement, modifications could result in PSLRA safe harbor and other financial statement disclosure issues, as well as issues arising out of the elimination or inclusion of bright-line disclosure thresholds.

Item 201—Market Price of and Dividends on the Registrant’s Common Equity and Related Stockholder Matters

Market prices. The SEC has updated the market price disclosure requirements: instead of requiring disclosure of the high and low sales prices and sales price as of the latest practicable date—which are readily available for free on numerous websites on a daily basis and likely more up to date—Item 201(a)(1) is amended to eliminate the detailed disclosure requirement to provide sale or bid prices for most issuers with common equity traded in an established public trading market and replaced with disclosure of the trading symbol. More specifically:

• Issuers with one or more classes of common equity will be required to identify the principal S. markets where each class is traded and the corresponding trading symbols used by the markets for each class of common equity. Foreign issuers will also be required to identify the principal foreign public trading markets, if any, and the trading symbols, for each class of their common equity.
• Issuers with common equity that is not traded on an exchange will be required to indicate, as applicable, that any over-the-counter market quotations in these trading systems reflect inter-dealer prices without retail mark- up, mark-down, or commission and may not necessarily represent actual
• Issuers with no class of common equity traded in an established public trading market will be required to state that fact and disclose the range of high and low bid information, if applicable, for each full quarter within the last two fiscal years and any subsequent interim In addition, these issuers must disclose the source and explain the nature of the quotations.

Dividends. The amendments also streamline the various redundant and overlapping requirements in Regulations S-X and S-K to discuss dividends. The SEC is eliminating the requirement in Item 201 to disclose restrictions that currently or are likely to materially limit the company’s ability to pay dividends on its common equity; instead, companies will be required to provide disclosure of material restrictions on dividends only in the notes to the financial statements under Regulation S-X. Likewise, the amendments eliminate the requirement in Item 201 to disclose the frequency and amount of cash dividends declared for the two most recent fiscal years and any subsequent interim period; rather, the amendments will mandate that Rule 3-04 of Regulation S-X, which currently requires financial statement disclosure of the amount of dividends per share and in the aggregate, be applied to interim periods.

Convertible/exercisable securities. In light of the broader GAAP requirement to disclose the terms of significant contracts to issue additional shares and other reasonably similar information, the SEC has eliminated the Item 201 requirement to disclose on Form S-1 or Form 10 the amount of common equity subject to outstanding options, warrants, or convertible securities when the class of common equity has no established U.S. public trading market.

Equity compensation plan table. Another overlapping provision that was proposed to be eliminated is instead being retained and referred to FASB for potential incorporation into GAAP: the SEC decided not to eliminate the mandate in Item 201(d) to provide tabular disclosure regarding existing equity compensation plans approved and not approved by shareholders. This information is currently required in a number of different forms, including Forms 10-K and proxy statements. In the proposal, the SEC had suggested elimination of the provision because it overlapped with a similar GAAP requirement and because the SEC believed that drawing the distinction between plans approved and not approved by shareholders was no longer useful to investors because the major exchanges now require, with limited exceptions, plan approvals by shareholders. However, relocating the disclosure to the financial statement notes would raise potential liability issues in the absence of PSLRA protection and would mean that the disclosure would no longer appear alongside information about equity compensation plans subject to shareholder action. At the end of the day, the SEC decided to retain and refer to FASB the overlapping requirement, recognizing the concerns expressed by commenters that GAAP does not explicitly require certain information that could be material to investors, such as the formula for calculating the number of securities available for issuance under the applicable plan. Note, however, that, although the final rules currently retain Item 201(d), referring it to FASB, they surprisingly still eliminate the provisions in Schedule 14A (proxy statements) and Form 10-K that currently mandate the inclusion of Item 201(d) disclosure in those documents. As a result, although item 201(d) disclosure would continue to be required in Form S-1 and Form 10, unless the staff indicates otherwise, under the new amendments, Item 201(d) disclosure would not be required in proxy statements or Forms 10-K. In informal discussions with the staff, we have been advised that the staff is aware of the issue and is considering it.

Item 303—Management’s Discussion and Analysis of Financial Condition and Results of Operations

Seasonality. The amendments eliminate Instruction 5 to Item 303(b) regarding seasonality because it required disclosures that convey reasonably similar information to that required under GAAP and the remainder of Item 303.

Item 503—Prospectus Summary, Risk Factors, and Ratio of Earnings to Fixed Charges

Ratio of earnings to fixed charges. The amendments eliminate the requirement in Item 503(d) to disclose the historical and pro forma ratio of earnings to fixed charges (and ratio of combined fixed charges and preference dividends to earnings) in connection with the registration of debt securities and preference equity securities. The SEC observed that now a “variety of analytical tools are available to investors that may accomplish a similar objective as the ratio of earnings to fixed charges.” In addition, the SEC noted, debt investors often negotiate covenants requiring issuers to provide more relevant financial information.

Item 601—Exhibits

Earnings per share. The final amendments eliminate Item 601(b)(11), which requires a statement showing the calculation of per-share earnings (unless the computation can be determined from information already in the report) in annual filings. According to the SEC, that requirement is duplicative of information required under GAAP, Regulation S-X, and IFRS.

Ratio of earnings to fixed charges. In connection with the elimination of Item 503(d), the related Item 601(b)(12) exhibit filing requirement has been eliminated.

Reports to shareholders. Various reports to security holders, required to be filed as exhibits under Items 601(b)(19) and (22), are also eliminated in light of, in the former case, other exhibit provisions or, in the latter case, the requirement to disclose shareholder voting results in a Form 8- K.

On the Horizon

With regard to those incremental disclosure requirements that were referred to FASB for consideration of whether they should be incorporated into GAAP, the SEC requested that FASB determine whether to add these items to its agenda within 18 months after publication of the adopting release in the Federal Register. In a statement to Bloomberg BNA, FASB indicated that it was “reviewing the SEC’s recommendations, and that board members will discuss the request at an upcoming public meeting.” Accordingly, depending on the position ultimately taken by FASB, financial reporting requirements could become more burdensome for all companies—and especially for smaller reporting companies—if FASB determines to incorporate these incremental disclosures into GAAP.

In addition, the SEC indicated that it planned to continue to study the question of the potential integration of the mandate under GAAP to disclose loss contingencies and the requirement under Item 103 of Regulation S-K to disclose certain legal proceedings, which are one type of loss contingency. Item 103 includes a bright line disclosure threshold in some cases of 10 percent of the issuer’s consolidated current assets, while GAAP provides a more general materiality threshold. However, the overlap has historically led many companies to either repeat the disclosures or cross-reference to them. In the proposing release, the SEC had considered referring the issue to FASB for potential incorporation into GAAP. As described by the SEC in the proposing release, incorporation of Item 103 requirements into GAAP would result in more instances of disclosure of the possible range of loss; more disclosure that is subject to audit or review, internal control, and XBRL requirements; more disclosure of prescribed facts (such as the court or agency, the date instituted, the principal parties involved, the alleged factual basis of the proceeding, and the relief sought); and a more general materiality threshold in connection with environmental legal proceedings (instead of the bright-line thresholds in Regulation S-K). It would also give rise to PSLRA safe-harbor protection issues and other financial statement concerns. The SEC observed in the adopting release that many commenters opposed the integration on a variety of bases, including the possible need to revisit the ABA policy statement regarding lawyers’ responses to auditors’ requests for information. Some commenters supported the integration, noting the repetition in many filings, and some recommended that the SEC conduct more analysis and outreach. Ultimately, the SEC apparently took that advice and determined to retain the current requirements and study the issue further.

Recently, the Securities and Exchange Commission (SEC) adopted amendments to the smaller reporting company (SRC) definition to increase the thresholds for eligibility and to adopt certain other changes. Under the new SRC definition, a company with less than $250 million of public float will be eligible to provide scaled disclosures. Companies with less than $100 million in annual revenues and either no public float or a public float that is less than $700 million will also be eligible to provide scaled disclosures. The SEC made no revisions to the actual scaled disclosure requirements available to SRCs. The revised SRC qualification rules are effective on September 10, 2018. 

What Is An SRC and What Did the SEC Change?

The SEC historically has recognized that a single-size regulatory structure for public companies does not fit all. As a result, the SEC has adopted a number of rules that, in effect, have created a graduated disclosure regime for public companies from accelerated filing requirements for larger companies to reduced disclosure requirements for emerging growth companies and SRCs. The SEC expects about 1,000 companies to qualify as an SRC as a result of the revised definition and to possibly take advantage of the new rule changes. Do you represent companies eligible to take advantage of these new changes, and if so should they take advantage of these new changes? What occurs if a company is initially not eligible, but becomes eligible at a later time? What exactly is “scaled disclosure,” and with which of the many SEC rules does a SRC need not comply? This article explores these and other related topics. 

The SEC’s new thresholds for determining SRC status are based on (1) having a public float of $250 million, or (2) a revenue test which also includes a public float component. Once a company determines that it qualifies as an SRC, it will remain an SRC until it exceeds the initial qualification thresholds. The new rules provide three paths to becoming an SRC: one for companies doing an initial public offering and two for existing public companies—a transition rule for this year using the IPO thresholds and, for companies that failed to meet the initial thresholds, the ability to become an SRC if it meets lower revenue and market cap thresholds. 

Initial Qualification 

The following table summarizes the amendments to the SRC thresholds for companies making an initial determination under the revised rules, or a current SRC confirming its continued compliance. A company must meet only one of the two thresholds. 

What If a Company Is Already Public?

Transition Rule for Existing Public Companies 

For the first fiscal year after September 10, 2018, existing public companies may qualify by applying the new initial qualification thresholds (summarized above) rather than the lower, subsequent qualification thresholds (summarized below). A calendar year company will test its status based on its revenues for the year ended December 31, 2017, and its public float as of June 29, 2018. 

What If a Company Is Initially Not Eligible, But Becomes Eligible At a Later Time?

Subsequent Qualification 

If a public company determines that it does not qualify for SRC status because it met neither of the foregoing thresholds, it will remain unqualified unless, when making a subsequent annual determination, it meets one or more lower qualification thresholds. The subsequent qualification thresholds, set forth in the table below, are set at 80 percent of the initial qualification thresholds. Stated differently, this test is for issuers that are currently required to file reports under sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended. 

The SEC provided the following example in its guidance: 

Example: A company has a December 31 fiscal year end. Its public float as of June 28, 2019 was $710 million and its annual revenues for the fiscal year ended December 31, 2018 were $90 million. It therefore does not qualify as a SRC. At the next determination date (June 30, 2020), it will remain unqualified for SRC status unless it determines that its public float as of June 30, 2020 was less than $560 million and its annual revenues for the fiscal year ended December 31, 2019 remained less than $100 million. 

What Is “Scaled Disclosure” And With Which Of The Many SEC Rules Does An SRC Need Not Comply?

The advantage of being an SRC is that such a company can comply with certain SEC rules and regulations that are less onerous. An SRC can pick and choose between scaled or nonscaled, financial and nonfinancial disclosure requirements on an item-by-item basis. For a side-by-side comparison of the SRC rules and rules applicable to non-SRCs, see Appendix A. 

There are specific rules regarding entering and exiting the SRC reporting regime, and most companies solicit expert advice regarding compliance with such rules. A larger reporting company that determines it qualifies to be an SRC as of the last business day of its most recently completed, second fiscal quarter is permitted to file as an SRC in its quarterly report for such quarter. When a company no longer qualifies as an SRC as of the end of its most recently completed, second fiscal quarter, it can continue to use the scaled disclosure accommodations available to SRCs through its subsequent annual report Form 10-K. The filing deadline for the Form 10-K will be based on the company’s filing status as of the end of the fiscal year covered by the Form 10-K. 

Is It Always Better To Be An SRC?

No. SRCs are subject to additional disclosure requirements with respect to transactions with related persons, promoters, and certain control persons under Regulation S-K, Item 404. However, rather than the $120,000 threshold under Item 404, SRCs are subject to a threshold that is the lesser of $120,000 or one percent of total assets. The resulting disclosure must address the two preceding years. In addition, SRCs are also subject to additional Item 404 disclosure requirements regarding any underwriting compensation received by their corporate parent or any related persons. This Item 404 disclosure is mandatory for all companies qualifying as an SRC, regardless of whether it elects to take advantage of the scaled disclosure accommodations for SRCs. 

Must SRCs File Auditors’ Attestation Reports Under Section 404(B) Of the Sarbanes-Oxley Act I?

Sometimes. Only “nonaccelerated filers” and “emerging-growth companies” are exempt from the requirement to provide an auditors’ attestation report. As a result, it is possible that a company could qualify as an SRC and be eligible to provide scaled disclosure, but at the same time meet the definition as an accelerated filer required to provide an auditors’ attestation report. Note that SEC Chairman Jay Clayton has directed SEC staff to exempt some companies from the Sarbanes-Oxley Act Section 404(b) auditors’ attestation report. 

Pointers:

• Companies that have completed an initial public offering in the last five years will soon lose their emerging growth company eligibility due to the passage of time. Qualifying for SRC status will enable them to take advantage of the scaled disclosure regime. 
• There will be a greater number of companies that qualify as both an SRC and an accelerated filer, and will be required to check both boxes on the cover page. 
• Companies should keep in mind the status of their competitors and whether qualifying as an SRC may negatively impact market perception of the company. Given the complexity of the federal securities laws, it is prudent to consider some of these issues sufficiently in advance. In addition, companies should keep in mind their long-term capital raising plans as the market practices develop. 
• Given the rampant use of stock buy-backs, a company could plan its entry into the SRC regime based on its revenues and public float. 
• It is possible for a company not to have a public float. This could occur if a company does not have any public common equity outstanding, or no market price for its common equity exists. 
• If you are a tech company, or a pre-clinical life sciences company, with no revenue, it is highly likely that you will qualify as an SRC. 

Appendix A 

A recent decision by the Louisiana Court of Appeals considered the effect of the seriatim deaths of several members of an LLC and, ultimately, whether an action for judicial dissolution initiated by a member who subsequently passed away could continue. In this instance, the court found that the action for judicial dissolution of the LLC could continue.  Schauf v Schauf, No. 51, 919-CA, __ So.3d __, 2018 WL 1937068 (La. App. 2d Cir. Apr. 25, 2018).

Angela Schauf organized the Schauf Family LLC in 2001, keeping 50 percent of the ownership for herself and distributing to each of her four children a 12.5-percent interest. Those four children were Peter, Paul, Mary, and Kathryn. Angela and all of the children executed an operating agreement. The LLC’s only asset was farmland that was leased out. Angela passed away, and her interest in the LLC was divided among the four children, resulting in each of them becoming a 25-percent member. Then, each of Peter and Kathryn passed away, leaving their interests in the LLC to their respective spouses, Jo Ann and Michael.

Thereafter, disagreements arose with respect to the LLC, and each of Jo Ann (assignee of Peter) and Michael (assignee of Kathryn), as well as Mary, an original member, sought to dissolve the LLC, sell its assets, and distribute the proceeds. Paul objected to any dissolution and also rejected the proposal that he buy out the other members. Nonetheless, everyone except Paul voted to dissolve the LLC and appoint Jo Ann as its liquidator.

Thereafter, Paul filed suit, asking for a ruling that the appointment of the liquidator and the vote to dissolve the LLC were null and void. Mary then passed away, and a motion was filed to substitute Jo Ann, Mary’s executrix, in the lawsuit. In turn, the trial court granted Paul’s application for summary judgment, in which the vote to liquidate and the appointment of Jo Ann as the LLC’s liquidator was declared void. Conversely, the defendants’ motion for summary judgment was denied on the basis that they had no authority to dissolve the LLC and liquidate its assets. The defendants filed this appeal.

The court’s opinion begins with a review of the status of the estate of a deceased member under the Louisiana LLC Act. Specifically, the estate does not become a member (absent a contrary provision in either the articles or operating agreement).

Thus, an LLC’s articles of organization or a written operating agreement could, but have not in this case, provide that a person who inherits a decedent member’s interest in the LLC would become a member of the LLC or would have certain rights that are provided only to members.

From there, the court offered some observations as to the status of a decedent member’s estate vis-a-vis the LLC, namely:

The rule treating a decedent member’s legal representative as an assignee of the decedent’s interest may be problematic. As an assignee of the decedent member’s interest, the decedent’s legal representative is entitled only to receive distributions from the LLC as authorized by the LLC’s operating agreement or by the members, to share in the LLC’s profits and losses, and to receive allocations of the LLC’s items of income, gain, loss, deduction, and credit. A decedent member’s legal representative may not become a member of the LLC or exercise any of the rights or powers of a member unless the LLC’s articles of organization or a written operating agreement provides otherwise or the legal representative is admitted as a member of the LLC. Thus, the legal representative of a decedent member may not participate in the management of the LLC, vote on the LLC’s affairs, or inspect the LLC’s records unless the LLC’s articles of organization or an operating agreement specifically accords such management rights to the decedent’s legal representative or the legal representative is admitted as a member of the LLC. Without the right to vote or inspect records, a decedent member’s legal representative will have little ability to protect the interests of the decedent’s estate or heirs with respect to the decedent’s interest in the LLC. Id. at *6–*7.

Still, the court noted that an action for judicial dissolution may be brought by any member on the grounds that it “is not reasonably practicable to carry on the business of the LLC in conformity with its articles of organization and operating agreement.” Id. at *3, quoting La. R. S. 12:1335. The court went on to find that Mary had been a member of the LLC at the time the petition for judicial dissolution was filed, that “[h]er death did not terminate the dissolution process once it had been initiated.” and that JoAnn, as Mary’s executrix, could continue the dissolution action. Id. at *8.

Almost in passing, the court rejected the suggestion that because the articles of organization provided that the LLC would dissolve after 25 years, it could not be dissolved prior to that time.

If this decision is restricted to its facts—namely, an action for judicial dissolution—it is an entirely reasonable outcome. At the time the action for judicial dissolution was filed, three of the four persons having a derivative economic interest in the LLC’s assets no longer wish to be in business together. Likewise, one-half of the members did not want to be in business with the other half. It would be dangerous, however, to extend this decision beyond the context of an action for judicial dissolution. If, in contrast, the suit were to have involved a derivative action or a request to inspect documents by a member who then passes away, different policy concerns focused upon the LLC’s internal management would arise.

Among the most important recent developments in Delaware corporate law is the establishment (or re-establishment) of the potentially case-dispositive impact of an affirmative stockholder vote in M&A litigation. The Supreme Court of Delaware’s 2015 decision in Corwin v. KKR Financial Holdings LLC held that a fully informed vote in favor of a transaction by disinterested stockholders invokes the application of the business judgment standard of review. Given that application of the deferential business judgment standard of review renders the challenged transaction almost certainly immune from further judicial scrutiny, it is difficult to overstate Corwin’s impact. Few cases survive Corwin’s application, an unsurprising result given that a faithful application of the doctrine places a significant burden on a stockholder plaintiff to allege, without the aid of discovery, a material omission or misstatement in connection with a stockholder vote. Due to this trend, the Delaware Supreme Court’s decision in Morrison v. Berry, which reversed a Court of Chancery decision dismissing a merger challenge based on Corwin, presents an important step in the continued development of the Corwin doctrine. As discussed below, it is apparent that Delaware’s high court expects the Court of Chancery to apply Corwin in a careful, searching manner that is consistent with the plaintiff-friendly motion to dismiss standard. Indeed, Morrison is the second of two recent Delaware Supreme Court cases (the first being Appel v. Berkman) that stress the careful application of Corwin.

The Corwin Decisions

Stockholders of KKR Financial Holdings LLC (KKR Financial) challenged its acquisition by KKR & Co., L.P. (KKR), alleging breaches of fiduciary duty against KKR, as controlling stockholder, and KKR Financial’s board. In opposing the defendants’ motion to dismiss, the plaintiffs argued that the entire fairness standard of review should apply because KKR was allegedly a controlling stockholder of KKR Financial and because, with respect to the claim against KKR Financial’s board, the complaint contained sufficient allegations to rebut the business judgment standard of review.

The Court of Chancery granted the defendants’ motion in full. Regarding plaintiffs’ claim against KKR, the court held that KKR was not a controlling stockholder and therefore owed no fiduciary duties to KKR Financial or its stockholders. As to the claims against KKR Financial’s board, the court first held that the complaint failed to allege facts sufficient to rebut the business judgment rule. Although the court could have ended its decision there, it went on to hold that, even if the complaint had adequately alleged such facts, “business judgment review would still apply because the merger was approved by a majority of disinterested stockholders in a fully-informed vote.” The Supreme Court of Delaware affirmed, likewise holding that “when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies.”

Fully Informed Stockholder Vote

Given that the plaintiffs in Corwin did not allege that the merger-related disclosures were deficient or contest the defendants’ argument that the business judgment rule was invoked by virtue of the affirmative stockholder vote, the Corwin decisions did not discuss what constitutes a “fully informed” stockholder vote sufficient to invoke the business judgment standard of review. In subsequent decisions by the Court of Chancery, the court has looked to the existing standards under Delaware law in the context of disclosure-based fiduciary duty claims regarding what is or is not material to the stockholders’ decision-making. Where a plaintiff adequately alleges that the merger disclosures were materially incomplete or misleading, the court has found that the stockholder vote was not fully informed.

Morrison v. Berry

The action relates to the 2016 acquisition of The Fresh Market (the Company) by Apollo Global Management LLC (Apollo) through a tender offer. Apollo submitted an unsolicited offer to acquire the Company in October 2015, noting that it had discussed the proposal with Ray Berry, the Company’s founder and a member of the board who, together with his son Brett, owned 9.8 percent of the Company’s outstanding stock. After a five-month process, a special committee of the board and the board recommended a transaction with Apollo that involved a tender offer and an equity rollover by Ray and Brett Berry. The tender offer closed in April 2016 with over 68 percent of outstanding shares validly tendered.

Following the announcement of the tender offer, a stockholder of the Company demanded books and records under section 220 of the Delaware General Corporation Law, through which she received “several key documents,” including board minutes and e-mails between Ray Berry’s counsel and Company counsel. The stockholder then filed suit alleging breaches of fiduciary duty against the board and a claim for aiding and abetting breaches of fiduciary duty against Brett Berry. The defendants moved to dismiss under Corwin, which had been applied to tender offers in an earlier Court of Chancery decision captioned In re Volcano Corp. Stockholder Litigation. The stockholder plaintiff argued that Corwin did not apply because the Company failed to disclose all material facts in its Schedule 14D-9; therefore, the stockholders’ decision to accept the tender offer was not fully informed. In a short letter opinion, the Court of Chancery granted the motion to dismiss, ruling that the alleged disclosure issues were immaterial and that the action was “an exemplary case of the utility of th[e] ratification doctrine, as set forth in Corwin and Volcano.”

On appeal, the Delaware Supreme Court reversed, finding that the stockholder plaintiff alleged four disclosure deficiencies that rendered the 14D-9 materially incomplete and misleading.

First, the Supreme Court concluded that the complaint adequately alleged that the 14D-9 omitted material information about Ray Berry’s agreement with Apollo and his representations to the board about the agreement. After withdrawing its initial offer, Apollo renewed its offer on November 25, 2015. A November 28, 2015 e-mail from Berry’s counsel to Company counsel read that Berry had one conversation with Apollo in the interim, during which “he agreed, as he did in October” to roll over his equity if Apollo reached an agreement with the Company. The 14D-9 did not include any reference to an agreement between Berry and Apollo in October. Whereas the Court of Chancery determined that this information was not material because Berry’s “position as of the time of the auction process and go-shop—that is, at the time material to stockholders—was adequately disclosed,” the Supreme Court determined that this information was material, especially in light of the 14D-9’s disclosure that Berry stated during an October 15 board meeting that he had not committed to a transaction with Apollo. The Supreme Court held that a reasonable stockholder would want to know both about Berry’s “level of commitment” to Apollo in October and that Berry was not forthcoming with the board about that commitment.

Second, the Supreme Court held that the 14D-9 was materially misleading because it included statements that Berry was open to considering other bidders and rolling over his equity in such transactions. The minutes from the board’s October 15 board meeting indicated, however, that Berry only committed to rolling over his equity if he was confident in the purchaser’s experience in the retail food industry, and he stated that Apollo was “uniquely qualified” in that respect. Without specifically addressing this alleged disclosure deficiency, the Court of Chancery held that Berry’s involvement with and commitment to Apollo was adequately disclosed. In contrast, the Supreme Court reasoned that stockholders would want to know facts suggesting that Berry preferred Apollo because these facts concern “the openness of the sale process.”

Third, the Supreme Court focused on statements in the November 28 e-mail from Berry’s counsel to Company counsel that Berry believed the board should pursue a sale of the Company “at this time,” and that he would sell his shares if the board failed to act. The Court of Chancery concluded that the omission of these facts from the 14D-9 was not material because “it would not have made investors less likely to tender.” The Supreme Court emphasized that the materiality standard considers whether there is a substantial likelihood that a reasonable stockholder would have considered the omitted fact important—not whether it would have caused the stockholder to change his or her vote. To this end, the Supreme Court held that stockholders “would want to know the rationale that Ray Berry gave the Board in encouraging it to pursue the sale, as well as his communication of his intent to sell his shares if such a transaction were not consummated.” In so reasoning, the Supreme Court cited to the decision it issued earlier this year in Appel v. Berkman, which held that the Schedule 14D-9 issued by Diamond Resorts International was materially misleading because it omitted information about why the company’s founder, chairman, and largest stockholder abstained from voting on proceeding with merger discussions. The company’s founder abstained because he thought mismanagement of the company had depressed the sale price and it was the wrong time to sell the company—facts the Supreme Court concluded would have been of interest to stockholders. Likewise, in Morrison, the Supreme Court held that stockholders would have been interested to know Berry’s rationale for pursuing the Apollo transaction.

Finally, the Supreme Court held that the 14D-9 was materially misleading in that it stated the Company created a special committee in October 2015 because it “could become the subject of shareholder pressure,” when in fact the contemporaneous board minutes reflected that the Company had already encountered “a significant amount” of stockholder pressure. The Supreme Court reasoned that, because the Company chose to address why the special committee was created, “stockholders were entitled to know the depth and breadth of the pressure confronting the Company” and that “it already existed.”

Because the 14D-9 was materially incomplete and misleading, the Supreme Court concluded that the stockholders’ decision to tender their shares was not fully informed, and the business judgment standard did not apply under Corwin. In so holding, the court warned directors and the attorneys who advise them to avoid “partial and elliptical disclosures,” which “cannot facilitate the protection of the business judgment rule under the Corwin doctrine.”

Takeaways

• Morrison demonstrates the Supreme Court’s willingness to closely scrutinize a company’s contemporaneous documents to see if they support the facts disclosed to stockholders. The court’s apparent willingness to so scrutinize the underlying record appears motivated by its recognition that “[c]areful application of Corwin is important due to its potentially case-dispositive impact.”
• In light of the court’s willingness to carefully examine the underlying record, Morrison reminds practitioners of the importance of full and accurate disclosures. This is especially so considering stockholder plaintiffs’ growing reliance on section 220 of the Delaware General Corporation Law as a means of avoiding dismissal by showing discrepancies between the record and the disclosures.
• Particular attention should be given to disclosures relating to the motivations and analysis of key board members and stockholders, given the Supreme Court’s decisions in Morrison and Appel.

The online retail marketplace bedevils major brand owners. It provides a vast, new market channel; it destroys brand owners’ exclusive channels. Amazon.com is not only a major force in the former but also the prime mover in the second. Take, for example, Versace’s “Bright Crystal” eau . Multiple sellers are linked to the product page on Amazon, offering the same, new product, often at reduced prices which may compromise Versace’s authorized dealer network’s profitability and stability.

Trademark infringement is the principal weapon brand owners have in combating unauthorized dealers. But there is nothing improper about selling genuine product by an unauthorized dealer, per se. The first sale doctrine in both trademark and copyright law bars the brand owner from controlling the downstream sales. The first sale doctrine provides that one who purchases a branded item generally has a right to resell that item in an unchanged state.[1]  But there’s an exception.

Trademark Infringement and “Genuine” Goods

 The first sale doctrine does not protect alleged infringers that sell trademarked goods that are “materially different” than those sold by the trademark owner or its authorized dealers. This is the case at least where there is a difference in the product, packaging, contents or warranties. The existence of a material difference between authorized and unauthorized goods sold under the same trademark creates “confusion over the source of the product and result in loss of [the trademark owner’s] good will.”[2] In other words, materially different goods sold by an unauthorized seller are not considered “genuine” because they are “confusingly different.”

 What is a “material difference”? It is virtually any physical or non-physical difference (however subtle) that exists between the authorized goods and unauthorized goods that a consumer would likely consider it relevant when purchasing the product. As one court put it, “it is by subtle differences that consumers are most easily confused,” and therefore “the threshold of materiality must be kept low enough to take account of potentially confusing differences—differences that are not blatant enough to make it obvious to the average consumer that the origin of the product differs from his or her expectations.”[3] Thus, for example, material differences could include differences in battery life between authorized and unauthorized batteries or alterations to packages or reference numbers and codes, or differences in warranty protection.[4]

From a brand owners’ enforcement perspective, the primary concern is trademark enforcement. However, copyright infringement can arise from lifting the brand owner’s copy or images. Other weapons at hand for brand owners include non-intellectual property rights, such as breach of contract, restrictions violating anti-trust principles, misleading statements regarding being “authorized”[5] and state warranty statutes.[6]

Doing Something: Takedowns and Suits Against the Infringer 

Armed with these weapons, one could sue the infringer or demand a takedown. However, Amazon is notorious for not honoring unauthorized dealer takedown requests: it distinguishes such issues from more traditional trademark infringement or counterfeit sales. “Asking Amazon to help police your brand will fall on deaf ears, even if you have protective assets like a patent or trademark. Amazon does not view unauthorized sellers (i.e. anyone but you and your authorized distributors) as policy violators.”[7] The Digital Millennium Copyright Act (DMCA) is of limited use, since the “primary” and more lasting offense is trademark. Moreover, as is typical on Amazon Marketplace, the true name and location of the third-party seller is usually cloaked, with only a fictitious alias to pursue.  Suing the seller thus becomes problematic.

Taking on Amazon:  A Problem with “Consent”

So what about suing Amazon as the enabler? Unfortunately for the brand owner, often it knowingly or unknowingly consented to Amazon’s practice, in its own initial listing of goods.  By doing so, Amazon claims the right to keep the product detail page on its site, even if the brand owner wishes to cease sales. Amazon goes on to claim unfettered sublicensing rights: “Additionally, when you add your copyrighted image to a detail page, you grant Amazon and its affiliates a non-exclusive, worldwide, royalty-free, perpetual, irrevocable right to exercise all rights of publicity over the material. . . . Other sellers can list their items for sale against pages that you have created or added your copyrighted images to.”[8] Amazon routinely refuses to provide information to brand owners of the identity of third-party sellers.

Assuming brand owners listed their products with Amazon, their enforcement path becomes troubled. Challenging the “consent” provisions is one of contract law.  Three questions immediately arise:

(1) Was there effective consent? Perhaps “browsewrap” issues apply to assumed electronic consent. 

(2) Is the agreement unenforceable and voidable by its terms? In other words, are the applicable provisions “unconscionable” or an “unfair business practice” under applicable state law? 

(3) Further, even if the agreement is otherwise enforceable, has it been rendered unenforceable by Amazon’s practice? One could argue that Amazon’s practice, in refusing to reveal the identity of third-party sellers to the brand owner on request, breaches the implied covenant of good faith and fair dealing. It arguably deprives the brand owner of the benefit of the bargain it supposedly expected in listing with Amazon in the first place. By the same token, the mutual understanding of the brand owner and Amazon that Amazon would act “responsibly” in sublicensing is an implied-in-fact condition that often is not being met.

These are not easy issues to address, but they are necessary. For the company with enough at stake, there is some interesting law to be made. Each is highly fact-specific, and some case law exists to support either side of the controversy on each point. The answer in any given case is, well, it depends.

[1] See, e.g., Dan-Foam A/S v. Brand Named Beds, LLC, 500 F.Supp.2d 296, 317 (S.D.N.Y. 2007).  

[2] Original Appalachian Artworks, Inc. v. Granada Electronics, Inc., 816 F.2d 68, 73 (2d Cir. N.Y. 1987). 

[3] Societe Des Produits Nestle, S.A. v. Casa Helvetia, Inc., 982 F.2d 633, 641 (1st Cir. 1992).

[4] Duracell, Inc. v. Global Imports, Inc., 12 U.S.P.Q.2d 1651 (S.D.N.Y. 1989)); Davidoff & Cie, S.A. v. PLD Int’l Corp., 263 F.3d 1297 (11th Cir. 2001); Fender Musical Instr. Corp. v. Unlimited Music Center, Inc., 35 U.S.P.Q.2d 1053 (D.Conn. 1995.

[5] 15 U.S.C. § 1125(a)(1).

[6] California Civil Code Sections 1797.8 et seq. require retail sellers offering unauthorized, imported consumer goods that normally have express, written warranties to post/affix conspicuously certain disclosures.

[7] www.bobsledmarketing.com/blog/protect-your-brand-on-amazon

[8] https://www.amazon.com/report/infringement

In the time before the internet made breaking news available 24/7/365, the most important breaking news came via the three television networks. When important (usually bad) news broke, each of the networks would suspend regular broadcasts with a special “up to the minute” report, and would introduce the report with the phrase, “We interrupt this program to bring you…”

This column interrupts our coverage of LLC-related remedies to discuss an important and interesting decision of the Iowa business court. The case, which Professor Matt Dore of Drake Law School recently brought to my attention, is REG Washington, LLC v. Iowa Renewable Energy LLC, Equity No. EQCE128952 (Iowa District Court for Scott County, Sept. 27, 2017) (REG v. IRE). What makes the case noteworthy is its discussion of transfer restrictions applicable to ownership interests in a limited liability company, and more particularly transfer restrictions applicable to so-called transferable interests, i.e., economic rights. Relevant precedent in the LLC context is somewhere between scant and nonexistent, so the case provides a useful first word on the subject. (Most cases considering transfer restrictions in limited liability companies or partnerships do so in the context of a right of first refusal (ROFR). See, e.g., Robertson v. Murphy, 510 So. 2d 180, 182–83 (Ala. 1987) (upholding ROFR under partnership agreement); RTS Landfill, Inc. v. Appalachian Waste Sys., LLC, 598 S.E.2d 798 (Ga. Ct. App. 2004) (rejecting a ROFR pertaining to LLC interests because the right was permanent in duration and purported to permit the purchase at $500,000 less than any third-party offer)). Moreover, the decision’s analysis centers around the “pick your partner” principle and expressly rejects any analogy to corporate law cases addressing stock transfer restrictions.

REG v. IRE involved an Iowa limited liability company, Iowa Renewable Energy, LLC (IRE), which “operates a bio-diesel production facility in Washington, Iowa,” and REG Washington, LLC (REG), “a producer of bio-based fuel and renewable chemicals located in Ames, Iowa.” The litigation arose out of two tender offers REG made for ownership interests in IRE.

Given that the IRE operating agreement has strict transfer restrictions, understanding the case begins with understanding the relevant provisions of the operating agreement. The IRE operating agreement refers to “Membership Interests” as comprising “two distinct interests in the company: ‘Membership Economic Interest’ and ‘Membership Voting Interest,’” and provides that “[t]he Membership Economic Interest of a Member is quantified by the Unit of measurement referred to herein as ‘Units.’” Through its tender offers, REG sought to purchase up to “49% of IRE’s Class A units and 49% of IRE’s Class B units.”

Section 9.1 of the IRE operating agreement contained a strict limitation on transfers: “Except for Permitted Transfers [not relevant to the case], no Member shall transfer all or any part of its Units, voluntarily or involuntarily, or by operation or process of law or equity, unless and until the Directors have approved the Transfer in writing, which approval may be withheld in the Directors’ sole discretion.” The operating agreement further provided that any purported transfer made without the directors’ approval was void. Although the operating agreement did not appear to quantify member voting interest in terms of units, the court held Section 9.1 applicable to both of the “two distinct interests.”

In any event, the focus of the case is on the operating agreement’s control over the transfer of economic rights. Despite its knowledge of the operating agreement’s transfer restriction, pursuant to its second offer, REG paid cash to 28 IRE members for, in the aggregate, 1,895 units, accompanied by signed proxies and powers of attorney. The IRE directors exercised their “sole discretion” and declined to give effect to the purported purchases. REG then brought suit “in equity seeking a writ of mandamus or, in the alternative, an injunction against Defendants Iowa Renewable Energy, LLC” and several individual defendants.

Like all LLC statutes, the Iowa act prohibits transfers of governance rights and complete membership interests unless authorized by the operating agreement or consented to by all the members. However, the “default setting” on economic rights is the opposite; unless the operating agreement provides otherwise, “a transfer, in whole or in part” of “a transferable interest . . . is permissible.” Iowa Code Ann. § 489.502(1)(a).

The Iowa LLC statute is based on ULLCA (2006). Like all other LLC statutes (including ULLCA (1996) and ULLCA (2013)), ULLCA (2006) gives no direct, express guidance on the extent to which an operating agreement may restrict the transferability of economic rights. However, all uniform LLC acts (including Iowa’s) provide a centralized list of “thou shall nots” that limit the power of an operating agreement. Restricting the transfer of transferable interests is not on the “thou shalt not” list. Moreover, Iowa Code Ann. § 489.502(6) provides categorically and without exception that “[a] transfer of a transferable interest in violation of a restriction on transfer contained in the operating agreement or another agreement to which the transferor is a party is ineffective as to a person having notice of the restriction at the time of transfer.”

In the corporate realm, where shares are freely transferable absent a contrary agreement, both case and statutory law impose some sort of reasonableness requirement on stock transfer restrictions. See, e.g., Iowa Code Ann. § 490.627(3) (stating that “[a] restriction on the transfer or registration of transfer of shares is authorized . . . [t]o maintain the corporation’s status when it is dependent on the number or identity of its shareholders[,] [t]o preserve exemptions under federal or state securities law[, and] [f]or any other reasonable purpose”) (derived from Mod. Bus. Corp. Act § 6.27; Elson v. Schmidt, 140 Neb. 646, 650–51, 1 N.W.2d 314, 316 (1941) (upholding a stock transfer limitation “[a]fter a careful reading of the authorities” because the limitation “is a reasonable restriction”).

In assessing the reasonableness of stock transfer restrictions (and thereby departing from a laissez faire or “freedom of contract” approach), courts have often written of the law’s hostility toward “restraints on alienation.” In REG v. IRE, REG invited the court to embrace that hostility, “argu[ing] that a transfer restriction is subject to a ‘reasonableness’ standard that some courts apply to transfers of corporate stock.”

The court rejected the invitation. Noting that “REG routinely cites corporate law cases to support its allegations that the Operating Agreement’s restrictions on transfers of Membership Interest are improper,” the court held that, “[w]hile analogies to corporate law may be appropriate in certain situations, the transferability of membership interest in an LLC entity is not one of them.” Quoting the official comments to ULLCA (2006) at section 502, the court emphasized the contractual nature of an LLC and explained:

Re-ULLCA counsels that the intention of the contracting parties must be controlling: “Unless the operating agreement otherwise provides, a member acting without the consent of all other members lacks both the power and the right to: (i) bestow membership on a non-member; or (ii) transfer to a non-member anything other than some or all of the member’s transferable interest.” Rev. Unif. Ltd. Liability Co. Act § 502 introductory cmt. (2006) (internal citations omitted). Here, IRE has provided otherwise. The Member parties contracting to form IRE specifically limited their ability to transfer any aspect of Membership Interest under the Operating Agreement by requiring approval by the Board of Directors.

Having rejected any reasonableness standard, the court had neither need nor occasion to consider the reasonableness of section 9.1 of the IRE operating agreement.

There is much to be said for the court’s holding. After all, in sharp contrast to the corporate construct, the LLC construct hardwires restraints on alienation into the entity-creating statute; all LLC statutes restrict the transfer of governance rights. See, e.g., ULLCA (2013) § 501, cmt. (“Absent a contrary provision in the operating agreement or the consent of the members, a “transferable [i.e., economic] interest” is the only interest in an LLC which can be transferred to a person who is not already a member.”) Moreover, many (perhaps most) LLC statutes also provide that as a default rule, a member’s dissociation strips away the dissociating person’s governance rights and locks the person in as a mere transferee of its own economic rights. See, e.g., ULLCA (2013) § 603(3) (providing that, upon a person’s dissociation, “any transferable interest owned by the person in the person’s capacity as a member immediately before dissociation is owned by the person solely as a transferee.”). Certainly, the typical limited liability company is the wrong place to be if one seeks free transferability of any aspect of one’s ownership interest.

On the other hand, however, how threatening is the transfer of economic rights to the pick-your-partner principle? LLC statutes provide transferees no entrée to (much less influence over) a limited liability company’s activities and affairs, see, e.g., ULLCA (2013) § 502(a)(3)(A), no right to participate in management, no general right to access to company financial information, and precious little access even to information directly relevant to the transferee’s interest, see, e.g., ULCCA (2013) §§ 502(a)(3)(B), 502(c) (providing that a transferee has no “access to records or other information concerning the company’s activities and affairs,” except that “[i]n a dissolution and winding up of a limited liability company, a transferee is entitled to an account of the company’s transactions only from the date of dissolution”).

However, in contrast to this general proposition, REG v. IRE involved at least two sets of circumstances that would have justified the application of a “sole discretion” standard. First, it is by no means certain that REG was seeking to obtain only economic rights. By acquiring proxies and powers of attorneys from its transferors as well as economic rights, in effect REG sought the transfer of governance rights. If so, the pick-your-partner principle was centrally at issue, and enforcing the restriction was indubitably necessary. Before the check-the-box regulations, practitioners and some academics worried that giving proxy rights to persons that were neither fellow members nor managers of the company created the corporate characteristic of free transferability of interests. At least one LLC statute addressed the concern directly. See Minn. Stat. § 322B.363(8) (“A member may not grant any proxy to any person who is an assignee of any member’s financial rights and who is not also a member.”).

Second, leaving the proxy argument entirely aside, the IRE operating agreement contains an unusual definition of economic rights. The agreement defines a “Membership Economic Interest” to include not only “the right to receive distributions of the Company’s assets,” but also (for some undiscussed reason) “the right to information concerning the business and affairs of the Company,” thereby providing unusual and potentially disruptive access rights to those who own merely member economic interests.

The court made neither of these points. Instead, it hitched its wagon to the pure, unvarnished pick-your-partner principle:

While analogies to corporate law may be appropriate in certain situations, the transferability of membership interest in an LLC entity is not one of them. Contrasted with other principles of incorporated business organizations, “[o]ne of the most fundamental characteristics of LLC law is its fidelity to the ‘pick your partner’ principle.”

It is not clear that the court chose the correct wagon, given the paradigmatic circumstances that gave rise to the principle. Under the first uniform partnership act promulgated in 1914 almost a century before the advent of the limited liability company:

1. general partnerships were closely held, i.e., only a few partners;
2. each partner had the inescapable power to bind the partnership (“statutory apparent authority”);
3. a partner’s power to bind the partnership was also the power to encumber the personal assets of the partners because each partner was personally liable for the partnership’s debts; and
4. the departure of even one partner from the enterprise dissolved the legal relationship of partnership.

Almost all limited liability companies are closely held, but statutory apparent authority for members is not ubiquitous, i.e., not in any manager-managed company and not at all under some LLC statutes. See ULLCA (2006 & 2013) § 301(a) (“A member is not an agent of a limited liability company solely by reason of being a member.”). As for member liability for the entity’s debts, limited liability is of course a hallmark of the limited liability company, and the dissociation-dissolution link is a thing of the past for virtually all (if not all) LLC statutes. Carter G. Bishop & Daniel S. Kleinberger, Limited Liability Companies: Tax & Business Law ¶ 1.01[3][e] (Warren Gorham & Lamont, 1994; Supp. 2018-1) (LLC characteristics after “check-the-box”).

An almost 25-year-old Louisiana appeals shows the above-described paradigm in action. The case, LeBreton v. Allain-LeBreton Co., 631 So. 2d 662, 664 (La. Ct. App.), writ denied, 637 So. 2d 159 (La. 1994), involved restrictions on the transfer of partner interests in a non-LLP general partnership. The party challenging the transfers argued for the corporate jurisprudence. The court rejected the argument, explaining as follows.

Every partner in a partnership is liable for the debts of the partnership, absent contrary agreement. Attempts to limit the ability of a partner to bind the partnership are invalid against a good faith party. Thus, because any partner may obligate the partnership and therefore, his partners, it would seem appropriate that there would be a presumption against transferability of interests in a partnership.

Unlike the circumstances in LeBreton, in the context of limited liability companies, only the closely held characteristic remains to justify applying the pick-your-partner principle to restrictions on the transfer of economic rights. In addition, as REG v. IRE itself exemplifies, even that characteristic has exceptions. According to the court, “IRE has issued over 26,000 units, which are held by approximately 600 unitholders.” Doubtlessly, the persons managing the limited liability company owed fiduciary duties to the company and in some circumstances to the unit holders, but a “community” of 600 is far from the paradigmatic closely held business in which personal, mutual relations of trust and confidence are expected and salutary. Note also that, at least for as long as uniform partnership acts have existed (since 1914), partnership law has protected the pick-your-partner principle while accepting economic interests as freely transferable.

Why then should LLC law invoke the mantra of pick your partner to make transfer restrictions on LLC transferable interests immune from judicial scrutiny? Yet, on information and belief, transfer restrictions like those in the IRE operating agreement are far from rare. Given the scarcity of precedent, REG v. IRE provides useful first words on the subject, but given the issues raised in this column, hardly the last.

Article 9 of the Uniform Commercial Code also bears on this issue. UCC sections 9-406 and 9-408 have overridden some transfer restrictions often included in partnership and operating agreements. In May and July 2018, the ALI and the ULC adopted amendments to sections 9-406 and 9-408, placing transfer restrictions on ownership interests in limited liability companies and partnerships outside the sections’ reach. For a discussion of the override issue and the new exception, see LLC and Partnership Transfer Restrictions Excluded from Article 9 Overrides, soon to be published in Business Law Today.

On June 21, 2018, the Supreme Court decided Lucia v. SEC, No. 17-130, 138 S. Ct. 2044, holding that the SEC’s Administrative Law Judges (ALJs), appointed under Title 5 of the U.S. Code, were “Officers of the United States,” that the Appointments Clause of the Constitution requires those ALJs to be appointed by the President, a court of law, or the Commission itself, and that an SEC order following a hearing before an improperly appointed ALJ was invalid. The Supreme Court, however, expressly declined to resolve several other constitutional questions raised by the case.

Immediately following the Supreme Court’s decision, the SEC issued a stay of all pending administrative proceedings that were commenced before an ALJ. On August 22, 2018, however, the SEC lifted the stay, remanded all proceedings to the Office of Administrative Law Judges, and provided procedures for proceedings on remand—setting the stage for litigants to begin to make constitutional challenges to the SEC’s adjudicative process based on the questions unanswered by Lucia.

Below we describe the Lucia ruling, track its impact as subsequent litigation works through proceedings at various administrative agencies, review the key questions the decision raises, and identify important considerations for future challenges to regulatory or enforcement actions before various agencies.

The Lucia decision raises more questions than it answers, although what seems clear is that the decision has begun to have far-reaching effects and will likely sponsor waves of litigation concerning the legitimacy of administrative enforcement proceedings that rely on ALJs or similar hearing officials at multiple agencies. For the SEC, key unanswered questions include whether the SEC’s “ratification” of an unconstitutional ALJ appointment cures the constitutional defect. Recognizing this uncertainty, on the same day of the Supreme Court’s order, the SEC stayed all pending administrative proceedings before ALJs and subsequently ordered them reheard by a new ALJ whose appointment was ratified by the SEC in the interim. However, the uncertainty extends beyond the SEC. As explored below, the Federal Trade Commission (FTC), Federal Regulatory Commission (FERC), Occupational Safety and Health Review Commission, Department of the Interior, Environmental Protection Agency (EPA), Federal Mine Safety and Health Review Commission, Department of Health and Human Services, and Consumer Financial Protection Bureau (CFPB), among others, all use ALJs or similar hearing officials in connection with administrative enforcement proceedings. Administrative enforcement proceedings at each agency are subject to similar challenges under Lucia.

Background on ALJ Hiring

Historically, federal agencies have made appointments of ALJs through a competitive-service application and examination process administered by the Office of Personnel Management (OPM). Federal statutes authorized the President to delegate his or her authority over competitive examinations to the director of OPM but barred the director from further delegating that authority, even though the director could delegate other authority to heads of agencies. 5 U.S.C. § 1104(a).

Federal regulations have provided that “[a]n agency may appoint an individual to an administrative law judge position only with prior approval of OPM, except when it makes its selection from the list of eligibles provided by OPM.” 5 C.F.R. § 930.204. OPM generally has required that agencies appoint “one of the top three highest scoring applicants interested in that geographical location.” Even when an agency “is insufficiently staffed with administrative law judges,” federal statutory law provides that the agency can use ALJs appointed by other agencies, but only if selected by OPM and with the consent of the other agencies. 5 U.S.C. § 3344. Moreover, a federal statute provides that, once appointed by an agency, an ALJ may be removed “only for good cause established and determined by the Merit Systems Protection Board on the record after opportunity for hearing before the Board.” Id. § 7521.

Facts and Holding of Lucia

The SEC has five ALJs who preside over almost all administrative proceedings in which the SEC seeks to enforce federal securities laws. Lucia, 138 S. Ct. at 2049. Staff members, rather than the Commission itself, have selected all of the ALJs from the list of eligible candidates identified by OPM. Id. The ALJs have the power to issue subpoenas, hear evidence, and impose sanctions. Id. The ALJs issue “initial decisions” that set out findings of fact and conclusions of law, which can be challenged on appeal to the full Commission, or which the Commission can review sua sponte. Id. In either case, the Commission can choose to review the ALJ’s decision or adopt the ALJ’s decision as final. Id.

In 2012, the SEC initiated an administrative proceeding against investment advisor Raymond Lucia and his investment company, alleging in the order instituting proceedings that Lucia misrepresented back-tested returns of fictional investment portfolios in his presentations, and thereby deceived prospective clients in violation of the Investment Advisers Act of 1940. After a hearing, the ALJ ruled that Lucia and his company had violated the Advisers Act and revoked their investment adviser registrations. See Initial Decision on Remand, In re Raymond J. Lucia Companies Inc., et al. (S.E.C. Dec. 6, 2013). The ALJ imposed a cease-and-desist order, a civil penalty of $50,000 against Lucia, a civil penalty of $250,000 against Lucia’s company, and a permanent industry-wide bar against Lucia. Id. at 58–61. Lucia appealed to the SEC, arguing among other things that the ALJ had not been constitutionally appointed because he was an officer of the United States under the Appointments Clause. See Respondent’s Motion to Stay Appeal and for Leave to Submit Additional Briefing, In re Raymond J. Lucia Companies Inc., et al., at 1–2 (June 12, 2015). The Commission rejected the argument, finding that “ALJs are not ‘inferior officers’ under the Appointments Clause.” Order of the Commission, In re Raymond J. Lucia Companies Inc., et al., at 33.

Lucia then filed a petition for review in the Court of Appeals for the D.C. Circuit. A three-judge panel denied Lucia’s petition, holding that the SEC’s ALJs were not “Officers of the United States” pursuant to the Appointments Clause because, among other things, they “neither have been delegated sovereign authority to act independently of the Commission nor, by other means established by Congress, do they have the power to bind third parties, or the government itself, for the public benefit.” See Raymond J. Lucia Cos., Inc. v. S.E.C., 832 F.3d 277 (D.C. Cir. 2016). After granting rehearing en banc, the full D.C. Circuit denied the petition for review by an equally divided court. Raymond J. Lucia Cos., Inc. v. S.E.C., 868 F.3d 1021 (D.C. Cir. 2017). When Lucia petitioned for certiorari in the Supreme Court, the government switched positions and asked the Supreme Court to grant certiorari and rule in favor of Lucia. The Supreme Court granted certiorari.

The Supreme Court reversed the D.C. Circuit, holding that the SEC ALJs were “Officers of the United States” under the Appointments Clause. The Supreme Court held that the test in determining whether ALJs are officers was twofold: whether the official (1) occupied a “continuing” position established by law, and (2) “exercised significant authority pursuant to the laws of the United States.” Lucia, 138 S. Ct. at 2051–52. The Supreme Court concluded that Freytag v. Commissioner, 501 U.S. 868 (1991), which held that the Tax Court’s special trial judges (STJs) are Officers of the United States, was dispositive. Relying on Freytag, the Supreme Court determined that the SEC’s ALJs hold a continuing position as they “receive[] a career appointment to a position created by statute.” Lucia, 138 S. Ct. at 2053. In addition, the Supreme Court concluded that the ALJs share the same four powers on which the Freytag Court relied in holding that STJs were officers: (1) they “take testimony” by receiving evidence and examining witnesses; (2) they “conduct trials”; (3) they “rule on the admissibility of evidence” and thus “critically shape the administrative record”; and (4) they “have the power to enforce compliance with discovery orders,” including by punishing contemptuous conduct. Id. at 2053–54. If anything, the Supreme Court concluded, ALJs are more clearly officers than STJs because they are more autonomous; whereas the Tax Court must review certain STJ decisions, the SEC need not review any particular ALJ decisions. Id. at 2053–55.

Turning to the issue of remedies, the Supreme Court held Lucia was entitled to relief because he filed a timely challenge to the validity of the ALJ’s appointment “before the Commission, and continued pressing that claim in the Court of Appeals.” Id. at 2055. Noting precedent holding that “the appropriate remedy for an adjudication tainted with an appointments violation is a new hearing before a properly appointed official,” the Court concluded that the new hearing official cannot be the same ALJ who heard the case originally. Id. Even if the ALJ who decided the case below had received a constitutional appointment in the interim, the Supreme Court held that the ALJ during the initial hearing cannot be the hearing official on remand because that same ALJ “cannot be expected to consider the matter as though he had not adjudicated it before.” Id.

Key Constitutional Questions the Court Declined to Resolve in Lucia

In reaching its decision, the Supreme Court declined to address several other constitutional arguments raised by the parties or by amici relating to the work of ALJs or the administrative state more broadly. For instance, the Court declined to resolve:

• Whether ratification of previously-appointed ALJs cures any constitutional deficiency. Although Lucia’s case was pending, the Commission entered an order purportedly “ratifying” the prior ALJ appointments made by SEC staff members. The Supreme Court did not decide whether the SEC’s order purportedly “ratifying” its ALJs cured the Appointments Clause violation. The Court explained that it would not address the issue because the SEC did not identify whether an ALJ or the Commission itself would hear the case on remand. at 2055 n.6.
• Whether statutory restrictions on removal of ALJs are constitutional. The Supreme Court also declined to decide whether the statutory restrictions on removing ALJs were constitutional, noting that no lower courts had addressed the issue. at 2050 n.1. The solicitor general argued before the Supreme Court that if ALJs constitute Officers of the United States, then the statutory restrictions on removing ALJs are unconstitutional restrictions on the President’s executive oversight authority under Article II. The Supreme Court also expressly declined to decide the issue. Given the open question, a presidential administration or private litigants may seek to challenge the removal restrictions on ALJs or similar hearing officers in future litigation, including if it disagrees with the ALJ’s legal reasoning. Elimination of the removal restrictions would allow a presidential administration or executive agency to exert significant control over ALJs and other civil servants who currently operate with certain amounts of independence. As Justice Breyer noted in his opinion concurring in part and dissenting in part, holding that the protections from removal for ALJS, for example, are unconstitutional, “would risk transforming [them] from independent adjudicators into dependent decisionmakers,” contrary to the “substantial independence” that was “a central part” of the scheme of the Administrative Procedures Act. Id. at 2060 (opinion of Breyer, J.).

Additionally, the Supreme Court left open the possibility that a private litigant may contend that it has standing to challenge the constitutionality of the removal restrictions in an attempt to have an enforcement action declared invalid. Although no lower court has yet addressed the removal restriction on ALJs, on July 16, 2018, the Fifth Circuit issued a key ruling in a case styled Collins v. Mnuchin, citing Lucia and holding that the removal restrictions on the Federal Housing Finance Agency’s director were unconstitutional. No. 17-20364, 2018 WL 3430826, at *11–25 (5th Cir. July 16, 2018). Private litigants seeking to challenge decisions by ALJs or officials in similar capacities are likely to rely on Collins as support for the proposition that they have standing to challenge the constitutionality of the removal restrictions because the petitioners in Collins were private parties challenging governmental actions. See id. at *1. The government, however, may rely on Collins to contend that the appropriate remedy for any constitutional infirmity in removal restrictions is to strike the removal limitations and not to invalidate any previous action, as the Fifth Circuit held that the remedy for the unconstitutional structure of the Federal Housing Finance Agency was to invalidate the removal restrictions on the agency’s director while “leav[ing] intact the remainder of [its] past actions.” Id. at *26.

• Whether the ALJs are principal officers who may be appointed only by the President with Senate consent. The Supreme Court assumed, but did not hold, that ALJs were inferior Officers of the United States—and not principal officers who can be appointed only by the President, with Senate consent, under the Appointments Clause.

The Court’s express decision not to resolve these issues signals to current and future litigants that they could raise these arguments in future challenges to administrative actions that were subject to a hearing before an ALJ or a similarly situated hearing officer.

Lucia’s Immediate Aftermath

The SEC and the White House have both taken major actions related to ALJs in the wake of the Lucia decision.

On the day Lucia was decided, the SEC issued an order staying for 30 days all administrative proceedings commenced before ALJs. Order, In re Pending Administrative Proceedings (SEC June 21, 2018).

On July 10, 2018, President Trump issued an executive order exempting all ALJ positions from the rules governing civil service, including the competitive examination process. Executive Order Excepting Administrative Law Judges From The Competitive Service, 2018 WL 3359654, at *1 (July 10, 2018). The order relies on Lucia, stating that, “as recognized by the Supreme Court in Lucia, at least some—and perhaps all—ALJs are ‘Officers of the United States’ and thus subject to the Constitution’s Appointments Clause, which governs who may appoint such officials.” Id. The order further states that “Lucia may . . . raise questions about the method of appointing ALJs, including whether competitive examination and competitive service selection procedures are compatible with the discretion an agency head must possess under the Appointments Clause in selecting ALJs.” Id. Noting that “there are sound policy reasons to take steps to eliminate doubt regarding the constitutionality of the method of appointing” ALJs, the order exempts ALJs from the competitive hiring rules and examinations requirements in an effort to “mitigate concerns about undue limitations on the selection of ALJs, reduce the likelihood of successful Appointments Clause challenges, and forestall litigation in which such concerns have been or might be raised.” Id.

The executive order also provides that “[e]xcept as required by statute, the Civil Service Rules and Regulations shall not apply to removals” of ALJs. Id. at *3. That provision, however, does not appear to alter the statutory restriction that ALJs may be removed only for good cause as determined by the Merit Systems Protection Board (MSPB) following a hearing. In a memorandum to heads of federal agencies and departments, OPM Director Jeff T.H. Pon stated that the statutory removal protections and related procedures prescribed by regulations will remain in effect. Dr. Jeff T.H. Pon, Memorandum for Heads of Executive Departments and Agencies (July 10, 2018), at 2. Further complicating the issue, on July 23, 2018, Reuters reported that a confidential Justice Department memorandum to top lawyers at federal agencies concluded that “the MSPB must be ‘suitably deferential’ to department heads who find an ALJ has failed to perform adequately or has not followed ‘agency policies, procedures or instructions.’” Alison Frankel, In Confidential Memo to Agency GCs, DOJ Signals Aggressive Stand on Firing ALJs, Reuters.com, July 23, 2018.

On July 20, 2018, the SEC extended its stay order an additional 30 days until August 22, 2018. Order, In re Pending Administrative Proceedings (SEC July 20, 2018). On August 22, 2018, the SEC allowed the stay to expire; remanded all proceedings pending before the Commission; vacated all prior opinions in the 126 pending matters; and ordered that, to the extent practicable, the Chief ALJ by September 21, 2018 shall designate an ALJ who did not previously participate in the matter to be the presiding hearing officer. Order, In re Pending Administrative Proceedings (SEC Aug. 22, 2018). “Within 21 days of being assigned to the proceeding, the ALJ shall issue an order directing the parties to submit proposals for the conduct of further proceedings.” Id. at 2. After considering the parties’ proposals, the ALJ “shall hold a new hearing and prepare an initial decision” and “shall not give weight to or otherwise presume the correctness of any prior opinions, orders, or rulings issued in the matter.” Id. If a party fails to submit a proposal, however, the ALJ may enter a default judgment. Id.

Lucia’s Impact and Potential Future Litigation Against the Administrative State

Lucia is likely to have varied impacts across a number of industries and practice areas. Businesses and individuals should consult with attorneys to assess Lucia’s impact on their industry and their regulators. Nonetheless, Lucia raises several salient questions—which may inform potential constitutional challenges—for businesses and individuals facing enforcement actions before ALJs or similar hearing officers in any federal agency. Those questions include:

• What constitutes a “timely challenge” for litigants who have already appeared before invalidly appointed ALJs, and are there grounds for excusing the untimeliness of a challenge?
  • In Jones Brothers, Inc. v. Secretary of Labor, the Sixth Circuit held that a petitioner challenging penalties imposed by an ALJ for the Mine Safety and Health Administration had forfeited its challenge by merely stating that “currently a split among the Circuit Courts of Appeal” exists regarding whether ALJs are inferior officers, but that “extraordinary circumstances” existed under the Mine Act, allowing the court to excuse the forfeiture. No. 17-3483, 2018 WL 3629059, at *6–7 (6th Cir. July 31, 2018).
  • By contrast, the United States District Court for the Central District of California has refused to consider four separate petitioners’ Appointments Clause challenges to the appointment of ALJs employed by the Social Security Administration because the petitioners “fail[ed] to raise it during [their] administrative proceedings.” See, e.g., Trejo v. Berryhill, No. 17-0879-JPR, 2018 WL 3602380, at *3 n.3 (C.D. Cal. July 25, 2018).
• Are the ALJs or hearing officers at other regulatory agencies “Officers of the United States,” like the SEC’s ALJs, or are their roles sufficiently different such that they might not be subject to the Appointments Clause?
• If the ALJs are Officers of the United States, who actually appointed them? Is that person a head of department as required by Article II?
• If the ALJs were invalidly appointed, were their appointments ratified by the head of department? Did the “ratification” of the appointment of the ALJ cure any constitutional infirmity?
  • In Jones Brothers, the chief administrative law judge, rather than the Federal Mine Safety and Health Review Commission (Mine Commission), appointed the ALJ who heard the petitioner’s case. 2018 WL 3629059, at *5. However, on April 3, 2008, while the case was pending before the Sixth Circuit, the Mine Commission issued an order purporting to “[r]atify the prior appointments of, and appoint,” all 13 active ALJs employed by the Mine Safety and Health Administration, including the ALJ who heard the petitioner’s case. Mine Commission, Notice (Apr. 3, 2018). The Sixth Circuit concluded that the ALJ had been improperly appointed and that ratification did not cure the constitutional defect, and held that “Jones Brothers is entitled to a new hearing before a constitutionally appointed administrative law judge.” Jones Bros., 2018 WL 3629059, at *7–8. The Sixth Circuit further held that, even if the previous ALJ “has since received a constitutional appointment,” the new hearing “must be before a new official.” at *8.
• Did OPM limit the head of department’s appointment discretion? If so, does that limitation on the head of department’s authority raise additional constitutional concerns? Do private litigants have standing to challenge any potential constitutional infirmity related to this issue?
• If the ALJs are Officers of the United States, are they inferior officers or are they principal officers who can only be appointed by the President with Senate consent?
• Are the statutory restrictions on the removal of the ALJs constitutional? Do private litigants have standing to challenge the statutory restrictions on the removal of the ALJs?
• If there are no ALJs whose appointment satisfies the constitutional requirements, does the rule of necessity, as discussed in a footnote 5 in Lucia, permit the head of department to conduct the proceedings to remedy the constitutional infirmity?

As demonstrated below, the answers to these questions could impact a variety of industry areas.

Potential Impact on Securities Regulation and Enforcement

Lucia has had a significant impact on pending SEC administrative proceedings, but its impact on future proceedings before SEC ALJs remains to be seen. Even after the SEC ordered re-hearings of pending proceedings before new ALJs, Lucia highlights several potential additional arguments under the Appointments Clause that litigants can raise in an attempt to beat back enforcement actions. Those arguments include that: (1) even if litigants receive a new hearing before an ALJ whose appointment has been “ratified” by the SEC or another agency, the new ALJ was still not properly “appointed” because ratification is different from appointment; (2) the statutory removal restrictions on ALJs are unconstitutional; and (3) the SEC ALJs are principal officers who must be appointed only by the President with Senate consent.

Lucia also may impact regulation and enforcement in the commodities and cryptocurrency markets by the Commodity Futures Trading Commission. Although it eliminated the use of ALJs, the CFTC authorized the use of a “judgment officer” and “presiding officers” for various proceedings, with each type of officer performing many of the same functions as the SEC’s ALJs. See 17 C.F.R. § 10.8 (providing that the presiding officer shall have the same authority and obligations as an ALJ, including the authority to issue subpoenas, receive evidence, examine witnesses, rule on motions, and sanction parties for noncompliance with orders); id. § 12.2 (providing that a judgment officer “is authorized to conduct all reparations proceedings”). Although the presiding officers are appointed for the purpose of “a particular proceeding,” 17 C.F.R. § 10.2(n), the judgment officer “is authorized to conduct all reparations proceedings” in the CFTC, id. § 12.2. Earlier this year, the CFTC issued an order ratifying the prior appointment of its judgment officer, though the CFTC did not specify who appointed the judgment officer. Ratification and Reconsideration Order, In re Pending Administrative Proceedings (CFTC Apr. 9, 2018). Any challenge to the constitutionality of the judgment officer’s appointment relying on Lucia is likely to turn on two questions: (1) who appointed the judgment officer, and (2) whether courts find the ratifications process to be sufficient to cure any constitutional defects. That said, CFTC litigants also might argue that the appointment was unconstitutional because the judgment officer is a principal officer, or that the removal restrictions on the judgment officer are unconstitutional. Similar questions may be raised by litigants appearing before presiding officers, though the limited appointment of such officers appears to reduce the risk of constitutional challenges in future proceedings.

Possible Impact on Data Privacy and Security Regulation and Enforcement

The Federal Trade Commission exercises the most significant data privacy and regulatory and enforcement authority among federal agencies. The FTC generally brings enforcement actions before an ALJ, and parties can appeal to the full Commission, although the FTC may also choose to prosecute claims in federal district courts. See LabMD, Inc. v. F.T.C., No. 16-16270, 2018 WL 3056794, at *8 (11th Cir. June 6, 2018). The FTC has only one ALJ, which, like the SEC’s ALJs, was appointed by staff and not the Commission itself. (For details on ALJs in various departments, click here.) The FTC’s ALJs have powers that appear to be analogous to those held by the SEC ALJs, upon which the Supreme Court relied to conclude that they were Officers of the United States:

• The FTC ALJ has the power to “administer oaths and affirmations,” “take depositions,” and “rule upon offers of proof and receive evidence.” 16 C.F.R. § 3.42(c)(1), (3), (5).
• Like SEC ALJs who have the power to conduct trials, the FTC ALJ has the power and “duty to conduct fair and impartial hearings.” § 3.42(c).
• The FTC ALJ has the power to rule on the admissibility of evidence, § 3.43(d), (g), and to shape the administrative record through both control of the proceedings, id. § 3.43(g), (i), and supervision of the creation of the record, id. § 3.44.

• The FTC ALJ has the power to “regulate the course of the hearings and the conduct of the parties and their counsel therein,” § 3.42(c)(6), and “suspend or bar from participation in a particular proceeding any attorney who shall refuse to comply with his directions, or who shall be guilty of disorderly, dilatory, obstructionist, or contumacious conduct,” id. § 3.42(d).

In 2015, after a party challenged the constitutionality of the appointment of the FTC’s ALJ, the FTC issued an order “ratifying” the appointment of its ALJ. See Order Denying Respondent LabMD, Inc.’s Motion to Dismiss, Exhibit A (Docket No. 9357, Sept. 14, 2015).

FTC litigants with ongoing proceedings may have different responses to Lucia depending upon when they appeared before an ALJ. For those who appeared before an ALJ prior to the ratification order where the proceeding remains ongoing, the party may be able to obtain a new initial hearing based on Lucia. Parties who appeared before the FTC ALJ after the ratification order may argue that the ratification did not cure the Appointments Clause violations discussed in Lucia.

Possible Impact on Financial Services Regulation and Enforcement

The Consumer Financial Protection Bureau utilizes one ALJ in its work, and two ALJs exercise authority under the Office of Financial Institution Adjudication. Like the FTC’s ALJ, the CFPB’s ALJ appears to share the same key characteristics with the SEC’s ALJs:

• The CFPB ALJ has the power to receive evidence. See 12 C.F.R. §§ 1081.103, 1081.303(g).
• The CFPB ALJ has the power to conduct trials. See id.§ 1081.302, 1081.303.
• The CFPB ALJ has the power to rule on the admissibility of evidence, § 1081.303(g), and thus shape the administrative record, see id. §§ 1081.303(h), 1081.304.
• The CFPB ALJ has the power to issue orders for the “exclusion or suspension of counsel from the proceeding” for “[d]ilatory, obstructionist, egregious, contemptuous or contumacious conduct at any phase of any adjudication proceeding.” 12 C.F.R. § 1081.107.

Litigants are likely to challenge the appointment of the CFPB’s ALJ because, although it is unclear who appointed the CFPB’s ALJ, even an appointment by the director of the CFPB might be unconstitutional. The Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which established CFPB, structured CFPB within the Federal Reserve System, such that the CFPB director might not qualify as a “head of a department.”

In addition, one commentator has noted that the Federal Reserve, the Office of Comptroller of the Currency, the Federal Deposit Insurance Corporation (FDIC), and the National Credit Union Administration do not individually appoint ALJs but nonetheless use the same two ALJs who are hired by the Office of Financial Institution Adjudication (OFIA). Barbara S. Mishkin, What Does the Supreme Court’s Lucia Decision Mean for the CFPB and Federal Banking Agencies?, ConsumerFinanceMonitor.com, July 2, 2018. Accordingly, litigants are likely to challenge the validity of OFIA’s appointments.

In 2017, the Fifth Circuit entertained such a challenge in Burgess v. Federal Deposit Insurance Corp., 871 F.3d 297 (5th Cir. 2017). In Burgess, the Fifth Circuit granted a petitioner’s interlocutory motion to stay an FDIC enforcement order finding that the petitioner was likely to succeed on the merits of his claim that an FDIC ALJ’s appointment violated the Appointments Clause because the FDIC ALJs’ position was established by law, and its duties were similarly important to those carried out by the STJs whom the Supreme Court determined to be officers in Freytag. Id. at 201–03. The court then stayed all proceedings pending the Supreme Court’s decision in Lucia. Order, Burgess v. Fed. Deposit Ins. Corp., No. 17-60579 (5th Cir. Jan. 22, 2018). On August 8, 2018, the FDIC filed an unopposed motion to remand the case to the agency for a new hearing. The Fifth Circuit granted the motion and remanded the case to the agency on August 20, 2018. Order, Burgess v. Fed. Deposit Ins. Corp., No. 17-60579 (5th Cir. Aug. 20, 2018).

Possible Impact on Healthcare Regulation and Enforcement

Aside from the Social Security Administration, the Department of Health and Human Services (HHS) employs more ALJs than any other agency. Perhaps most significantly for healthcare providers, HHS utilizes ALJs in the five-level Medicare appeals system. Specifically, ALJs preside over the third level of the Medicare appeals system. There are more than 100 ALJs at the Office of Medicare Hearings and Appeals (OMHA) at HHS. The Medicare program depends heavily on the ALJs to adjudicate appeals. Medicare appeals are often material and may involve multi-million dollar extrapolated overpayments.

As of January 2018, OMHA had approximately 502,000 pending appeals before ALJs. Those ALJs (the OMHA Medicare ALJs) appear to share the two of key characteristics with the SEC’s ALJs: (1) OMHA Medicare ALJs have the power to receive, review, and exclude evidence; and (2) OMHA Medicate ALJs have the power to conduct trials. See 42 C.F.R. § 405.1000(a)–(d); id. § 405.1002; id. § 405.1028(a)–(b); id. § 405.1030. However, the HHS regulations do not expressly authorize OMHA Medicare ALJs to issue sanctions as significant as those issued by certain other ALJs, see id. § 405.1030(b)(3), and the regulations further provide that the administrative record should include “any evidence excluded or not considered by the ALJ” id. § 405.1042(a)(2). Medicare appeal litigants who have received unfavorable ALJ decisions within technical appeal deadlines could potentially challenge those decisions based on the theory that the ALJ was improperly appointed. Providers typically have 60 days to appeal an ALJ’s decision to the Medicare Appeals Council. Id. § 405.1102(a). These litigants may have grounds for applying Lucia to the ALJs working in OMHA, as OMHA ALJs have many similarities to the SEC ALJs—including authorization to conduct hearings at which they receive testimony and evidence, id. § 405.1030(b), and the ability to issue subpoenas, id. § 405.1036(f).

HHS also uses ALJs in a variety of other matters, and each context will present different questions about Lucia’s impact. Id. § 498.5(l). For example, ALJs are used by the HHS Office of Inspector General in “exclusion” proceedings, in which HHS seeks to place an individual or an entity on a list of individuals and entities barred from participating in any federally funded healthcare programs. Here, Lucia could potentially be used to challenge the validity of the ALJ appointment in an attempt to obtain a new ALJ hearing. The precise vehicle and venue for such a challenge, however, is unclear because those ALJ decisions may not be “appealable” by statute or regulation.

Possible Impact on Energy-Related Regulation and Enforcement

Lucia’s most significant possible impacts in the area of energy regulation and enforcement are likely to be in proceedings before the Federal Energy Regulatory Commission (FERC) and the Department of the Interior. FERC currently utilizes 12 ALJs, and nine ALJs exercise authority within the Department of the Interior. The FERC chairperson has been making the ALJ appointments for FERC, and the FERC ALJs exercise many of the same powers as SEC ALJs. A key issue for FERC ALJs is whether the FERC chairperson is a “Head[] of Department[]” under the Appointments Clause. In Free Enterprise Fund v. Public Company Accounting Oversight Board, the Supreme Court held that the entire Securities and Exchange Commission is a “Head[] of Department[]” under the Appointments Clause, suggesting that the SEC chairperson alone is not because the “Commission’s powers . . . [were] generally vested in the Commissioners jointly, not the chairperson alone. 561 U.S. 477, 512–13 (2010). Using this precedent, litigants likely will contend that any ALJ appointments made by a chairperson, rather than by the entire commission, are invalid. The government, however, may argue that, unlike the SEC chairperson, the FERC chairperson is the “head[] of Department[]” because of the special authority given to the person in that role. For example, federal law provides that the FERC “Chairman shall be responsible on behalf of the Commission for the executive and administrative operation of the Commission,” including “the appointment and employment of” ALJs. 42 U.S.C. § 7171(c).

Environmental, Health, and Safety Regulation and Enforcement

Lucia also may have an impact in environmental, health, and safety regulation and enforcement. Specifically, litigants may raise constitutional challenges to proceedings brought before ALJs by the Occupational Safety and Health Review Commission, which currently employs 11 ALJs; the Department of the Interior, which utilizes nine; the Environmental Protection Agency, which utilizes three; the Federal Mine Safety and Health Review Commission, which utilizes 15; and the Departmental Appeals Board of the Department of Health and Human Services, which utilizes five.

As noted above, the Sixth Circuit has ruled that the appointment of ALJs by the chief ALJ of the Mine Safety and Health Administration was unconstitutional, and that those ALJs were required to have been appointed by the Federal Mine Safety and Health Review Commission. Jones Bros., 2018 WL 3629059, at *7–8. In addition, although the issues raised for businesses and individuals subject to environmental, health, and safety regulation and enforcement before other agencies will be varied, the key questions will be those identified above, common to all industry areas.

Possible Impact on Antitrust Regulation and Enforcement

The FTC is the only governmental entity to utilize ALJs in the course of antitrust regulation and enforcement. There is no parallel mechanism at the Department of Justice’s Antitrust Division, and the Antitrust Division must begin any proceedings it initiates in federal court. Accordingly, the impact of Lucia on antitrust regulation and enforcement is likely to be the same impact as on data privacy and security regulation and enforcement, detailed above.

Conclusion

The long-term effects of Lucia remain to be seen. As demonstrated above, however, in the near term, it is reasonable to expect additional challenges to the authority of ALJs or similar hearing officials in multiple administrative contexts.

Consider the following three statements, each of which might be found in a written agreement for a commercial transaction:

• Borrower hereby grants a security interest in all of Borrower’s personal property to secure [the loan].
• Seller [of goods] makes no warranty, express or implied, in connection with this transaction.
• Licensee may not assign its rights under this Agreement.

Each of these statements is clear and unambiguous. Yet none of them is likely to be effective. That is because each would run afoul of a legal rule that requires a heightened degree of explicitness for a particular term to be effective. This article refers to such rules as “rules of explicitness.”¹

There are many rules of explicitness. Some are judicial in origin; others are statutory. Some are specific to one state; some are incorporated in the common law or in uniform legislation, and thus apply widely; and some are federal, and so apply nationally.

If rules of explicitness merely required transacting parties or their lawyers to add a few words to the written agreements they draft, the rules would perhaps be of little consequence. However, some of the rules impose substantial impediments to perfectly legitimate transactions. Others are not widely known, particularly by transacting parties that draft their own documents, and therefore function as traps for the less informed. They surprise lawyers and frustrate parties’ expectations, much like secret liens. This article identifies and critiques several of these rules.

Benign Rules

Not all rules of explicitness are bad. Some are consumer protection rules that, in effect, require disclosure or the use of clear language so as to inform consumers of the consequence of entering into a transaction. Although many of these rules are premised on the highly dubious assumption that consumers actually read the agreements they sign,² such rules are beyond the scope of this article.

Some other rules of explicitness appear to be premised on the belief that contracting parties normally do not intend a particular statement to have its literal meaning. For example, U.C.C. § 2-312(2) states that the warranty of title in a sale of goods can be disclaimed or modified “only by specific language or by circumstances which give the buyer reason to know that the person selling does not claim title in himself or that he is purporting to sell only such right or title that he or a third person may have.” Consequently, the language “Seller makes no warranty, express or implied, in connection with this transaction” would be ineffective to disclaim the warranty of title.³ This probably makes sense. It is likely that most buyers of goods think of warranties as relating to the quality of the goods, not to ownership or the right to sell them. Moreover, few buyers would be willing to pay the purchase price for goods that the seller does not or might not own. So requiring more explicit language or circumstances simply reflects the reasonable observation that contracting parties ordinarily do not understand or intend “no warranty” to exclude the warranty of title.

Similarly, the phrase “time is of the essence” is often included in written agreements to indicate that a delay in performance is material. In other words, it is a somewhat cryptic way of saying “any delay in performing any duty under this agreement is a material breach,” and thereby authorizes the non-breaching party to suspend its own performance. But it is doubtful that the parties to an agreement containing such a phrase really intend that a brief delay in performing a minor duty is a material breach. Consequently, some courts will not give literal effect to the phrase,⁴ although they would likely enforce a more specific statement (e.g., “any delay in delivery is a material breach”).

A rule of explicitness, such as those described in the previous two paragraphs, designed to give effect to the parties’ likely intent is benign and perhaps even beneficial. Most rules of explicitness are, however, either silly or downright dangerous in the sense that they are traps for the unwary.

Silly Rules             

Disclaiming the Warranty of Merchantability

Section 2-316 of the U.C.C. states that, to disclaim the warranty of merchantability in a contract for the sale of goods, the seller must mention “merchantability” or use language—such as “as is” or “with all faults” —that in common understanding makes plain that there is no warranty.⁵ Applying this rule, a statement such as “seller makes no implied warranty with respect to the goods” or the shorter and arguably clearer “seller makes no warranty” is probably ineffective to disclaim the implied warranty of merchantability.⁶

To a limited extent, this rule makes sense. The warranty of merchantability is implied in contracts for the sale of goods when the seller is a merchant with respect to goods of that kind.⁷ The warranty requires, among other things, that the goods be fit for the ordinary purposes for which such goods are used.⁸ In short, the goods must work. However, many buyers probably think of warranties as dealing with the future performance of the goods—that is, how long the goods will last—not with whether the goods work at the time of sale. Consequently, a phrase such as “seller makes no implied warranty with respect to the goods” probably does not signify to many buyers that the goods might not work now. In contrast, a phrase such as “as is” does convey that possibility.

However, the policy underlying the rule seems to have been forgotten when the rule shifts from the language it renders ineffective to the language it regards as effective.  The statement “seller makes no implied warranty with respect to the goods” is ineffective to disclaim the warranty of merchantability but the statement, “seller makes no implied warranty of merchantability with respect to the goods” can be effective.⁹ In short, adding the words “of merchantability” can change an ineffective disclaimer into an effective disclaimer.  If buyers truly understood those two statements differently, the rule might be justifiable.  But there is no reason to think that buyers do that.

Describing Collateral in a Security Agreement

Unless an exception applies, for a security interest to attach to personal property, the debtor must authenticate a security agreement that contains a description of the collateral.¹⁰ The description need not be specific as long as it reasonably identifies what is described.¹¹ Moreover, a description by type of collateral defined in the U.C.C. is effective.¹² However, U.C.C. § 9-108(c) provides that a description such as “all the debtor’s assets” or “all the debtor’s personal property” is ineffective. This rule adds a bit of unnecessary length to a security agreement intended to encumber all of the debtor’s existing personal property. Thus, consider the following two ways of describing the collateral for such a transaction:

The description on the left is, with two exceptions,¹³ effective to cover all personal property to which Article 9 of the U.C.C. applies. The description on the right is ineffective. So, the law effectively mandates that transactional attorneys use an additional 17 words¹⁴ that neither the debtor nor the secured party might understand. There is absolutely nothing unclear or ambiguous about “all personal property.” In fact, that phrase is probably far more likely to be understood by the parties than the more detailed list that is effective. Yet that simpler and shorter phrase is ineffective. It is telling that the official comments do not attempt to justify this rule; they merely state that it “follows prevailing case law,”¹⁵ as if that were an explanation.

Gotcha! Rules

Describing Commercial Tort Claims  

While on the subject of security agreements, let us consider the language needed for a security interest to attach to a commercial tort claim. For this purpose, a commercial tort claim includes any claim arising in tort if the debtor (the claimant) is a business entity.¹⁶ U.C.C. § 9-108(e)(1) provides that describing collateral by its statutorily defined type is ineffective for a commercial tort claim. Thus, describing the collateral to include “all commercial tort claims” in fact covers none.

This rule is far more problematic than the rule of § 9-108(c) which renders “all personal property” ineffective as a description of collateral in a security agreement. Consider a transaction in which a lender will be making a sizeable loan to a business entity and expects in return to get a security interest in all the entity’s assets. To cover existing commercial tort claims, the security agreement must describe each such claim with some particularity.¹⁷ Yet it is possible that a tort might have already occurred of which the debtor is unaware even though such a tort claim might be one that, in time, will seriously undermine the value of the business. In such a case, it would effectively be impossible for the security agreement to properly describe the claim.¹⁸ An explicitness rule is not supposed to prevent otherwise permissible transactions.¹⁹

The explicitness rule of § 9-108(e)(1) applies not merely to security agreements, but also to financing statements, where it makes even less sense. Financing statements serve a different purpose than do security agreements. They are designed merely to give interested parties notice of a possible security interest and information about whom to contact for more information. Hence a general description of collateral as “all assets” or “all personal property” is effective in a financing statement.²⁰ As a result, we end up with a truly anomalous set of rules:

(i) a description of “all commercial tort claims” is ineffective in a financing statement, but

(ii) either a more specific description (“all tort claims arising from the explosion of debtor’s factory”) or a more general description (“all assets”) is effective.²¹

It is hard to understand what policy could be served by a rule that validates a very specific description and a very general description, but invalidates one in the middle.

Providing for Attorney’s Fees

In at least one state, a term in an agreement providing that “in any action relating to this Agreement, the prevailing party will be entitled to reasonable attorney’s fees,” does not cover fees incurred in a successful appeal. To cover such fees, the clause must expressly refer to fees incurred in appellate proceedings.²² The rule is apparently premised on the state supreme court’s belief, in the mid-1960s, that the members of the bar generally understood that a contractual stipulation for attorney’s fees would not include attorney’s fees incurred on appeal.²³ Of course, that belief was not based on any empirical data and it completely ignored the fact that contracting parties occasionally draft their own agreements without the assistance of legal counsel.

In several states, the judicial penchant for the so-called “American Rule,” which requires each party to pay its own attorney’s fees, has resulted in a rule that an award of attorney’s fees incurred in litigating the entitlement to or amount of attorney’s fees will not be available unless the agreement provides for it “in a clear and decided fashion.”²⁴ Nothing about this rule is premised on the likely intent or understanding of the people who draft agreements, yet the rule can significantly undermine the benefit and purpose of a contractual clause on attorney’s fees.

Providing for Interest

At least two explicitness rules deal with the right to interest on indebtedness. One relates to the agreement between the creditor and the debtor, the other applies to an intercreditor agreement.

A promissory note, loan agreement or any other contract that provides for an extension of credit will often provide for a specified rate of interest “until payment is made,” although it might also provide for a higher interest rate after default. While such terms are typically enforceable,²⁵ they will not apply to interest that accrues after a judgment is rendered in federal court. Unless the note or agreement expressly refers to interest “post-judgment,” interest will accrue after the judgment is rendered at the federal statutory rate, which is likely to be much lower.²⁶ This rule, which apparently applies even if the judgment is merely one that confirms an arbitration award, is a trap both for those who draft loan agreements and for litigators choosing a forum in which to file a claim.

A subordination agreement between creditors of the same debtor typically will, at least after the debtor defaults if not before, entitle the senior creditor to be paid in full before the junior creditor may receive any payment. If both creditors are undersecured, so that the debtor’s bankruptcy estate will not be paying post-petition interest to either of them, this might mean that the senior creditor is entitled to post-petition interest before the junior creditor is entitled to return of principal. Perceiving this to be unfair, New York courts have adopted and adhered to a rule called “the Rule of Explicitness,” which requires express reference to “post­-petition interest” if the junior creditor’s claim to principal is to be subordinated to the senior creditor’s right to post-petition interest. A reference merely to interest until the debt is paid in full is not sufficient.²⁷

Given that subordination agreements tend to involve sophisticated parties, each of whom is represented by a lawyer, this rule is unlikely to be major problem. Nevertheless, it is trap for anyone who is unaware of the rule.

Contractual Choice of Law

Unless a contrary intent is manifest, states interpret a contractual choice-of-law clause as dealing only with substantive law, not procedural law.³¹ That distinction can be critical because many states regard a statute of limitations as procedural, and therefore when serving as the forum for litigation, apply their own statute of limitations rather than applicable statute of limitations law.³² It seems doubtful that parties who choose one state’s law to govern their contractual rights and obligations want another jurisdiction’s statute of limitations to apply. So, to the extent that contracting parties want and are permitted to select the limitations period for claims between them, their choice-of-law clause should expressly refer to the chosen law’s statutes of limitations.

Consider the following scenario. A merchant in Detroit regularly contracts to buy and sell goods with business entities in other locations. The merchant’s transaction documents—whether they be agreements formally executed by both parties or unilaterally issued purchase orders or sales acknowledgments that form and memorialize the deal—provide that “the law of the State of Michigan governs the agreement and all matters relating to the relationship of the parties thereto.” That language is effective when the counter-party is located in the United States.²⁸ However, if the counter-party is located in Canada or Mexico, each of which has ratified the United Nations Convention on Contracts for the International Sale of Goods (“CISG”), the choice-of-law clause is likely to be ineffective. Even though contracting parties are free to make the CISG inapplicable to their transaction,²⁹ most courts dealing with the issue have concluded that more specific language is needed to do that.³⁰ They have done so not because the intent of the language is unclear, but due to the rather formalistic notion that, due to the Supremacy Clause, the CISG is part of each state’s law. So, to opt out of the CISG, the choice-of-law clause needs to be rephrased to something like: “the law of the State of Michigan, other than the CISG, governs the agreement and all matters relating to the relationship of the parties thereto.”

Unless a contrary intent is manifest, states interpret a contractual choice-of-law clause as dealing only with substantive law, not procedural law.³¹ That distinction can be critical because many states regard a statute of limitations as procedural, and therefore when serving as the forum for litigation, apply their own statute of limitations rather than applicable statute of limitations law.³² It seems doubtful that parties who choose one state’s law to govern their contractual rights and obligations want another jurisdiction’s statute of limitations to apply. So, to the extent that contracting parties want and are permitted to select the limitations period for claims between them, their choice-of-law clause should expressly refer to the chosen law’s statutes of limitations.

Restrictions on Assignment of Rights

Contractual restrictions on the assignment of contract rights often involve a clash between two fundamental policies of American law: (i) freedom of contract, which suggests that contracting parties should be allowed to agree to restrict either or both parties’ right to assign; and (ii) the free alienability of property, which suggests that anyone with contract rights should be able to transfer them, provided doing so has no material impact on the duties or rights of the contractual counter-party.

To some significant extent, the law now sides with the latter principle by overriding contractual restrictions on assignment.³³ But when it does not—that is, when the law permits contracting parties to prohibit or restrict assignment of their contract rights—it nevertheless imposes a rather peculiar rule of explicitness. Under this rule, a contractual term prohibiting the assignment of contract rights merely gives rise to a claim for breach; it does not render assignment ineffective.³⁴ As the U.S. Court of Appeals for the Third Circuit has explained, there is a difference between the right to assign and the power to assign, and contractual language that merely prohibits assignment affects only the former.³⁵ If the parties want to make an attempted assignment ineffective, they need to expressly so state by adding language such as “and any attempted assignment is void.”

At a superficial level, this rule of explicitness makes some sense. The statement “neither party may assign its rights” is phrased as a denial of discretion or permission, not of power. The statement “neither party shall assign its rights” appears to be a covenant: that is, a promise not to assign rights. Neither statement purports to deal with the consequence of an assignment.  However, given that damages for breach of either statement are likely to be very small and difficult to prove, interpreting either statement as merely a basis for breach makes the statement almost a nullity. It is far more likely that parties using either statement intend to prevent assignment.  Thus, requiring additional language to make that clear is somewhat silly and probably frustrates the parties’ intent.

Scope of Arbitration

In general, a presumption exists that any ambiguity concerning the scope of an arbitration clause should be resolved in favor of arbitration.³⁶ This presumption does not apply, however, to issues of arbitrability.  Instead, there is a presumption that the parties intend courts, not arbitrators, to decide disputes about arbitrability,³⁷ including questions such as whether the parties are bound by a given arbitration clause, or whether an arbitration clause in a concededly binding contract applies to a particular type of controversy.³⁸ In short, courts treat the issue of arbitrability as one for judicial resolution absent clear and unmistakable evidence that the parties delegated the issue to the arbitrator.³⁹ Consequently, an arbitration clause covering “all claims or controversies arising out of or relating to this Agreement” is not sufficient to delegate the issue of arbitrability to the arbitrator.⁴⁰

Applying this explicitness rule, the courts have reached some questionable distinctions.⁴¹ More relevant to this article, however, most courts regard an incorporation by reference of the rules of the American Arbitration Association, which give the arbitrator authority to rule on the existence, scope, or validity of the arbitration agreement,⁴² as sufficiently clear to delegate issues of arbitrability to the arbitrator.⁴³ As a result, the two clauses below, which differ only by the language in blue, have very different effects with respect to delegating issues of arbitrability, even though neither speaks directly to the issue:

This is not a rule of explicitness; it is a rule of inexplicitness.⁴⁴

Notes:

1. A contractual term covered by a rule of explicitness will be enforceable if drafted properly. In contrast, a contractual term that offends public policy might not be enforceable no matter how carefully drafted.

2. See Restatement (Third) of Consumer Contracts, Reporter’s Introduction at 3 (Council Draft No. 4, Dec. 2017) (“disclosure of standard terms generally does not render the assent process any more meaningful, because consumers rarely read the disclosed terms”). These rules are also premised on the assumption – perhaps less dubious but nevertheless unproven – that consumers understand the terms even when the mandated language is used and read.

3. See, e.g., Sunseri v. RKO-Stanley Warner Theatres, Inc., 374 A.2d 1342, 1344-45 (Pa. Super. Ct. 1977) (“Seller shall in nowise be deemed or held to be obligated, liable, or accountable upon or under guaranties (sic) or warranties, in any manner or form including, but not limited to, the implied warranties of title” was ineffective to disclaim the warranty of title). See also Rochester Equip. & Maint. v. Roxbury Mountain Serv., Inc., 891 N.Y.S.2d 781, 782 (App. Div. 2009) (sale of vehicle “as is” did not disclaim the warranty of title).

Note also that the warranty of title is not designated as an “implied warranty,” and thus even if the quoted language were effective to disclaim all implied warranties – which it is not, see infra notes 4-5 and accompanying text – it would still not be effective to disclaim the warranty of title.  See U.C.C. § 2-312 cmt. 6.

4. See, e.g., Kodak Graphic Communications Canada Co. v. E.I. du Pont de Nemours and Co., 640 F. App’x 36 (2d Cir. 2016) (despite a “time is of the essence” clause, a jury could conclude that timely delivery was not a material term); Foundation Development Corp. v. Loehmann’s Inc., 788 P.2d 1189 (Ariz. 1990) (a tenant’s two-day delay in paying the common area charge was not a material breach despite a provision in the lease that time is of the essence); Restatement (Second) of Contracts 242 cmt d & ill. 9 (stock phrases such as “time is of the essence” do not necessarily make every delay in performance a material breach).  See also Boston LLC v. Juarez, 199 Cal. Rptr. 3d 452 (Cal. Ct. App. 2016) (parties to a lease cannot contract around the materiality requirement so that every breach results in a forfeiture); Asif Saleem, Think Twice before Using “Time Is of the Essence,” 7 The Transactional Lawyer 1 (Aug. 2017).  But cf. Mining Investment Group, LLC v. Roberts, 177 P.3d 1207 (Ariz. Ct. App. 2008) (refusing to extend Loehmann’s to a real estate purchase agreement that, instead of having a general time-is-of-the-essence clause, expressly stated that the breach at issue – failure to timely pay – was material); Milad v. Marcisak, 762 N.Y.S.2d 282 (N.Y. Sup. Ct. 2003) (When “time of the essence” is expressly stated, the parties to a real property purchase agreement are obligated to strictly comply with the terms of the contract).

5. U.C.C. § 2-213(2), (3).

6. See, e.g., Pay Tel Sys., Inc. v. Seiscor Techs., Inc., 850 F. Supp. 276, 280-81 (S.D.N.Y. 1994) (language purporting to disclaim any unspecified “warranty, express or implied . . . to any dealer, customer, owner, or user” was ineffective to disclaim the implied warranty of merchantability); Richard O’Brien Cos. v. Challenge-Cook Bros., Inc., 672 F. Supp. 466, 469-70 (D. Colo. 1987) (conspicuous clause stating that “[t]here are no warranties, express or implied, made by Seller on the products sold by it to Dealer, or anyone else” was ineffective to disclaim the warranty of merchantability); Tarter v. MonArk Boat Co., 430 F. Supp. 1290, 1294 (E.D. Mo. 1977) (a statement after an express warranty that “[t]he above policy is [the seller’s] entire warranty and no other warranty is intended or implied other than the above stated policy” did not disclaim the warranty of merchantability).

This conclusion is supported not only by cases, but by the last sentence of § 2-­316(2), which indicates that a phrase such as “there are no warranties which extend beyond the description on the face hereof” can disclaim the implied warranty of fitness but, by its silence, suggests the phrase does not disclaim the implied warranty of merchantability.

7. U.C.C. § 2-314(1).

8. U.C.C. § 2-314(2)(c).

9. It must be made either orally or conspicuously in a writing.

10. See U.C.C. § 9-203(b)(3)(A). Exceptions include situations in which the collateral is in the possession of the secured party pursuant to an oral security agreement, see § 9-203(b)(3)(B), and transactions outside the scope of Article 9, see § 9-109(d).

11. U.C.C. § 9-108(a).

12. U.C.C. § 9-108(b)(3).

13. One exception is consumer goods, for which a more specific description is required. See U.C.C. § 9-108(e)(1).  The other exception is commercial tort claims, discussed infra notes 15-20 and accompanying text.

14. Many transactional attorneys representing secured parties insist that the longer phrase begin with “all personal property, including,” which causes the longer phrase to be 20 words more than the shorter phrase. One possible benefit to including a reference to “all personal property” is that those words might be effective to encumber property if a security interest in it would be outside the scope of Article 9.

15. U.C.C. § 9-108 cmt. 2. To the extent that the now-codified rule is intended to prevent overreaching, it is poorly designed.  Overreaching is more properly addressed through a restriction on what contracting parties may do, see, e.g., U.C.C. § 9-­204(b)(1) (preventing an after-acquired property clause in a security agreement from encumbering consumer goods except in narrow circumstances), than through a rule requiring particular language.

16. U.C.C. § 9-102(a)(13)(A). The tort claim of an individual debtor is a commercial tort claim if the claim arises in the course of the individual’s business or profession and does not include damages for personal injury or death.  U.C.C. § 9-102(a)(13)(B).

17. See U.C.C. § 9-108 cmt. 5 (providing some guidance on how specific the description must be).

18. Moreover, it is unclear whether some types of statutory claims – such as antitrust claims – qualify as tort claims and thus it remains uncertain whether such claims are subject to the rule of § 9-108(e)(1).

19. During the revision of Article 9 in the 1990s, which expanded Article 9’s scope to cover security interests in commercial tort claims, concern was expressed that debtors would inadvertently create security interests in tort claims and that the secured party and its lawyers would interfere with the conduct of the tort litigation. To deal with this, it was decided to limit security interests in commercial tort claims to situations in which the secured party was really relying on the claim as collateral, and the explicitness rule of § 9-108(e)(2) was devised as a proxy for that reliance.

20. See U.C.C. § 9-504(2).

21. Moreover, if a commercial tort claim were proceeds of other collateral, a financing statement that described only that other collateral and which neither described the commercial tort claim nor purported to cover “all assets” would nevertheless be effective to perfect a security interest in the commercial tort claim. See U.C.C. § 9-315(c), (d)(1).  As a result, a prospective lender seeking to determine if a commercial tort claim is encumbered by a perfected security interest cannot safely ignore any financing statement filed against the debtor, regardless of how that financing statement describes the collateral.

If all this were not enough, the rule of § 9-108(e)(2) has also confused courts and led to some astoundingly bad decisions.  See, e.g., Carl S. Bjerre & Stephen L. Sepinuck, Spotlight, Commercial Law Newsletter 9, 11-12 (Nov. 2016) (discussing Bayer Cropscience LP v. Stearns Bank, 837 F.3d 911 (8th Cir. 2016)).  The Permanent Editorial Board is reportedly working on a draft commentary to explain why Bayer Cropscience is incorrectly decided.

22. Synectic Ventures I, LLC v. EVI Corp., 261 P.3d 30 (Or. Ct. App. 2011) (discussing Adair v. McAtee, 388 P.2d 748 (Or. 1964)).

23. Id. at 32.

24. See, e.g., 214 Wall Street Associates, LLC v. Medical Arts-Huntington Realty, 953 N.Y.S.2d 124 (N.Y. App. Div. 2012); Allen Benson, Fees on Fees – Drafting to Include Attorney’s Fees Incurred in Seeking Fees, 4 The Transactional Lawyer 1 (Aug. 2014).

25. A higher rate of interest after default can be invalidated as a penalty. See Stephanie J. Richards, The Enforceability of Default Interest, 5 The Transactional Lawyer 1 (Oct. 2015).

26. Stephen L. Sepinuck, Very Interesting . . . or Is It: Limitations on Default Interest, 3. The Transactional Lawyer 2 (Feb. 2013).

27. See In re Southeast Banking Corp., 710 N.E.2d 1083 (N.Y. 1999). See alsoS. Bank v. T.D. Bank, 569 B.R. 12 (Bankr. S.D.N.Y. 2017) (by providing that the lenders were “entitled to receive post-petition interest . . . to the fullest extent permitted by law,” the intercreditor agreement was sufficiently explicit that both the senior and junior lenders were entitled to post-petition interest before the principal of either the senior or junior debt is paid; it did not matter that post-petition interest would not have been available in the bankruptcy proceeding because  this was not a bankruptcy case and, in any event, the agreement defined “Obligations” to include “interest and fees that accrue after the commencement . . . of any Insolvency or Liquidation Proceeding . . . regardless of whether such interest and fees are allowed claims in such proceeding”); Stephen L. Sepinuck The Dangers of Uni-tranche Loans & the Rule of Explicitness, 3 The Transactional Lawyer 3 (Oct. 2013).

28. See U.C.C. § 1-301(a).

29. See CISG Art. 6 (“The parties may exclude the application of this Convention or, subject to article 12, derogate from or vary the effect of any of its provisions”).

30. BP Oil Int’l, Ltd. v. Empresa Estatal Petroleos, 332 F.3d 333 (5th Cir. 2003); Travelers Prop. Cas. Co. of Am. v. Saint-Gobain Technical Fabrics Canada Ltd., 474 F. Supp. 2d 1075 (D. Minn. 2007); American Mint LLC v. GOSoftware, Inc., 2006 WL 42090 (M.D. Pa. 2006); Ajax Tool Works, Inc. v. Can-Eng Mfg. Ltd., 2003 WL 223187 (N.D. Ill. 2003); Asante Techs., Inc. v. PMC-Sierra, Inc., 164 F. Supp. 2d 1142 (N.D. Cal. 2001). But see American Biophysics Corp. v. Dubois Marine Specialties, 411 F. Supp. 2d 61 (D.R.I. 2006).

31. See, e.g., Restatement (Second) of Conflict of Laws § 122; Parker v. K & L Gates, LLP, 76 A.3d 859 (D.C. 2013).

32. See, e.g., Pivotal Payments Direct Corp. v. Planet Payment, Inc., 2015 WL 9595285 (Del. Super. Ct. 2015) (because, under Delaware law, a choice-of-law provision in a contract does not apply to statutes of limitations unless the provision expressly says so, the parties’ general selection of New York law did not make the N.Y. limitations period applicable, and thus the plaintiff’s fraudulent inducement claim was time barred under Delaware law); Citizens Bank v. Merrill, Lynch, Pierce, Fenner and Smith, Inc., 2012 WL 5828623 (E.D. Mich. 2012) (applying Michigan procedural law, including its six-year statute of limitations, instead of the chosen law of New York, with its three-year limitations period, to tort and contract claims brought under New York law). But cf. In re Sterba, 852 F.3d 1175 (9th Cir. 2017) (exceptional circumstances existed warranting application of the statute of limitations from the chosen state’s law); Restatement (Second) of Conflict of Laws 142 & cmt. f (as amended in 1988) (“The view that statutes of limitations should ordinarily be characterized as procedural has been abandoned in many recent decisions”).  The Restatement distinguishes between and treats differently situations in which the forum state has a longer limitations period than does the chosen law and situations in which the forum state has a shorter limitations period.

33. See, e.g., U.C.C. §§ 2-210(2), (3), 9-406(d), 9-408(a).

34. See Restatement (Second) of Contracts322(2)(b).

A different interpretive rule provides that a contractual term prohibiting assignment of “the contract” merely bars delegation of duties, not assignment of rights.  See Restatement (Second) of Contracts § 322(1); U.C.C. § 2-210(4).  This is probably a desirable interpretive principle, premised on the assumption that contracting parties are more likely to be concerned with delegation of duties than with assignment of rights.

35. Bel-Ray Co. v. Chemrite (Pty) Ltd, 181 F.3d 435 (3d Cir. 1999). See also BSC Assocs., LLC v. Leidos, Inc., 2015 WL 667853 (N.D.N.Y. 2015); Gallagher v. Southern Source Packaging, LLC, 564 F. Supp. 2d 503 (E.D.N.C. 2008); United Health Servs. Credit Union v. Open Solutions Inc., 2007 WL 433090 (E.D. Wash. 2007); Marion Blumenthal Trust ex rel. Blumenthal v. Arbor Com. Mtg. LLC, 2013 WL 3814385 (N.Y. Sup. Ct. 2013); Shao v. Li, 2013 WL 3481411 (N.Y. Sup. Ct. 2013). Contra Travertine Corp. v. Lexington-Silverwood, 683 N.W.2d 267 (Minn. 2004) (right to payment under a management contract); Texas Dev. Co. v. Exxon Mobil Corp., 119 S.W.3d 875 (Tex. Ct. App. 2003); but cf.G. Wentworth S.S.C. Ltd. P’ship v. Callahan, 649 N.W.2d 694 (Wis. Ct. App. 2002) (agreement stating that a party had no “power” to assign structured settlement rendered attempted assignment ineffective); Rother-Gallagher v. Montana Power Co., 522 P.2d 1226 (Mont. 1974) (agreement providing that one party “shall not assign this contract, or any portion thereof, . . . without the written consent”  of the other party was effective to prevent assignment).

36. E.g., Mitsubishi Motors Corp. v. Soler Chrysler–Plymouth, Inc., 473 U.S. 614, 626 (1985); Moses H. Cone Mem. Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24–25 (1983).

37. See, e.g., First Options of Chi., Inc. v. Kaplan, 514 U.S. 938, 944-45 (1995).

38. BG Group, PLC v. Republic of Argentina, 134 S. Ct. 1198, 1206 (2014).

In contrast, an issue about whether the entire agreement is void or voidable is presumptively for the arbitrator.  E.g., Buckeye Check Cashing, Inc. v. Cardegna, 546 U.S. 440 (2006).

39. See, e.g., Rent-A-Ctr., W., Inc. v. Jackson, 561 U.S. 63, 69 n.1 (2010); Simply Wireless, Inc. v. T-Mobile US, Inc., 877 F.3d 522, 526 (4th Cir. 2017) State ex rel. Pinkerton v. Fahnestock, 531 S.W.3d 36, 43 (Mo. 2017).

40. Simply Wireless, Inc., 877 F.3d at 526-27. See also Hernandez v. San Gabriel Temp. Staffing Servs., LC, 2018 WL 1582914 at *5-6 (N.D. Cal. 2018) (“Any dispute that arises out of or relates to Employee’s employment” was insufficient to delegate issue or arbitrability).

41. Compare Baker v. Bristol Care, Inc., 450 S.W.3d 770 (Mo. 2014) (an arbitration clause covering “any dispute relating to the applicability or enforceability of the Agreement” did not delegate issues of arbitrability to the arbitrator), with Ford Motor Credit Co., LLC v. Jones, 2018 WL 1384505 (Mo. Ct. App. 2018) (an arbitration clause covering “[c]laims regarding the interpretation, scope, or validity of this provision, or arbitrability of any issue” did delegate the issue of arbitrability). The reference in Baker to the “enforceability of the Agreement” would seem, necessarily, to cover the enforceability of the arbitration clause contained in the Agreement, and thus delegate issues of arbitrability to the arbitrator.

42. AAA Commercial Arbitration Rules and Mediation Procedures, Rule 7(a) (2013).

43. E.g., Brennan v. Opus Bank, 796 F.3d 1125, 1129 (9th Cir. 2015); Petrofac, Inc. v. DynMcDermott Petroleum Operations Co., 687 F.3d 671, 674 (5th Cir. 2012); Fallo v. High-Tech Inst., 559 F.3d 874, 877-78 (8th Cir. 2009); Qualcomm Inc. v. Nokia Corp., 466 F.3d 1366, 1373 (Fed. Cir. 2006); Terminix Int’l Co. v. Palmer Ranch LP, 432 F.3d 1327, 1332 (11th Cir. 2005); Contec Corp. v. Remote Solution Co., 398 F.3d 205, 208 (2d Cir. 2005); State ex rel. Pinkerton, 531 S.W.3d at 45. See also Simply Wireless, Inc. v. T-Mobile US, Inc., 877 F.3d at 525-28 (incorporation of Judicial Arbitration & Mediation Services rules was sufficient to delegate issue of arbitrability); Belnap v. Iasis Healthcare, 844 F.3d 1272, 1281-82 (10th Cir. 2017) (same); Cooper v. WestEnd Capital Mgmt., LLC, 832 F.3d 534, 546 (5th Cir. 2016) (same); Oracle Am., Inc. v. Myriad Group A.G., 724 F.3d 1069 (9th Cir. 2013) (incorporation of UNCITRAL arbitration rules was sufficient to delegate issue of arbitrability).

The result might be different if either or both contracting parties is not a sophisticated business entity, e.g., Meadows v. Dickey’s Barbeque Restaurants Inc., 144 F. Supp. 3d 1069, 1078-79 (N.D. Cal. 2015), but the bulk of authority appears to be to the contrary, e.g., Esquer v. Education Mgmt. Corp., 2017 WL 5194635 (S.D. Cal. 2017); Cubria v. Uber Techs., Inc., 242 F. Supp. 3d 541, 549-50 (W.D. Tex. 2017).

44. Perhaps in part because of this, that is, because the rule is so opaque, courts have also had to resolve thousands of disputes about what language is a clear and unmistakable delegation of authority to an arbitrator. Thus, the rule appears to have generated litigation rather than reduce it.

Steven L. Sepinuck