Deadlock-Breaking Mechanisms in LLCs—Flipping a Coin Is Not Good Enough, but Is Better Than Dissolution

Posted on March 23, 2017 by - Uncategorized

This article provides a framework for addressing the importance of adopting deadlock-breaking mechanisms in limited liability company (LLC) operating agreements as an alternative to seeking judicial dissolution when a deadlock arises in an LLC.

The problems arising from deadlock in the management of an LLC are obvious to almost all practitioners, so we will not spend too much time discussing them, but a few points bear addressing. First, deadlocks in an LLC typically arise in a number of circumstances involving important decisions, including:

1. the failure of equal members or managers to reach agreement;
2. the failure to obtain a required majority vote;
3. the failure to obtain a required approval from a member with approval rights; and
4. the failure to obtain unanimous consent where unanimity is required.

Second, the failure to provide deadlock-breaking mechanisms that address any or all of the above in an operating agreement will result in significant expense, hard feelings, loss of time, and possible mediation, arbitration, or litigation—all of which are covered later in this article. Third, the ultimate stage of unresolved deadlock often will result in dissolution of the LLC, which typically involves excessive expense, lost opportunity, and bitter consequences for the members of the LLC.

Judicial Dissolution

If a deadlock arises and an LLC has not adopted a deadlock-breaking mechanism in the operating agreement, the parties most often will turn to a court seeking judicial dissolution, or a court-ordered alternative to dissolution, to resolve the deadlock. “Dissolution” has been a term of art in the law of unincorporated entities since at least the time of Roman law. Joseph Story, Commentaries on the Law on Partnership § 266 at 408 (2d ed. 1850) (“The Roman law . . . declared[] that partnership might be dissolved in various ways. . . .”).

Under the Revised Uniform Limited Liability Act (RULLCA) promulgated by the Uniform Law Commission (last revised in 2013), a limited liability company is dissolved, and its activities and affairs must be wound up, upon the occurrence of any of the following:

(1) an event or circumstance that causes dissolution under the operating agreement;

(2) the affirmative vote or consent of all the members;

(3) the passage of 90 consecutive days during which the company has no members unless, before the end of the period:

(A) consent to admit at least one specified person as a member is given by transferees owning the rights to receive a majority of distributions as transferees at the time the consent is to be effective; and

(B) at least one person becomes a member in accordance with the consent;

(4) upon application by a member, the entry by the appropriate state court of an order dissolving the company on the grounds that:

(A) the conduct of all or substantially all the company’s activities and affairs is unlawful;

(B) it is not reasonably practicable to carry on the company’s activities and affairs in conformity with the certificate of organization and the operating agreement; and

(C) the managers or those members in control of the company:

(i) have acted, are acting, or will act in a manner that is illegal or fraudulent; or

(ii) have acted or are acting in a manner that is oppressive and was, is, or will be directly harmful to the applicant (“oppression” of one or more members in an LLC is a basis for judicial dissolution under RULLCA, but not in many other state LLC acts, even in some states that have adopted RULLCA-based LLC acts, such as Florida); or

(5) the signing and filing of a statement of administrative dissolution by the Secretary of State.

Deadlock as Grounds for Judicial Dissolution

Most state statutes rely on the judicial-dissolution provisions of the LLC Act as the judicially imposed remedy when the members or managers are deadlocked and are without a clear and effective private ordering provision to control the resolution of the deadlock. Of course, there are numerous problems with leaving resolution of member or manager deadlock disputes to the courts.

Under most states’ LLC Acts and case law, a Member or Manager may seek judicial dissolution in a judicial proceeding if it is established that:

1. the conduct of all or substantially all of the activities and affairs of the LLC are unlawful;
2. it is not reasonably practicable to carry on the company’s activities and affairs in conformity with its articles and operating agreement;
3. the members or managers in control of the LLC are acting or are reasonably expected to act in a manner that is illegal or fraudulent;
4. LLC assets are misappropriated or wasted, causing irreparable injury to the LLC or to one or more of its members; or
5. the members or managers of the LLC are deadlocked in the management of the LLC’s activities or affairs, the members or managers are unable to break the deadlock, and irreparable injury to the LLC is threatened or suffered.

The Court’s Power to Provide Alternative Remedies in Deadlock

It is important to note that some state statutes (e.g., Florida) that provide for deadlock as grounds for judicial dissolution also expressly provide in such a proceeding that the court has more flexibility than simply ordering dissolution. Such statutes typically include language such as the following: “in a proceeding brought under [the section addressing judicial dissolution] the court may order a remedy other than dissolution.” Consequently, one must be prepared for the court to fashion a remedy that one or more of the parties did not anticipate and would not appreciate, e.g., mandating that one of the members be bought out by the company or other member(s). Additionally, courts have exercised their equitable powers to fashion alternative remedies even though the statute does not contain the express statutory provision described above.

For example, in Lyons v. Salamone, 32 A.D.3d 757, 758, 821 N.Y.S.2d 188 (N.Y.A.D. 1 Dept. 2006), the court held: “[w]e reject plaintiff’s argument that the absence of a provision in the Limited Liability Company Law expressly authorizing a buyout in a dissolution proceeding rendered the IAS court without authority to grant the parties mutual buyout rights, and find that it is an equitable method of liquidation to allow either party to bid the fair market value of the other party’s interest in the business, with the receiver directed to accept the highest legitimate bid.

In the infamous Delaware case of Haley v. Talcott, 864 A.2d 86, 97 (Del. Ch. 2004), the court ordered dissolution under the “not reasonably practicable standard” even though the operating agreement provided a put mechanism as a method for avoiding the impasse, noting that the operating agreement did not expressly substitute the put mechanism for the judicial-dissolution remedy, and holding that the put mechanism was not fair and equitable because it would leave the exiting member personally liable on a mortgage.

The take-away from Haley is that, if a put is intended to be part of the “reasonably practicable” solution to a deadlock in the operation of the LLC, the operating agreement must explicitly state as much, and must expressly acknowledge that it is to be enforced by a court in lieu of the court exercising its equitable power to fashion a different remedy. Of course, in many states, such a provision must withstand any challenge that it is “manifestly unreasonable” and therefore unenforceable (perhaps because it results in imposing company liabilities on the remaining members and exempting the exiting member from those liabilities).

Mechanisms Addressing Deadlock

The creativity that parties can employ in creating a deadlock-breaking mechanism is nearly limitless. All states provide for contractual freedom in drafting operating agreements, subject only to the “nonwaivable” default rules in the applicable LLC act. Based on Haley, it is critical that the operating agreement specify whether a court must enforce the chosen deadlock-breaking mechanism, unless it is deemed “manifestly unreasonable” (more on this later).

LLC operating agreements that address deadlock generally do so with a few well-known mechanisms:

1. Buy-Sell Provisions. Most often these take the form of either: (i) an “appraisal” model (requiring an independent appraisal by a qualified expert as to the value of the interest to be purchased); or (ii) a “shotgun” or “Russian Roulette” or “Texas Shoot Out” (or any number of other colorful names) model, which essentially permits one member to offer to purchase the interest of the other deadlocked member at a set price and terms, and the offeree must then either accept that price and terms, or purchase the offeror’s interest for the same price and terms (assuming equivalent percentage interests). The results of so-called shotgun models have been seen to generate litigation and unfair results, particularly where the parties have wildly different ideas about value, where there is a significant gap in knowledge about the specific business or industry, or where the parties have significantly different economic resources. On the other hand, under the right circumstances, these mechanisms have proven rather effective at forcing parties to find a way to break a deadlock to avoid the potential of one party actually pulling this trigger.

2. External or Internal “Tie-breakers.” This is where the parties that are deadlocked will refer the decision to a tie-breaker, which may be a group like the board of an affiliated entity, inside or external professional advisors, one or more mediators/arbitrators, or “industry expert(s).” A significant problem with this approach often is that, in taking such an action, the decision is removed from the parties most familiar with the company and its business and put in the hands of third parties who may not have the requisite insight. Therefore, this mechanism should be used only when there are parties to whom the decision may be referred that have some history and familiarity with the specific business and industry.

3. “Rotating/Alternating” or “Casting” Vote Mechanisms. These mechanisms, which allow the members to rotate “tie-breaking” or “casting” votes whenever there is a deadlock on a decision, often are complicated to draft (to limit gamesmanship) and frequently leave everyone unhappy. In essence, the members (assuming a member-managed LLC) will try to reach agreement on a list of “major issues” when they arise, but if they fail to come to an agreement, one member will break the deadlock by exercising his or her casting vote. The next time there is a deadlock on a major issue, another member gets the “casting vote,” and so on it goes. Obviously, this has significant drawbacks and rarely is successfully employed.

4. “Put or Call Mechanisms.” These mechanisms are well known and often used as deadlock-breaking provisions in LLC operating agreements because they are common in many other contexts. However, the nuances of these mechanisms are significant and must be carefully drafted. Aside from the valuation issues in put and call mechanisms (which are an article unto themselves), perhaps the most important issues associated with put/call provisions involve the determination of triggering events. A triggering event is essentially the action, event, or circumstance that will allow one party to exercise a put or call. These provisions are heavily negotiated and careful drafting is essential. Consider questions such as whether they should be based on deadlock or on only a few specific matters (e.g., whether the company should take out a loan, make a capital call, admit a new member, or change the business), or whether they should be exercisable on matters that go beyond deadlocked vote. The list can be quite extensive, or it can be narrowly drafted. Some examples are below:

X’s Triggering Events:

  • Any material failure by [X] to perform its obligations under this Agreement that is not cured to [Y’s] reasonable satisfaction within ten (10) days after Notice of breach by [X] regarding monetary default and within thirty (30) days after Notice of breach by [X] regarding a nonmonetary default (provided that such cure period for a nonmonetary default shall be extended for an additional period, not exceeding an additional ninety (90) days, so long as [X] as the case may be, is diligently pursuing the cure of such default during such extended cure period);
  • The failure by [X] to fund, in full, any Required Amount under [the operating agreement];
  • Any transfer or encumbrance of [X’s] Membership Interest in the Company or any portion thereof or any direct or indirect interest therein not permitted herein without the Approval of [Y]; and
  • Any act of gross negligence, willful misconduct, or fraud by [X] concerning its obligations under this Agreement.

Y’s Triggering Events:

  • Any material failure by [Y] to perform its obligations under this Agreement as Member [or Manager] that is not cured to [X’s] reasonable satisfaction within 10 days after Notice of breach by [Y] regarding monetary default and within 30 days after Notice of breach by [Y] regarding nonmonetary default (provided that such cure period for a nonmonetary default by [Y] shall be extended . . . .);
  • Any material breach of a representation, warranty, or covenant: (i) by [Y] or its Affiliates under the Noncompetition and Right of First Opportunity Agreement; (ii) by the Manager under a Management Agreement; or (iii) by [Y] or its Affiliates under any Related Party Agreement, in each case in the event such material breach is not cured within any applicable grace period. . . .;
  • The failure by [Y] to obtain the Approval of [X] prior to taking any action requiring the Approval of [X] hereunder. . . .;
  • The failure by [Y] to fund, in full, any Required Amount under [the operating agreement] including any grace period provided therein;
  • Any transfer or encumbrance of [Y’s] Membership Interest or any portion thereof or any direct or indirect interest therein not permitted herein without the Approval of [X];
  • Any [Y] Material Change in Control not Approved by [X] under [Section _ of the operating agreement]; and
  • Any act of gross negligence, willful misconduct, or fraud by [Y] or by any Affiliate of [Y] under this Agreement or any Related Party Agreement or otherwise in connection with the management and operation of the business and affairs of the Company.

Remedies for [X or Y] Triggering Event:

Upon the occurrence of an X Triggering Event, and at any time thereafter, Y may, at its option, exercise any one or more of the following remedies without the Approval of any other Member:

  • cause the Company to market and sell the Properties to a third party for such price and on such terms as [Y] deems appropriate, without the need for Approval of [X] and without any right on the part of [X] to purchase any of the Properties;
  • dissolve the Company;
  • exercise, in its sole discretion, the Company’s right to terminate (or otherwise enforce any other remedy with respect to) any Property Management Agreement or any other Related Party Agreement between the Company or any Subsidiary and [X], or any Affiliate of [X];
  • replace [X] as the Member vested with day-to-day management control of the affairs of the Company as set forth in Section _, and/or remove [X] as the Property Manager with respect to the Properties; and
  • in the case of an [X] Triggering Event under Section _ only, purchase the Membership Interest of [X] for an amount equal to the lesser of: (i) seventy-five percent (75%) of the [unreturned Capital Contributions] of [X]; or (ii) the [Fair Market Value] of [X’s] Membership Interest.

5. Partition or Sale of the Company or Its Assets. The possibility of partition of the LLC business, or a forced sale of the Company or its assets, can also compel disagreeing members or managers to find a way to resolve their deadlock. Partition of the LLC assets or business can work only in limited circumstances, typically where the assets or business activities are easily segregated among the members without destroying the business model itself and where the values of those assets are equal and division is easily agreed upon by the disputing members. A forced sale of the company or its assets also has complications, particularly timing, market forces, lack of interested buyers, or understanding who sets the price and terms (remember there is already deadlock, so these issues may be difficult to agree upon later); therefore, the initial drafting must be comprehensive and often must be turned over to third parties to facilitate.

When All Else Fails: Litigation and Alternative Dispute Resolution Options

When deadlock-breaking mechanisms fail or are absent from the operating agreement, the most common alternatives include:

  • involuntary or judicial dissolution
  • custodianship or receivers
  • injunctions
  • specific performance
  • judicial expulsion

1. Involuntary or Judicial Dissolution

An action seeking involuntary dissolution by a member is by far the most common form of getting out of an LLC in the absence of a deadlock-breaking mechanism. Involuntary dissolution petitions may be coupled with claims for other forms of relief, such as demands for an accounting, appointment of a receiver or custodian, a change in control of the LLC, etc. The petitioner ordinarily must allege and establish the following elements: (i) there is a voting deadlock; (ii) the operating agreement does not provide a means for breaking deadlock; and (iii) the LLC is functioning only as the result of “residual inertia,” and there is no other reasonable method of resolving deadlock. The cons associated with judicial dissolution include a lower realized value for the membership interests or assets and an inability to continue the business.  The respondent in a petition for involuntary dissolution often asserts bad faith by the petitioning member(s) as a defense. The remedy can rapidly become expensive.

2. Custodianship/Receivership

Think of a custodian as a form of receiver. A custodian may be appointed by a court to operate the LLC in circumstances where the members’ division is so severe that it prevents the orderly operation of the business and threatens the entity with irreparable injury. The court-appointed custodian effectively replaces the members or managers in control of the company and is charged with the responsibility to operate the business until the court fashions a more permanent remedy. The principal advantages of custodians include that the cause and effect of the members’ division, and the management’s inability to manage the business, are removed, and the company may be saved from liquidation unless it is already insolvent. The principal disadvantage is that management decisions are placed in the hands of a third party rather than in the hands of the members or managers of the company. The custodian’s exit from the scene should be accompanied by a negotiated mechanism to resolve future deadlock should the need again arise. A receiver can be appointed to liquidate the company if there is no viable alternative.

3. Injunction

Injunction is a familiar tool to most litigators. An injunction is a court order prohibiting or requiring the performance of certain conduct that is necessary to prevent irreparable injury to the company or its members. Injunction is often a precursor to eventual dissolution and may be used in the context of deadlock offensively or defensively. In other words, a party may petition the court for an injunction to prevent looting, waste of corporate assets, breach of fiduciary duties, or oppression by managing members. A party that is the target of a petition for judicial dissolution or appointment of a custodian may seek an injunction to neutralize the attack. Injunction orders can be very simple affairs that prevent or mandate a well-defined behavior, or they can be more complex documents that specify the manner in which the company will do business and the managers who will manage it. Injunctions may be granted only where the requesting party can demonstrate a likelihood of success on the merits of its claim, where there is no other adequate remedy at law (e.g., the absence of a deadlock-breaking mechanism in the operating agreement and no guidance from the LLC statute), and there is a risk of irreparable harm if the relief is not granted. Although an injunction theoretically allows for the continuance of the company’s business, it does not resolve deadlock, it holds a bad relationship together, and it is difficult to obtain due to a high standard of proof.

4. Specific Performance

A party may seek specific performance of obligations owed by another party if the claim arises under a contract that describes the obligations to be performed, but that the respondent is not performing. Essentially, the petitioner asks the court to force the respondent to perform its contractual obligations (including obligations under the operating agreement). The standard of proof often is “clear and convincing,” which is a higher standard than for most claims (preponderance of the evidence). Specific performance is not always available due to the existence of remedies at law. It features the unfortunate characteristic of forcibly keeping a contentious relationship together without providing a method to resolve future deadlock.

5. Judicial Expulsion

Expulsion is an extreme remedy because it removes a member from the LLC. The standards of proof parallel those for involuntary dissolution, where it is “not reasonably practicable” for the LLC to serve the purposes and function specified in the operating agreement. The remaining members may continue to operate the company. The inquiry is peculiarly fact-driven, and the trier of fact must be satisfied that the high standard of proof establishes adequate “fault” to support expulsion of a member. Mere disagreement over how to operate the company is not sufficient. Not all states provide the remedy of expulsion.

6. Alternative Dispute Resolution: Mediation and Arbitration

Operating agreements that do not provide mechanisms for breaking deadlock may nevertheless provide alternate methods of resolving disputes, such as mediation and arbitration. Mediation is a voluntary negotiation presided over by a neutral that assists the parties to overcome their differences and achieve a voluntary resolution through negotiation. Many sophisticated courts now feature mandatory mediation programs. Mediation is useful in situations where the parties are motivated to compromise, but it may be fruitless when the parties are so hostile and entrenched that compromise is impossible. A strong neutral, frequently a retired judge, often is the key to a successful mediation. A strong neutral can force the parties out of their echo chambers and recognize the risks and expense—and the distraction from profitable activity—that is associated with continued litigation.

Arbitration is another option. Like mediation, arbitration is conducted out of court, but unlike mediation it does not involve achieving a negotiated compromise. Arbitrations essentially are private trials. One or more neutrals are paid to function as trial judges. They conduct discovery and motions practice, often in a streamlined manner, and preside at trial. Testimony is taken and evidence is submitted to the arbitral panel for consideration. The goal of arbitration is to obtain a resolution in an adversary manner more quickly than might occur in state or federal court. An advantage of arbitration is that the parties participate in selecting the triers of fact and, as a result, are often able to secure the services of neutrals with substantial experience with the subject matter in dispute. A drawback to arbitration is the need to compensate the arbitrators, an additional expense not associated with traditional litigation in which the parties pay only their attorneys. Arbitration awards may be recorded as judgments and enforced in like manner.

A thoughtful and properly drafted operating agreement will provide deadlock-breaking mechanisms that may help the members of LLCs avoid the need for costly and distracting litigation. When all else fails, however, these tools provide parties with flexible alternatives to obtain resolution through adversary proceedings.

This article is based on materials and a panel discussion presented by the authors at the 2016 ABA LLC Institute in Arlington, Virginia, as members of the ABA Committee on LLCs Partnerships and Unincorporated Business Entities.

Nonprofit LLCs

Posted on March 23, 2017 by - Uncategorized

LLCs increasingly intersect with the nonprofit sector. LLCs are used within the sector as tax-exempt subsidiaries (see, e.g., IRS Announcement 99-102 (requiring I.R.C. section 501(c)(3) organizations to report the activities of their single-member LLCs (SMLLCs) on the organization’s annual IRS Form 990)); as vehicles for charitable giving (see e.g., IRS Notice 2012-52 (allowing contributions to an SMLLC owned by a (c)(3) to qualify for a charitable contribution deduction under I.R.C. section 170); see also Priv. Ltr. Rul. 200150027 (Dec. 14, 2001) (disregarded SMLLC established by (c)(3) to receive contribution of real property subject to potential environmental liabilities)); as private foundation substitutes; and as stand-alone, tax-exempt entities in lieu of nonprofit corporations or unincorporated nonprofit associations (see Reg. § 301.7701-3(c)(1)(v)(A) (submission of application for (c)(3) status constitutes an election to be treated as a corporation for federal income tax purposes)). A few states even have a nonprofit form of the LLC (see Ky. Rev. Stat. Ann. §§ 275.520–540 (2017); Minn. Stat. § 322B.975 (2017); N.D. Cent. Code §§ 10-36-01 to -09 (2017); Tenn. Code Ann. § 48-101-809 (2017)).

Furthermore, because it is so flexible, the LLC has proven useful for hybrid for-profit/nonprofit endeavors (i.e., the benefit LLC and the L3C) (see generally Cassady V. Brewer, Elizabeth Carrott Minnigh & Robert A. Wexler, Social Enterprise by Non-Profits and Hybrid Organizations, 489 Tax. Mgmt. at A-33) and joint ventures between tax-exempt and nontax-exempt entities (see, e.g., Rev. Rul. 2004-51 (attributing “insubstantial” activities of an ancillary LLC joint venture to an exempt member); Rev. Rul. 98-15 (attributing “substantial” activities of a whole hospital LLC joint venture to an exempt member)).

Using a hypothetical to illustrate, this article summarily explores the use of LLCs within the nonprofit sector, including a few words about their use as hybrid for-profit/nonprofit enterprises.

Hypothetical

Assume that a local, unincorporated men’s group has been operating an annual four-day men’s retreat in the Smoky Mountains for the past five years. Each year there are approximately 50 attendees. The retreat is educational in nature, focusing upon the role of men in the family and upon living a more spiritual life. Special, invited guests speak at the retreat, and the attendees participate in workshops and discussion groups centered upon each speaker’s topic. Selected leaders of the group annually front the expenses of the retreat (accommodations, meeting rooms, food, drink, etc.) and are reimbursed via collections taken from all the attendees during the retreat. Last year, however, a fatality occurred during the men’s retreat, so the leaders of the group have decided to seek the assistance of an attorney to explore their options for liability protection and possible incorporation as a nonprofit.

Discussion and Analysis

Unincorporated Nonprofit Association

Organizations with a charitable, educational, religious, or other exempt purpose such as our hypothetical men’s retreat often begin operating without a formal legal structure. Eleemosynary associations such as literary clubs, church groups, and “friends of” organizations largely begin as self-funded organizations that may not even consider themselves “nonprofit” in the traditional sense. Nevertheless, these organizations are in fact operating in a recognized legal form: the unincorporated nonprofit association.

The unincorporated nonprofit association is the nonprofit equivalent of a general partnership (see Revised Uniform Unincorporated Nonprofit Association Act (RUUNAA)).The law varies from state to state as to whether an unincorporated nonprofit association is considered a legal entity apart from its members. California and states that have adopted versions of the Uniform Unincorporated Nonprofit Associations Act (UUNAA) regard the association as a separate entity. (Thirteen jurisdictions adopted the original version of the UUNAA (1996): Alabama, Arkansas, Colorado, Delaware, DC, Hawaii, Idaho, Illinois, Louisiana, North Carolina, Texas, Wisconsin, and Wyoming. So far, six have adopted the RUUNAA: Arkansas, DC, Iowa, Kentucky, Nevada and Pennsylvania. California has had an unincorporated association law since 1947, and the law was significantly revised in 2004 and 2005.)

Tax-exempt status is obtainable for an unincorporated nonprofit association, just as with a charitable trust or a nonprofit corporation. (More informal aggregations of individuals are not automatically considered a “corporation, community chest, fund, or foundation” that can claim exempt status under I.R.C. section 501(c)(3) (see Trippe v. Commissioner, 9 TCM (CCH) 622 (1950)). If, however, the organization has sufficient organizing documents binding the members, then the tax “entity” can be considered a “corporation, community chest, fund, or foundation” and therefore qualify for exempt status (see Morey v. Riddell, 205 F. Supp. 918 (S.D. Cal. 1962), in which the court found organizing documents sufficient to support a finding that an entity was created). The principal requirement is that the unincorporated nonprofit association and its members subject themselves to the “nondistribution constraint” (see I.R.C. § 501(c)(3): “no part of the net earnings of which inures to the benefit of any private shareholder or individual”) that is standard for I.R.C. section 501(c)(3) organizations. However, even though an unincorporated nonprofit association may qualify as an organization separate from its members and thereby exempt under federal law, not all jurisdictions recognize it as a separate legal entity under state law. In these states, the association may not be authorized to hold title to property, may not be able to enter into and enforce contracts, may not be able to sue or be sued, and may not offer liability protection for its members (see UUNAA, at 2). The RUUNAA and UUNAA ameliorate these legal problems in adopting states, but most states have not adopted either statute.

Although there are valid reasons (e.g., (i) the organization has both U.S. and non-U.S. members (e.g., Canada) and does not want to create separate entities in each country; (ii) the organization does not want governmental regulation that accompanies incorporation; (iii) the organization does not want to comply with the legal formalities associated with a juridical entity; (iv) the organization is too small or engages in activity (e.g., a literary society) that seldom, if ever, requires liability protection or a formal governance structure; or (v) the organization is simply a local chapter of a national organization (e.g., a labor union)) why an eleemosynary organization such as our hypothetical men’s retreat may want to operate as an unincorporated nonprofit association, in most cases a formal legal entity makes more sense. Where a formal legal entity is chosen, the choice most often comes down to one of two forms: a nonprofit corporation or an LLC. (In the authors’ experience, charitable trusts generally are not used because trusts typically do not engage in active business or charitable endeavors. Most trusts are formed for the sole purpose of passively holding and managing assets and making distributions to beneficiaries. There are exceptions, of course, but trusts are not as flexible with respect to changes in purposes or activities or changes in governance (unlike nonprofit corporations and LLCs)). A nonprofit corporation for our hypothetical men’s retreat is a logical choice, and it undoubtedly is the predominate form (see C. Brewer, Chapter 14: Nonprofit and Charitable Uses of LLCs in Research Handbook on Partnerships, in LLCs and Alternative Forms of Business Organizations 229 (R.W. Hillman & M.J. Lowenstein eds., Edward Elgar 2015)), but the LLC also may be a proper choice in the right circumstances, as explained further below.

Limited Liability Company—Either For-Profit or Nonprofit, but Not Tax-Exempt

The men’s group in our hypothetical almost certainly could be formed as an LLC organized to operate the annual retreat. Virtually all states allow an LLC to be organized for any lawful purpose—unlike for-profit corporation statutes which typically require a “business” purpose. Moreover, as noted above, four states authorize nonprofit LLCs. Formation as an LLC offers significant advantages over an unincorporated nonprofit association, not the least of which would be liability protection for the members of our hypothetical men’s group. The members of the men’s group could become members of an LLC, could fund the retreat via payments—arguably capital contributions—to the LLC, and could appoint managers of the LLC to arrange and manage the retreat.

From a federal income tax perspective, the LLC essentially would operate as an expense-sharing arrangement, and thus most likely would not be treated as a partnership or other tax entity for federal income tax purposes (see Reg. § 301.7701-1(a)(2) (two or more persons joining together to construct a drainage ditch does not constitute a partnership for federal income tax purposes)). Even if the LLC were considered a partnership for federal income tax purposes, its expenses almost certainly would match its income from the payments (capital contributions?) by the members. Note, however, that the contributions of the men towards the expenses of the annual retreat would not be tax deductible. Instead, such contributions would be considered nondeductible personal expenses (see I.R.C. § 262). To be tax deductible, the LLC would have to qualify under I.R.C. section 501(c)(3), and any contributions by the members would have to qualify as charitable gifts under section 170, not payments in exchange for the return benefit of goods and services received at the retreat (Reg. § 1.170A-1(h)).

Interestingly, the IRS’s current position is that an LLC patterned after our hypothetical men’s group cannot function as a (c)(3) organization unless all of its members are (c)(3) organizations, governmental units, or instrumentalities thereof. Apparently, this is the IRS’s position even if the organization otherwise would qualify as charitable, educational, religious, or exempt in some other fashion under section 501(c)(3). Note, however, that this is only the IRS’s position. It is not settled law. Clearly, a nonprofit corporation with an exempt purpose may have nonexempt, nongovernmental members and nevertheless qualify as a (c)(3) organization, provided the “nondistribution constraint” is met, and other required provisions are set forth in the organization’s governing documents. If the IRS’s position is litigated, it is conceivable that a properly organized and operated LLC could qualify as a (c)(3) organization even if it has nonexempt, nongovernmental members. Arguably, this clearly should be so if the LLC is formed in one of the four states that statutorily authorize nonprofit LLCs. Those four states noted above impose the “nondistribution constraint” (as well as other requirements) on nonprofit LLCs similar to the restrictions imposed upon nonprofit corporations. It is unlikely, though, that a taxpayer would be willing to challenge the IRS’s position when a duly formed nonprofit corporation easily can obtain IRS approval for (c)(3) status.

SMLLC Subsidiary of Tax-Exempt Organization (or Fiscal Sponsorship)

Alternatively, our hypothetical men’s group could be formed as a SMLLC owned by an existing charitable organization that is exempt under section 501(c)(3). For instance, if the men’s group was affiliated with a church, then the church could form and be the sole member of an LLC that conducts the annual retreat. The SMLLC owned by the church would be considered an exempt division of the church itself.

A variation of the charitably owned SMLLC is a “fiscal sponsorship” using an LLC (see S. Chiodini & G. Colvin, The Use of LLCs in Fiscal Sponsorship—A New Model, 22 Tax’n of Exempts 7 (2011)). A fiscal sponsorship arrangement essentially lends the sponsor’s (c)(3) status (including administrative functions) to a project aligned with the sponsor’s exempt purpose. The fiscal sponsor thereby may receive charitable grants and tax-deductible contributions that it otherwise would be unable to receive. For example, a church or other (c)(3) affiliated with our hypothetical men’s group could enter into a fiscal sponsorship agreement with the LLC (likely owned by the (c)(3) but conceivably owned by the members) to conduct the annual retreat. So long as the (c)(3) exercises complete control over the LLC’s finances concerning the retreat, grants and contributions to the LLC (provided they are not payments for goods or services) should be tax deductible as if contributed to the (c)(3) itself.

Although the church also could form a nonprofit corporation instead of an SMLLC to organize and conduct the retreat, the SMLLC has at least one significant advantage. Specifically, before the existence of disregarded SMLLCs, (c)(3) organizations or their donors used “supporting organizations” or “title-holding corporations” to function as exempt subsidiaries. Because they are not disregarded like an SMLLC, however, supporting organizations are highly regulated and must separately apply to the IRS for recognition of their exempt status. Title-holding corporations are, as the name suggests, exempt organizations formed to hold title to real property. Although not required to separately apply for exempt status, title-holding corporations are subject to strict limitations on their activities (I.R.C. § 501(c)(25) (limited to being organized to hold title to real property and collect the income therefrom for remittance to the title holding company’s exempt parent)). Operating a men’s retreat likely would not be permitted.

Despite the advantages associated with the use of disregarded SMLLCs by (c)(3) organizations, some caveats are in order. For instance, SMLLCs are not disregarded for employment tax purposes (Reg. § 301.7701-2(c)(2)(iv)-(v) rev’g Notice 99-6, 1999-1 C.B. 321). Therefore, if a nonprofit or charitable organization’s disregarded SMLLC has employees, it ordinarily will be subject to employment tax filings and payments distinct from the parent organization (see Reg. §§ 31.3121(b)(3)-1T; 31.3127-1T; 31.3306(c)(5)-1T; 301.7701-2T (generally treating SMLLC as separate entity for employment tax purposes but also permitting SMLLC to be disregarded for certain religious exceptions)). Furthermore, even though most states follow the default federal income tax classification of SMLLCs as disregarded entities, not all states do so. Moreover, nonincome-based state taxes—such as franchise, sales, use, and property taxes—can apply to nonprofit and charitable SMLLCs absent a specific exclusion. Finally, as far as the authors are aware, current law is unclear whether federal or state charitable immunity or other laws protecting volunteers of nonprofit organizations (as opposed to the organization itself) from tort claims apply to volunteers of disregarded SMLLCs of nonprofit organizations. Tort liability protection for volunteers could be a critical determining issue for our hypothetical men’s retreat.

“Social Enterprise” and LLCs

In addition to their growing use within the nonprofit sector, LLCs are used for quasi-charitable (social enterprise) purposes. Social enterprise has no legal definition, but generally it is understood as using traditional for-profit business approaches to address social or environmental concerns. For instance, if our hypothetical men’s group sought to operate the retreat on a for-profit basis, opened it to the public, and charged fees to attendees, then the organization might be considered an educational social enterprise. Note that there are no tax benefits associated with operating a business as a social enterprise.

Low-profit limited liability companies (L3Cs) can be used to conduct a social enterprise with a charitable or educational purpose. An L3C essentially is a variant of a regular LLC (and the enabling statute typically is set forth in the jurisdiction’s normal LLC statute). To be an L3C, an LLC: (i) must further the accomplishment of a charitable purpose; (ii) would not have been formed but for its relationship to the charitable purpose; (iii) must have “no significant purpose” of producing income or appreciation in property; (iv) must not have a political or legislative purpose; and (v) must use the name “low-profit limited liability company” or the abbreviation “L3C” in its name. Eight states have L3C statutes:

  1. Vermont (Vt. Stat. Ann. tit.11, §§ 4161, 4162)
  2. Illinois (805 ILCS 180/1-5, 805 ILCS 180/1-10, 805 ILCS 180/1-26, 805 ILCS 180/5-5)
  3. Louisiana (La. Rev. Stat. Ann. §§ 12:1301(A)(11.1), (12), 12:1302(C), 12:1305 (B)(3), 12:1306(A)(1), 12:1309(A))
  4. Maine (Me. Rev. Stat. Ann. tit. 31, §§ 1502(16), 1508, 1611)
  5. Michigan (Mich. Comp. Laws § 450.4102(m))
  6. Rhode Island (R.I. Gen. Laws §§ 7-16-2(27), 7-16-9, 7-16-49, 7-16-76)
  7. Utah (Utah Code §§48-2c-412, 48-2c-1411)
  8. Wyoming (Wy. Stat. §17-29-102(a)(ix), et seq.)

At one point, North Carolina had an L3C statute, but repealed its law effective January 1, 2014 (see N.C. Gen. Stat. §§ 57D-2-01, 57D-2-21, 55D-20(a) (2013) as repealed by S.B. 439).

L3Cs are designed to dovetail with and satisfy (at least in their organizational documents) the program-related investment (PRI) requirements set forth in the I.R.C. (at section 4944) and corresponding regulations (at section 53.4944-3). PRIs are investments made with a primary purpose of accomplishing a charitable purpose. PRIs occasionally are used by private foundations to make risky but worthwhile investments (e.g., low-interest loans) in private enterprises to accomplish charitable purposes rather than simply making a grant to the same enterprise. In other respects, the L3C statutes leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the L3C to the articles of organization and the operating agreement.

Critics justifiably point out that, because the L3C is not preapproved by the IRS to accept PRIs, unless and until such preapproval is granted, the L3C has no meaningful advantage over a traditional LLC. In fact, the ABA Business Law Section opposes L3C legislation. On the other hand, although the L3C originally was envisioned as a vehicle for PRIs, there is no requirement that an L3C be funded by a PRI or that an L3C have even one private foundation or other tax-exempt member. Hence, if our hypothetical retreat charged fees to attendees and served the purpose of educating men on their role in families and living a spiritual life, it could be organized as an L3C (including an SML3C) instead of an LLC (or SMLLC). Of course, an LLC with appropriate language in its governing documents regarding its educational role also would be sufficient to consider the LLC a social enterprise.

Another social enterprise form of the LLC—the benefit LLC—exists in two states: Maryland (at section 4A-1107(b)) and Oregon (at sections 60.750 to -.770). Oregon’s approach is slightly different than Maryland. Instead of having a separate statute applicable to LLCs like Maryland, Oregon’s statute sets forth the requirements for a “benefit company,” which includes both benefit LLCs and benefit corporations. The Maryland and Oregon benefit LLC statutes essentially mirror the respective statutes for a Maryland or Oregon benefit corporation. In particular, a Maryland or Oregon benefit LLC must have the purpose of creating a “general public benefit” through “activities that promote a combination of specific public benefits.” A “general public benefit” is defined for this purpose as “a material positive impact on society and the environment, taken as a whole.” A benefit LLC also may (but is not required to) adopt a specific public benefit purpose. Specific public benefits (if any) must be set forth in the LLC’s articles of organization and include, but are not limited to, the following: (i) providing low-income or underserved individuals or communities with beneficial products or services; (ii) promoting economic opportunity for individuals or communities beyond the creation of jobs in the normal course of business; (iii) preserving or improving the environment; (iv) improving human health; (v) promoting the arts or sciences or the advancement of knowledge; (vi) increasing the flow of capital to entities with a public benefit purpose; and (vii) accomplishing any other identifiable benefit for society or the environment.

Other requirements also are imposed upon Maryland and Oregon benefit LLCs—similar to the requirements imposed upon Maryland and Oregon benefit corporations. Importantly, the Maryland and Oregon benefit LLC statutes offer fiduciary liability protection to the managers of a benefit LLC when making decisions concerning the pursuit of profit versus the benefit purposes of the LLC. This added fiduciary liability protection might make the Maryland or Oregon benefit LLC especially attractive in some circumstances. On the other hand, most LLC statutes allow the operating agreement of an LLC to limit the fiduciary liability of the managers under any circumstances—regardless of any quasi-charitable purpose for the LLC. Uniquely, Maryland requires a benefit LLC to use the term “benefit” in its name.

Beyond the foregoing, the Maryland and Oregon benefit LLC statutes, like the L3C acts, leave the details of the economics, management duties, transaction approvals, voting, indemnification, and other matters of the LLC to the articles of organization and the operating agreement. In essence then, aside from the specific statutory provisions summarized above, Maryland and Oregon benefit LLCs should be treated just like regular LLCs.

For the same reasons that our hypothetical men’s group could be organized as an L3C, it similarly could be organized as a benefit LLC with a general public benefit and a specific public benefit of promoting the “advancement of knowledge” (i.e., the role of men in the family and living a more spiritual life).

Conclusion

As demonstrated above, an LLC in one of its many variations might be the best solution for our hypothetical men’s group. An LLC could provide liability protection, unlike an unincorporated nonprofit association, without imposing the added compliance burdens that accompany a standalone, tax-exempt nonprofit corporation. The table below summarizes the various choice-of-entity considerations discussed in this article.

Factors to Consider

Unincorporated Association

Nonprofit Corporation

LLC (Including Nonprofit and Hybrid LLCs)

Limited Liability for Owners

Generally, no, but some states grant protection

Yes

Yes

Ease of Formation

Yes

No

Moderate

501(c)(3) Exempt Status Possible?

Yes

Yes

Law is unsettled. IRS position is “No” unless all members are (c)(3)s.

Formalized Management and Governance

Generally, no, absent a written association agreement.

Yes

Yes

Hold Title, Sue and Be Sued, Enforce Contracts, and Otherwise Have Legal Rights as an Entity

Generally, no, but some states grant legal rights.

Yes

Yes

Contributions Deductible?

Yes, if (c)(3) exempt status has been obtained.

Yes, if (c)(3) exempt status has been obtained.

Yes, if (c)(3) exempt status has been obtained. If not, then no charitable deduction and contributions likely treated as personal cost sharing arrangement under Reg. § 301.7701-1(a)(2).

Can Be Disregarded for Tax Purposes

No, but practically speaking, many unincorporated associations effectively are disregarded by members from legal and tax perspective.

No

Yes

S Corporation Limited Liability Companies: Pick Your Paradigm

Posted on March 23, 2017 by - Uncategorized

Introduction

An oft-touted feature of the limited liability company as a preferred choice of entity is the extraordinary flexibility it accords to equity owners for structuring their legal and economic relationships. Seasoned practitioners in the field of entity planning and governance have found that the LLC permits the largely unhindered private ordering of relationships among business owners, investors, and other relevant stakeholders, especially in jurisdictions such as Delaware and others whose LLC statutes endorse a broad, “contractarian” approach. Corporations, by contrast, often operate under more rigid and well-established legal principles that often are difficult, and sometimes impossible, to circumvent.

Prior to the adoption of the so-called check-the-box regulations in 1996, the choice of a particular form of business entity (i.e., corporation or partnership) usually dictated the tax regime to which it was subject. The check-the-box regulations largely decoupled the choice of tax regime from the choice of entity. They allow limited liability companies and other entities not organized as a business corporation under state law to “elect” to be classified for federal tax purposes as a corporation or, if the entity satisfies the applicable criteria, to further elect to be taxed as an S corporation under the Internal Revenue Code (the Code).

For a variety of reasons, several of which are discussed below, it has become increasingly common for LLCs to choose to be taxed as subchapter S corporations. This article will explore some of the possible rationales for choosing the S corporation tax regime. Following that discussion is a brief recap of the rules applicable to subchapter S corporations and the mechanics of the subchapter S election. After contrasting some of the relative advantages and disadvantages of being taxed as an S corporation, the article concludes with practice points and drafting guidance for the organization, governance, and operation of a limited liability company that has elected to be taxed as an S corporation.

Why Choose Subchapter S?

When considering the relative costs and benefits of electing subchapter S taxation, it is important to first ask the question: “relative to what?” Generally, it is relative to the federal income tax regimes applicable to a regular C corporation, a disregarded entity, or a partnership. Although LLCs can (and for a variety of reasons often do) elect to be taxed as a C corporation, the C corporation lacks the benefit of “pass-through” taxation afforded to S corporations. The C corporation remains a viable, and indeed preferential, option in several settings. Although a full exposition of those circumstances is beyond the scope of this article, in many cases pass-through taxation may not be desirable to certain investors (such as 501(c)(3) qualified entities). In addition, the potential for gain exclusion afforded to qualified small business stock under section 1202 of the Code is only available to C corporation shareholders. The choice between subchapter S and disregarded entity status is relevant only for entities with a single equity owner. In the case of the solo business owner, the perceived potential for payroll tax savings, as discussed in greater detail below, is an oft-cited reason for making an S election. That benefit must be contrasted with the necessity of filing a separate tax return for the entity, and more importantly, the limitations of subchapter S. Finally, there is the choice between federal income taxation of S corporations and partnerships. The tax accounting required for partnerships generally is more complex and compliance more expensive—a situation often compounded by unique and complex economic arrangements among the parties. The trade off, of course, is the planning limitations associated with the S corporation regime.

There are perceived payroll tax advantages under subchapter S. It is important to note that there is no real distinction between subchapter S and subchapter C in this regard—subchapter C offers the same payroll tax advantage as subchapter S, but only subchapter S offers pass-through taxation. Generally, corporations are allowed a deduction for “reasonable compensation” paid to employees, even if the party receiving the compensation is also a shareholder of the corporation. In contrast, allocated profits from a partnership potentially are treated as earnings from a trade or business and therefore taxed as self-employment income. As a general rule, in an S corporation, a shareholder’s pro-rata share of net income is not considered earnings from self-employment either when earned or when distributed as dividends unless, and to the extent that, the dividends are paid in lieu of reasonable compensation for services rendered to the corporation by the shareholder. In that case, the income may be recharacterized as wages subject to employment taxes. Using a simple example, if an S corporation shareholder is paid an annual salary of $120,000, and his or her distributable share of net income is $380,000 (assuming that the $120,000 payment represents “reasonable compensation” to the shareholder for services rendered to the corporation), the $380,000 distributive share of net income is not subject to employment taxes. Under the partnership tax rules, that same $380,000 distributive share of net income (irrespective of whether it is characterized as a guaranteed payment in exchange for services rendered by the partner or as the partner’s allocable share of net income) could result in imposition of an additional employment tax liability of nearly $15,000. Given that there is no cap on the Medicare tax or the additional employment tax imposed under the Affordable Care Act, the higher the distributive share of net income, the greater the potential employment tax savings (as a subchapter S corporation) or employment tax liability (as an LLC taxed as a partnership under subchapter K).

There is a tension between the self-employment tax (which generally is imposed on a partner’s active trade or business income) and the net investment income tax (which generally is imposed on passive income). With proper planning, including the use of “guaranteed payments” made to a member as reasonable compensation for services, it is possible to limit the amount of partnership income subject to self-employment taxes, but also maintain a sufficient level of activity in the business to avoid imposition of the net investment income tax. Service partnerships (i.e., those in which all of the members provide professional or other consulting services) and member-managed LLCs present special planning challenges and more limited planning opportunities around these issues. If care is taken in the proper characterization of income and preparation of the underlying documents, however, in many cases the perceived payroll tax benefit thought to be available to S corporations can be achieved in the partnership context.

Several other planning considerations may drive a decision in favor of subchapter S taxation. Although a detailed review of these situations is beyond the scope of this article, they include utilization of an employee stock ownership plan, partial shifting of the tax burden on built-in gains, and effecting gain deferral through the use of a tax-free reorganization with another S corporation or a C corporation.

The Choice of Entity

As noted above, decoupling the decision on the form of entity from the applicable mode of taxation allows the planner to independently consider the relative nontax advantages of one form of entity over another. Most state law corporate enabling statutes impose certain rules relating to the formation and operation of those entities. In some cases, the rules are mandatory (i.e., they may not be modified in the corporation’s organizational documents or in a separate shareholders’ agreement). In others, the rules are normative (i.e., they will apply in the absence of a contrary provision in the certificate or articles of incorporation or the bylaws). In all cases, however, one must first look to the statute as the primary “roadmap” for permissible “alternative routes.” In contrast, enabling legislation for LLCs (especially more modern iterations) generally ensconce the characteristic of “freedom of contract” and impose few mandatory requirements. Although most of these LLC statutes also contain many normative provisions, these usually can be modified (to a greater or lesser extent) by the agreement of the members. The adage that with great power comes great responsibility applies with particular force in this context, as this freedom of contract imposes an enhanced obligation of care and precision on the draftsperson.

Among the areas of entity governance and operation for which LLCs offer great flexibility are enforceability of restrictions on transfer, including the ability to relegate a nonpermitted transferee to the status of an “economic interest holder.” Additional benefits include the elimination of formalities associated with the roles traditionally ascribed to shareholders, directors, and officers; the ease with which alternate classes and series of equity may be established; the creation of individualized governance, management, and voting structures; the modification or elimination of rights and duties, including fiduciary duties; and the ability to restrict access to information and, in some states, access to judicial remedies such as derivative claims, oppression claims, and judicial dissolution. In view of the expansive capacity for creativity and innovation, it is little wonder that LLCs are preferred by many practitioners.

Although many of the benefits of the LLC form are preserved following an S election, there are several important areas in which it is curtailed, particularly those involving economic rights. However, with careful consideration of the subchapter S restrictions and equally careful drafting, much flexibility, especially in the area of control and governance, can be retained. There is practically nothing that can be done by or with a corporation that cannot also be done equally well or better with an LLC. As one practitioner stated: “I have formed my last corporation.” Although the corporate form is not yet fully obsolete, given the choice (at least in the realm of privately held companies), the LLC has undeniable advantages.

Subchapter S Basics and How to Get There

Many mistakenly believe that a subchapter S corporation is a corporation that is taxed like a partnership. Subchapter S modifies the rules applicable to the taxation of corporations that elect subchapter S status. It is a series of modifications to the rules that otherwise apply to all corporations. Although the tax results under subchapter S and subchapter K may be similar in some circumstances, in many others they are significantly different.

The eligibility requirements for subchapter S status apply at both the entity and shareholder levels. At the entity level, the entity must be one that: (i) is formed within the United States; and (ii) does not have more than a single class of stock. At the shareholder level, the entity may have no more than 100 shareholders (a husband and wife are treated as a single shareholder), all of whom (with limited exception) must: (i) be individuals; and (ii) not be a nonresident alien. Certain estates and trusts, employee stock ownership plans, and other tax-exempt entities may also be eligible shareholders of an S corporation.

In order for an LLC to elect to be taxed as an S corporation, it must make certain filings with the Internal Revenue Service. The regulations allow an LLC that otherwise would be classified as a partnership or a disregarded entity to elect to be taxed as a corporation. There are two, primary means to accomplish the election. The first is for the LLC to initially elect to be treated as an “association taxed as a corporation” by filing Form 8832, Entity Classification Election. Once the LLC elects association status, its owners may further elect S corporation status by filing Form 2553, Election by a Small Business Corporation. It often is not necessary to first file Form 8832 to elect association status and Form 2553 to elect S corporation status. The regulations allow a single election to be made solely via the filing of Form 2553. A timely filed Form 2553 is a deemed filing of Form 8832. The “deemed association” election accomplished in this manner is effective only if the electing entity meets all of the qualifications of an S corporation as of the time of filing, and is not effective if the entity does not meet those qualifications. An LLC that first files Form 8832, but does not qualify to be taxed as a subchapter S corporation upon its subsequent filing of Form 2553, will revert to the status of a regular C corporation. By contract, an LLC that files only Form 2553 (which is effective only if all qualifications for subchapter S are satisfied as of the date of the election) will result in the entity reverting to its default tax classification (usually a partnership or disregarded entity). However, if the entity initially qualifies as a subchapter S corporation by timely filing of Form 2553 and subsequently becomes disqualified, it will revert to the status of a C corporation as well.

Subchapter S or Subchapter K

From a planning perspective, the clearest disadvantages of subchapter S taxation are the so-called single-class-of-stock rule and shareholder eligibility requirements. The single-class-of-stock rule applies solely to economic rights and requires that all equity owners receive allocations of income and loss as well as distributions of cash or property in strict proportion to their ownership percentages. Although voting and management need not be proportional to share ownership, economic rights must be. Similarly, the inability to issue or transfer shares to nonnatural entities can severely restrict the pool of available equity capital. Finally, the consequence of a “blown” subchapter S election, which will trigger a reversion to regular C corporation status and its attendant second layer of taxation, could be catastrophic. Imposing an absolute restriction on transferability of LLC interests may provide an extra layer of protection against this possible consequence. However, it may not be possible under certain state’s LLC statutes to restrict the transferability of economic interests, which presumably would have the same negative consequences.

A nonexclusive list of potential additional advantages of subchapter K over subchapter S include the ability to:

  • include entity-level debt in partner basis;
  • step up the basis of the partnership’s assets upon the death of, or other transfer of interests by, an equity owner;
  • make disproportionate or special allocations, including in the year in which an interest is sold or redeemed;
  • allocate built-in gain or loss to the contributing owner; and
  • maintain consistency between inside and outside basis.

Additionally, if an entity plans to expand through acquisition in exchange for equity, the constraints of section 351 of the Code (subchapter S) may not permit the transaction to be a nonrecognition event for the contributing owner, whereas section 721(subchapter K) is much more flexible and often can accommodate a more favorable result.

There are many other differences between the two tax regimes, a thorough discussion of which is beyond the scope of this article. Suffice it to say that it is never safe to assume that the tax consequences of any transaction under subchapter S are identical to those under subchapter K.

Practice Points and Drafting

All too often, operating agreements for an LLC that has elected to be taxed as an S corporation contain the full complement of provisions that address capital account maintenance, which are designed to satisfy the “substantial economic effect” requirements of section 704 of the Code. Among the provisions typically found in these agreements are requirements that liquidating distributions be made “in proportion to the members’ positive capital account balances.” Given that it is quite possible (and perhaps likely) that those balances do not and will not be strictly proportionate to the party’s ownership percentages, the effect of that provision is an immediately “blown” subchapter S election. The only potential silver lining in this situation is that S elections are more commonly made only by filing Form 2553 (rather than filing Form 8832 ahead of Form 2553), so the S election was defective from the start. As noted above, this results in “no change” to the entity’s default classification. This is but one example of the importance of proper drafting of operating agreements to account for the special qualifications of an S corporation. It is not enough to simply cut and paste into the document the subchapter S maintenance provisions from your favorite form of shareholder agreement. The drafter must also take care to excise the subchapter K provisions from the agreement. In certain states, the LLC statute itself may provide for a “default” liquidating distribution scheme that, if applicable, would be a prima facie violation of the single-class-of-stock rule. In that case, the operating agreement must contain language that specifically overrides any offending statutory scheme.

Examples of the kinds of provisions that must be considered in operating agreements of an LLC that has elected to be taxed as an S corporation include the following:

Heading. Indicate in the agreement’s heading (cover page, first page, signature page, and unit/share tabulation page) that the LLC is an S corporation.

Recitals. Recite the filing of Form 2553 to be classified as a corporation electing to be taxed as an S corporation, and any wholly owned corporate subsidiaries thereof electing to be taxed as qualified subchapter S subsidiaries.

Company-Purpose Provision. Consider: “Company’s Purpose. The purpose of the Company is to engage in any lawful business or other activities for which a limited liability company may be organized under the Act other than engaging in any activities that may cause it to become an “ineligible corporation” within the meaning of Code § 1361(b)(2) or that may otherwise cause the Company’s status as an S corporation to terminate (the “Company’s Business”).” When including provisions that require vigilance such as this, consider the exposure to the manager/management and whether there should be personal liability for noncompliance or absolution/exculpation.

S-Election Provision. Consider: “Election and Preservation of Company’s Status as an S Corporation. The Company and the Interest Owners shall take all necessary and appropriate actions to elect, preserve, and if need be restore the Company’s status as an S corporation (including taking such action as may be necessary under Code § 1361(f) to remedy an inadvertent termination of the Company’s election to be an S corporation). Each Interest Owner shall execute, acknowledge, and cause to be filed with the appropriate taxing authorities (including the Internal Revenue Service) any certificates, statements, forms, schedules, reports, or other documents as may be required, or that the Manager determines to be necessary or appropriate for the Company to be, and otherwise be treated as, an S corporation (including signing Internal Revenue Service Form 2553 acknowledging Interest Owner’s consent and agreement to the Company’s election to be an S corporation, and taking such actions as may be necessary or appropriate to maintain or reinstate or otherwise restore that election or status as an S corporation). In furtherance of the foregoing, the Company shall not issue any Shares or other ownership interests to any corporation, partnership, limited liability company, trust, or any other Person who is not eligible to be a shareholder of an S corporation as contemplated by Code §§ 1361(b)(1)(B) and (C) or issue any Shares or other ownership interests that may be considered to be a second class of stock as prohibited by Code § 1361(b)(1)(D).”

Capital Contributions and Ownership Interests. Consider: “Special Vote to Issue Additional Shares. Without the consent of at least [____%] of the Voting Shareholders, the Company may issue only Shares, and each Share must be deemed to be of the same, single class of Shares (within the meaning of, and as necessary to satisfy the “one class of stock” requirement of, Code § 1361(b)(1)(D)), and those Shares may only be issued to individuals (i.e., natural persons) other than nonresident aliens and to certain estates and trusts that are eligible to be shareholders of S corporations; that is, a Person’s ownership of Shares in the Company must not result in the Company ceasing to be an SBC, or that Person’s ownership of Shares or other membership or economic interests in the Company must not otherwise cause the termination of the Company’s election to be an S corporation.”

Change S Status. Consider: “Special Vote to Change the Entity Character of the Company. Without the consent of at least [____%] of the Voting Shareholders, the Company shall not convert or reorganize the Company into another Entity form (including a corporation) or cause the Company to be taxed as a “C” corporation (as defined by Code § 1361(a)(2)) or a partnership (as defined by Code §§ 761(a) or 7701(a)(2)) for federal income tax purposes or otherwise cause the Company to be deemed to have sold all of its assets or dissolved or liquidated for federal income tax purposes except in accordance with Section 10.1 hereof.”

Allocation of Profits and Losses. Consider: “Allocations. The Company’s income or loss, as determined in accordance with applicable federal income tax accounting principles, including all items of income, gain or loss (whether taxable or tax-exempt), deduction and expense, and all credits, are to be allocated among the Interest Owners in the manner provided and otherwise contemplated by Code § 1366 and, more generally, Subchapter S of the Code, the Code itself, and other applicable federal and state income tax Law.”

Nonliquidating Distributions. Consider: “Distributions. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(1) for the Company to be deemed to have only one class of stock outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.” This provision is in addition to the general requirement that distributions (including tax distributions) are to be made in accordance with percentage interests (i.e., in proportion to outstanding shares/units).

Restrictions on Transfers and Encumbrances. Consider: “General Prohibition without Authorization by the Manager. An Interest Owner may not Transfer or Encumber all or any portion of the Interest Owner’s Interest: (i) in a way that may cause the Company to be deemed to have more than one class of stock outstanding as contemplated by Code § 1361(b)(1)(D); (ii) to a corporation, partnership, limited liability company, trust, or other Person described in Code §§ 1361(b)(1)(B) or (C) whose ownership of such interest will cause the Company to fail to be an SBC; (iii) to any Person or Persons if by doing so may cause the Company to have more than one-hundred (100) “shareholders” as prohibited by Code § 1361(b)(1)(A) for the Company to be an SBC; or (iv) in any other way or to any other Person or Persons that would cause the termination of the Company’s election as an S corporation; and any purported Transfer or other Encumbrance or other action by an Interest Owner in violation of the foregoing or that would otherwise cause the termination of the Company’s election as an S corporation shall be void ab initio and will have force and effect whatsoever and shall otherwise be treated as if that transaction or other action had never taken place or occurred.” The above restriction is in addition to the more general restriction requiring board, member, or other approval to any transfer or encumbrance of ownership interests, which approval may be denied, or otherwise withheld, in the decision makers “sole discretion,” which (as that term may be defined) need not be objectively reasonable or disinterested.

Certifications of Shareholder Eligibility. Consider: “Written Attestations, Eligibility of Transferee to Be an S Corporation Shareholder. In the case of the Transfer of Shares, the proposed transferee’s delivery of a written certification or other statement to the Company that the prospective transferee is a “United States person” within the meaning of Code § 7701(a)(30) and is not a person described in Code §§ 1361(b)(1)(B) and (C) whose ownership of Shares other than ownership interest in the Company will cause the Company to cease to be an SBC.”  Ineligible members/shareholders include corporations, limited liability companies, partnerships, nonresident aliens, and most trusts. If the proposed transferee is a trust, consider giving the board, members, or other decision makers the right to require an opinion of counsel that the trust is eligible to be a shareholder of an S corporation.

Liquidating Distributions. Consider: “Liquidating Distributions. The balance [after payment of liabilities], if any, to be distributed to the Interest Owners in accordance with their Percentage Interests at the time those distributions are to be made. Each Share (whether a Voting Share, Nonvoting Share, Economic Interest Share, or any other Share that may be outstanding) shall confer identical economic rights (i.e., identical rights to distribution and liquidation proceeds as contemplated in Treas. Reg. § 1.1361-1(l) for the Company to be deemed to have only one class of stock of outstanding as, and to the extent required by, Code § 1361(b)(1)(D)) as any of the Company’s other outstanding Shares.”

Vote to Terminate S Election. Consider: “Revocation of S Election. Consent of at least [____%] of the Voting Shareholders is required to cause the Company to revoke its S election under Code § 1362(d)(1), or take any other action with the expressed written intent to cause the Company to cease to be an S corporation. In connection with, or following, the amendment to this Agreement to cause the revocation or other termination of the Company’s S election, the Company and all of the Interest Owners shall take such action as may be necessary or appropriate to effect such revocation or other termination of the Company’s S election, including executing and filing with the Internal Revenue Service or other Governmental Authority all consents and other certificates and documents that may be necessary or appropriate to cause that revocation or other termination to occur as directed by the [Voting Majority].”

Certain Definitions

“‘Economic Interest’ of an Interest Owner means only the Interest Owner’s right under this Agreement and applicable Law to: (i) share in the profits and losses of the Company; and (ii) receive distributions from the Company and therefore does not include any right to participate in, vote on, or authorize or approve any decision concerning the management or affairs of the Company or any other matter subject to the vote or approval of members of a limited liability company under the Act or of the Members under this Agreement.”

“‘Economic Interest Owner’ means a Person who holds an Economic Interest but has not been admitted as, and otherwise is not, a Member. The limited rights of an Economic Interest Owner are described in Section [____].”

“‘Economic Interest Share’ means the Shares that comprise an Economic Interest. Each Economic Interest Share confers identical rights as any other of the Company’s outstanding Shares to “distribution and liquidation proceeds” as contemplated by Treas. Reg. § 1.1361-1(l) and therefore are not to constitute a separate class of stock or otherwise cause the Company to have more than “one class of stock” within the meaning of Code § 1361(b)(1)(D).”

“‘Interest Owner’ means an Economic Interest Owner or a Member.”

“‘QSSSs’ means each of those Entities, if any, that would otherwise be classified as a corporation (as defined by Code § 7701(a)(3)) in which the Company is the sole shareholder or member and that is a “qualified subchapter S subsidiary” under Code § 1361(d).”

“‘S Corporation’ means an SBC that has an election under Code §§ 1362(a)–(c) in effect to be an S corporation (within the meaning of Code § 1361(a)(1)).”

“‘SBC’ means an Entity that meets the requirements for being, or otherwise is treated as, or is deemed to be, a “small business corporation” within the meaning of Code § 1361(b)(f).”

“‘Shares’ means the shares or units of ownership into which an Interest Owner’s Interest is divided and includes Voting Shares and Nonvoting Shares as well as Economic Shares. Except with respect to voting and approval rights or as otherwise provided in this Agreement, the relative rights, privileges, benefits, preferences, and limitations attributable to Voting Shares and Nonvoting Shares are identical, and the Economic Interest Shares, Voting Shares, and Nonvoting Shares confer identical rights “to distribution and liquidation proceeds” as required by Treas. Reg. § 1.1361-1(1) for the Company to be recognized as having only one class of stock under Code § 1361(b)(1)(D). Unless otherwise provided herein, references made to an Interest Owner’s Shares include all of that portion of the Interest Owner’s Interest that relates, or is attributable to, those Shares. Notwithstanding anything in this Agreement or any other agreement to which the Company may be a party or deemed to be a party or otherwise subject to, the outstanding Shares are to be treated as a single class of common stock for purposes of Code § 1361(b)(1)(D), for which Code § 1361(c)(4) recognizes and otherwise allows “differences in voting rights among the shares of common stock” to not cause the corporation or association taxable as a corporation to be deemed to have more than one class of stock.”

Conclusion

As hopefully is evident from the preceding discussion, the decision of an LLC to elect subchapter S status must be based on thoughtful consideration of all potential benefits and pitfalls, not solely as a gambit on potential employment tax savings. The cost of an ill- considered or improperly executed subchapter S election often will far outweigh the potential short-term benefits.

If subchapter S is the best alternative, care in drafting and, equally important, care in execution by the entity will help ensure realization of the tax benefits that were sought at the planning stage.

This article is based upon a presentation by the author, together with Warren Kean, Esq. of Schumaker, Loop & Kendrick of Charlotte, North Carolina, and Professor Martin J. McMahon, James J. Freeland Eminent Scholar and director of The Graduate Tax Program at the University of Florida Law School, that was made at the ABA Business Law Section LLC Institute in November 2015. The sample contract provisions included under “Practice Points and Drafting” were part of Warren Kean’s program materials and are used with his permission. The author would like to thank both Warren and Marty for their contributions to the program, their dedication to legal education and scholarship, and most importantly, for their patience with my (nontax practitioner’s) vain attempt to address these concepts from the perspective of the uninitiated.

LLCs, Partnerships and Unincorporated Business Entities

Posted on March 23, 2017 by - Uncategorized

Each fall, the committee on LLCs, Partnerships and Unincorporated Entities sponsors the LLC Institute. Historically held in Arlington, Virginia, over the course of two days, the LLC Institute uniquely brings together practitioners and academics to discuss and exchange ideas about both the substantive law of LLCs and partnerships and as well the interrelationship of those areas of law with tax, bankruptcy, securities and other fields. Under the leadership of current committee chair Garth Jacobson, the 2017 LLC Institute will be held on November 2–3. Block out those dates on your calendar now to attend; registration information will be distributed via the ABA.

This mini-theme issue of Business Law Today features four articles, three of which are based upon presentations from the 2016 LLC Institute and one from the 2015 LLC Institute.

The first of these articles, “Nonprofit LLCs,” addresses the often ignored the issue of whether and how nonprofit LLCs may be utilized. The article as well considers the Unincorporated Nonprofit Association, a new organizational form available in a variety of states. These and other issues are compared and contrasted against a hypothetical venture.

The next article, “Deadlock-Breaking Mechanisms in LLCs—Flipping a Coin is Not Good Enough, But is Better Than Dissolution,” addresses why it is important that LLC operating agreements incorporate mechanisms to address deadlock. As the authors point out, in the event of a failure to do so, the only remedy that may be available is judicial dissolution of the venture. By addressing the issue in the operating agreement, it likely will be possible to preserve the value of the venture for those who continue with it while increasing the value to the parties who are bought out or otherwise separated.

The last of the articles from the 2016 LLC Institute, “It’s a Bird, It’s a Plane, No, It’s a Board-Managed LLC!”, addresses issues that arise when corporate organizational structures such as a board of directors and officers with titles such as “president” are incorporated (pun intended) into LLC operating agreements. Based upon a pair of decisions, the article explains how the utilization of corporate concepts in LLCs, referred to as “Corporification,” can actually add ambiguity to the agreement. Hence, to the degree that such corporate law concepts are incorporated into the document, they must be done with great precision and is well appropriate limitation.

The fourth article, based upon a presentation from the 2015 LLC Institute, addresses those LLCs that elect, rather than as the typical rule of being taxed as a partnership, to be taxed as an S-Corporation. In that most LLC Acts presuppose that any LLC created thereunder will be taxed either as a partnership or as a disregarded entity, careful drafting of S-Corp LLC operating agreements is absolutely necessary. This article provides guidance as to those requirements.

We hope to see you at the 2017 LLC Institute.

12 Rules for Ethically Dealing With Social Media

Posted on February 16, 2017 by - Uncategorized

The practice of law constantly changes. Despite the technological changes, it remains remarkably similar to how we practiced 10, 30, or even 50 years ago. Although computers, smartphones, and social media didn’t exist when many of us passed the bar exam, neither did MRIs or other medical tests, and they didn’t prevent doctors from changing.

Consider email, whose rise in popularity was highlighted by the phrase, “You’ve Got Mail,” which even became a popular movie. Eventually, lawyers began to embrace this method of communicating. Next came the Internet, which begat websites, Google, smartphones, and, eventually, social media. Yes, social media, those massively popular websites where people—including clients and lawyers—gossip and reveal their deepest secrets.

Gossip has existed since man could talk, and will endure long after Facebook goes the way of MySpace and Friendster and other previously “hot” websites. But for lawyers trying to contain the damage from rash, thoughtless, or spiteful comments or postings by clients (or the lawyers themselves), social media creates new challenges: How can lawyers limit the spread of important client-related information on social media? Fortunately, the American Bar Association Center for Professional Responsibility, and numerous state and local bar ethics committees have issued ethical guidance to help lawyers understand the obligations that arise with social media. From those opinions, I offer the following 12 tips gleaned from that guidance (remember to review the opinions from jurisdictions where you are licensed to confirm that they agree with these opinions):

1. Attorneys may not contact a represented person through social networking websites.

2. Attorneys may not contact a party or a witness by pretext. This prohibition applies to other parties and witnesses who are either identified as a witness for another party or are witnesses the lawyer is prohibited from contacting under the applicable Rules of Professional Conduct.

3. Attorneys may contact unrepresented persons through social networking websites, but may not use a pretextual basis for viewing otherwise private information on those websites.

4. Attorneys may advise clients to change the privacy settings on their social media page. In fact, lawyers should discuss the various privacy levels of social networking websites with clients, as well as the implications of failing to change these settings.

5. Attorneys may instruct clients to make information on social media websites “private,” but may not instruct or permit them to delete/destroy relevant photos, links, texts, or other content, so that it no longer exists. This rule is no different from the obligation not to destroy physical evidence, i.e., evidence is evidence, regardless of how it was created.

6. Attorneys must obtain a copy of a photograph, link, or other content posted by clients on their social media pages to comply with requests for production or other discovery requests.

7. Attorneys must make reasonable efforts to obtain photographs, links, or other content about which they are aware if they know or reasonably believe it has not been produced by their clients.

8. Attorneys should advise clients about the content of their social networking websites, including their obligation to preserve information, and the limitations on removing information.

9. Attorneys may use information on social networking websites in a dispute or lawsuit. The admissibility of the information is governed by the same standards applied to all other evidence.

10. Attorneys may not reveal confidential client information in response to negative online reviews without a client’s informed consent. Thus, responses should be proportional and restrained.

11. Attorneys may review a juror’s Internet presence.

12. Attorneys may connect with judges on social networking websites provided the purpose is not to influence judges in carrying out their official duties.

This advice is identical to the advice an attorney would give to clients in the pre-Internet and pre-social media world. Telling clients not to talk about their cases and to preserve evidence, reminding lawyers they cannot reveal confidential information without consent, and knowing that lawyers cannot contact parties and witnesses by pretext, is same advice they gave before the Internet, but is merely repackaged for technology. In short, the more things change, the more they really stay the same, including issues related to ethics and social networking.

Delaware Supreme Court Precludes Fraudulent Inducement of LLC Agreement and Employment Agreement as Defense in Advancement Proceeding

Posted on February 16, 2017 by - Uncategorized

In the corporate context, Delaware has long recognized a public policy in favor of both indemnification and advancement. “Indemnification encourages corporate service by capable individuals by protecting their personal financial resources from depletion by the expenses they incur during an investigation or litigation that results by reason of that service.” Homestore, Inc. v. Tafeen, 888 A.2d 204, 211 (Del. 2005). Similarly, in an effort to induce able corporate managers to serve in Delaware corporations, “[a]dvancement provides corporate officials with immediate interim relief from the personal out-of-pocket financial burden of paying the significant on-going expenses inevitably involved with investigations and legal proceedings.”

Despite the policy reasons favoring indemnification and advancement, the Delaware Limited Liability Company Act (the LLC Act) does not mandate either. This is unsurprising given the LLC Act’s policy “to give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.” 6 Del. C. § 18-1101(b). However, recognizing the importance of the dual incentives of indemnification and advancement, the LLC Act provides that “a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.” 6 Del. C. § 18-108 (emphases added). The Court of Chancery has repeatedly interpreted this language as granting LLC agreement drafters complete discretion on the issues of whether to grant members or managers indemnification or advancement. See, e.g., Fillip v. Centerstone Linen Servs., LLC, 2014 WL 793123, at *3 (Del. Ch. Feb. 27, 2014).

This freedom of contract on the issue of advancement raises the question: are typical contractual defenses, such as fraudulent inducement, available in a summary proceeding seeking to enforce a party’s advancement rights? In the recent decision of Trascent Management Consulting, LLC v. Bouri, __A.3d __, 2016 WL 6947014 (Del. Nov. 28, 2016), the Delaware Supreme Court found that a defendant may not avoid advancing fees by arguing that the underlying LLC agreement was fraudulently induced. According to the court, to allow such a defense “would permit Trascent to escape its clear promise to make advancement until a court found indemnification inappropriate.”

Background Facts

When George Bouri was hired as an executive of Trascent, he also became a manager. After approximately 16 months in these positions, Trascent terminated Bouri and sued him for, among other things, breach of his employment agreement. Bouri’s employment agreement provided:

Unless a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required, [Trascent] shall, upon the request of Executive, advance or promptly reimburse Executive’s reasonable costs of investigation, litigation or appeal, including reasonable attorneys’ fees; provided, however, that Executive shall, as a condition of Executive’s right to receive such advances or reimbursements, undertake in writing to repay promptly the Company for all such advancements and reimbursements if a court of competent jurisdiction determines that Executive is not entitled to indemnification. . . .

The Trascent LLC agreement contained almost identical language, except “Executive” was replaced with “Covered Person.” Trascent admitted that Bouri was an “Executive” under the terms of the employment contract and a “Covered Person” under the terms of the Trascent LLC agreement.

Based on the language in the Trascent LLC agreement and his employment agreement, Bouri sought advancement from Trascent to defend the underlying litigation. When Trascent refused to advance legal fees, Bouri filed an action in the Court of Chancery seeking to enforce his right to advancement under both agreements.

Background on Delaware’s Summary Advancement Proceedings

Under the Delaware General Corporation Law (DGCL), certain types of court proceedings are “fast-tracked” based on the inherent need to decide the matter in dispute quickly. For example, when there is a challenge to the election of directors, an action filed pursuant to Section 225 of the DGCL to decide the outcome is summary in nature so as to provide “a quick method for review of the corporate election process to prevent a Delaware corporation from being immobilized by controversies about whether a given officer or director is properly holding office.” Box v. Box, 697 A.2d 395, 398 (Del. 1997). Similarly, advancement proceedings are summary in nature and are, accordingly, “limited to determining the issue of entitlement” to advancement. Homestore, 888 A.2d at 213.

Section 145(k) of the DGCL specifically provides that advancement proceedings should be summary in nature. This reflects a policy of “providing prompt reimbursement to present and former directors and officers who have had to incur attorneys’ fees and related expenses.” Mooney v. Echo Therapeutics, Inc., 2015 WL 3413272, at *8 (Del. Ch. May 28, 2015). Although the LLC Act does not contain a provision with language tracking Section 145(k), the Court of Chancery also treats actions seeking to enforce advancement rights in the LLC context as summary proceedings because “policy objectives surrounding 8 Del. C. § 145 … extend to similar provisions found in operating agreements in the LLC context.” Tulum Mgmt. USA LLC v. Casten, 2015 WL 7269811, at *3 (Del. Ch. Nov. 9, 2015). 

Contract May Not Be Challenged in Summary Advancement Proceeding on Fraudulent Inducement Grounds

In Trascent, the defendant attempted to avoid advancing attorneys’ fees by arguing that both the employment agreement and LLC Agreement had been fraudulently induced by Bouri. The Court of Chancery found that the plain language of the contracts at issue mandated advancement unless and until “a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required….” Trascent, 2016 WL 6947014, at *2-3 (emphasis added). Advancement and indemnification are two separate issues. Although advanced fees usually have to be clawed-back if a court ultimately finds indemnification is not warranted, that does not mean that fees must not be promptly advanced before that determination is made. Indeed, one of the primary benefits of advancement is that fees are advanced to defend the underlying litigation before the entitlement to indemnification is litigated. According to the Court of Chancery, if it permitted the fraudulent inducement defense in this case, advanced fees would be effectively denied until the underlying plenary action over the contracts was decided. Accordingly, the court rejected the defense and awarded advancement.

On appeal, the Delaware Supreme Court affirmed the Court of Chancery’s decision. Relying on the plain language of the LLC agreement in rejecting the injection of a fraudulent inducement defense into an advancement proceeding, the Delaware Supreme Court explained:

Trascent knew when it entered the contract that Bouri would be entitled to advancement “[u]nless a determination has been made by final, nonappealable order of a court of competent jurisdiction that indemnification is not required.” Thus, Trascent knew it agreed to provide a right, subject to expedited specific enforcement, and it could not reasonably believe that it could deny that right simply by alleging that the contract was invalid. Trascent may later show that Bouri is not entitled to indemnification by proving that the entire employment agreement or the advancement provision was invalid and fraudulently induced. But, Trascent cannot refuse to provide advancement by arguing that Bouri has the duty in an advancement proceeding to disprove Trascent’s belated allegations. That is especially so in this case when Trascent sued Bouri to enforce its rights under the same contract in which Bouri’s right to advancement is set forth, when it was Trascent’s own decision to sue that triggered Bouri’s right to advancement, and when there is a great deal of overlap with Trascent’s substantive claims which seek to deprive Bouri of the benefits of his previous employment and lose any further rights under the employment agreement and LLC agreement, including advancement, on the grounds that he induced his hire by fraud.

The Delaware Supreme Court also found that permitting a party to argue fraudulent inducement in an advancement proceeding would undermine policies for providing efficient, summary proceedings in the advancement context.

Conclusions

A number of conclusions can be drawn from the Trascent decision. First, Delaware courts will continue to treat advancement cases arising out of LLC agreements as summary proceedings, which are meant to be efficient and quick. Second, because of the summary nature of advancement proceedings, defenses such as fraudulent inducement that would derail the proceeding and effectively transform into a litigation over the validity of the underlying contract are unlikely to be permitted. Finally, LLCs are creatures of contract. Section 18-108 of the LLC Act leaves to the drafters’ sole discretion whether to include advancement provisions in the LLC agreement. LLCs remain free to operate without such provisions. However, if the drafters use their discretion to include advancement provisions in the LLC agreement and the member, manager, or officer qualifies for advancement under the terms of the contract, Delaware courts will hold the parties to the terms of that agreement.

Eleventh Circuit Confirms that Issuers Are Not Required to Disclose Retention of Outside Promotional Firms

Posted on February 16, 2017 by - Uncategorized

On December 15, 2016, the U.S. Court of Appeals for the Eleventh Circuit affirmed the dismissal of a securities class action against Galectin Therapeutics Inc., a Georgia-based biotechnology company. See In re Galectin Therapeutics, Inc. Sec. Litig., __ F.3d __, No. 16-10324, 2016 WL 7240146 (11th Cir. Dec. 15, 2016). The suit alleged that Galectin violated the federal securities laws by failing to disclose that it had retained third-party firms to publish promotional articles about the company. Although a number of district courts have opined on whether an issuer must disclose the hiring of such outside promotional firms, the Eleventh Circuit is the first appellate court to publish an opinion on the question. See, e.g., Stephens v. Uranium Energy Corp., No. H-15-1862, 2016 WL 3855860 (S.D. Tex. July 15, 2016); In re CytRx Corp. Sec. Litig., No. CV 14-1956-GHK (PJWx), 2015 WL 5031232 (C.D. Cal. July 13, 2015); In re Galena Biopharma, Inc. Sec. Litig., 117 F. Supp. 3d 1145 (D. Or. 2015).

The Galectin decision confirms that the duty to disclose payments to outside firms who publish promotional material regarding a company and its stock rests with the third-party firms, not the issuer.

Background

In May 2015, lead plaintiff Glynn Hotz filed suit on behalf of a putative class of Galectin shareholders alleging violations of Section 10(b) of the Exchange Act and Rule 10b-5(b) promulgated thereunder, as well as Section 20(a). The complaint alleged that Galectin and certain of its current and former officers and directors defrauded the company’s investors by secretly hiring third-party firms to publish positive articles about the company and to “tout” its stock. The complaint did not allege that any of the third-party articles were actually false or misleading under the federal securities laws, but rather were “exceedingly boastful.” The complaint did allege, however, that it was false for Galectin to state—in two private contracts between Galectin and its sales agent for two “at-the-market” offerings—that Galectin had not “directly or indirectly” taken any actions that caused or resulted in the “manipulation” of its stock price. The contracts were private agreements between Galectin and its sales agent MLV & Co. concerning the company’s at-the-market offerings. Each was attached as an exhibit to a Form 8-K filed with the Securities and Exchange Commission pursuant to Item 1.01 of SEC Form 8-K, requiring issuers to disclose entry into material definitive agreements. According to Hotz, hiring third-party firms to promote the company was “manipulating” its stock price. Therefore, because the company had stated that it had not engaged in any such “manipulation,” its statements to that effect from the two “at-the-market” offering sales agent agreements were allegedly false.

The U.S. District Court for the Northern District of Georgia granted Galectin’s motion to dismiss the complaint for failure to state a claim. In re Galectin Therapeutics, Inc. Sec. Litig., 157 F. Supp. 3d 1230 (N.D. Ga. 2015). The district court concluded that Galectin did not impermissibly “manipulate” the price of its stock because paying outside promotional firms to publish admittedly truthful information does not constitute stock price “manipulation.” As a result, the challenged “no manipulation” statements were not false or misleading, and there was no duty for Galectin to disclose its retention of the promotional firms. The district court also considered whether Galectin could be considered the “makers” of the statements in the third-party articles, and thus could be liable for statements in the articles under Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135, 131 S. Ct. 2296 (2011). Relying on Janus, the district court held that Galectin’s mere payment of the stock promoters was insufficient to suggest that it “made” the stock promoters’ statements. Hotz appealed the district court’s decision to the Eleventh Circuit.

The Eleventh Circuit’s Opinion

In a unanimous published opinion written by Judge Frank M. Hull, the Eleventh Circuit affirmed the district court’s dismissal of the complaint for failure to allege actionable claims under Section 10(b) or Section 20(a) of the Exchange Act. In re Galectin Therapeutics, Inc. Sec. Litig., __ F.3d __, No. 16-10324, 2016 WL 7240146 (11th Cir. Dec. 15, 2016).

The court considered whether the challenged statements from Galectin’s underwriting agreements that it had not engaged in any “manipulation” of its stock price were false in light of Hotz’s allegations that Galectin had “secretly” paid outside firms to “tout” its stock. In affirming the lower court’s dismissal, the Eleventh Circuit recognized that “nothing in the securities laws prohibits Galectin as a company . . . from hiring analysts to promote Galectin, circulating positive articles about its drug development, or recommending the purchase of Galectin’s stock.” The court confirmed that “manipulation” is “‘virtually a term of art when used in connection with securities markets,’ generally referring ‘to practices, such as wash sales, matched orders or rigged prices, that are intended to mislead investors by artificially affecting market activity.’” (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476, 97 S. Ct. 1292, 1302 (1977)). Hotz’s complaint was devoid of allegations that Galectin had engaged in such practices. “The defendants’ lawfully engaging third parties to ‘promote’[] Galectin stock through publications of boastful but truthful articles is not stock price ‘manipulation’ as a matter of law.” The court thus held that, because the complaint failed to allege conduct by Galectin that amounted to “manipulation,” it failed to allege that Galectin’s “no manipulation” statements were false in violation of Section 10(b).

In addition, the court recognized that, under Section 17(b) of the Securities Act, “the duty to disclose promotional payments lies with the parties that receive the payments for promotional activities,” not the issuer that paid for the promotional activities. Consequently, there was no statutory duty imposed on Galectin to disclose payments to outside promotional firms, and Galectin did not violate the securities laws by failing to do so.

Finally, the court concluded that, under Janus, Defendants did not “make” the statements in the articles published by the outside promotional firms, and therefore could not face liability for statements or omissions in those articles, even if they had been alleged to be false. The court acknowledged Hotz’s allegations that Galectin had paid certain firms to write the articles and coordinated with the firms to maximize the effect of the articles, including timing the publications of the third-party articles with the company’s press releases. But the court found that those allegations were insufficient to support a finding that Galectin had “ultimate authority” or “control” over the third-party statements, as required by Janus. In reaching its conclusion, the court confirmed that an issuer’s mere retention of and payment to a promotional firm to publish positive articles about the company does not render the issuer the “maker” of the statements in the articles.

In light of its holding that the complaint failed to state a claim for relief under Section 10(b), the court held that Hotz could have no secondary liability under Section 20(a), and therefore affirmed the district court’s dismissal of Hotz’s control person claim.

Implications of the Decision

The Eleventh Circuit’s Galectin decision is the first published circuit court opinion to address whether an issuer must disclose the hiring and utilization of third-party promotional firms to recommend investment in a publicly traded company. Although a few lower courts had previously concluded that disclosure was required under the circumstances presented there, the Eleventh Circuit in Galectin concluded that disclosure was not required, and distinguished the prior cases. The court’s ruling could prove important to “small cap” companies seeking to bring new technologies or products to market, particularly those in the healthcare, biotechnology, or pharmaceutical sectors, as those companies often rely on third-party firms to promote awareness of the company, its product, and/or its stock. More often than not, such emerging companies lack the revenues and resources to support an internal investor relations department, yet may be heavily dependent upon new investment capital to fund ongoing operations during the developmental phases of their new product or drug. Such companies must often hire outside firms to assist in raising their profile with potential investors and/or consumers. After the Galectin ruling, these emerging companies, or at least those located within the Eleventh Circuit, need not worry about facing expansive securities fraud liability for failing to disclose their retention of such outside firms. Rather, as the Eleventh Circuit made clear, the duty of disclosure under the federal securities laws rests on the third-party firms, not the company.

Ten Key Points about the Bank Examination Privilege

Posted on February 16, 2017 by - Uncategorized

In January, the Business Law Section published The Bank Examination Privilege: When Litigants Demand Confidential Regulatory Reports by Eric B. Epstein, David A. Scheffel, and Nicholas A.J. Vliestra, a practical, user-friendly resource to understand the intricacies of the bank examination privilege. The book is available to order at the Section member price of $69.95 here.

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Bank examinations are integral to the government’s supervision of the banking industry. A bank examination is an inspection of a bank or other financial institution by a federal or state regulator. The purpose of a bank examination is to assess the institution’s financial health and/or its compliance with applicable laws and regulations.

Bank examinations generally are non-public. Typically, an examination report is not shared beyond the regulator and the bank. However, when a bank is involved in a lawsuit, keeping such records confidential can be difficult. In a lawsuit, a party may seek copies of such records in the hope of using them as evidence as trial.

That’s where the bank examination privilege comes into the picture. The privilege is a federal rule that shields examination records, to an extent, in federal litigation.

The bank examination privilege is an evidentiary privilege. Evidentiary privileges exempt specific types of evidence from disclosure during a lawsuit. The bank examination privilege evolved from federal judicial decisions, and thus can be classified as a federal common-law evidentiary privilege. In many states, state law also shields examination records. The term “bank examination privilege” usually is understood to refer to the overarching federal rule, rather than the rule that exists in any particular state.

The privilege has a number of nuances that counsel should keep in mind when representing a financial institution in a federal lawsuit. We review ten of them below. A more comprehensive overview of the privilege can be found in our new treatise, The Bank Examination Privilege (American Bar Association 2017).

1. The Privilege Belongs to Regulators

The privilege belongs to regulators, not banks. Therefore, in a lawsuit, when a party asks a bank to turn over confidential examination records, the bank should promptly reach out to the regulator that conducted the examination. If the regulator asserts the privilege, one of two things may happen next. First, the bank’s adversary may back down. Second, the bank’s adversary may ask the court to override the regulator’s decision.

If the bank’s adversary asks the court to override the regulator’s decision, the bank can remain neutral and let the dispute play itself out between the regulator and the bank’s adversary. Often, however, the bank will actively work with the regulator to defend the privilege, and will submit arguments in support of the regulator’s position.

2. Courts Follow a Specific Procedure When Applying the Privilege

To resolve disputes related to the privilege, courts follow a specific procedure. First, the court considers whether the examination records fall within the scope of the privilege. Different judicial decisions use different wording to describe the exact boundaries of the privilege. In essence, the privilege protects an examiner’s confidential opinions and recommendations, and other deliberative aspects of the examination process.

The regulator bears the burden of showing that the records fall within the scope of the privilege. To determine whether the regulator has met this burden, a court may directly review the records, or a sampling of the records, in camera.

Next, if the records are privileged, the court will consider whether there is good cause to require disclosure of the records. The party seeking disclosure bears the burden of showing good cause. The good cause analysis usually focuses on five main factors: (1) the relevance of the records to the case; (2) whether the party can obtain the same information from other sources; (3) the seriousness of the case; (4) the government’s role in the lawsuit, and (5) whether disclosure will have a chilling effect on future bank examinations.

In some cases, after conducting this analysis, the court makes an across-the-board determination that the privilege shields all, or none, of the sought-after examination records. In other cases, the court finds that the privilege protects some documents but not others, or covers particular portions of documents.

3. The Privilege Is Not Limited to ROEs

Often, at the conclusion of a bank examination, the examiner will prepare a formal report known as a Report of Examination, or ROE. Much of the case law regarding the privilege concerns the applicability of the privilege to ROEs.

However, the privilege is not limited to ROEs. The privilege can extend to any type of communication. When applying the privilege, the relevant question is not what form the communication takes. The relevant question is whether the substance of the communication reveals privileged information.

For example, the privilege can encompass:

  • Regulator-to-bank communications other than ROEs, such as letters, e-mails, or oral communications;
  • Internal agency communications that are not shared with banks;
  • Bank-to-regulator communications, such as a response to an ROE; and/or,
  • Internal bank communications that are not shared with regulators, such as internal bank e-mails discussing communications with an examiner.

4. The Privilege Is Not Only about Documents

The majority of judicial decisions regarding the privilege concern the applicability of the privilege to documents. But the privilege is equally applicable to oral testimony. When giving oral testimony at a deposition or at trial, a bank employee may be entitled to withhold privileged information about the bank’s interactions with examiners.

5. Various Regulators May Assert the Privilege

Many of the legal precedents regarding the bank examination privilege involve three specific federal regulators: the Office of the Comptroller of the Currency (OCC), the Federal Reserve, and/or the FDIC. But that does not mean that the privilege is necessarily limited to these three regulators. Other federal regulators, such as the Consumer Financial Protection Bureau, also have taken the position that the privilege encompasses their communications with supervised institutions. Financial institutions should not assume that the privilege is confined to examinations by the OCC, Federal Reserve and/or FDIC.

6. The Privilege Is Distinct from FOIA Exemption 8

Outside of the litigation context, members of the public may ask administrative agencies to release records under the Federal Freedom of Information Act (FOIA). FOIA contains various exemptions that permit agencies to withhold specific types of records. Exemption 8 allows agencies to withhold records related to bank examinations.

At times, FOIA Exemption 8 is mistakenly conflated with the bank examination privilege. Clearly, FOIA Exemption 8 and the privilege stem from the same underlying concern: the need to preserve the confidentiality of bank examinations.

However, the exemption and the privilege focus on two different procedural situations. FOIA Exemption 8 applies to FOIA requests. The privilege governs the exchange of information in a lawsuit under the Federal Rules of Civil Procedure.

The exemption and the privilege also differ substantively. For example, as noted earlier, parties potentially can show good cause to override the privilege. By contrast, FOIA Exemption 8 does not contain a good cause exception.

7. The Privilege Is Not an Administrative Regulation

A variety of federal administrative regulations restrict the disclosure of bank examination records. For example, the OCC’s policy is that such records are “non-public OCC information,” and therefore are “confidential and privileged.” See 12 C.F.R. § 4.36(b). As a result, the OCC “will not normally disclose this information to third parties.”

The bank examination privilege is not a direct application of such regulations. The privilege recognizes that such regulations are grounded in reasonable concerns. However, the privilege is a common-law doctrine, not an administrative regulation.

8. The Privilege Is Related to the Deliberative Process Privilege

The deliberative process privilege shields the internal deliberations of administrative agencies. Some courts have described the bank examination privilege as an extension of the deliberative process privilege. In effect, the bank examination privilege extends the deliberative process privilege to cover a specific type of external agency communication: communications between agencies and financial institutions.

9. State Statutes Sometimes Displace the Privilege

In federal litigation, when the parties’ claims and defenses are based solely in federal law, courts generally resolve privilege disputes by applying federal privilege law. By contrast, when the parties’ claims and defenses are based solely on state law, federal courts usually decide privilege disputes by applying state privilege law.

Based on this rule, when a case involves federal-law claims and defenses, federal courts routinely apply the federal bank examination privilege. But in some state-law cases, federal courts instead have looked to state privilege law to determine whether bank examination records are privileged. Depending on the state, state privilege law may offer more, less, or the same degree of protection for examination records.

10. There Often Are Other grounds for Withholding Examination Records

The bank examination privilege is an important tool for keeping bank examination records confidential during a federal lawsuit. However, in many cases, there also are other valid reasons to withhold such records. For example, a bank may be able to show that such records are entirely irrelevant to the lawsuit. Such records also may come within the scope of other evidentiary privileges. For instance, if such records reflect communications between a bank and the bank’s counsel, they may be subject to the attorney-client privilege. Because the bank examination privilege is not an absolute privilege, it is important for financial institutions to assert all applicable bases for withholding examination records.

A Simple Guide to Machine Learning

Posted on February 16, 2017 by - Uncategorized

Introduction

Lawyers know a lot about a wide range of subjects—the result of constantly dealing with a broad variety of factual situations. Nevertheless, most lawyers might not know much about machine learning and how it impacts lawyers in particular. In this article, I provide a short and simple guide to machine learning at a level understandable to the typical attorney.

The phrase “artificial intelligence” usually refers to machine learning in one form or another. It might appear as the stuff of science fiction, or perhaps academia, but in reality machine learning techniques are in broad use today. Such techniques recommend books for you on Amazon, help sort your mail, find information for you on Google, and allow Siri to answer your questions.

In the legal field, Westlaw and Lexis use machine learning tools in their natural-language search and other features. ROSS Intelligence is an “AI” research tool that finds relevant “phrases” from within cases and other sources in response to a plain-language search. Kira Systems uses machine learning to quickly analyze large numbers of contracts. These are just two of dozens of new, machine-learning-based products. On the surface, these tools might seem similar to current legal products, but you will see by the end of this article that they do something fundamentally different, making them not only potentially far more efficient and powerful, but disruptive as well. For example, machine learning is the “secret sauce” that enables ride-sharing services like Uber, allowing it to efficiently adjust pricing to maximize both the demand for rides and the availability of drivers, predict how long it will take a driver to pick you up, and calculate how long your ride will take. With machine learning, Uber and similar companies are rapidly displacing the traditional taxicab service. Understanding what machine learning is and what it can do is key to understanding its future effects on the legal industry.

What Is Machine Learning?

Humans are good at deductive reasoning. For example, if I told you that a bankruptcy claim for rent was limited to one year’s rent, you would easily figure out the amount of the allowed claim. If the total rent claim were $100,000, but one year’s rent was $70,000, you would apply the rule and deduce that the allowable claim is $70,000. Now reverse the process. Assume I told you that your client was owed $100,000 and that the annual rent was $70,000, and then told you that the allowable claim was $70,000. Could you figure out how I got that answer? You might guess that the rule is that the claim is limited to one year’s rent, but could you be sure? Perhaps the rule was something entirely different. This is inductive reasoning, and it is much more difficult to do.

Machine learning techniques are computational methods for figuring out “the rules,” or at least approximations of the rules, given the factual inputs and the results. Those rules can then be applied to new sets of factual inputs to deduce results in new cases.

Here is an example that is easy to understand. You all know the old number series games. For example:

2  4  6  8  10  _?_

The next number is 12, right? Here, the inputs are the series of numbers 2 through 10, and from this we induce the rule for getting the next number—add 2 to the last number in the series. Here is another one:

1   1   2   3   5  _?_

The next number is 8. This is a Fibonacci sequence, and the rule is that you add together the last two numbers in the series.

These games illustrate the use of inductive reasoning to figure out the rule. You then apply that rule to get the next number. Broken down a little, the prior game looks like this:

Input                         Result

1   1                                2

1   1   2                           3

1   1   2   3                      5

1   1   2   3   5               _?_

We look at the group of inputs and induce a rule that gives us the shown results. Once we have derived a workable rule, we can apply it to the last row to get the result “8,” but more importantly we can apply it to any group of numbers in the Fibonacci sequence. This is a simple (very simple) example of what machine learning does.

Naturally, real-world problems are more complex. Instead of a short series of numbers as inputs, a real-world problem might use dozens, perhaps thousands, of possible inputs that might be applied to an undiscovered rule to obtain a known answer. We also do not necessarily know which of the inputs are the ones our unknown rule uses!

To solve a more complex problem, we might begin by building a database with the relevant points of information about a large number of cases, in each instance collecting the data points that we think might affect the answer. To build our prediction model, we would select cases at random to use as a “training set,” putting the remainder aside to use as a “test set.” Then we would begin to analyze the various relationships among the data points in our training set using statistical methods. Statistical analytics can help us identify the factors that seem to correlate with the known results and the factors that clearly do not matter.

Advanced statistical methods might help us sort through the various relationships and find an equation that takes some of the inputs and provides an estimated result that is pretty close to the actual results. Assuming we find such an equation, we then try it out on the test set to see if it does a good job there as well—predicting results that are close to the real results. If our predictive model works on our test set, then we consider ourselves lucky.

For real-world problems, this kind of analysis is difficult. The job of collecting the data, cleaning it, and analyzing it for relationships takes a lot of time. Given the large number of potential variables that affect real-world relationships, identifying those that matter is somewhat a process of trial and error. We might get lucky and generate results quickly, we might invest substantial resources without finding an answer at all, or the relationships might simply prove to be too complex for the methods I described to work adequately. Inductive reasoning is difficult to do manually. This brings us to machine learning. Machine learning can efficiently find relationships using inductive reasoning.

As an example of what machine learning can do, consider these images:

Assume we want to set up a computer system to identify these handwritten images and tell us what letter each image represents. Defining a rule set is too difficult for us to do by hand and come up with anything that is remotely usable, but we know there is a rule set. The letter A is clearly different from the letter P, and C is different from G, but how do you describe those differences in a way a computer can use to consistently determine which image represents which letter?

The answer is that you don’t. Instead, you reduce each image to a set of data points, tell the computer what the image is of, and let the computer induce the rule set that reliably matches all the sets of data points to the correct answers. For the image recognition problem, you might begin by defining each letter as a 20 pixel by 20 pixel image, with each pixel having a different grey-scale score. That gives you 400 data points, each with a different value depending on how dark that pixel is. Each of these sets of 400 data points is associated with the answer—the letter they represent. These sets become the “training set,” and another database of data points and answers is the “test set.” We then feed that training set into our machine-learning algorithm—called a “learner”—and let it go to work.

What does the “learner” actually do? This is a little more difficult to explain, partially because there are a lot of different types of learners using a variety of methods. Computer scientists have developed a number of different kinds of techniques that allow a computer program to infer rule sets from defined sets of inputs and known answers. Some are conceptually easier to understand than others. In this article, I describe how one type works. Machine learning programs will use a variation of one or more of these techniques. The most advanced systems include several techniques, using the one that fits the specific problem best or seems to generate the most accurate answers.

In general, think of a learner as including four components. First, you have the input information from the training set. This might be data from a structured, or highly defined, database, or unstructured data like you might find in a set of discovery documents. Second, you have the answers. With a structured database, a particular answer will be closely identified with the input information. With unstructured information, the answer might be a category, such as which letter an image represents or whether a particular e-mail is spam, or the answer might be part of a relationship, such as text in a court decision that relates to a legal question asked by a researcher. Third, you have the learning algorithm itself—the software code that explores the relationships between the input information and the answers. Finally, you have weighting mechanisms—basically parts of the algorithm that help define the relationships between the input information and the answers, within the confines of the algorithm. Once you have these four components, the learner simply adjusts the weighting mechanisms in a controlled manner until it finds values for the weighting mechanisms that allow the algorithm to accurately match the input information with the known correct answers.

The techniques take a lot of computational power. Machine learning programs, however, can figure out the relationships when there are millions of data points and billions of relationships—when modeling the systems is impossible to do by hand because of the complexity. Machine learning systems are limited only by the quality of the data and the power of the computers running them.

An Example of a Machine Learning System

One example of a type of machine learning system is a neural network. The term “neural network” conveys the impression of something obscure and mysterious, but it is probably the easiest form of a machine learning system to explain to the uninitiated. This is because it is made up of layers of a relatively simple construct called a “perceptron.”

Credit: https://blog.dbrgn.ch/2013/3/26/perceptrons-in-python/

This perceptron contains four components, the first being one or more inputs represented by the circles on the left. The input is simply a number, perhaps between 0 and 1. It might represent part of our input information, or it might be the output from another perceptron.

Second, each input number is given a weight—a percentage by which the input is multiplied. For example, if the perceptron has four inputs of equal importance, each input is multiplied by 25 percent. Alternatively, one input might be multiplied by 70 percent while the other three are each multiplied by 10 percent, reflecting that one input is far more important than the others.

Third, these weighted input numbers are added to generate a weighted sum—a single number that reflects the weights given the various inputs.

Fourth, the weighted sum is fed into a step function. This is a function that outputs a single number based on the weighted sum. A simple step function might output a “0” if the weighted sum is between 0 and .5, and a “1” if the weighted sum is between .5 and 1. Usually a perceptron will use a logarithmic step function designed to generate a number between, say, 0 and 1 along a logarithmic scale so that most weighted values will generate a result at or near 0, or at or near 1, but some will generate a result in the middle.

Some systems will include a fifth element: a “bias.” The bias is a variable that is added or subtracted from the weighted sum to bias the perceptron toward outputting a higher or lower result.

In summary, the perceptron is a simple mathematical construct that takes in a bunch of numbers and outputs a single number. That output number might be fed to another perceptron, or it might relate to a particular “answer.” For example, if your learner is doing handwriting recognition, you might have a perceptron that tells you the image is the letter “A” based on whether the output number is closer to a 1 than a 0.

In a neural network, the perceptrons typically are stacked in layers. The first layers receive the input information for the learner, and the last layer outputs the results.

Credit: http://www.intechopen.com/books/cerebral-palsy-challenges-for-the-future/brain-computer-interfaces-for-cerebral-palsy

In between are what are called “hidden layers” of perceptrons, each taking in one or more input numbers from a prior layer and outputting a single number to one or more perceptrons in the next layer.

The computer scientist building the neural network determines its design—how many perceptrons the system uses, where the input data comes from, how the perceptrons connect, what step function gets used, and how the system interprets the output numbers. However, the learner itself decides what weights are given to each input as the numbers move through the network, and what biases are applied to each perceptron. As the weights and biases change, the outputs will change. The learner’s goal is to keep adjusting the weights and biases used by the system until the system produces answers using the input information that most closely approximates the actual, known answers.

Returning to the handwriting recognition example, remember that we broke down each letter image into 400 pixels, each with a greyscale value. Each of those 400 data points would become a input number into our system and be fed into one or more of the perceptrons in the first input layer. We add some hidden layers in the middle. Finally, we would have an output layer of 26 perceptrons, one for each letter. The output perceptron with the highest output value will tell us what letter the system thinks the image represents.

Then, we pick some initial values for the weights and biases, run all the samples in our training set through the system, and see what happens. Do the output answers match the real answers? Probably not even close the first time through. So, the system begins adjusting weights and biases, with small, incremental changes, testing against the training set and continuously looking for improvements in the results until it becomes as accurate as it is going to get. Then, the test set is fed into the system to see if the determined set of ideal weights and biases produces accurate results. If it does, we now have an algorithm that we can use to interpret handwriting.

It might seem a little like magic, but even a relatively simple neural network, properly constructed, can be used to read handwriting with a high degree of accuracy. Neural networks are particularly good at sorting things into categories, especially when using a discrete set of input data points. What letter is it? Is it a picture of a face or something else? Is a proof of claim possibly objectionable or not?

Other machine learning algorithms play an important role in interpreting unstructured data and tasks like natural-language processing. They can identify relationships among words or concepts. The computer does not understand the words, what the concepts are, or what they mean, but it can identify the relationships as relationships and, like a parrot that repeats what it hears, convey the impression of understanding.

Machine Learning in Action

My examples are basic, designed to provide some understanding of what are fairly abstract systems. Machine learners come in many flavors—some suitable for performing basic sorting mechanisms, and others capable of identifying and indexing complex relationships among information in unstructured databases. Some systems work using fairly simple programs and can run on a typical office computer, and others are highly complex and require supercomputers or large server farms to accomplish their tasks.

To understand the power of machine learning systems compared with nonlearning analytic tools, let’s revisit the first example in the article: ROSS Intelligence. ROSS is built on the IBM Watson system, although it also includes its own machine learning systems to perform many of its tasks. Watson’s search tools employ a number of machine learning algorithms working together to categorize semantic relationships in unstructured textual databases. In other words, if you give Watson a large database of textual material dealing with a particular subject, Watson begins by indexing the material, noting the vocabulary and which words tend to associate with other words. Even though Watson does not actually understand the text’s meaning, it develops, through this analysis, the ability to mimic understanding by finding the patterns in the text.

For example, when you conduct a Boolean search in a traditional service for “definition /s ‘adequate protection,’” the service searches its database for an exact match for those terms applying the Boolean search logic provided. ROSS does something different. It looks within the search query for word groups it recognizes and then finds the results it has learned to associate with those word groups. You should not even have to use the term “adequate protection” to get an answer back discussing the concept when that is the appropriate answer to your question. So long as your question triggers the right associations, the system will, over time, learn to return the correct responses.

The key is that a machine learning system learns. In a way, we do the same thing ROSS does. The first time we research a topic, we might look at a lot of cases and go down a lot of dead ends. The next time, we are more efficient. After dealing with a concept several times, we no longer need to do the research. We remember what the key case is, and at most we check to see if there is anything new. We know how the cases link together, so the new materials are easy to find.

A machine-learning-based research tool can do this on a much broader scale. It learns not just from our particular research efforts, but from those of everyone who uses the system. As the system receives more use, it continues to use user feedback to assess how its model performs and allow for periodic retraining. As a result, it will become extremely adept at providing immediate responses to the most common user queries. Even though the system does not have an understanding of the material in the same manner as a human, its ability to track relationship building over a large scope of content and a large number of interactions allow it to behave as you might, if you had researched a particular point or issue thoroughly many times previously. This provides a research tool far more powerful than existing methodologies.

Legal tools based on machine learning have enormous application. Learners already in use by lawyers help with legal research, categorize document sets for discovery purposes, evaluate pleadings and transactional documents for structural errors or ambiguity, perform large-scale document review in M&A, or identify contracts affected by systemic change—like the Brexit. General Motors’ legal department, and likely other large companies, are exploring using machine learning techniques to evaluate and predict litigation outcomes and even help choose which law firms they employ. Machine learning is not the solution for every question, but it can help answer a large number of questions that simply were not answerable in the past, and that is why the advent of machine learning in the legal profession will prove truly transformational.

Interested in learning more about AI and data? Join the Section’s new Legal Analytics Working Group

The Legal Analytics Working Group’s mission is to explore, and educate business lawyers about, the use of math and economics in the substantive practice of business law. Specifically, we are focused on the use and application of:

  • Data analytics, statistics and probability theory
  • Economic theories of choice under uncertainty
  • Game theory
  • Behavioral economics
  • Machine learning, and
  • Computational law aka “QuantumLaw”

The legal community has already started adopting these complex mathematical and economic techniques. This trend is accelerating.

Come join us!

Who’s Calling? TCPA Litigation in the Aftermath of Spokeo

Posted on February 16, 2017 by - Uncategorized

By all accounts, litigation under the Telephone Consumer Protection Act (TCPA) is out of control, having “blossomed into a national cash cow for plaintiff’s attorneys specializing in [such] disputes.” Bridgeview Health Care Ctr., Ltd. v. Clark, 816 F.3d 935, 941 (7th Cir. 2016). In 2007, 14 TCPA cases were filed. As of October 31, 2016, more than 4,000 TCPA cases had been filed. WebRecon LLC, TCPA Cracks 4K, Smashes Record with 2 Months Still to Go, 5K in Sight? With TCPA litigation so far out of control, businesses had high hopes that the Supreme Court’s decision in Spokeo v. Robins, 136 S. Ct. 1540 (2016), might rein in this “national cash cow.” Recent federal court decisions applying Spokeo in the context of TCPA litigation have produced mixed results, with some cases offering defendants glimmers of hope, and others not so much.

TCPA litigation has impacted nearly every industry, from payment systems to ride sharing, and from pharmaceuticals to social networking. See, e.g., Roberts v. Paypal, Inc., 621 F. App’x 478 (9th Cir. 2015); Lathrop v. Uber Techs., Inc., No. 14-CV-05678-JST, 2016 WL 97511 (N.D. Cal. Jan. 8, 2016); Kolinek v. Walgreen Co., No. 13 C 4806, 2015 WL 7450759 (N.D. Ill. Nov. 23, 2015); Sherman v. Yahoo! Inc., 997 F. Supp. 2d 1129 (S.D. Cal. 2014). Even the Los Angeles Lakers have faced a TCPA lawsuit. Emanuel v. Los Angeles Lakers, Inc., No. CV 12-9936-GW SHX, 2013 WL 1719035 (C.D. Cal. Apr. 18, 2013).

Given that TCPA cases generally are brought as class actions, with statutory damages ranging from $500 to $1,500 for each call or text message, companies face tremendous exposure. In one such lawsuit, Chase Bank faced the specter of a $48 billion judgment—and bankruptcy—if a jury had found it willfully violated the TCPA. This exposure creates pressure to settle, and settle companies have, sometimes for enormous sums. Capital One settled a TCPA case for $75 million; AT&T, for $45 million; Bank of America, for $32 million; MetLife, for $23 million; Papa John’s Pizza, for $16 million; and Walgreen’s Pharmacy, for $11 million. Adonis Hoffman, Sorry, Wrong Number, Now Pay Up, Wall Street J. (June 15, 2015).

This was never the intent of the TCPA. Passed in 1991, the TCPA was intended to help consumers recover from abusive telemarketers without hiring an attorney. See U.S. Chamber of Commerce Institute for Legal Reform, The Juggernaut of TCPA Litigation: The Problems with Uncapped Statutory Damages. Instead of capturing aggressive telemarketers (with small pockets), however, the law has ensnared business calls and text messages from legitimate businesses (with big pockets) simply because the calls or texts may be automated. The automated fraud alerts, prescription reminders, and coupons that come to our cell phones—the hallmarks of our modern technology-based society—have become the basis for TCPA litigation. These automated messages and alerts are a far cry from abusive robo-calls from marketers. For anyone hoping the United States Supreme Court would rein in this “national cash cow” in Spokeo, that day largely came and went.

Spokeo Fails to Address the Crisis Directly…

In Spokeo, the Supreme Court was asked to decide whether a plaintiff had standing to sue when the plaintiff suffered no concrete injury and could point solely to a violation of federal statute. Thomas Robins filed suit against Spokeo, alleging that information available through the company’s people search engine was false. According to Robins, Spokeo’s website indicated he was married with children, employed, held a graduate degree, and was relatively affluent. Robins asserted that none of this information was accurate and was therefore a violation of the Fair Credit Reporting Act (FCRA). Whether these inaccuracies alone were enough to sustain a class-action lawsuit was the question for the Supreme Court. If they were not—if a bare violation a federal statute without more was not enough to invoke the jurisdiction of the federal courts—then litigation under the TCPA and other similar statutes might have been dealt a major blow.

Although noting that a plaintiff “cannot satisfy the demands of Article III by alleging a bare procedural violation” such as an “incorrect zip code,” and that “Article III standing requires a concrete injury even in the context of a statutory violation,” the Supreme Court also determined that “the violation of a procedural right granted by statute can be sufficient in some circumstances to constitute injury in fact.” A concrete injury is a real injury that actually exists, but it does not necessarily mean a tangible injury. “‘Concrete’ is not, however, necessarily synonymous with ‘tangible.’” Ultimately, the Supreme Court ducked ruling on the sufficiency of the injury before it, holding that the U.S. Court of Appeals for the Ninth Circuit had not properly analyzed the standing issue, “having failed to fully appreciate the distinction between concreteness and particularization . . . .” The Supreme Court vacated the Ninth Circuit’s decision and remanded the case for additional analysis.

. . . But Still Leaves Some Hope

Spokeo failed to tackle the statutory violation issue directly, but district court cases have given defendants some helpful precedent for attacking TCPA plaintiffs’ standing. In Kostmayer Constr., LLC v. Port Pipe & Tube, Inc., No. 2:16-CV-01012, 2016 WL 6143075, at *1–2 (W.D. La. Oct. 19, 2016), the plaintiff alleged that it “personally received at least six unsolicited faxes that violated the TCPA” and that the receipt of these faxes caused the plaintiff and the purported class those statutory damages “contemplated by Congress and the [FCC].” Looking to Spokeo, the court found such allegations insufficient to establish standing at the dismissal stage: “Kostmayer must allege facts to establish a concrete injury, and his general references to damages contemplated by congress is insufficient.” See also Sartin v. EKF Diagnostics, Inc., No. CV 16-1816, 2016 WL 3598297, at *3 (E.D. La. July 5, 2016) (“[The complaint’s] vague reference to Congress and the FCC provides no factual material from which the Court can reasonably infer what specific injury, if any, Dr. Sartin sustained through defendants’ alleged statutory violations.”).

Kostmayer Construction’s allegations were vague and unspecific. In Smith v. Aitima Med. Equip., Inc., No. ED 16 CV 339 ABD-TBX, 2016 WL 4618780, at *4 (C.D. Cal. July 29, 2016), the plaintiff’s allegations were more specific, alleging that an unsolicited call (albeit a single call) from the defendant had caused her aggravation, drained her phone’s battery, and served as a nuisance. These allegations, although perhaps specific, were too de minimus to confer standing. More to the point, because the plaintiff had received “only one call,” any amendment would be futile, warranting dismissal with prejudice. See also Supply Pro Sorbents, LLC v. Ringcentral, Inc., No. C 16-02113 JSW, 2016 WL 5870111, at *3 (N.D. Cal. Oct. 7, 2016) (dismissing junk fax case where it was unclear how the plaintiff had “specifically suffered these particular harms”—loss of the use of the fax machine, paper, and ink toner, waste of recipient’s valuable time, and interruption of privacy—from “the single line identifier on the optional cover sheet of a solicited four-page fax it received.”).

In Stoops v. Wells Fargo Bank, N.A., No. CV 3:15-83, 2016 WL 3566266, at *11 (W.D. Pa. June 24, 2016), the district court applied Spokeo to attack the constitutional standing of a professional TCPA plaintiff who had filed nine TCPA lawsuits and had at least 35 cell phone numbers. Finding that a plaintiff who has “admitted that her only purpose in using her cell phones [was] to file TCPA lawsuits” could not have suffered the “nuisance, invasion of privacy, cost, and inconvenience” that the TCPA was intended to guard against. Stoops also found that the plaintiff could not establish that she had prudential standing because her interests were “not within the zone of interests intended to be protected by the TCPA.” “[I]t is unfathomable that Congress considered a consumer who files TCPA actions as a business when it enacted the TCPA as a result of its outrage over the proliferation of prerecorded telemarketing calls to private residences . . . .”

Romero v. Dep’t Stores Nat’l Bank, No. 15-CV-193-CAB-MDD, 2016 WL 4184099, at *1 (S.D. Cal. Aug. 5, 2016), takes these holdings even farther. Elisa Romero claimed to have received 290 unwanted calls from the defendant, causing her emotional distress and other harms. Because each alleged violation of the TCPA is a separate claim, a plaintiff must establish standing—an injury in fact—for each such violation. Each alleged violation by the defendant often comes with different factual underpinnings: a recipient’s phone may be turned off when dialed, may ring but go unheard or unanswered, or is answered.

As a matter of law, a plaintiff lacks standing to assert a TCPA violation for calls that she does not hear. “For Plaintiff to have suffered ‘lost time, aggravation, and distress,’ she must, at the very least, have been aware of the call when it occurred.” The same is true of calls that are heard but that go unanswered, for there is nothing to distinguish, from the plaintiff’s perspective, a call made by a family member or employer from a call made by a manually or ATDS-dialed marketer. “No reasonable juror could find that one unanswered telephone call could cause lost time, aggravation, distress, or any injury sufficient to establish standing.” See also Juarez v. Citibank, N.A., No. 16-CV-01984-WHO, 2016 WL 4547914, at *3 (N.D. Cal. Sept. 1, 2016) (distinguishing aspects of Romero, but noting that calls “made to a neglected phone that go unnoticed or calls that are dropped before they connect may violate the TCPA but not cause any concrete injury.”).

Even among the answered calls, there was no evidence tying the alleged injuries to the fact of a marketer calling from an automated dialing system (a TCPA violation) as opposed to having manually dialed the number (not a TCPA violation). “Although these calls seeking to collect debts may have been stressful, aggravating, and occupied Plaintiff’s time, that injury is completely unrelated to Defendants’ use of an ATDS to dial her number. Plaintiff would have been no better off had Defendants dialed her telephone number manually.” Despite allegations of 290 calls, the Romero court found that the plaintiff had not suffered “an injury in fact traceable to Defendants’ violation of the TCPA” and therefore lacked standing.

Defendants Should Not Get Too Excited; Each of the Cases Cited Above Has Its Foil or Its Detractors

District courts have dismissed TCPA cases for lack of standing following Spokeo, but have also found that the logic of Spokeo is not easily adapted to the TCPA. Spokeo concerned the FCRA, where a violation of the statute—the failure to ensure the accuracy of a consumer report—has the potential to cause serious harm, such as the loss of employment opportunities or a decrease in the consumer’s creditworthiness. A.D. v. Credit One Bank, N.A., No. 14 C 10106, 2016 WL 4417077, at *6 (N.D. Ill. Aug. 19, 2016). A violation of the FCRA could just as easily fail to cause any kind of harm or material risk of harm (such as having an incorrect zip code). Violating the FCRA does not necessarily cause the harm that Congress sought to guard against by passing the statute. The “same cannot be said of the TCPA” because the TCPA does not “require the adoption of procedures to decrease congressionally-identified risks.” By its very nature, a violation of the TCPA causes the privacy-related harm or intrusion that Congress sought to protect by enacting the TCPA. “There is no gap—there are not some kinds of violations of section 227 that do not result in the harm Congress intended to curb, namely, the receipt of unsolicited telemarketing calls that by their nature invade the privacy and disturb the solitude of their recipients.”

Rejecting the logic of Sartin, the Credit One Bank decision held that a TCPA plaintiff’s standing does not turn on whether the plaintiff had suffered “additional tangible harms like wasted time, actual annoyance, and financial losses” because Congress identified that unsolicited telephone contact constitutes an intangible, concrete harm. See also Griffith v. ContextMedia, Inc., No. 16 C 2900, 2016 WL 6092634, at *1 (N.D. Ill. Oct. 19, 2016) (“Courts in this district have held, both before and after the Court’s decision in Spokeo . . . that loss of time and privacy are concrete injuries for the purpose of conferring Article III standing.”).

Sartin is not the only case to have its logic questioned. Aitima Medical Equipment, 2016 WL 4618780, at *4, held that a single phone call was too de minimus to confer standing. Other courts have reached the opposition conclusion. In Etzel v. Hooters of America, LLC, No. 1:15-cv-1055 LMM (N.D. Ga. Nov. 15, 2016) (Doc. 39 at 9), the court found that a single call was sufficient to confer Article III standing (“[I]n light of the plain language of the TCPA and Congress’s role in elevating injuries to legally cognizable status, sending a single text message in violation of the TCPA constitutes an injury-in-fact to the recipient so as to provide Article III standing.”) (emphasis added). See also Aranda v. Caribbean Cruise Line, Inc., No. 12 C 4069, 2016 WL 4439935, at *6 (N.D. Ill. Aug. 23, 2016) (disagreeing with “the reasoning of the judge in Aitima Medical Equipment” and noting that it “does not matter whether plaintiffs lack additional tangible harms like loss of cell phone battery life, actual annoyance, and financial losses.”). The Juarez court reached the same conclusion. Juarez, 2016 WL 4547914, at *3 (“Even a single phone call can cause lost time, annoyance, and frustration.”).

Romero also has its detractors. According to LaVigne v. First Cmty. Bancshares, Inc., No. 1:15-CV-00934-WJ-LF, 2016 WL 6305992, at *3 (D.N.M. Oct. 19, 2016), accepting the reasoning of Romero would make it all but “impossible for a plaintiff to allege a private right of action under the TCPA for automated solicitation calls.” Instead, LaVigne believed that the history and judgment of Congress suggested that a violation of the TCPA, on its own, constituted a concrete, de facto injury. “The list [of cases] goes on, with each finding that the bare statutory violation of the TCPA constitutes sufficient ‘concrete’ injury for Article III standing.” LaVigne also noted that Article III’s standing requirements do “not contain a minimum cost or harm threshold.” A harm, no matter how small, is actual and real.

More to the point, Romero has likely been overruled by the Ninth Circuit’s recent decision in Van Patten v. Vertical Fitness Group, No. 14-55980 (9th Cir. Jan. 30, 2017), which held that “[u]nsolicited telemarketing phone calls or text messages, by their nature, invade the privacy and disturb the solitude of their recipients.” (emphasis added). As a result, a plaintiff alleging a violation of the TCPA “need not allege any additional harm beyond the one Congress has identified” to satisfy Spokeo and Article III’s standing requirements. 

Spokeo Is Still Not the Last Word

In July 2015, the FCC issued a Declaratory Ruling and Order that clarified the TCPA’s definition of “automatic telephone dialing system” and created a “very limited safe harbor” for calls made to reassigned numbers. Lathrop v. Uber Techs., Inc., No. 14-CV-05678-JST, 2016 WL 97511, at *2 (N.D. Cal. Jan. 8, 2016). Nine entities filed petitions with the U.S. Court of Appeals for the District of Columbia Circuit seeking to have the FCC’s ruling vacated, and these nine appeals were consolidated into a single case: ACA International v. Federal Communications Commission, No. 15-1211 (D.C. Cir. 2015).

Two of the five FCC commissioners issued sharp dissents in the July 2015 ruling. If the D.C. Circuit adopts the reasoning of these dissents and determines that the FCC reached the wrong conclusions in its July 2015 Order, such a decision “could potentially be dispositive” of current TCPA issues before the district courts. Fontes v. Time Warner Cable Inc., No. CV14-2060-CAS(CWX), 2015 WL 9272790, at *4 (C.D. Cal. Dec. 17, 2015). One court has already sided with the dissenting Commissioners and stated its belief that portions of the “FCC’s majority interpretation . . . contradict[] the plain language of the statute” and are “not entitled to deference on appeal.” Gensel v. Performant Techs., Inc., No. 13-C-1196, 2015 WL 6158072, at *2 (E.D. Wis. Oct. 20, 2015).

Even after Spokeo, some courts have decided to wait on a decision from the D.C. Circuit in ACA International, believing that a decision in that case has the potential to clarify and streamline important legal issues. See Rajput v. Synchrony Bank, No. 3:15-CV-1595, 2016 WL 6433150, at *1, *8 (M.D. Pa. Oct. 31, 2016) (lifting a stay following the Spokeo decision but then granting another stay pending the D.C. Circuit’s disposition of ACA International); Frable v. Synchrony Bank, No. 16-CV-0559 (DWF/HB), 2016 WL 6123248, at *4 (D. Minn. Oct. 17, 2016) (staying TCPA case until the D.C. Circuit Court of Appeals issues a decision in ACA International); but see Konopca v. Ctr. for Excellence in Higher Educ., Inc., No. CV155340FLWDEA, 2016 WL 4644461, at *3 (D.N.J. Sept. 6, 2016) (refusing to stay the case while the ACA International case remains pending). Spokeo is not the last word in TCPA litigation, and ACA International may also find its way to the Supreme Court.