The growing importance of social considerations (the “S” in ESG) has appeared in numerous headlines, as companies learn the hard way that cutting corners in areas like supply chain and human capital does not pay off in the long run. In the past two years, a number of Fortune 500 companies have had to pay out large sums to mitigate the consequences of their poor choices surrounding overseas production. In this article we focus on the “S” aspects of ESG with regards to conducting M&A due diligence, and what companies should evaluate prior to approving an M&A deal.

As discussed in our prior ESG in M&A article, a large number of investors believe that companies with strong ESG initiatives are more lucrative investments, pose less risk, and are better positioned for the long term. Moreover, because of the SEC’s announced plan^[1] to create an ESG reporting framework that would complement the current financial reporting framework, targets with higher ESG scores are perceived, in many cases, as having higher market value. Environmental and governance aspects of ESG seem to be easier to measure, which may explain why companies find it easier to tackle those issues first. Acquirers often overlook the social aspects of ESG metrics, which can result in minimal evaluation of social issues during ESG due diligence.

The “S” part of ESG is a broad topic that covers a wide range of social issues; diversity and inclusion, fair pay, workplace safety and environment, employee turnover, company ethics, and reputation are among the factors that are evaluated when assessing a company’s “social” health in ESG metrics. Increasingly, we have seen companies reevaluating their production practices to address supply chain hiccups and questionable labor practices. Many companies have had significant problems resulting from cargo crime,^[2] the invasion of Ukraine,^[3] the growth of e-commerce, sudden shortages, centralized inventory, and a patchwork of logistics,^[4] all of which are significant supply chain problems that fall under the “S” in ESG. We will examine a few of these issues more closely.

1. Supply Chain Risks

Since the beginning of the COVID-19 pandemic, companies have been suffering frequent and major disruptions to global supply chains. Prominent examples include shortages of lumber to build houses and of semiconductor chips for vehicles and mobile phones. To address these issues, manufacturing companies often sought out alternative suppliers. The manufacturers often failed to conduct proper vetting of such alternative suppliers and in many cases wound up with less reputable vendors as a result. In some cases, improperly vetted alternative vendors may be less transparent with their “social” practices and also less ethical in general. Vendor practices are increasingly “broadcast” worldwide via online and social platforms such as TikTok and Instagram. The questionable practices of suppliers—after coming to light—are often viewed by third parties as a reflection of the manufacturer’s practices and ethics, with the publishers of ESG ratings, and sometimes even litigants, holding the manufacturer accountable for its vendors’ practices. Some of the examples of ethical issues in supply chains are:

• corruption and bribery;
• unsafe labor conditions;
• non-living wages or forced labor;
• child labor;
• cargo crime;
• environmental harm; and
• discriminatory work environment.

To combat these issues and demonstrate their commitment to social and environmental performance, more businesses are looking to third-party certification processes. For example, many companies dealing with these issues choose to become “B Corp” certified. B Corp certification of for-profit companies is offered by the B Labs Global. The designation confirms that a business is meeting high standards of verified performance, accountability, and transparency on factors from employee benefits and charitable giving to supply chain practices and input materials. As of September 2022, there were 5,697 certified B Corporations across 158 industries in 85 countries. Among some of the best known B Corp certified companies are Ben & Jerry’s,^[5] TOMS,^[6] and Patagonia.^[7] Many of these companies also donate their products to charity to match purchases by consumers. For example, for every pair of TOMS shoes purchased, a pair of new shoes is given to a child in need in partnership with humanitarian organizations.

According to Accenture Strategy’s Global Consumer Pulse Research, more than 60% of surveyed consumers closely consider a company’s ethical values and authenticity before a purchase. Moreover, the research showed that 42% of consumers “stopped doing business with a company because of its words or actions about a social issue.”^[8]

To illustrate this with a real-world example, a confectioner was struggling to ensure that harvesting the ingredients it used, like cocoa and soy, did not contribute to deforestation. Also, several confectioners were accused of child labor issues in recent years, and were named in a lawsuit over child labor in cocoa production countries. As a result, the company made changes, such as setting strict policies on deforestation and promising to train all of its buyers on human rights issues. Child labor, forced labor, deforestation, women’s rights, and living wages were among the most pressing human rights issues across the value chain for these companies. Another real-world case that attracted headlines was the investigation of fashion retailer Boohoo, which was accused of being aware of its suppliers underpaying their staff and exposing workers to life-threatening risks in their workplaces.^[9] As a result, multiple online retailers removed Boohoo’s products from their websites.^[10]

Some companies have chosen an alternative solution to supply chain social concerns: bringing manufacturing in house. However, the high costs, risks, and logistics associated with this option mean it is not always a feasible choice to address supplier concerns.

2. M&A Due Diligence and Supply Chain Risks

The great difficulty with addressing these social and ethical issues is that they are often not discussed or uncovered in the M&A process until the company becomes a defendant in a lawsuit, the subject of an investigation, or the object of press or social media attention. At that point, the company has already suffered severe damage to its reputation due to actions taken by another party, not to mention potential exposure to monetary damages resulting from pre-closing actions. It is hard to measure many of these practices when they are defined differently across industries and from country to country. It also requires significant corporate resources to monitor each vendor and each of their sites. Nevertheless, with the growing pressure from customers and investors, ethical production is a critical component to have a successful and sustainable business in the 21^st century.

So, how should a buyer assess a target company’s approach to social compliance in its supply chain? Buyers should confirm that the target company is communicating regularly and often with its vendors and conducting periodic site visits, if possible. It is a good idea for a company to include its ESG standards in its supplier contracts to ensure that the company’s ESG policies have been clearly communicated and vendors know its expectations in that regard. Another good practice is to ask whether the target uses supply chain mapping to maintain awareness of its production sites and those of its vendors. With effective supply chain mapping, a company divides its vendors into different categories, which can allow it to see weak points in its supply chain and avoid incurring costly issues.

What impact do social issues have for potential buyers and targets in M&A transactions? To start with, buyers need to be aware of the prevalence and impact of these issues and be proactive in identifying and evaluating them. According to a study conducted by Accenture during the early months of the COVID-19 pandemic, 94% of Fortune 1000 companies are seeing supply chain disruptions, 75% of companies have had “negative or strongly negative impacts” on their business, and 55% of companies plan to downgrade their growth outlook or have already done so.^[11] Based on a survey conducted by Datasite of 200 UK-based dealmakers, almost 20% stated that supply chain problems were the cause of at least one deal falling apart in 2021, and 22% identified supply chain issues as the number one cause that would trigger an M&A deal to fall through in 2022.^[12] Many companies that had order backlogs of one to two months prior to COVID-19 now have increased their estimate of the backlog by up to four times.^[13] For instance, a target that had backups for almost every component in their products but one key part with no alternate supplier had to be taken down from the market due to potential buyers’ concern.^[14] Such a potential outcome suggests that targets also would be well advised to conduct thorough internal due diligence on these topics prior to going to market.

3. Fair Labor Practices and Unionization

Fair labor practices are another important aspect of the social responsibility portion of ESG. More U.S. stakeholders are urging companies to improve labor practices and working environments. If a company’s ESG policies assert that they ensure equitable labor practices, they may face scrutiny if they fail to actively address workplace issues with their suppliers. Moreover, the recent resurgence of unionization activities is evidence of its importance. Unionization offers additional protection and benefits for employees, but can also pose extra costs and burdens on employers; oftentimes a company’s response to these activities is perceived as an indicator of a company’s labor practices and hence a part of its ESG assessment. A Starbucks store in Buffalo, New York, became the first Starbucks location in the U.S. to unionize in 2021.^[15] Since then, over 270 Starbucks stores have unionized.^[16] Starbucks, like other food and beverage companies, is bracing for the impact of the threat of higher labor costs due to unionization, and has also faced national scrutiny for its response to workers’ attempts to unionize.^[17]

In addition to the growing unionization in the U.S., more and more companies are addressing safe labor practices in their non-U.S. factories. One example of such an effort was the result of the tragic accident in Rana Plaza, a factory in Bangladesh that collapsed in 2013 killing over 1,100 people. Workers had noticed cracks in the structure before the building collapsed and begged not to be sent inside, but they were rebuffed by their employers.^[18] The collapse of the eight-story building, which housed five garment factories supplying at least 29 global brands, remains one of the deadliest industrial accidents to date.^[19] Such a “mass industrial homicide,” as union leaders called it, drew the attention of global organizations that took action to create safer working standards. These standards now show up in retailers’ ESG reports.

However, despite the aforementioned efforts to improve the conditions of factories in Bangladesh and other countries with significant garment sectors, the working environment for many employees remains far from ideal. A 2020 U.S. Senate Report titled “Seven Years After Rana Plaza, Significant Challenges Remain” discusses the unsafe practices of these factories, especially during the COVID-19 pandemic.^[20] The report found that in factories that remained in operation during the pandemic, workers were forced to work without adequate precautions, leaving them and their families at great risk of COVID-19 infection.^[21]

More recently, a fire at the Nandan Denim factory in India killed seven people in 2020.^[22] According to the Nandan Denim website, it is the biggest denim producer in India.^[23] The manufacturer sells jeans to more than twenty countries for many high street brands, and import data showed shipments entering the United States from the factory just one month before the fire occurred. Unfortunately, the Nandan Denim fire is not a rarity, as fires in retail factories are not an uncommon occurrence.^[24] Such occurrences can lead to damaged reputations as well as an influx of civil lawsuits and a criminal investigation. Following the Nandan Denim incident, the production facility came to a halt, and the director, general manager, and fire safety officer of Nandan Denim were taken into police custody. Additionally, six individuals from the factory’s parent group were charged with homicide and negligence.^[25]

In light of these frequent tragedies, more and more U.S. stakeholders are asking companies to improve their labor practices and working environments, with some even supporting union organization activity. Employers that don’t actively inquire into the workplace issues of their suppliers may find themselves under scrutiny if their ESG policies state that the company ensures fair labor practices outside of the United States. Further, where a company represents that it strives to ensure fair labor practices for its vendors, taking action to oppose union organization in the U.S. may be seen as inconsistent with such claimed commitment to fair labor practices.

4. ESG Due Diligence

It is advisable for buyers in M&A transactions to conduct due diligence investigations regarding ESG practices of the target not only to determine whether there are potential risks, but also to ensure that the target will integrate well into the buyer’s own ESG practices and policies. A buyer should request information on whether there have been recent changes in supply chain vendors and suppliers of the target company. Also, a buyer should gain an understanding of how the target company monitors its supply chain and review its applicable contracts. Specifically, a buyer should look into whether there are any contractual requirements outlining ESG expectations in a target’s agreements with vendors and suppliers. Furthermore, buyers should visit physical sites, review compliance certificates, and provide questionnaires in order to be better aware of a target’s supply chain practices. Some industries are likely to have more significant exposure to ESG issues in the supply chain than others, particularly businesses in the automotive, semiconductors, industrials, and retail industries. Lastly, even after conducting appropriate ESG due diligence, a buyer should consider including ESG-related provisions in the purchase agreement. These clauses can include ESG representation and warranties, closing conditions, and ESG-specific indemnities. Such provisions can go hand-in-hand with (and often enhance) a thorough diligence process to give the buyer the best chance of avoiding post-closing losses.

1. Allisson Herren Lee, “A Climate for Change: Meeting Investor Demand for Climate and ESG Information at the SEC,” U.S. Securities and Exchange Commission, March 15, 2021. (The SEC has “begun to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need.”) ↑

2. Rachel Layne, “Clogged U.S. supply chains lead to cargo theft,” CBS News, November 2, 2021. ↑

3. Knut Alicke et al., “Supply chains: To build resilience, manage proactively,” McKinsey & Company, May 23, 2022. ↑

4. Kyle VanGoethem, “What Are the 5 Biggest Supply Chain Issues Today?” Stord, May 3, 2022. ↑

5. “Ben & Jerry’s Joins the B Corp Movement,” Ben & Jerry’s, last accessed April 4, 2023. ↑

6. “TOMS, Certified B Corporation,” B Lab Global Site, last accessed April 4, 2023. ↑

7. “Patagonia Works, Certified B Corporation,” B Lab Global Site, last accessed April 4, 2023. ↑

8. Rachel Barton et al., “From me to we: The rise of the purpose-led brand,” Accenture, December 5, 2018. ↑

9. Archie Bland, “Boohoo knew of Leicester factory failings, says report,” The Guardian, September 25, 2022. ↑

10. Don-Alvin Adegeest, “Zalando, Next and Asos stop selling Boohoo brands after damning report,” Fashionunited, July 8, 2020. ↑

11. “Building supply chain resilience: What to do now and next during COVID-19,” Accenture, March 17, 2020. ↑

12. Datasite contributor, “Rising Inflation and Supply Chain Challenges: Will EMEA M&A Deals Be at Risk in 2022?” City A.M., February 17, 2022. ↑

13. Al Statz, “How Supply Chain Issues are Complicating M&A Dealmaking,” Exit Strategies, February 2, 2022. ↑

14. Id. ↑

15. Mary Yang, “Starbucks union organizing gave labor a jolt of energy in 2022,” NPR, December 9, 2022. ↑

16. “278+ STORES UNIONIZED AND 41,000+ UNION SUPPORTERS IN SOLIDARITY!” Starbucks Workers United, accessed January 30, 2023. ↑

17. Justin Stabley, “Why scrutiny of Starbucks’ alleged union violations is boiling over now,” PBS NewsHour, March 29, 2023. ↑

18. Michael Safi et al., “Rana Plaza, five years on: safety of workers hangs in balance in Bangladesh,” The Guardian, April 24, 2018. ↑

19. Shams Rahman and Aswini Yadlapalli “Years after the Rana Plaza tragedy, Bangladesh’s garment workers are still bottom of the pile,” The Conversation, April 22, 2021. ↑

20. A Minority Staff Report, 116^th Cong., “Seven Years After Rana Plaza, Significant Challenges Remain,” 116–17 (2020). ↑

21. “Bangladesh: Seven years on from Rana Plaza factory collapse, garment workers’ lives at risk again amid COVID-19,” Business & Human Rights Resource Center, April 24, 2020. ↑

22. Tara Donaldson, “Fire Kills Seven in Indian Factory that Made Denim For Major US Brands,” Rivet, February 10, 2020. ↑

23. “Nandan One World With Denim,” Nandan, accessed January 2, 2023. ↑

24. Express News Service, “Fire breaks out in footwear factory in Delhi’s Narela Industrial Area; no casualties yet, say officials,” The Indian Express, November 5, 2022. ↑

25. Clean Clothes Campaign, Deadly Indian Factory Fire Again Shows Need for Preventive Safety Measures and Justice for Workers, International Labor Rights Forum, February 17, 2020. ↑

We have seen a tsunami of cryptocurrency exchange bankruptcies—FTX, Celsius, and Voyager, to name a few. Often, disputes arise among stakeholders in these bankruptcy cases regarding whether cryptocurrency maintained by a customer with an exchange in a pure custody relationship is property of the customer or property of the bankruptcy estate. Usually the litigation turns on the account agreement, including what are often referred to as the “Terms of Service,” entered into between the customer and the exchange, and the application of nonstatutory common law contract and property law principles. Given the uncertainty evidenced by this litigation and out of concern for customer protection, federal and state regulators have called for greater clarity on the issue through new regulation or, given the lack of clear regulatory authority, legislation. Yet many customers, exchanges, regulators, and legislatures seem to be unaware of an already existing statutory tool for addressing and resolving the issue: Article 8 of the Uniform Commercial Code (“UCC”).

UCC Article 8: The Basics

The UCC, promulgated by the American Law Institute and the Uniform Law Commission, has been enacted in substantially uniform form by every state of the United States and the District of Columbia. Article 8 of the UCC provides a statutory scheme for the holding and transfer of investment securities, whether held directly by an investor from an issuer (so-called directly held securities) or held indirectly by an investor through a bank, broker, or other custodian acting for its customers, including the investor (so-called indirectly held securities). Of relevance here is the system for holding indirectly held securities (“indirect holding system”).

While the primary focus of Article 8 is generally on investment securities, Article 8’s indirect holding system provisions, contained in Part 5 of Article 8, can apply more broadly to any so-called financial assets as defined under Article 8. “Securities,” as defined in Article 8 (which may not coincide with the definition of securities under securities and other laws), are by definition financial assets. However, any other asset that the securities intermediary and its customer agree to treat as a financial asset is also a financial asset under Article 8 and is therefore within the scope of Article 8’s indirect holding system provisions. The agreement by which the exchange and the customer agree to treat an asset as a financial asset under Article 8 is referred to herein as a “financial asset election.”

Once the financial asset election is made and the financial asset is credited to the customer’s “securities account” at the securities intermediary, the customer (referred to in Article 8 as the “entitlement holder”) obtains a proprietary interest in, and contractual and statutory rights against the securities intermediary with respect to, the financial asset. That proprietary interest and contractual right are, together, referred to in Article 8 as a “security entitlement.”

A securities intermediary has a duty under Article 8, among other duties, at all times to maintain sufficient financial assets of each type to satisfy security entitlements to financial assets of that type. And, of chief importance here, financial assets to which the entitlement holder has a security entitlement are generally not property of the securities intermediary and are generally not subject to the claims of the securities intermediary’s creditors under Article 8.

Application of UCC Article 8 to Cryptocurrency in an Indirect Holding System

A cryptocurrency exchange could be a securities intermediary under Article 8, with the cryptocurrency held for the customer being treated as a financial asset credited to a securities account of the customer at the exchange under a financial asset election included in the account agreement. If that were the case, the cryptocurrency would generally not be property of the exchange and generally not be subject to the claims of the exchange’s creditors. If the exchange became a debtor under the Bankruptcy Code, absent contrary terms in the account agreement, the financial asset election under Article 8 would reduce, if not entirely eliminate, the need to litigate the terms of the account agreement over whether the cryptocurrency is customer or exchange property. This is because Article 8 states so clearly that financial assets maintained by a securities intermediary for its customer are generally not the securities intermediary’s property and are generally not subject to the claims of the securities intermediary’s creditors. In other words, in this circumstance, the cryptocurrency would be property of the customer rather than property of the exchange.

A securities intermediary is a person that in the ordinary course of its business maintains securities accounts for others and is acting in that capacity. It is true that the most common examples of securities intermediaries are clearing corporations holding securities for their participants, banks acting as securities custodians, and brokers holding securities on behalf of their customers. But nothing in the definition of the term securities intermediary as used in Article 8 limits securities intermediaries to clearing corporations, banks, or brokers. In addition, because a securities account is an account to which a financial asset is or may be credited in accordance with an agreement under which the person maintaining the account undertakes to treat the person for whom the account is maintained as entitled to exercise the rights that comprise the financial asset, and the definition of financial asset is not limited to “securities” as defined in Article 8, a person may be a securities intermediary even if that person does not credit securities to the account. Rather, the securities accounts that a securities intermediary maintains may consist exclusively of assets that the securities intermediary has agreed to treat as financial assets—even if the financial assets are not securities.

The assets could, indeed, be cryptocurrencies. In 2022, the American Law Institute and the Uniform Law Commission promulgated amendments to the UCC providing rules for digital assets, referred to in a new Article 12 of the UCC as “controllable electronic records.” Controllable electronic records include most cryptocurrencies. The Official Comments to the 2022 amendments, including amendments to Article 8, confirm that a cryptocurrency exchange can be a securities intermediary under Article 8. Furthermore, under the 2022 amendments, a controllable electronic record maintained by a customer with an exchange can be a financial asset if there is a financial asset election under Article 8.

Examples of other assets treated as financial assets that are sometimes credited to a securities account and that are not securities include negotiable instruments, banker’s acceptances, certificates of deposit, and cleared swap agreements.^[1] It is not necessary that the cryptocurrency be considered a security or commodity under other law for the asset to be a financial asset under Article 8.

Moreover, the indirect holding provisions of Article 8 are technologically neutral. To obtain financial asset status, it would not matter whether the cryptocurrency is maintained by the exchange on-chain or off-chain or whether the customer has its own private keys to any wallet maintained by the exchange for the customer but with the exchange having ultimate control over the cryptocurrency.

The policy rationale for this broad and flexible interpretation of Article 8 in the context of the indirect holding system is explained in Article 8 itself. The Prefatory Note to Article 8 states, “Rapid innovation is perhaps the only constant characteristic of the securities and financial markets. The rules of Revised Article 8 are intended to be sufficiently flexible to accommodate new developments.”^[2] And the Official Comments to Article 8 provide, “That question [of the scope of Part 5 of Article 8] turns in large measure on whether it makes sense to apply the Part 5 rules to the relationship.”^[3] Here, the rules of the indirect holding system fit well when the financial asset election is made. The customer obtains the benefits of the duties of a securities intermediary, set forth in Part 5 of Article 8, owed to the customer by the exchange—including the duty of the exchange to maintain sufficient cryptocurrency of each type to satisfy all customer security entitlements to the cryptocurrency of that type. The exchange assumes the Part 5 duties with the ability to modify those duties, to the extent permitted by Part 5 of Article 8, with the agreement of the customer. And, as is the case with indirectly held investment securities, cryptocurrencies held as financial assets credited to the securities accounts of customers generally are not subject to the claims of the exchange’s creditors. There is no obvious policy reason not to permit the exchange and the customer to agree to the benefits and burdens of the indirect holding provisions of Article 8.

Of course, some cryptocurrency exchanges may commingle their proprietary cryptocurrency with cryptocurrency of customers as part of a single fungible bulk. An exchange doing so does not in any way alter the result under Article 8 if there is a financial asset election. Article 8 contains no provision that requires a securities intermediary to segregate proprietary financial assets from customer financial assets. The key is for the books and records of the securities intermediary to reflect what quantity of financial assets of which type is subject to security entitlements and which customers hold the respective security entitlements. If there is a shortfall in the cryptocurrency necessary to satisfy security entitlements to the cryptocurrency of any type, the customers’ rights under their security entitlements will generally be superior to the proprietary interests of the exchange in the cryptocurrency of that type.

UCC Article 8 and Bankruptcy of a Cryptocurrency Exchange

Although there is so far no bankruptcy case addressing the issue, there is no reason why Article 8’s protections for customers’ cryptocurrency should not be recognized if the exchange were to become a debtor under the Bankruptcy Code. Based on the holding from the U.S. Supreme Court in Butner v. United States,^[4] the extent of a bankruptcy debtor’s interest in property is determined under applicable non-insolvency law, absent a compelling federal interest to the contrary—and there is no compelling federal interest why the applicable nonbankruptcy provisions of Article 8, after giving effect to financial asset election under Article 8, should not apply to determine the limitations of the exchange’s interest in the cryptocurrency maintained by the exchange for the customer. The interest of any creditor of the exchange would generally be similarly limited.

At most, the exchange’s interest would be limited to mere nominal title, which should not be problematic in the exchange’s bankruptcy case. Under Bankruptcy Code §§ 541(a)(1) and (d), the exchange’s nominal title is includable in the bankruptcy estate of the exchange. However, the bankruptcy estate’s nominal title in the cryptocurrency would remain subject to the limitations on the rights of the exchange as a securities intermediary, described above. The customer as the entitlement holder would have a security entitlement with respect to the cryptocurrency. Despite the exchange’s nominal title to the cryptocurrency, under Bankruptcy Code §§ 541(a)(1) and (d) the security entitlement itself remains the property of the customer and would not be included in the exchange’s bankruptcy estate. The customer may need relief from the automatic stay, and the assistance of the bankruptcy court in the bankruptcy case, for the cryptocurrency to be delivered out to another exchange or to the customer directly. If there is a shortfall in the cryptocurrency of the same type available to satisfy the security entitlements of all customers to cryptocurrency of that type, the customers would bear the shortfall ratably, and each customer would be treated as a general unsecured creditor of the exchange to the extent of the customer’s ratable share of the shortfall.

Caveats

To be sure, a cryptocurrency exchange and its customers making a financial asset election is not a panacea for what many see as the risks of owning cryptocurrency, or for the lack of regulation of cryptocurrency exchanges. A financial asset election under Article 8 in and of itself cannot prevent fraud, self-dealing, or even poor record-keeping by an exchange—or be a substitute for regulation of cryptocurrency as a security, commodity, or otherwise or for regulation of a cryptocurrency exchange as a money transmitter or other licensee. Moreover, the Article 8 protections, even with a financial asset election, may not apply under choice-of-law rules contained in Article 8 or in the Hague Securities Convention, when the customer permits the exchange to use the cryptocurrency for the exchange’s own benefit (including where the customer is promised a return from the exchange’s use of the cryptocurrency), or in exceptional circumstances referred to in Article 8.

Conclusion

Article 8 is clear and flexible, built to practically accommodate areas of expanding economic activity such as the emergence of cryptocurrency exchanges. Cryptocurrency exchanges and their customers should seriously consider the benefits of a financial asset election, and regulators and legislators should seriously consider requiring cryptocurrency exchanges to build a financial asset election into their Terms of Service or other account agreement provisions. An example of a statute requiring a financial asset election is the Uniform Law Commission’s proposed Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act.^[5] The comments to that proposed supplemental act go into greater detail on the substantive provisions of Article 8 and related choice-of-law rules applicable to a financial asset election.

Carl S. Bjerre is the Kaapcke Professor of Business Law at the University of Oregon School of Law. Sandra M. Rocks is counsel emeritus at Cleary, Gottlieb, Steen & Hamilton LLP. Edwin E. Smith is a partner at Morgan, Lewis & Bockius LLP. Steven O. Weise is a partner at Proskauer Rose LLP. The views expressed in this article are the personal views of the authors and not of their respective organizations.

1. See generally Flener v. Alexander (In re Alexander), 429 B.R. 876 (Bankr. W.D. Ky. 2010), aff’d, Case No. 11-5054, 2011 WL 9961118 (6th Cir. Dec. 14, 2011) (treating a bank certificate of deposit as a financial asset credited to a securities account); Wells Fargo Bank, N.A. v. Est. of Malkin, 278 A.3d 53 (Del. 2022) (treating an insurance policy as a financial asset credited to a securities account). ↑

2. U.C.C. art. 8, prefatory n. (Am. L. Inst. & Unif. L. Comm’n 1994). ↑

3. Id. official cmts. ↑

4. 440 U.S. 48 (1979). ↑

5. Supplemental Commercial Law for the Uniform Regulation of Virtual-Currency Businesses Act (Unif. L. Comm’n 2017), https://www.uniformlaws.org/committees/community-home?CommunityKey=fc398fb5-2885-4efb-a3bb-508650106f95. ↑

Introduction

The Conference on Consumer Finance Law (“Conference” or “CCFL”) is probably best known to the members of the Business Law Section for its well-attended Frederick Fisher Memorial Program—named in honor of its chairman, Frederick G. Fisher Jr. (1921–1989) (figure 1)—that it has cosponsored at the Section’s Spring Meeting for many years. But it does more than that. The Conference’s law review, the Consumer Finance Law Quarterly Report (“Quarterly Report”) has been published since 1946, nearly as long as the seventy-eight-year history of The Business Lawyer. The Conference also hosts its own educational programs. It has been an affiliate of the American Bar Association (“ABA”) since its founding in 1927.

Fig. 1: Frederick G. Fisher Jr.

This article will give a summary of the CCFL’s history, based primarily on what has been published over the years in the Quarterly Report since 1946. A longer version of this history, including complete footnote references, will be published in the Quarterly Report in the near future.

The Founding of the CCFL

The CCFL was founded when two prominent attorneys, Reginald Heber Smith (1889–1966) (figure 2), known as both the father of legal aid and the father of the billable hour, and Edmund Ruffin Beckwith (1890–1949) (figure 3), known as judge advocate general of the New York State Guard and as the father of Beneficial Finance, brought together a group of about thirty attorneys who were interested in personal finance law at the Annual Meeting of the ABA in Buffalo, New York, in September 1927 to form the Conference.

Fig. 2: Reginald Heber Smith.

Fig. 3: Edmund Ruffin Beckwith.

Reginald Heber Smith

Smith joined the six-man Boston firm of Hale and Dorr as managing partner in 1919, and he remained in that position until 1956. The firm, now Wilmer Cutler Pickering Hale and Dorr LLP, reports on its website that Smith pioneered the use of the billable hour to rationalize the operations of the law firm, along with “[a]ccurate accounting methods, budgets, a mathematical system of profit distribution, [and] timesheets,” over the objections and resistance of his partners. He first made use of these techniques as counsel to the Boston Legal Aid Society after graduating from Harvard Law School in 1913, reducing the average net cost of handling a legal aid case from $3.93 to $1.63 in just two years.

Smith’s 1919 book, Justice and the Poor, based on his experiences as director of the Boston Legal Aid Society, has been called “one of the most important books about the legal profession in history” because of his finding that “people without money were denied access to the courts,” which “undermined the social fabric of the nation.”^[1] His book “shamed the elite bar into action and led to the creation of the modern legal aid movement” by arguing that “[w]ithout equal access to the law, the system not only robs the poor of their only protection, but places in the hands of their oppressors the most powerful and ruthless weapon ever invented.”^[2] His book led the ABA to create the Special Committee on Legal Aid Work, resulting in the establishment of legal aid programs across the country by the middle of the twentieth century. Smith also published four articles about the rationalization of law firm operations that the ABA published in book form in 1943 under the title Law Office Organization, which went through eleven editions by the early 1990s. Smith’s public service through the ABA also encompassed the creation of lawyer referral services for people of modest means, the establishment of client security funds, and advocating for vigorous professional discipline. Smith’s contributions to the ABA, which the ABA characterized as “prodigious,”^[3] led to his becoming the seventeenth recipient of the ABA Medal, its highest honor, in 1951.

Smith’s cofounding of the CCFL was of a piece with his other public service. His “Inaugural Statement” for the Quarterly Report in 1946 encapsulated some of his thoughts on the role of lawyers in society in connection with the field of consumer finance. For example, he asked, “[W]hat should be the maximum charge on a $25.00 loan? Economics says one thing, sociology says the opposite, and the law, forced to compromise, wavers in an unstable equilibrium.” He further noted that

[j]ustice in this country is administered 10% by judges in court rooms and 90% by lawyers in law offices. In that process we have learned that many of our severest battles are with our own clients; anger and vengeance have to be extirpated from their minds and emotions, and a sense of justice instilled. We have to teach them the limits of law; that, for example, no statute or code can rekindle the flame of love that has been extinguished between husband and wife.

Edmund Ruffin Beckwith

Cofounder Beckwith served as chairman of the Conference’s General Committee until his death in 1949.

Beckwith practiced law in Montgomery, Alabama, for ten years after his graduation from University of Alabama Law School in 1915 and then relocated to New York City to serve as counsel to “a group of companies engaged in the field of consumer finance,”^[4] which he combined to form Beneficial Industrial Loan Corporation, later known as Beneficial Finance Corporation.

Beckwith also joined the New York State Guard and became its judge advocate general in 1940, retiring from service with the rank of brigadier general. During World War II, “he perceived that the new citizen-army would insist on legal assistance as well as medical assistance” in all parts of the world.^[5] To achieve that goal, “he proposed to rally the whole force of the organized bar—national, state, and local” and successfully carried through on that unprecedented proposal despite the doubts and opposition of many “eminent lawyers and devout patriots” who maintained that “it could not be done and so would lead to disaster.”^[6]

Beckwith’s memorial stated that his work caused him to want to do something to benefit the public as well as his clients:

As he studied the economic matrix in which his corporate structure must be formed he was appalled to find that in our democracy the average man had so much difficulty in obtaining credit on simple, clean, and decent terms. He was enraged that the legal provisions were conflicting, inadequate, or altogether lacking.

He proposed to do something about it, and his sure instinct told him to proceed through the instrumentality of the legal profession.

Thus was born the Conference, of which he was the guiding spirit for the remainder of his life and the active head except for the periods when he was in the service of his country.^[7]

The Leadership and Activities of the Conference

Leadership of the Conference

In the first issue of the Quarterly Report in 1946, Beckwith was shown as chairman of the General Committee (“Committee”), which included eleven other men. Among them were Smith, who became president of the Conference the following year; Jackson R. Collins (1896–1978) (figure 4), secretary of the Committee from 1946 to 1963 and last survivor of the original 1927 group of thirty founders when he died in 1978; Linn K. Twinem (1903–1997) (figure 5), assistant secretary of the Committee, editor of the Quarterly Report, and general counsel of Beneficial Finance Corporation of New York; and James C. Sheppard (1898–1964) (figure 6), a founding member of the Los Angeles firm that would become Sheppard Mullin Richter and Hampton and Beckwith’s successor as Committee chairman in 1949. These men formed a close-knit group as they performed leadership functions for the Conference for many years.

Fig. 4: Jackson R. Collins.

Fig. 5: Linn K. Twinem.

Fig. 6: James C. Sheppard.

Fig. 7: George R. Richter Jr.

Sheppard remained chairman of the Committee through 1962, when his partner, George R. Richter Jr. (1910–2002) (figure 7), took over the chairmanship through 1979 after he had served in the newly created position of vice president from 1960 to 1962. Before that, Richter had been added as Commercial Code editor for the Quarterly Report in 1951 as the Uniform Commercial Code (“UCC”) was being drafted and finalized for submission to the state legislatures; he served in that function through 1986. Among other things, Richter was the California commissioner for the National Conference of Commissioners on Uniform State Laws, now the Uniform Law Commission, and was elected its president in 1959. He also served as chairman of the ABA Section of Corporation, Banking and Business Law, now the Business Law Section, from 1962 to 1963.

Activities of the Conference

The Conference held its twenty-fifth Annual Meeting at the ABA’s Annual Meeting in San Francisco in September 1952, indicating that it had held similar meetings each year after being founded in 1927. The same issue of the Quarterly Report that reported on the Conference’s Annual Meeting also announced that the General Committee of the Conference would hold its midyear meeting in Chicago in February 1953, in connection with the ABA’s midyear meeting, at which “[s]pecial projects of the Conference will be discussed and considered.” The same pattern holds true to the present as the Conference’s Governing Committee, as the General Committee was renamed in 1991, has held its Annual Meeting and midyear meeting in conjunction with ABA or Business Law Section meetings, discussing and considering projects for the Conference and other business.

The report on the twenty-fifth Annual Meeting consisted of several photographs that showed what the General Committee did. Chairman Sheppard handed out twenty-five-year awards to the three remaining founding members of the Conference. Other photos showed the judges and participants in the Annual Argument that the Conference staged on a current issue, with the participants being drawn from the ABA Young Lawyers Division. The Annual Argument was a prominent feature of the Quarterly Report from that point forward through 1989, with judges being prominent jurists like California Supreme Court Justice Roger J. Traynor or prominent attorneys like University of Texas School of Law Dean W. Page Keeton. In 1990, the Annual Argument was replaced by the first annual Frederick G. Fisher Jr. Memorial Lecture, also presented at the ABA or Business Law Section’s Annual or Spring Meeting until the COVID-19 pandemic upended all in-person meetings in 2019.

Along with the report on the twenty-fifth Annual Meeting, the Quarterly Report announced the Conference’s first annual law student writing contest, cosponsored by the ABA’s Law Student Program. For first, second, and third prizes of $500, $250, and $150, respectively, which in those days could pay for a significant portion of a year’s law school tuition, contestants were to write essays of not more than 2,500 words on a question about current interest rate caps in state statutes and constitutions where case law permitted amounts paid to third parties for collateral expenses to be charged, but not always if the lender’s employees rendered such services. The question to be answered was this:

What is the present state of the law, and what should be the policy of the law, with respect to reasonable charges made by the lender for services rendered by the lender or his staff? Should the lender be permitted to or should it be prohibited?^[8]

From its beginning through the commencement of the Quarterly Report, the Conference was largely concerned with the state laws that regulated, or failed to regulate, small personal loans and with case law developments on that subject because no federal law existed at that time that dealt with consumer finance issues. Even the UCC was nothing more than a gleam in some law professors’ eyes at that time.

When the UCC became a reality, it was clear to the leaders of the Conference that this was a momentous change, particularly the provisions of Article 9 that dealt with security for financial transactions. This development led Richter to produce a six-part series from the Winter 1951 issue through the Summer 1953 issue in which he and five other authors thoroughly explained what was in Article 9 and its ramifications for personal finance.

During this period, the Conference also began to sponsor stand-alone programs that presented panel discussions on the latest developments in consumer finance law for the benefit of the practicing bar. The first such program was presented at the New York University Law Center in April 1953.

The Next Generation

The early 1970s marked momentous changes for the Conference as the founders retired to emeritus status or passed away. The first federal consumer law, the Truth in Lending Act (“TILA”), which imposed a uniform system of disclosures on all forms of consumer credit but left interest rates for the states to regulate, was enacted in 1968. This was followed by many more federal laws that regulated consumer finance. The Federal Reserve Board also drafted sets of implementing federal regulations for these statutes that grew in length and complexity as the years rolled by.

Fig. 8: Lawrence A. Young.

Fig. 9: Alvin C. Harrell.

The Changing of the Guard

As the new federal regulatory regime for consumer finance emerged, a new editor for the Quarterly Report, Lawrence A. Young (1943–2022) (figure 8), who started his career at Beneficial Finance in New Jersey and then had a long private practice at firms in Houston, succeeded Twinem in 1977. Young edited the Quarterly Report through mid-1984, when Bernice B. Stein took over. She in turn was succeeded in 1988 by Alvin C. Harrell (figure 9), professor at Oklahoma City University School of Law, who edited the Quarterly Report until his retirement in 2017. Harrell also edited the “Annual Survey on Consumer Finance Law” in The Business Lawyer for twenty-two years, until 2013.

The leadership of the Conference also changed. Fisher, mentioned above, succeeded Richter as chairman from 1980 until his death in 1989. As Young often told the story at the start of the Frederick Fisher Memorial Program at the Spring Meeting of the ABA Business Law Section, a young Fred Fisher came to the public’s attention in 1954 when he was attacked by Senator Joseph McCarthy as a suspected Communist in an attempt to smear his boss, the U.S. Army’s counsel, Joseph Welch of Hale and Dorr, during the McCarthy-Army hearings in which McCarthy accused the Army of harboring Communists. Welch’s emotional defense of Fisher during the televised hearings turned the public mood against McCarthy and led to his eventual disgrace and downfall. During Fisher’s long tenure at Hale and Dorr, he held many positions in the ABA and became president of the Massachusetts Bar Association from 1973 to 1974.

Fig. 10: Walter F. Emmons.

Fig. 11: Lawrence X. Pusateri.

Upon his death, Fisher was succeeded as chairman by Walter F. Emmons (1928–2013) (figure 10) for two years and then by Lawrence X. Pusateri (1931–2005) (figure 11) from 1993 to 1998. Pusateri was the first summa cum laude graduate of DePaul University College of Law in Chicago when he graduated in 1953 and had a varied and interesting career thereafter. As an assistant staff judge advocate in the U.S. Army from 1954 to 1957, he was a prosecutor in the famed Bamberg, Germany, rape trial in which the seven defendants were convicted, which became the subject of the movie Town Without Pity in 1961. He then served two terms in the Illinois House of Representatives and became president of the Illinois State Bar Association. After serving as a justice of the Illinois Appellate Court, Pusateri reentered private practice and focused on consumer finance law.

Changes in the Quarterly Report

Young once told the author of this article that the Quarterly Report was “pamphlet-sized” before Harrell became its editor. This was confirmed by surveying the extant issues. The Quarterly Report under Twinem as editor had about 80 pages per year in 1947 and 1948, then grew to 100–160 pages from 1959 to 1976. Under Young as editor, it had a range of 76–108 pages from 1977 through 1984; it then had a range of 56–64 pages through 1987 under Stein as editor. One noticeable feature for today’s reader is the almost total absence of footnotes in the Quarterly Report from 1946 through 1987.

When Harrell became editor in 1988, the Quarterly Report suddenly became a full-fledged law review, with every article thoroughly footnoted. It also mushroomed in size, going from 56 pages in volume 41 under editor Stein to 224 pages in volume 42 under Harrell—and then to 274 pages in volume 43 and 398 pages in volume 45. Law professors’ articles began to be published with some frequency.

Even before the panoply of federal laws regulating consumer finance began to be enacted in 1968, the Quarterly Report’s growth in the 1950s reflected the expansion of its coverage beyond the regulation of personal loans. Consumer bankruptcy law, a subject of great importance to small loan lenders, became a frequent topic. Each state’s enactment of the UCC was chronicled. Mortgage lending and auto finance also became important topics.

In the 1960s and 1970s, each new federal consumer finance law received suitable coverage in the Quarterly Report, as did the development and state enactment of the Uniform Consumer Credit Code (“U3C”). For example, just as when Article 9 of the new UCC was discussed at length in a six-part series of articles, the proposed disclosure regimens in the TILA and the U3C were introduced to the readership of the Quarterly Report in 1967. When the TILA became law, another article explained what was in the final enactment. The “private attorney general” provisions of the TILA that enabled and encouraged private litigants to file class actions, which have been a fruitful source of employment for consumer finance litigators as well as fertile ground for legal commentators to the present day, were also covered in an early Quarterly Report article. The 1967 Annual Argument dealt with the question of whether a federal statute could validly prohibit discrimination by lending institutions well before the Equal Credit Opportunity Act was enacted in 1974.

The CCFL and the Quarterly Report Enter the Twenty-First Century

Fig. 12: Jerry D. Bringard.

At the turn of the twenty-first century, the CCFL’s leadership began a regular rotation. Jerry D. Bringard (figure 12), who had been president for six years during Pusateri’s chairmanship, became chairman for two years from 1999 to 2000. Young then became chairman from 2001 to 2002. The rotation of officers became institutionalized when the Governing Committee of the CCFL adopted bylaws in 2003. Three-year terms were established for the chairman, who was to be automatically succeeded by the president when the term ended, and the other officers.

The turn of the twenty-first century also brought programming changes to the CCFL. Harrell greatly expanded the CCFL’s programming by instituting specialized two-day seminar programs for bankruptcy, debt collection, mortgage lending, and auto finance in addition to an annual two-day overall compendium of consumer finance law issues similar to the Conference’s original 1953 consumer finance law program. However, attendance at the programs dwindled following the foreclosure crisis of 2007–2008 as financial institutions cut back on personnel and expenses. By the time Harrell presented Consumer Credit 2011 in October of that year, it had become uneconomical for such programming to continue, and the CCFL exited the legal education field.

Consumer finance law developments did not cease during this period, however, and the Quarterly Report continued to cover them in depth. The page count grew to a peak of 516 pages in 1994 and continued in the range of 300 or more pages from 1995 to 2005. Volume 60 carried a record 722 pages in 2006—and then the record was broken with 954 pages in volume 61. For the rest of Harrell’s tenure as editor, the Quarterly Report comprised 300 or more pages per volume. A myriad of consumer finance topics was covered, paying close attention to state law developments as well as all of the federal law developments both before and after the landmark sixteen-title Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in 2010 and a new federal agency, the Consumer Financial Protection Bureau, was created to oversee the federal law end of things.

Following Harrell’s retirement in 2017, changes were made to streamline the Quarterly Report and to more fully engage the members of the Governing Committee, which now has more than one hundred members drawn from law firms and in-house counsel offices in all parts of the country, in the operations of the CCFL. Professors Ramona L. Lampley and Chad J. Pomeroy of St. Mary’s University School of Law were recruited to serve as co–executive directors and coeditors of the Quarterly Report.

The CCFL reinstituted two-day seminars in 2016 in partnership with Loyola University Chicago School of Law and Texas A&M University School of Law. After the programs went virtual during the pandemic, live seminar programming resumed in 2022.

With an expanded group of officers as well as a large, diverse Governing Committee whose members are committed to participating in its mission to “encourage study and research in the field of consumer finance law,” to “promote, through education, the sound development of consumer finance law,” and to “provide a forum through which interested persons may exchange opinions,”^[9] the CCFL is well positioned to continue for its second century to exercise the leadership that it has exercised in this field since 1927.

John L. Ropiequet is of counsel to the Litigation Group at Saul Ewing LLP’s Chicago office, where he has practiced since 1973. John was chairman of the Conference on Consumer Finance Law from 2015 to 2018, is a fellow of the American College of Consumer Finance Lawyers, and has been coeditor of the “Annual Survey on Consumer Finance Law” in The Business Lawyer since 2012. He is also coeditor of The Law of Truth in Lending (4th ed. forthcoming 2023), has published scores of articles in The Business Lawyer and other publications, and is the author of countless thousands of footnotes.

1. See John M.A. DiPippa, Reginald Heber Smith and Justice and the Poor in the 21st Century, 40 Campbell L. Rev. 73 (2018) (abstract), https://scholarship.law.campbell.edu/clr/vol40/iss1/3/. ↑

2. See Justice and the Poor, https://en.wikipedia.org/wiki/Justice_and_the_Poor (last visited Dec. 23, 2022). ↑

3. Reginald Heber Smith, 1889-1966, 52 Am. Bar Ass’n J. 1138 (1966) ↑

4. See Jackson R. Collins, DeVane K. Jones & Reginald Heber Smith, Memorial Statement, 4 Q. Rep. 3 (1949). ↑

5. See id. at 4. ↑

6. Id. ↑

7. Id. at 3. ↑

8. See Announcement – 1953-54 Essay Contest, 7 Q. Rep. 98 (1953). ↑

9. See Mission Statement, 75 Consumer Fin. L.Q. Rep. ii (No. 4, 2021). ↑

Insurers like to make their coverage obligations someone else’s problem. One of the ways they do this is by saying that another insurer has to go first. In other words, insurers will sometimes take the position that another insurer has to pay its full policy limit before the first insurer pays anything. The insurers play this finger-pointing game by citing the “other insurance” provision, which is standard in most liability insurance policies. In certain circumstances, courts will “cancel out” dueling “other insurance” clauses and require each insurer to pay on a 50–50 basis when coverage truly overlaps. Other times, courts will establish a “proportional” split of responsibility if one insurer provided higher limits than the other insurer when multiple policies are triggered. As always, the precise words of the insurance policy will directly impact a court’s analysis of the disputed coverage provisions. Recently, the New Jersey Supreme Court tackled another “other insurance” dispute that does not often garner much attention but may be important for corporate policyholders to consider, especially if those policyholders “self-insure” a significant part of their insurance program. 

In Statewide Insurance Fund v. Star Insurance Company, a young boy sadly died on the beach in Long Branch. His family sued the town, and they settled the case. Long Branch was part of a “joint insurance fund,” or “JIF,” administered by Statewide, which was an organization of towns in New Jersey that pooled their resources and insurance risk exposures in one fund up to a certain threshold—$10 million. Long Branch also had a separate policy of insurance issued by Star that provided a $10 million limit. When Long Branch settled the claim with the family, Star refused to contribute, taking the position that it was “excess” coverage and Star was on the hook only after “other insurance,” i.e., the Statewide funding, was exhausted. Statewide filed a declaratory judgment action seeking to establish that its coverage was excess to any coverage provided under the Star policy. 

Sorting through the finger-pointing, the New Jersey Supreme Court determined that Star was solely responsible for the settlement of the claim. The Court took the commonsense approach that so-called “self-insurance” is not really “insurance” at all when considering the “other insurance” provision contained in the Star policy. That is because in a self-insuring pool such as the JIF, “members retain significant risk by paying claims from member assessments,”^[1] and the Court readily acknowledged that such risk pooling stands in stark contrast to typical insurance, where an insurer takes on risk in exchange for the payment of a premium. Accordingly, the Court held that the money Long Branch could get from the JIF was not “other insurance” and that Star had to honor its promise to serve as the primary insurer and was first in line to pay the claim.

The Court’s opinion makes clear that if an insured is responsible for its own loss, it is not to be considered “insured” at all and, therefore, should not lose the benefit of actually valid and collectible insurance available elsewhere. While insurers likely will want to declare this decision is an “outlier” or limited to the “unique” facts of a risk pooling program, the holding of Statewide has far broader implications because it draws a clear distinction between “self” insurance and “real” insurance.

Many corporate policyholders utilize “self” insurance to serve as primary coverage through captive insurance programs or by carrying large self-insured retentions and then having “real” excess coverage. In fact patterns where that same policyholder has additional insured rights under another party’s insurance policy—for example, in the context of a construction defect claim where an owner may have its own insurance coverage and have rights under insurance policies held by general contractors (GCs) or subcontractors—the “other insurance” clause may rear its head again. Insurers for the GC and/or the subs may try to draw the owner into paying for some or all of a claim by invoking their “other insurance” provisions. Relying on Statewide, owners now have an additional arrow in their quiver to push back against that contribution demand. Rather, owners would have the ability to take the position that they have no “other insurance” available because they are self-insured and the GC and subcontractor insurers are first in line to pay.

At bottom, corporate policyholders that utilize captive or fronting insurance, carry large self-insured retentions, or employ other bespoke risk transfer mechanisms need to take a careful look the next time they are told by an insurer that it wants to head to the back of the payment line based on an “other insurance” clause. As the Statewide decision demonstrates, the nuances associated with insurance programs and coverage disputes are complex but also important. Any policyholder that receives a denial of coverage based on an “other insurance” clause will be well served to review that disclaimer with experienced coverage counsel before agreeing to accept responsibility for any payment obligation.

1. Statewide Ins. Fund v. Star Ins. Co., — N.J. — (Feb. 16, 2023) (slip op. at 16) (emphasis deleted). ↑

The U.S. Trustee Program’s (USTP) rule entitled Uniform Periodic Reports in Cases Filed Under Chapter 11 of Title 11 (Final Rule) became effective on June 21, 2021, and provided for the filing of a single Monthly Operating Report and a single Post-Confirmation Report in non-small business Chapter 11 cases.^[1] This article highlights key benefits of the two reports, provides an update on enhancements made to the reporting process since June 2021, and shares important practice tips.^[2]

The New Reports

To help bankruptcy professionals transition to the new Monthly Operating Reports (MORs) and Post-Confirmation Reports (PCRs), USTP staff provided training nationwide on how to complete, finalize, and file the new forms. In July 2021, the first new forms were filed, and since then bankruptcy professionals have filed thousands of MORs and PCRs with bankruptcy courts across the country. The bankruptcy community appears to have made a smooth transition to reporting under the Final Rule. The success of the transition is a credit to the bankruptcy community and reflects the shared and ongoing commitment to greater transparency and efficiency in the bankruptcy system.

Benefits of the New Reports

In addition to the uniformity and consistency provided by having a single MOR and PCR for use in every non-small business Chapter 11 case, the updated forms confer several other new and important benefits.

Modernization: The new MORs and PCRs represent a significant advance in Chapter 11 periodic reporting. The data-embedded “smart forms” allow users to enter and save data in interactive, fillable PDF forms. Plus, with embedded data, the forms offer enhanced searching and extraction capabilities. To simplify data extraction, the forms employ standard barcode technology used widely across government and industry, such as on postage stamps, RealID driver licenses, common carrier shipping labels, and boarding passes issued by commercial airlines. To enhance the user experience with periodic reporting, the USTP introduced MORs and PCRs that are compatible with Windows and Mac operating systems.

Simplicity: The MOR and PCR forms contain easy to understand questions and are accompanied by clear and concise instructions that guide filers through the steps required to complete, save, and finalize reports for filing with bankruptcy courts on CM/ECF.

Transparency: Transparency is a vital pillar of the bankruptcy system. To advance that important interest, the Final Rule requires that MORs and PCRs be filed with bankruptcy courts on CM/ECF. Prior to the effective date, there was no universal filing requirement. Publicly accessible reports promote transparency by providing non-party stakeholders—including members of Congress, the public, academics, and the press—access to information across cases and districts. With greater access to data summarizing Chapter 11 debtors’ post-petition operations, stakeholders can more effectively analyze and report on the operational results of the bankruptcy system.

Enhancements to the Reporting Process

The Final Rule, new forms, and accompanying instructions are the byproduct of the USTP’s collaboration with numerous stakeholders in the bankruptcy system, both before and after the effective date. In response to internal and external stakeholder feedback, the USTP acted quickly to implement certain items that already have enhanced the reporting process. Some key examples follow.

The USTP recognized the need for an efficient and effective way to share important information about periodic reporting with stakeholders across the country. To fulfill that need, the USTP created the “Chapter 11 Operating Reports Email Updates” feature on its website. Presently, almost 1,000 stakeholders nationwide have enrolled to receive email updates from the USTP about periodic reporting. Recent updates were provided in late 2022, when the USTP: (i) announced that updated instructions for MORs and PCRs were posted on its website for immediate use; and (ii) explained how to avoid a mismatch between data reflected on the face of a form and the data embedded in the barcodes by highlighting the need to generate new barcodes any time a report is edited after the “Generate PDF for Court Filing and Remove Watermark” step has been completed.

In December 2021 (about six months after the effective date of the Final Rule), the USTP incorporated barcode technology into the MOR and PCR forms. The barcodes contain the embedded data reflected on the face of the forms, and they provide visual confirmation that the forms have been finalized properly for filing with the bankruptcy court on CM/ECF. Specifically, the presence of barcodes signifies that each field on the form has been completed and that the forms’ data embedded features have been activated properly, thereby preventing the filing of incomplete or flattened forms. The barcodes are generated at the end of the forms automatically after filers complete the “Generate PDF for Court Filing and Remove Watermark” step. Additionally, the barcodes further the Congressional mandate in the Bankruptcy Abuse Prevention and Consumer Protection Act that the new forms “facilitate compilation of data” and maximize public access to the data contained on the forms by providing parties-in-interest, the public, academics, and the press an efficient means of aggregating data from a high volume of reports filed across the country.^[3]

The USTP has also helped several national financial advisory firms transition to reporting under the Final Rule. These firms routinely represent hundreds of debtors in large cases across the country. In addition to answering substantive, procedural, and technical questions through ongoing discussions, the USTP provided schema and data dictionaries for the MORs and PCRs to help the firms design electronic tools to expedite the process of populating individual reports for debtors in large jointly administered Chapter 11 cases. During the ongoing collaboration, the USTP also tested numerous forms prepared by the firms to ensure that their respective methods successfully embedded data in the new forms.

In response to stakeholder feedback received since the effective date, the USTP issued updated Instructions for both the MOR and PCR forms in December 2022. With several substantive, procedural, and technical revisions, the updated Instructions help clarify certain questions raised by stakeholders. The updated Instructions are available on the USTP’s website.

An important feature of the USTP’s commitment to efficiency in the reporting process is the on-demand technical support that it provides to all stakeholders. In addition to offering user-friendly “Troubleshooting Tips” on its website, the USTP provides email access to a team dedicated to responding to technical inquiries related to MORs and PCRs. By emailing inquiries to [email protected], stakeholders can obtain individualized assistance when the need arises. The USTP immediately acknowledges receipt of every email with an automated response that provides troubleshooting tips addressing many commonly asked questions. Quite often stakeholders quickly reply to the automated response indicating that it was all they needed to resolve their inquiry. For instance, one of the most common inquiries involves stakeholders using the prior version of the forms that were deactivated and removed from the USTP’s website in December 2021. Once directed to the active forms on the USTP’s website and provided a hyperlink for quick access, those inquiries are resolved. If these common answers do not resolve the issue, a USTP representative contacts the inquirer directly to work out a solution. Since the effective date in June 2021, the USTP team has successfully resolved hundreds of inquiries from across the country.

On the rare occasion when inquiries are too complex to be resolved by email, the USTP team engages with stakeholders telephonically or by video conference. In one recent instance, a debtor’s counsel had difficulty generating barcodes on an MOR despite using the correct version of the form and following the instructions step by step. To ensure that the forms could be finalized and filed prior to the impending deadline, two members of the USTP team immediately video-conferenced with counsel, working together for an hour. During that time, the USTP team not only diagnosed and corrected the problem—an incorrect default computer setting—but ensured that counsel understood how to finalize and file forms on their own. Since then, counsel has continued to file forms without the need for further USTP assistance.

Whether substantive, procedural, or technological, the post–effective date enhancements will continue to promote the efficiency and transparency of the reporting process.

Practice Tips

Efficiency in the bankruptcy process is a mission priority for the USTP. To further that priority, the USTP recommends that stakeholders responsible for preparing or filing MORs and PCRs adopt the practice tips that follow.

• Take the time to become familiar with the reports and the completion and filing processes. Get acquainted with the periodic reporting resources that the USTP offers by visiting its “Chapter 11 Operating Reports” webpage where stakeholders can find updates, forms, Instructions, Troubleshooting Tips, and other resources and information.
• Always start your reports by downloading the latest version of the form from the USTP website. To start the reporting process, download the latest version of the MOR or PCR form from the USTP website. Be sure to select the form that is compatible with the filer’s operating system (i.e., Windows or Mac). After downloading the MOR or PCR, launch Adobe Reader or Adobe Acrobat to complete the PDF version of the form—do not attempt to complete the form in an internet browser. For step-by-step assistance with this process, consult the Guide for Opening the MOR/PCR Forms posted on the USTP’s website. Note that once you download the latest version of the forms, you can begin by working from an editable version from a prior reporting period, rather than downloading a new form each month or quarter.
• Always complete the forms electronically without inserting or attaching anything. Complete the MOR and PCR forms electronically and do not flatten the forms when finished (i.e., do not print and scan the forms before filing). In addition, do not insert or attach additional pages to the forms. Any supporting documentation, including exhibits, explanatory notes, or bank statements, must be filed as separate PDF attachments.
• Follow the MOR or PCR instructions to prepare your reports for filing. Once all the required information has been entered onto the MOR or PCR and an editable version has been saved, select the “Generate PDF for Court Filing and Remove Watermark” button at the end of the form. Although this step will not file a report with a bankruptcy court, it is required to remove the watermark, embed data, and generate barcodes on the report. To ensure that all data is embedded in the version of the form to be filed with the bankruptcy court, do not edit a report after the watermark has been removed. If last-minute changes to a report are required, revert to the editable version of the report and simply repeat the “Generate PDF for Court Filing and Remove Watermark” step after making the edits. For step-by-step guidance on this process, consult the Instructions for the MOR and PCR posted on the USTP’s website.
• File your reports using the correct CM/ECF docket entry as a stand-alone PDF. When filing forms with the bankruptcy court, select the correct docket entry on CM/ECF established by the local court for MORs or PCRs. In addition, file all pages of each report, including all barcodes. File each report as a stand-alone PDF, and do not combine multiple reports or barcodes into a single PDF.
• Use the technical assistance available on the USTP website and through a dedicated help email. Visit the “Troubleshooting Tips” page on the USTP’s website for technical guidance. If further assistance is required, filers can request technical assistance with MORs and PCRs by emailing inquiries to [email protected]. The USTP has a team dedicated to responding to MOR- or PCR-related technical inquiries. Case-related inquiries may be directed to the local USTP office overseeing the Chapter 11 case, as before.
• Sign up for the USTP’s subscription service to receive all updates on the forms and Instructions. Finally, stay informed by taking advantage of the USTP’s subscription service. Subscribers will receive emails about updated forms, Instructions, and other important information related to periodic reporting under the Final Rule. To subscribe, visit the Chapter 11 Operating Reports webpage.

Conclusion

Periodic reporting remains a vital part of every Chapter 11 case. Fiduciaries have an obligation to account for estates’ operational and financial performance, both pre- and post-confirmation. With those fiduciaries reporting on the modernized and streamlined MORs and PCRs for over a year now, stakeholders in the bankruptcy system have benefitted from increased uniformity, consistency, and transparency. With almost 39,000 MORs and PCRs filed with bankruptcy courts across the county, the USTP is encouraged by stakeholders’ performance under the Final Rule, and it looks forward to the enhanced efficiency and transparency in the bankruptcy system that the new MORs and PCRs provide.

1. 28 C.F.R. § 58.8. The forms promulgated under the Final Rule are designated as UST Form 11-MOR and UST Form 11-PCR. These forms are applicable only in judicial districts where the USTP operates. ↑

2. For an extensive discussion of the rule-making process, including discussion of the public comments, testimony at the public hearing and the USTP’s response, refer to the article entitled Introducing the USTP’s New Chapter 11 Periodic Reports, published in the February 2021 edition of the American Bankruptcy Institute Journal, at page 24. ↑

3. 28 U.S.C. § 589b(b). ↑

As cybercriminals become increasingly sophisticated, they find new ways to infiltrate systems and disrupt operations. Corporations, legal and other firms, nonprofit organizations, academic institutions and government agencies are among the countless victims of data breaches every year.

Until recently, breaches largely involved encryption where threat actors accessed networks and locked down systems, causing business interruption and often demanding a ransom for their release. While this tactic remains a common tool in most breaches, the growing threat that emerged in 2022 is incorporating data exfiltration into the toolkit. Now—with increasing frequency—multiple threat factors are becoming involved in a single incident: encrypting systems, stealing and selling data they have accessed, and threatening to expose the fact that an organization’s data was stolen unless they are paid the requested ransom. Among the many breaches experts handled in Q4 of 2022, very few did not include an element of exfiltration, which is in stark contrast to the first half of 2020, where less than 30% of data extortion incidents included exfiltration.

Due to the rise of exfiltration, lawyers should be on guard and ensure they are compliant with Rule 1.6(c) of the American Bar Association’s Model Rules of Professional Responsibility: “A lawyer shall make reasonable efforts to prevent the inadvertent or unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.” If lawyers do not take “reasonable efforts,” they may risk sanctions, disbarment, and legal liability in the event of a data breach. The ABA issued an opinion^[1] on Model Rule 1.6 clarifying that what constitutes a reasonable effort is not a “hard and fast rule,” but rather a flexible set of factors that are weighed on a case-by-case basis.

The ABA opinion’s factors to be weighed include:

• the sensitivity of information;
• the likelihood of disclosure if additional safeguards are not employed;
• the cost of employing additional safeguards;
• the difficulty of implementing the safeguards;
• and the extent to which the safeguards adversely affect the lawyer’s ability to represent clients.

The ABA Standing Committee on Ethics and Professional Responsibility stresses that attorneys should assess the risk of inadvertent disclosure of client information before connecting to unsecure networks, using computers and servers without anti-virus software, and sending unencrypted communications.^[2]

In some cases of data exfiltration, the threat actors download a copy of the data; in other cases, they download a copy of the data and then also delete it from the network from which it was taken. The latter scenario reinforces the importance of regularly backing up all systems and the data they contain, so that in the event of deletion during a breach, the organization can reinstall a recent version of that data to reduce the impact on regular business operations.

Once stolen, data is often sold or threatened to be sold. Data may be posted on the dark web, or the threat actor may have a buyer already identified before the theft. Regardless of what the criminals do with exfiltrated data, dealing with this type of breach is a logistical nightmare. In many cases the stolen data includes trade secrets or the personally identifiable information of employees and/or clients of the organization, posing a substantial risk to everyone involved.

Among the growing impacts of data breaches is the risk of class-action lawsuits. As more people understand the effects of having their data compromised, more are taking action by initiating or joining class actions. And this isn’t limited to breaches that occur in large organizations like Equifax, Twitter, or Uber, for example. Smaller companies dealing with breaches affecting as few as 1,000 data subjects—small by previous standards—are now facing litigation as well. While the number of impacted data subjects may be relatively small, the scope of the impact felt by the data subjects and the organization is often the same as in larger breaches.

Companies can’t do much to prevent these lawsuits once a data breach has occurred, but they can take steps to help mitigate the consequences:

• Pre-event: Establish strong security protocols upfront, which will help in passing a reasonableness test in the event a suit is filed. If an organization can prove to a court that it took reasonable care in protecting customer data and to prevent a breach, it is more likely to prevail against negligence claims in a suit. Examples of reasonable security measures an organization might point to include having a dedicated security officer, maintaining ISO 27001 and SOC 2 certifications, mandating multi-factor authentication, and providing quarterly cybersecurity training for all employees.
• Post-event: Likewise, if the company can demonstrate it has followed all regulatory compliance requirements, met deadlines, and taken reasonable and necessary steps to address the situation without delay and with as much transparency as possible, it can lower the risk of penalties and fines.

Key tips for dealing with cyberattacks:

1. Lawyers should ensure that their organizations or clients take every incident seriously and put in place mandatory, periodic employee cybersecurity training to help employees understand what incidents might look like, how to prevent them, and to immediately report anything suspicious to IT. From a compliance perspective, lawyers should instruct their organizations or clients not to dismiss something strange as nothing if they do not encounter any immediate impacts, as the company may be vulnerable to a further attack or breach at a later time. Recently a Reddit employee contacted Reddit’s IT department shortly after falling victim to a spear-phishing attack—which led to a website that cloned Reddit’s internal systems and allowed threat actors to steal credentials and second-factor tokens. Had the employee not made that notification, the results could have been disastrous.^[3]
2. The legal department should be informed immediately of a potential incident and should encourage the organization or their client to take immediate action. This is important from both a compliance and mitigation standpoint, as well as the potential for privilege to apply to certain communications in the case of post-event lawsuits. Do not delay, and do not assume that a threat has been resolved once it has been identified, as it may be ongoing. In the Reddit scenario discussed above, because the employee reported the incident right away and Reddit’s IT department took immediate action on the threat, the attacker’s window of opportunity was reduced, and the damage was limited.
3. Lawyers should instruct their organizations or clients to consider retaining a third-party digital forensics expert to verify the risk is contained and that it is safe to conduct business. Digital forensics experts can check all systems and networks to ensure the threat is resolved and that there is no additional risk of ongoing or subsequent threats. This will provide the company and its customers with peace of mind and will limit the business repercussions, to a degree. The third-party digital forensics report and corresponding forensics expert can provide compelling facts in eventual litigation as well.

Importantly, an ounce of prevention is worth a pound of cure. Cybersecurity awareness training remains a critical function for every organization, but it typically does not get the attention it deserves. Threats are constantly evolving, so your training should, too. Keep all employees up to date on the latest protocols and best practices to prevent breaches, as they are your first line of defense against cyberattacks.

1. See American Bar Association Standing Committee on Ethics and Professional Responsibility, Formal Opinion 477R*. Issued May 11, 2017, revised May 22, 2017. Pages 4–5. Available at: https://www.americanbar.org/content/dam/aba/administrative/professional_responsibility/aba_formal_opinion_477.pdf. ↑

2. See id. at pages 6–7. ↑

3. See Reddit Press Release, “We had a security incident. Here’s what we know.” February 5, 2023. Available at: https://www.reddit.com/r/reddit/comments/10y427y/we_had_a_security_incident_heres_what_we_know/. ↑

Mergers and acquisitions (M&A) play a major role in modern economies. Since 2010, there have been more than 500,000 merger and acquisition deals worldwide. According to Statista, in 2021 alone, there were more than 63,000 international M&A transactions.

Due diligence is an essential part of the M&A process. However, many obstacles can get in the way of effective due diligence, including language barriers and cultural differences. This is where legal translation steps in: this specialized field can help smooth the way to a successful transaction.

The Importance of Legal Translations in the M&A Due Diligence Process

The purpose of due diligence during an M&A transaction is to gather all the information needed about the target company to determine if a deal is viable. This allows businesses considering a merger or acquisition to pin down the potential risks and opportunities in the transaction.

Language barriers and cultural differences can complicate due diligence in international M&A transactions. Each country and region has its own legal system and regulations, so any lack of knowledge of these specific complexities can lead to a deal falling apart. Cultural differences can also bring about misunderstandings and miscommunication, which can negatively impact the overall success of the deal.

This is where legal translation services become essential. This domain of translation not only requires that translators be fluent in another language, but they must also have an in-depth understanding of the legal systems of both invested parties as well as cultural awareness and knowledge of specific legal jargon.

Legal translations are crucial in ensuring that cross-border transactions are free of any miscommunication and misunderstandings; certified translation of any foreign-language documentation involved in the process can ensure that the language barrier won’t be a reason a deal is not successful.

Translating contracts and agreements ensures that both parties are on the same page and that their obligations, rights, and liabilities are all properly met. By translating financial statements, parties can have a detailed analysis of the target company’s financial performance, which is critical in determining the deal’s viability.

Despite the rise of AI translation software, it is essential to have language professionals who are specialized in legal translations as part of the process, as there are aspects of law and linguistic nuances that machine translation is not able to reliably convey. Language professionals can also be held responsible if any aspect of the translation goes awry.

Best Practices for Legal Translation in M&A

How do you ensure that a legal translation meets the criteria of something as complex and integral to the M&A process as due diligence? Here are a few of the best practices you can implement to guarantee you are on the path to success.

1. Work with Legal Translators Specialized in M&A

Not all legal translators have experience dealing with corporate finance due diligence and M&A. That’s why it is important to make sure you collaborate with an expert in the field who has experience in the specific countries relevant to the deal. This will help ensure that all the needed information has been laid out effectively.

2. Develop Cultural Awareness

An M&A deal is the beginning of another chapter for the companies involved. The long-term success of an M&A transaction depends on how management is prepared to assimilate into the new culture. Translations during the deal process facilitate effective information sharing and therefore serve as a way for both parties to develop trust and transparency.

3. Quality Assurance and Accuracy

Many legal translation services have documents undergo a thorough quality assurance process that involves the use of state-of-the-art translation tools and human expertise to evaluate the translated documents’ clarity and accuracy. It’s also vital that, from your end, you conduct quality assurance and review documents to ensure that all the details are found in the agreement.

4. Data Security and Privacy

The pandemic didn’t just bring change to the process and practice in due diligence for M&A, but it also changed how transactions are being made. As remote work and hybrid arrangements have become prevalent and more deal closings are occurring digitally, concerns about data security and privacy protocols in place have become more significant. It is important to ensure that the platform used for sharing translations and other aspects of a transaction is secure.

Conclusion

Although according to PwC’s 26^th Annual Global CEO Survey 73% of CEOs didn’t have a positive view of global economic growth in the coming year, about 60% of them stated that they do not plan delay deals in 2023. International M&A due diligence will continue to be important, and having experts in legal translations to bridge cultural and linguistic barriers is a necessity. Businesses looking to close global deals should consider the impact of legal translations on their due diligence process and use the best practices in this article to help minimize the risks and maximize the opportunities associated with cross-border M&A transactions.

Lisa Stark, Business Law Today editor-in-chief: Judge Montgomery-Reeves, you have been hailed as a trailblazer—the first-ever African American to serve as a Vice Chancellor of the Delaware Court of Chancery as well as the first African American associate justice and the youngest jurist to sit on the Delaware Supreme Court. You recently started a new position as a federal judge on the Third Circuit Court of Appeals, having been nominated by President Biden, in June 2022. 

What have been the key drivers of these tremendous accomplishments?

Judge Tamika Montgomery-Reeves: The two main reasons for my career accomplishments are sponsorship and timing. As I have said before, no one gets very far alone in life. I am here because I stand on the shoulders of giants. Many people came before me, in Delaware and on the federal bench, and those people paved the way for me to follow. I also have been extremely fortunate to have people, like former Chancellor William B. Chandler III, who not only mentored me but sponsored me during my career. Finally, I think it is important to put your name in the hat and to take chances on yourself, even if the timing and circumstances are not exactly what you had planned.

Lisa: Did you always want to be a judge?

Judge Montgomery-Reeves: I knew I wanted to be a lawyer in elementary school. I first developed an interest in the law from my grandmother. She grew up in Mississippi, and while she was not highly educated, she talked to me all the time about the importance of the law and knowing your rights. She talked to me about the inequities she witnessed growing up in Mississippi in the 1930s and 1940s, and she influenced me to pursue the study of law.

Lisa: What do you most enjoy about your job?

Judge Montgomery-Reeves: Finding the right answer. My role as a judicial officer is to study the record before me and the applicable law and come to the correct outcome based on that.

Lisa: Who have been the biggest influencers in your career trajectory?

Judge Montgomery-Reeves: My judicial mentor is Chancellor Chandler. He is very smart, and he works very hard. When I worked with him, he was in early, and he stayed late. He was constantly studying all things corporate law. He was a titan in corporate law, but you would never know that from the way he treated people. Every litigant, lawyer, law clerk, really anyone he encountered, he treated with the utmost respect. He is a person who cares deeply about other people, about making sure that everyone feels heard and is treated fairly, and you can see that in every interaction he has.

Lisa: You have worked to improve diversity in the judiciary. Is that something that you feel passionate about?

Judge Montgomery-Reeves: I think the judiciary should reflect the population it serves. And I think this for two reasons. First, having the judiciary reflect the whole population fosters trust in the judicial system, which is essential. Second, it allows children to see themselves in the people on the bench and start to think, “Hey, maybe I can do that too.”

Lisa: Studies have shown that more men than woman argue cases before the country’s high courts. What can we do to increase opportunities for women in the courtroom?

Judge Montgomery-Reeves: It is important that each of us recognizes that we all have the power to influence positive change whatever our position. For example, I make sure to treat every person before me, regardless of gender, with the same levels of engagement and respect. And I would encourage attorneys to consider who is arguing motions or presenting oral argument. If an associate drafted the motion, knows the entire record, and is going to prep the partner for argument, perhaps she should be the one arguing the motion instead.

Lisa: What are your favorite things to do when you are not on the bench?

Judge Montgomery-Reeves: I love to travel, eat good food, and spend time with my family and friends.

This article is adapted from The Fraudulent Transfer of Wealth: Unwound and Explained by David J. Slenn, available from the American Bar Association Business Law Section. Check out the related Book Chat video for more information.

Business Planning

Typical business planning transactions often can trigger fraudulent transfer law. Evidence of intent with respect to transactions involving an entity can be gleaned from direct evidence,^[1] but, like transactions involving individuals, is often gleaned from facts and circumstances. Resorting to the use of a business entity to hinder or delay creditors may result in avoidance under fraudulent transfer law.

In 1932, the Supreme Court decided a case involving a Pennsylvania lumber dealer who was unable to pay his debts as they came due and whose creditors were seeking payment. The dealer believed he could retain assets if a receiver was appointed. However, Pennsylvania did not permit the appointment of a receiver for a business conducted by an individual as distinguished from one conducted by a corporation. Consequently, the Pennsylvania dealer formed a Delaware corporation, then transferred all his assets in exchange for all the stock. The new corporation also assumed all the dealer’s debts. The dealer then sued in conjunction with a creditor against the new corporation.

Justice Cardozo noted the transfer to the corporation was fraudulent as well as the resulting receivership because it was part and parcel of a scheme whereby the form of a judicial remedy was to supply a protective cover for a fraudulent design. “A conveyance is illegal if made with an intent to defraud the creditors of the grantor, but equally it is illegal if made with an intent to hinder and delay them. Many an embarrassed debtor holds the genuine belief that, if suits can be staved off for a season, he will weather a financial storm, and pay his debts in full. Means v. Dowd, 128 U.S. 273, 281, 9 S.Ct. 65, 32 L.Ed. 429. The belief even though well founded, does not clothe him with a privilege to build up obstructions that will hold his creditors at bay.”^[2]

Limited liability companies

Because the asset protection trust is laced with evidence of intent to hinder creditors ab initio, the use of a limited liability company is tempting because it enjoys a disguise as a valid business entity unrelated to the owner’s personal creditor issues. However, if a creditor can show a debtor fraudulently transferred assets to an LLC (e.g., through a contribution of capital), the transfer to the LLC may be voided, just as a fraudulent transfer to a trustee of a trust may be voided.^[3] To the surprise of some planners, a contribution of capital in exchange for membership interests does not necessarily equate to “reasonably equivalent value.”^[4]

The limited liability company, and its charging order protection preventing creditors from reaching a member’s distribution until the LLC makes a distribution, is expressly permitted by most state laws. In a minority of states, an LLC need not have more than one member but still provide charging order protection. With an LLC, a veil of protection is created so that a business owner’s individual assets are protected from the claims of creditors of the business (inside creditors).^[5] This protection helps promote entrepreneurial spirit and is long recognized by the courts. “After all, there is nothing fraudulent or against public policy in limiting one’s liability by the appropriate use of corporate insulation.”^[6] But where the LLC is used as a trust substitute to protect assets from a member’s personal creditors, the member’s concern is not creditors of the business, but rather, the debtor’s personal creditors (outside creditors.)

LLCs as Trust Substitutes

Conceptually, the LLC is developing into a variant of the self-settled trust, where the rights of members and creditors are handled primarily by statutes, which in turn, permit the parties to do as they please under an operating agreement. This contrasts with centuries of developed case law and modern statutes adopting the case law as it applies to the use of trusts. With trust law, certain safeguards developed over time to protect creditors, the most obvious being the centuries old rule against self-settled trusts, which essentially provides one cannot use a trust to have his cake and eat it, too. The LLC and the law of contract, coupled with the benefit of not having to account to beneficiaries, are options for some to sidestep centuries of trust law and its protections for creditors and beneficiaries alike.

Today, some may attempt to enjoy the benefits of a self-settled trust in the form of an LLC. Managers can make decisions instead of trustees. The tax treatment can be replicated as well. A self-settled trust is usually treated as a so-called grantor trust in tax parlance, meaning the settlor pays the income tax on trust income. The LLC achieves the same result where it has a single member. This is because the default classification of a single-member LLC, for federal tax purposes, is to treat the LLC as disregarded (meaning all the tax consequences flow through to the member.)

The concept of a charging order has roots in trust law. At its core, a charging order is a lien on a debtor’s interest where a creditor has to wait for distributions to be made from a third party to the debtor before seizing the distributed property.^[7] In the trust setting, generally a court does not refer to this lien as a “charging order” but instead enters an order permitting a creditor to attach present and future mandatory distributions due to a trust beneficiary. If the trust is discretionary, a court may enter an order permitting garnishment of distributions when made in the discretion of a trustee.^[8]

According to section 736.0504(2), a former spouse may not compel a distribution that is subject to the trustee’s discretion or attach or otherwise reach the interest, if any, which the beneficiary may have. The section does not expressly prohibit a former spouse from obtaining a writ of garnishment against discretionary disbursements made by a trustee exercising its discretion. As a result, it makes no difference that the instant trusts are discretionary. Casselberry is not seeking an order compelling a distribution that is subject to the trustee’s discretion or attaching the beneficiary’s interest. Instead, she obtained an order granting writs of garnishment against discretionary disbursements made by a trustee exercising its discretion.^[9]

Where the trust is self-settled, generally, a creditor may reach the maximum amount that could be distributed to the settlor. Where a debtor does not contribute assets to a trustee but is merely a discretionary beneficiary of the trust (referred to as a third-party trust), the beneficiary’s interest generally is protected from creditors, at least until distributions are made.^[10]

Contrast with the LLC, which essentially takes a best of both worlds approach; the debtor-member may contribute assets to the LLC much like the debtor would a self-settled trust, however, the debtor-member is essentially treated as a beneficiary of a third-party trust because the LLC charging order statutes permit a creditor to reach distributions only if made by the LLC.^[11] If the LLC was treated like the self-settled trust, a creditor could, like a creditor of a beneficiary of a self-settled trust, take the maximum amount distributable to the member. With an LLC, this would mean foreclosing on the member’s interest, voting the member’s interest, etc.

But the LLC is not a trust; the LLC is a business entity. The charging order for purposes of trust law was meant to ensure a beneficiary could not thwart a creditor by enjoying the benefits of a trust despite an obligation to creditors. For LLCs (and partnerships), the charging order is justified on the grounds that a creditor should not step into the debtor’s shoes as a member of the LLC. Instead, the creditor may receive the same economic benefits the debtor member enjoyed. The goal with the LLC charging order is to prevent the creditor from interrupting other members of the LLC in conducting LLC business. But if there is no business other than dodging creditors, the public policy supporting the charging order weakens.

The law in some jurisdictions is written in a way that makes it difficult to disregard public policy. Like choice of law disputes in the trust context, debtors also attempt to hardwire the governing law of an operating agreement to force creditors to play by the rules of debtor-friendly states or countries.

In sum, the LLC is increasingly being used as a quasi-trust with the goal of protecting a member’s assets from the member’s personal creditors. Consequently, creditors who engage in discovery will look for evidence of the LLC serving as a personal use vehicle. This may lead to a court viewing the LLC as an alter ego or sham, permitting the creditor to reach the assets. Not only can general creditors rely on personal use evidence to reach assets, but the lack of a true business purpose can have negative consequences for federal tax law purposes.

Capital Contributions

In some cases, the contribution of an asset to a business entity is not meant to assist with business operations but instead intended to help the owner insulate the transferred asset from the claims of the owner’s creditors. Fraudulent transfer law provides a creditor with an opportunity to challenge the transfer of assets to a business entity.

In Firmani v. Firmani, the court reviewed debtor’s argument that the transfers to an LLC were made not to hinder a creditor, but for estate planning purposes. The court did not buy the excuse and found the transfer to the LLC to be fraudulent under an actual fraud analysis.

Defendants failed to present any substantial evidence to counter the strong inference of fraudulent intent established by these badges of fraud. Firmani submitted a certification which asserted that he established the Family Partnership and conveyed the Haddonfield property to this entity for “estate planning purposes.” However, we are unable to discern from Firmani’s certification how the transaction could have served any estate planning purposes, except by increasing the total amount of his estate by the $25,000 he seeks to avoid paying plaintiff and by the amounts of the judgments that certain casinos have against him. In any event, N.J.S.A. 25:2–25(a) does not require that an intent to hinder, delay, or defraud a creditor be the exclusive motivation behind a transfer in order for the transfer to be deemed fraudulent.^[12]

If more than one person transfers assets to an LLC, but only one person is a debtor, such that his transfer is voidable by a creditor, it should not matter if the transaction involved a non-debtor; one cannot insulate a fraudulent transfer by arguing the avoidance would complicate matters or affect another person’s interest. Such was the case in First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, where the debtor transferred his 50 percent interest in real property, together with the other 50 percent owner (Whiteman), to PDC, LLC. It should be noted that debtor offered evidence of his intent, which included legitimate business planning, to no avail.^[13] Despite the complications of unwinding a transfer to an LLC where some members do not have fraudulent intent, the court ruled in favor of the creditor:

Accordingly, we find the conveyances of Whiteman’s 50 percent interest and Clifton’s 50 percent interest to PDC were each distinct transfers that Whiteman and Clifton merely chose to accomplish in a single deed. The fact they utilized one instrument to transfer their separate interests does not negate the distinct ownership interest each person possessed in the Property. As mutually exclusive conveyances, we also find that the invalidity of one does not necessarily invalidate the other. To that end, Whiteman’s intent in transferring her share of the Property to PDC is irrelevant to the circuit court’s finding of fraudulent intent as to Clifton. Clifton’s proportional interest is subject to the claims of his creditors, and he cannot legitimize the fraudulent transfer of his interest by lumping it together with Whiteman’s presumably valid transfer of her interest. Regardless of the parties’ choice of instrument to convey the Property, we find the circuit court properly set aside the conveyance pursuant to the Statute of Elizabeth.^[14]

The transfer of assets to an LLC may be viewed as a badge of fraud where the debtor removed assets by transferring to an LLC to enjoy charging order protection.^[15] The Official Comments to the UVTA also address the intersection between charging order protection and fraudulent transfer law.^[16]

In Interpool, the debtor, Cuneo, transferred non-exempt assets to an LLC (RMC). The RMC interests were then transferred to a trust (RAC). The court examined the transfers under both New York and Florida fraudulent transfer law, finding their holding would have been the same, regardless of the applicable law because there was no conflict between the state laws. As is typical in wealth transfer transactions challenged under fraudulent transfer law, the debtor argued he was motivated by non-creditor reasons. This did not persuade the court to find in the debtor’s favor.

Cuneo was deposed in March 1995 in connection with the proceedings to enforce the judgment. His explanation for the challenged transfers was un-illuminating. He was unable, or chose not, to explain how he and his wife determined what property to transfer into RMC and RAC or why the transfers were made other than to say that he “picked stuff that [he] thought had a worth to it” and that he did so on the advice of counsel for “estate planning” reasons. He testified that he did what [Attorney] suggested and that he “assume[d] that it had to do with tax purposes if [he] die[d].” But he did not articulate any specific reasons why he believed the transfers to be advantageous.^[17]

As to whether the membership interests received in exchange for non-exempt assets constituted reasonably equivalent value, the court did not focus on the LLC’s value, and thus, the potential value of the LLC interests Cuneo received in exchange for his assets. Instead, the court focused on a creditor’s rights to the property that was transferred. In other words, the court examined a creditor’s rights before and after the transaction in determining the value of the debtor’s asset from the creditor’s perspective.

The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited *266 partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.

Interpool can be contrasted with United States v. Holland, where the debtor transferred assets to a limited liability company but remained the sole member. The transfer of assets to a single-member LLC, where the governing law does not provide single-member charging order protection, is akin to the transfer of assets to a revocable trust.

The US contests this characterization, contending that, when compared to the prospect of garnishing the Royalty Assets, the 1998 Transaction left Holland’s creditors with “the far less appealing recourse of seizing [Holland’s] partnership interest (which is subject to major partnership-level debts).” (Doc. 310, p. 7). In this connection, the US asserts that “a conveyance is not an exchange for equivalent value when it makes the debtor ‘execution proof.’” (Id.). In support, the US cites Interpool Ltd. v. Patterson, 890 F.Supp. 259 (S.D.N.Y. 1995), in which a debtor-husband transferred assets to a partnership jointly owned by his wife, and Dunn v. Minnema, 323 Mich. 687, 36 N.W.2d 182, 184 (1949), in which a debtor-husband “invest [ed] of $9,600 of his personal assets in property to which he and his wife held title by the entireties.”

Under the particular facts of this case, the transfer to EHLP did not make Holland “execution proof” because, unlike the debtors at issue in Interpool and Dunn, Holland was the sole owner of the assignee entity, EHLP. Accordingly, seizing Holland’s partnership shares would, apparently, enable a creditor to reach the Royalty Assets. The US is correct that, under this scenario, the Royalty Assets would be subject to “partnership-level debts.” However, because Holland received the benefit of such partnership-level debts in the form of the Note proceeds, this factor is of no avail to the US. If Holland had simply left the Note proceeds in his bank account, his creditors would have been no worse off—they could garnish the cash and recover the remaining value of the Royalty Assets upon repayment of the Notes.

In view of these factors, the 1998 Transaction and 2005 Transaction did not significantly hinder Holland’s creditors. Accordingly, the transfer did not result in the type of “wrong” that would support a finding that (i) that EHLP held title to the Royalty Assets as Holland’s nominee, (ii) that Holland fraudulently conveyed the Royalty Assets to EHLP, or (iii) that EHLP is the alter ego of Holland. Because the US demonstrates no basis for attaching property held by EHLP, the Court must deny its motion for summary judgment.^[18]

United States v. Holland illustrates why some states have enacted statutes providing charging order protection for a single-member limited liability company. The LLC becomes a quasi-exemption debtors may use to avoid paying their personal creditors. Like the asset protection trust, the single-member LLC offering charging order protection presents public policy issues relevant to fraudulent transfer law and choice of law for debtors attempting to import protections into their own state against their personal creditors.

Although avoiding a transfer to a business entity has an impact on the business and its owners, this is of no consequence if the transfer is fraudulent. As previously addressed, some have argued that it is unfair to other business entity owners if a creditor may void a transfer to the business entity by a debtor. This argument has also been used in the trust context, where some maintain it is not fair to void a transfer to a trust if the debtor created rights in third parties (via beneficial interest.) Like the choice of law in a trust agreement, or avoidance of a transfer to a self-settled trust, a creditor who has been injured and seeks relief under fraudulent transfer law is not always held subject to rules created in advance by a debtor. Stated differently, a debtor cannot transfer assets to an entity or trustee, muddy the ownership rights to such property by creating rights in third parties (often insiders), and then expect these third-party interests will automatically defeat a creditor.

If business entities are utilized to effectuate a fraudulent transfer, there is a risk that the court will disregard the business entity. This could have the effect of rendering the individual who controls the business entity liable as transferee. For example, In re Pace featured an attorney who helped his client (the debtor) transfer assets to an LLC controlled by the attorney. This was done to avoid the debtor’s creditors. The court held the LLC was the initial transferee, and further found that the attorney, due to his participation, was jointly liable and might have been considered the person for whose benefit the transfer was made.^[19] As discussed in the civil liability section of this book, lawyers must be careful as to their degree of involvement in fraudulent transfers.

1. Fish v. East, 114 F.2d 177, 182 (10th Cir. 1940). (“The court found that an additional object of making that lease and organizing the Placers Company to receive the grant or demise as lessee was ‘to hinder and delay creditors’ of the Mines Company, direct evidence of such fact being found in the minutes of the meeting of the board of directors of the bankrupt held November 2, 1932, at which a resolution was adopted to the effect that the stock of the Placers Company should be issued to Edward Cunningham, Erland F. Fish, and John A. Traylor, as trustees for the Mines Company, and the president of the Placers Company, stating that one of the reasons for this arrangement was that it was desired to have the stock ‘out of the name of Mines Company, so it could not be attached.’ In re Holbrook Shoe & Leather Co., D.C., 165 F. 973; In re Looschen Piano Case Co., D.C., 261 F. 93; Shapiro v. Wilgus, 287 U.S. 348, 53 S.Ct. 142, 77 L.Ed. 355, 85 A.L.R. 128.”) ↑

2. Shapiro v. Wilgus, 287 U.S. 348, 354, 53 S. Ct. 142, 144, 77 L. Ed. 355 (1932). ↑

3. See SE Prop. Holdings, LLC v. McElheney, No. 5:12CV164-MW/EMT, 2016 WL 7494300, at *11 (N.D. Fla. May 7, 2016). (“For Crestmark, it appears at this point that there is nothing to garnish—there is no debt owed to McElheney individually by the LLC. But SE Property may be able to garnish assets of Crestmark if it can show that McElheney transferred those assets to Crestmark fraudulently.”) ↑

4. See, e.g., Interpool Ltd. v. Patterson, 890 F. Supp. 259, 265-66 (S.D.N.Y. 1995) (“The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.”) ↑

5. See generally, Thomas O. Wells & Jordi Guso, Asset Protection Proofing Your Limited Partnership or LLC for the Bankruptcy of A Partner or Member, Fla. B.J., January 2007, at 34. (“An FLP has two types of creditors — inside creditors and outside creditors. Inside creditor claims arise from alleged actions or omissions of the FLP. Inside creditors may levy against the assets of an FLP, but generally cannot levy against the individual assets of limited partners or members of the FLP. Outside creditor claims arise from alleged actions or omissions by a debtor partner of the FLP. This article’s focus is on the rights of outside creditors to the debtor partner’s interest in the FLP.”) ↑

6. See Miller v. Honda Motor Co., 779 F.2d 769, 773 (1st Cir. 1985). ↑

7. See Loring and Rounds, Section 5.3.3.3(a). (“A creditor is then left with little recourse other than perhaps to attempt to obtain a judicial charging order that, if granted, might snare any discretionary distributions actually made to the beneficiary.” citing Hamilton v. Drogo, 241 N.Y. 401, 401, 150 N.E. 496 (1926) (“By the enactment of section 684 of the Civil Practice Act, providing that an execution may issue against a certain proportion of income from trust funds due and owing, or thereafter to become due and owing to a judgment debtor, it was the intention of the Legislature to extend the scope and effect of an execution as it had theretofore existed. There is no requirement that the income be due at the time the order is made and the execution served. It is enough either that it will become due in the future from the trustee to the cestui que trust, or that it may become so due. If ever the day of payment arrives the lien of the execution attaches.”) ↑

8. Historically, a beneficiary has a “reachable” interest in a trust when the interest has vested. This may occur when an event occurs such as the death of a lifetime beneficiary where the debtor-beneficiary receives the trust corpus outright, or when a trustee has decided to make a distribution in favor of the debtor-beneficiary. An interest may vest in a debtor-beneficiary but be non-possessory; in this situation, a creditor may reach the property unless state law provides otherwise. (See Ariz. Rev. Stat. Ann. §14-10506. “Whether or not a trust contains a spendthrift provision, a creditor or assignee of a beneficiary may reach a mandatory distribution of income or principal if the trustee has not made the distribution to the beneficiary within a reasonable period after the mandated distribution date unless the terms of the trust expressly authorize the trustee to delay the distribution to protect the beneficiary’s interest in the distribution.”) ↑

9. Berlinger v. Casselberry, 133 So. 3d 961, 965–66 (Fla. Dist. Ct. App. 2013). ↑

10. See, e.g., Hamilton v. Drogo, 241 N.Y. 401, 150 N.E. 496 (1926). (“In the present case no income may ever become due to the judgment debtor. We may not interfere with the discretion which the testatrix has vested in the trustee any more than her son may do so. Its judgment is final. But at least annually this judgment must be exercised. And if it is exercised in favor of the duke then there is due him the whole or such part of the income as the trustee may allot to him. After such allotment he may compel its payment. At least for some appreciable time, however brief, the award must precede the delivery of the income he is to receive and during that time the lien of the execution attaches.”) ↑

11. Transfers to an LLC are subject to avoidance under fraudulent transfer law. Florida’s charging order statute also expressly refers to fraudulent transfer relief. See Florida Statute Section 605.0503(7)(b). (“This section does not limit any of the following: *** The principles of law and equity which affect fraudulent transfers.”) ↑

12. Firmani v. Firmani, 332 N.J. Super. 118, 123, 752 A.2d 854, 857–58 (App. Div. 2000). ↑

13. See First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 342, 797 S.E.2d 409, 414 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (“At trial, Clifton asserted he transferred the Property to PDC at the insistence of Whiteman. Clifton testified that Whiteman was ‘hammering’ him every day to place the Property into an LLC based on her fear of the liability associated with the Property being used for recreational hunting. Renee Gilreath, Clifton’s daughter, also testified they transferred the Property to PDC based on Whiteman’s liability concerns as well as for legitimate business purposes.”) ↑

14. First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, 419 S.C. 333, 344, 797 S.E.2d 409, 415 (Ct. App. 2017), reh’g denied (Mar. 16, 2017). (Emphasis added.) ↑

15. Firmani v. Firmani, 332 N.J. Super. 118, 122–23, 752 A.2d 854, 857 (App. Div. 2000). (Firmani’s conveyance of the Haddonfield property to the Family Partnership manifested at least five of the “badges of fraud: set forth in N.J.S.A. 25:2–26. Defendant was the sole general partner and primary limited partner of the Family Partnership prior to the conveyance, and therefore the conveyance was made to an insider. N.J.S.A. 25:2–26(a); see Gilchinsky, supra, 159 N.J. at 478–79, 732 A.2d 482. By continuing to use the Haddonfield property as a residence and place of business, and as the sole general partner with a total ninety-five percent interest in the Family Partnership, defendant clearly retained possession or control of the property after the conveyance. N.J.S.A. 25:2–26(b). Firmani does not dispute that he was aware that the $25,000 had become due to plaintiff, and therefore he knew or should have known that absent voluntary payment, an enforcement action *123 probably would be brought. N.J.S.A. 25:2–26(d). By putting plaintiff in a position where she could only recover the money owed through the Limited Partnership charging process, defendant “remove . . . assets.” N.J.S.A. 25:2–26(g); see Gilchinsky, supra, 159 N.J. at 479, 732 A.2d 482 (“[I]n transferring assets from New York to New Jersey [where more debtor-protective IRA laws exist], defendant effectively prevented them from being attached by [her creditor].”). ↑

16. See Comment 8 to UVTA Section 4. (“Likewise, it is voidable for a debtor intentionally to hinder creditors by transferring assets to a wholly-owned corporation or other organization, as may be the case if the equity interest in the organization is more difficult to realize upon than the assets (either because the equity interest is less liquid, or because the applicable procedural rules are more demanding). See, e.g., Addison v. Tessier, 335 P.2d 554, 557 (N.M. 1959); First Nat’l Bank. v. F. C. Trebein Co., 52 N.E. 834, 837-38 (Ohio 1898); Anno., 85 A.L.R. 133 (1933).”) ↑

17. Interpool Ltd. v. Patterson, 890 F. Supp. 259, 263 (S.D.N.Y. 1995). ↑

18. United States v. Holland, No. 213CV10082MOBMKM, 2017 WL 4676607, at *5 (E.D. Mich. Sept. 12, 2017). ↑

19. In re Pace, 456 B.R. 253, 278 (Bankr. W.D. Tex. 2011). (“The court’s previous findings and conclusion that Hensley [the attorney] did not act in good faith in connection with the transfer of the condo underscores the conclusion here that Hensley used CFM to help Pace [the debtor] carry out a fraudulent transfer. That evidence is sufficient to justify piercing the corporate veil and to thus recover the condo from both Hensley and CFM under the theory of joint and several liability. See Resource Dev. Int’l, LLC, 487 F.3d at 303 (affirming district court’s conclusion that defendant shareholder had ‘utilized his control over defendant corporation’ to perpetuate the debtor’s fraudulent conduct where defendant had agreed with debtor to pay debtor’s legal fees in exchange for a wire transfer to defendant’s corporation, and holding defendant and defendant’s corporation jointly and severally liable under section 550).”) ↑

In today’s digital world and especially as businesses move toward building large brands, companies are building and accumulating significant intellectual property portfolios, whether it be trademarks in branding assets, copyrights to website pages, patents to artificial intelligence processing applications and modules, or trade secrets to a highly valuable recipe or a client list. As businesses combine, divide, and engage in mergers and acquisition activities, many businesses are finding that their value may be partly grounded in their intellectual property and that evaluating their intellectual property assets makes up a core portion of the diligence behind such a transaction.

A major part of intellectual property due diligence today also includes issues relating to technology (aka information technology due diligence). The goal of any intellectual property due diligence in a potential transaction will include determining what intellectual property (if any) the target holds and its value. It will also include understanding the target company’s policies and practices regarding document retention; its various intellectual property registrations across jurisdictions; past, ongoing or anticipated disputes; intellectual property enforcement; intellectual property protection measures; and the location of any intellectual property owned or licensed by the target company, as well as the local practices and IP compliance environment.

In cross-border deals or deals that involve target companies with foreign subsidiaries or affiliates, where the buyer company is looking at intellectual property assets abroad, the goal of such intellectual property due diligence will also be to understand the relevant jurisdictions’ intellectual property laws. For example, in Canada, there is no “work for hire” concept, and moral rights in intellectual property not only exist, but stay with the inventor or creator. And in India, for example, intellectual property in software is handled only by copyright and cannot be patented.

Assessing the quality and integrity of the intellectual property assets helps the acquirer, whether domestic or abroad, not just determine the risks associated with them, but also their value and therefore the overall value of the business. For example, the integrity of the chain of development, acquisition, and transfer of intellectual property from the creator to the eventual beneficial “owner” often surfaces as the biggest risk in transactions involving companies based in India.

To illustrate: the way India handles IP in software (being only eligible for copyright and not patent rights) may be the reason why a strict movement of IP is not documented or easily done. There may also be issues that arise when intellectual property is owned by a third party or jointly owned with a third party. In carve-out transactions, it is important to inquire whether the intellectual property is owned or used by the target or an affiliate that is not being acquired. Often, the seller assumes that even after the intellectual property is transferred, it will continue to be used by third parties or affiliates! Not all such inconsistencies are deal breakers, but they definitely are red flags.

As a buyer’s counsel providing a due diligence request list to the seller’s counsel, it is critical to understand that the disclosures and agreements provided by the seller, while useful, often do not paint the full picture of the target’s intellectual property portfolio, assets, and liabilities. It is, therefore, important to understand the proposed deal and the parties’ motivations for exploring and entering into the deal, and to seek more context from each party when necessary. In addition to the context of the deal, market standards and practices are important to bear in mind while conducting an intellectual property due diligence, both domestically and abroad. It is only then that one can articulate any issues that need to be remedied pre- or post-closing to solidify the buyer’s rights and ability to protect the intellectual property being purchased in the M&A transaction. For example, while in the West it is common for due diligence to be separated based on category or portion of the deal (like a separate intellectual property team or a separate security or privacy team), in India, due diligence teams typically report into the same partner to take a more holistic view, reviewing many elements, such as the findings on accounting and financials of the company, as well as the intellectual property due diligence report.

As the world continues to digitize, moving to a more digital standard with an increasing number of companies in IT, data, and online spaces and with fewer brick-and-mortar operations, often there is proprietary software (i.e., the software is the primary product of the target company) at stake. So it is not just a reliance on representations and warranties that is needed, but a deeper knowledge of the primary software itself, the intellectual property being purchased.

As such, the intellectual property due diligence must involve review of invention assignment agreements to confirm they contain present-tense assignment language or meet other assignment criteria in the relevant jurisdictions. The due diligence should also include review of employment agreements, licensing agreements, service agreements, etc. These should be taken in light of the relevant jurisdiction of the target, the intellectual property, and any applicable subsidiaries or affiliates.

For example, since India doesn’t have any trade secret laws, one needs to review confidentiality obligations, use restrictions, and other protections of trade secrets. Open source is a concern while reviewing software licenses and other documents related to use of such software. In addition to the above, there are other pieces of standard information typically reviewed and/or requested, including:

• Patents and patent applications;
• Trademarks;
• Copyrights;
• Trade secrets (usually protected by contract);
• Corporate names;
• Domain names;
• Tag lines, by-lines, slogans, and brand hashtags;
• Publicity rights;
• Written works;
• Brand assets;
• Websites, online publications, and social media;
• Software; and
• Databases (data, particularly personal data, is the new asset class requiring scrutinous review).

Privacy and data security diligence often raises data and intellectual property issues. This particularly happens with trade secrets, as maintaining their value and status as a trade secret largely falls on confidentiality, security, and privacy measures taken by the holder. It also arises today because of the digital nature of how businesses are run; many (if not most) intellectual property assets are captured in, stored in, transmitted by, used in, and/or concern a digital medium, which inevitably and with any reasonable care requires data and security activity.

This article is based on a CLE program that took place during the ABA Business Law Section’s 2022 Hybrid Annual Meeting. To learn more about this topic, view the program as on-demand CLE, free for members.