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

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

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

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

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

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

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

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

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

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

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

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

Servotronics Petitions the Supreme Court to Bridge the Divide

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

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

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

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

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

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

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

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

[4] Id. at 213.

[5] Id. at 214.

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

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

[8] Id. at 693.

[9] Id. at 695.

[10] Id.

[11] Id.

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

[13] Id. at 695.

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

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

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

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

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

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

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

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

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

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

The Great Recession

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

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

State Concentration Limits

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

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

Uniform Limited Offering Exemption

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

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

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

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

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

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

The ULOE and Preemption

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

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

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

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

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

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

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

[14] 17 CFR §200.501 et seq.

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

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

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

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

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

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

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

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

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

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

[25] 17 CFR 240.15I-1.

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

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

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

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

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

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

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

[33] 134 S.Ct. at 1069.

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

[35] Id. at 1070.

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

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

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

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

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

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

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

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

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

1. Practice, then just do it.

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

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

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

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

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

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

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

2. Joint sessions work particularly well over Zoom.

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

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

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

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

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

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

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

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

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

a. Deposition

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

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

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

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

b. Bench Trial

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

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

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

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

Conclusion

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

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

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

Exhibit A

MEDIATION CONFIDENTIALITY: FEDERAL EVIDENCE RULE 408 LEAKS LIKE A SIEVE

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

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

Uh, oh!

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

Rule 408

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

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

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

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

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

Sieve-like Exceptions

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

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

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

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

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

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

Conclusion

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

Exhibit B

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

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

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

1. Hearsay Rules

a. Availability—Irrelevant

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

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

b. Unavailability—Required

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

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

c. Unavailability—Criteria

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

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

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

2. Zoom and Availability.

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

Examples of such issues are these:

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

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

Conclusion

Zoom is revolutionizing litigation processes. 

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

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

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

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

[3] Id.

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

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

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

Restructuring of the Debtor-Creditor Relationship

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

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

Integral to the Restructuring:

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

Not Integral to the Restructuring:

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

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

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

Consent to Adjudication

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

Public Rights Doctrine

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

Nonconsensual Third-Party Releases in Chapter 11 Plans

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

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

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

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

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

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

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

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

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

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

Conclusion

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

Companies that are planning mergers and acquisitions should be aware of proposed changes to the disclosures required by the Hart-Scott-Rodino Act (HSR), changes that could make more M&A transactions reportable, with more detail required in filings. The Federal Trade Commission published the proposed rule changes in the Federal Register on September 21, 2020, with the concurrence of the Antitrust Division of the U.S. Department of Justice.

In announcing the proposed changes, the agencies underscored their interest in receiving HSR filings that contain enough information to assess whether a deal would be anticompetitive, but also in not receiving filings about acquisitions that would be unlikely to raise competition concerns.

The agencies say that two categories of filings make it difficult for them to focus their resources effectively.

1. Filings for acquisitions by certain investment entities. “[D]ue to changes in investor structure and behavior since the HSR Act and Rules went into effect, filings from certain investment entities do not capture the complete competitive impact of a transaction. When certain investment entities file as acquiring persons, the Rules and Form do not currently require the disclosure of substantive information concerning both the complete structure of the acquiring person and the complete economic stake being acquired in an issuer.”
2. Filings for acquisitions of 10 percent or less of an issuer. The agencies say they “regularly receive filings involving proposed acquisitions, not solely for the purpose of investment, that would result in the acquiring person holding 10 percent or less of an issuer.” They say these filings “almost never present competition concerns.”

The changes would exempt the acquisition of 10 percent or less of an issuer’s voting securities unless the acquiring person already has a “competitively significant” relationship with the issuer. 

In addition to the 10 percent threshold, according to the proposed rules, an acquiring person would not have a competitively significant relationship if:

• The acquiring person is not a competitor of the issuer (or any entity within the issuer);
• The acquiring person does not hold voting securities in excess of 1 percent of the outstanding voting securities (or, in the case of a noncorporate entity, in excess of 1 percent of the noncorporate interests) of any entity that is a competitor of the issuer (or any entity within the issuer);
• No individual who is employed by, a principal of, an agent of, or otherwise acting on behalf of the acquiring person is a director or officer of a competitor of the issuer (or of an entity within the issuer); and
• There is no vendor–vendee relationship between the acquiring person and the issuer (or any entity within the issuer), where the value of sales between the acquiring person and the issuer in the most recently completed fiscal year is greater than $10 million in the aggregate.

Also proposed is a change that would require filers to disclose additional information about their associates and to aggregate acquisitions in the same issuer across those entities, according to the Federal Trade Commission (FTC).

The FTC is seeking information on seven topics it says will “help determine the path for future amendments to the HSR rules and interpretations of those rules.” These topics are:

1. Transaction size.
2. Real estate investment trusts.
3. Noncorporate entities.
4. Acquisitions of small amounts of voting securities.
5. Influence outside the scope of voting securities.
6. Transactions or devices for avoiding HSR requirements.
7. Issues pertaining to the HSR filing process.

The bottom line is that more deals will be reportable, because:

1. The rules would expand the definition of a “person.” Currently, the ultimate parent entity (UPE) of the acquiring “person” is responsible for the HSR filing. In the case of investment funds, each fund serves as its own UPE. Entities not controlled by a common UPE do not have to combine the holdings of commonly managed affiliated funds to determine their reporting obligations. “Treating these non-corporate entities as separate entities under HSR is often at odds with the realities of how fund families and MLPs are managed,” the agencies explain. Under the new rule, filers must disclose information about their associates and aggregate acquisitions. In other words, “associates” of a UPE and the UPE will be considered the same acquiring person. The term person will now mean “(a) an ultimate parent entity and all entities which it controls directly or indirectly; and (b) all associates of the ultimate parent entity.”
2. The rules would narrow the de minimis exemptions. Currently, deals that result in the acquirer controlling 10 percent or less of an issuer’s voting securities do not have reporting obligations. This exemption was carved out for investors. The FTC’s proposed de minimis exemption would truly narrow what is not reportable, since the exemption would only apply if an acquiring fund or any commonly managed fund has 1 percent or less in a competitor. The proposed rule defines a competitor broadly, which the FTC acknowledges: “[A]ny person that (1) reports revenues in the same six-digit NAICS Industry Group as the issuer, or (2) competes in any line of commerce with the issuer.” The agencies say that the broad definition will benefit the public because it will net more potentially anticompetitive deals.

Practical Effects

The impacts of the proposed rule changes would be significant, especially for private equity and other investment funds that operate through a family of commonly managed funds.  And while the new de minimis exemption would allow minority investors to participate in active corporate governance of the issuer, unlike the current “Investment Only” and “Institutional Investor” exemptions, the requirement of no “competitively significant” relationship is key. The definition of “competitively significant” relationships in the proposed rule is rather broad, so we will need to wait and see how that plays out in practice. 

A few weeks ago we called out the importance of companies needing to provide their stakeholders with a clear public statement on their values and overriding commitment to diversity, equity, and inclusion.[1] While speaking out is essential, words alone are not enough, and business leaders need to settle on the specific actions that the company will be taking to contribute to the cause. Planning for action begins with the internal and external engagement processes that the company should have used to craft its public position on racial justice reforms. All of the information collected during those exchanges should be carefully cataloged and analyzed by the company’s leaders and the members of the working group formed by the chief executive officer (CEO). The group should prepare a report on the information collected during the engagement process, giving due respect to requests for anonymity. The report should be released to all relevant stakeholders, along with an explanation of how the group weighed the information, and should use it to make decisions on the steps that will be taken to address and remediate problems of racial injustice in the company’s operations. Transparency is essential to building and maintaining the trust needed to make meaningful changes. It should be recognized that in some cases the disclosures will be painful, documenting acts or ongoing practices that fall short of the company’s aspirations with respect to racial justice. However, it is important for the company to acknowledge its past failures and for leaders to demonstrate that they understand the need to change and explain exactly what they intend to do in order to make those changes.

The engagement process and the organization of the information collected during that process should allow the leaders of the business to identify the problems that are most material to their own situation. The leaders should also generate ideas on how the company might be able to contribute its resources to addressing issues that require a collective response involving governmental bodies, other businesses, nonprofits, and civil society groups.  For example, the engagement process, as well as reviews of relevant data already compiled by the company, may clearly identify shortcomings in the company’s willingness and ability to recruit and retain people of color. A large number of complaints regarding discrimination and harassment against are also a “red flag” that should have been noticed and addressed earlier. All this means that the company’s action plan must address diversity and inclusion issues in the hiring process and provide training and take other steps to embed “zero tolerance” of discrimination into the company’s organizational culture. At the same time, most companies can identify a number of ways to help improve conditions for people of color in the communities in which they are operating. The action plan should also include initiatives that are feasible given the company’s resources, including investments, and should support volunteering by the company’s employees as well as advocacy for governmental policies and public programs that will lead to meaningful social changes.

Commitments to action regarding racial equality and justice are specific to each organization and must take into account stakeholder feedback and available resources, together with the issues and problems that are most salient and immediate for the company.  The menu of commitments presented below is based on suggestions made by Kramer and others and touches on wide swaths of a company’s activities internally and in the communities and stakeholder relationships in which they are involved.[2] Some steps appear to be surprisingly simple and quick to initiate, but others will take time and will be accompanied by increases in short-term costs. These costs will need to be explained to investors as being necessary and prudent to create long-term shared value and further the social purpose of the enterprise. For example, it is important to emphasize that studies have shown that closing the racial pay gap would lead to significant improvements in overall economic performance as measured by gross domestic product and that raising entry-level wages would improve financial performance by increasing productivity and reducing turnover. In some cases the suggested actions are specific to workers; however, companies should be attentive to opportunities that would extend commitments to assist members of the communities in which they are operating as part of an effort to be “good citizens.”

Embedding Diversity, Equity, and Inclusion

• Commit to supporting racial equality in the business by implementing organizational structures and expectations of accountability that embed diversity, equity, and inclusion into operations such as forming a permanent full-time team, with relevant experience and expertise drawn from throughout the company (e.g., engineers, data scientists, researchers, designers) in order to focus exclusively on advancing inclusion and rooting out bias in key activities such as product design, marketing, and customer service
• Commit to antiracist personnel policies which make it clear that the company will have “zero tolerance” for racism and will act swiftly to discipline workers who engage in actions that discriminate against co-workers, customers, and community members on the basis of race
• Commit to racial-equity training to support the success of the policies mentioned above and further understanding of the underlying causes of the problems, making sure that training is required for everyone in the organization, ranging from the directors and members of the executive team to the hourly workers
• Commit to giving employees a voice by creating and respecting processes for ensuring that hourly employees, women, and people of color are represented in all employment decisions and are either represented on, or have full access to, the board of directors 

Financial Equity and Security

• Commit to pay equity in order to eliminate shocking disparities in wages paid to people of color (especially women of color), a process that should begin with a wage equity audit and then continue with appropriate adjustments, reviewed and updated on a regular basis, to achieve and maintain fair and equitable pay throughout the organization
• Commit to paying a living wage and offering all workers competitive benefits and stable scheduling to avoid disruptions to their incomes and lives
• Commit to an employee emergency relief fund or low-cost loan program that workers can access to cover emergency expenses, realizing that a significant percentage of Americans, particularly people of color, do not have sufficient savings to cope with the unexpected and are often forced to deal with payday lenders that charge outrageous fees or run up high-interest credit card debt
• Commit to paid parental and sick leave through direct company financial support and/or advocacy for governmental funding, recognizing that people of color face disproportionate challenges in affording unpaid time off from work to care for children and other family members
• Commit to full health care coverage for all workers and support efforts to improve public health and achieve equity and universal coverage in health care in order to ensure that workers keep more of their paychecks and that people of color are better protected against the tragic impacts of health-related challenges such as the Covid-19 pandemic
• Commit to programs to assist workers with caregiving responsibilities by implementing flexible work schedules and allowing for telecommuting, thus making it easier for workers to care for children and other family members, and providing on-site child care, all of which can ease stress on workers and help attract a broader and diverse pool of candidates

Diversity and Inclusion in the Workforce

• Commit to democratize recruitment processes by eliminating questions on employment applications and testing that disproportionately exclude people of color (e.g., “felony convictions” and testing for use of marijuana and other drugs not required by law or the nature of the job), eliminating college degree requirements for jobs that do not actually require higher education, and developing hiring, mentoring, and training programs for young people of color without high school degrees and thus at higher risk for unemployment
• Commit to transparency in disclosing strategies and results relating to diversity and inclusion initiatives beginning with the collection, analysis, and reporting of data relating to recruiting, promotion, wages, and other issues as to which bias is likely to arise
• Commit to expanding diversity in the recruitment pool by focusing on local communities, dramatically expanding the size of internship programs for people who do not meet traditional educational requirements, committing to setting aside a significant portion of the slots to young people of color, and increasing recruiting at historically black colleges and universities
• Commit to having a diverse workforce that mirrors the customer base, which means ensuring that core business units such as product development, marketing, sales, and customer service include employees who can raise concerns about discriminatory, exclusionary or insensitive actions in their areas and in the company’s training and external messaging

Diversity in the Boardroom and C-Suite

• Commit to diversity in the boardroom through purposeful inclusion of women and people of color as members of the board of directors and on advisory boards created to focus on the company’s environmental and social responsibilities and commitments and by requiring that directors hold themselves and management accountable for specific objectives around recruitment, retention, and promotion of people of color
• Commit to tying compensation for the CEO and other members of the executive team to diversity and inclusion metrics and ensuring that contributing to economic justice is part of the CEO’s formal duties and responsibilities

Community Investment and Engagement

• Commit to advocating for good by earmarking a significant amount of your company’s lobbying and advocacy budget and related resources to supporting measures that would have a material impact on improving conditions for communities of color (e.g., increasing access to quality education and training, rebuilding infrastructure, ending racial oppression, reforming criminal justice systems and public and mental health systems and rebuilding the safety net) and working to identify and support local leaders who are committed to racial and social justice
• Commit to supporting employees in their interests in getting involved in community-based programming focusing on racial and economic justice by implementing programs that allow employees to volunteer for these programs while being paid by the company and contributing cash and other resources to such programs
• Commit to supporting full participation by workers and community members in democracy by making Election Day a paid holiday, supporting registration of workers and community members for voting (e.g., setting up tables for voter registration at the workplace), providing assistance to ensure that workers and community members are actually able to vote, and hosting forums for candidates to speak to workers and community members and provide their views on economic and social justice issues
• Commit to rebuilding trust between businesses and communities of color that has often been breached by past discriminatory practices, including intentional failures to provide people of color with access to products and services on the same terms offered to white customers
• Commit to supporting minority businesses through investments and preferences in procurement practices starting with localizing purchasing commitments, developing and using lists of contractors led by people of color, and requiring that professional services providers (e.g., lawyers, accountants, and bankers) have at least one person of color in a meaningful role on the team working for the company

Products and Services

• Commit to offering products and services that effectively meet the distinctive needs of markets of color by authentically understanding the needs of those markets and the root causes for the failure of those markets to be effectively and fairly served in the past and investing in designing and redesigning products and services to meet the discrete needs of customers in those markets 

It should not be overlooked that while many of the commitments mentioned above are framed in terms of steps to be taken to promote racial justice and equitable treatment for people of color, the goals have a broader resonance and imagine a workplace and broader community in which everyone has more opportunities and a higher quality of life. For example, discrimination and harassment are problems that extend beyond people of color, and no business can be as productive and impactful as it could be if workers are struggling because they are not being paid a living wage and are unable to take the time that is necessary for them to care for their own health and the needs of their families without fear of losing their income. Diversity and inclusion in the boardroom and in the workplace promote innovation, which leads to new products and services that create jobs for people from all racial and ethnic backgrounds.

As mentioned above, the company needs to demonstrate to its internal and external stakeholders that the engagement process has been meaningful and has driven the leaders of the business to make formal commitments to actions that they are willing to announce and distribute publicly in order to create accountability. A statement of commitments should be prepared and carefully reviewed by the board of directors, and the directors should take the opportunity to discuss the data and feedback underlying each of the proposed commitments with the members of the working group. Attention to detail is important at this point: The commitments themselves will necessarily be somewhat general and will lack details on specific tactics, timelines, and metrics to track performance; however, the company must already have a good idea of the steps that will be taken.  Proposed commitments should be discussed with legitimate representatives of key stakeholders so that they understand the process that the company has taken in engaging with stakeholders, conducting internal assessments, prioritizing commitments, and customizing commitments to address the company’s specific situation. Stakeholders will inevitably want companies to “do more” in relation to the issues that are of greatest concern to them. The goal at this point is to make stakeholders recognize that the company takes the issues seriously and is prepared to report on and be held accountable for its actions.

An action plan for each of the commitments needs to be prepared by the working group and should identify the leaders within the organization who will have primary responsibility for overseeing the steps to be taken in order to address each of the issues identified in the plan. The plan should also specify the resources that will be allocated to each issue and the specific performance metrics that will be used to track the company’s progress toward fulfilling its commitments. The leaders assigned to each issue need to understand that they will be held accountable for the company’s performance and that the success of the plan will be a material factor in the leader’s compensation and overall progress within the organization. The action plan should also provide for regular and continuous review, including ongoing engagement with relevant stakeholders to gather their input on the effectiveness of the steps taken by the company to address each of the issues. In addition, the company should undertake to issue additional reports to stakeholders that include the updated stakeholder feedback and data on the performance metrics, accompanied by an analysis of how the plan implementation process has worked.

[1] Alan S. Gutterman is the Founding Director of the Sustainable Entrepreneurship Project (www.seproject.org), a California nonprofit public benefit corporation with tax-exempt status under IRC section 501(c)(3) formed to teach and support individuals and companies, both startups and mature firms, seeing to create and build sustainable businesses based on purpose, innovation, shared value, and respect for people and planet. Alan is also currently a partner of GCA Law Partners LLP in Mountain View, California (www.gcalaw.com) and a prolific author of practical guidance and tools for legal and financial professionals, managers, entrepreneurs, and investors on topics including sustainable entrepreneurship, leadership and management, business law and transactions, international law, and business and technology management. He is the co-editor and contributing author of several books published by the ABA Business Law Section, including The Lawyer’s Corporate Social Responsibility Deskbook, Emerging Companies Guide (3rd Edition) and Business and Human Rights: A Practitioner’s Guide for Legal Professionals (Forthcoming Fall 2020). More information about Alan and his work is available at the Project’s website and at his personal website at www.alangutterman.com. This article is adapted from the chapter on racial equality and nondiscrimination recently released on the Project’s website: https://seproject.org/wp-content/uploads/2020/07/EDI-_C1-Racial-Equality-and-Non-Discrimination.pdf

[2] See M. Kramer, “The 10 Commitments Companies Must Make to Advance Racial Justice.” Harvard Business Review (June 4, 2020), https://hbr.org/2020/06/the-10-commitments-companies-must-make-to-advance-racial-justice.  See also Six Small But Impactful Ways to Support Social Justice within Your Organization, Forbes Nonprofit Council (December 6, 2017).

The Canadian government’s long-awaited overhaul of existing federal private-sector privacy legislation finally arrived on November 17, 2020, with the first reading of Bill C-11 An Act to enact the Consumer Privacy Protection Act and the Personal Information and Data Protection Tribunal Act and to make consequential and related amendments to other Acts, also known as the Digital Charter Implementation Act, 2020 (Bill C-11) Bill C-11 would enact the Consumer Privacy Protection Act (CPPA) and the Personal Information and Data Protection Tribunal Act (PIDPTA). Together, the CPPA and the PIDPTA have introduced bold new measures into Canada’s privacy law and have brought it into closer alignment with European data protection and privacy standards. This article provides some highlights of the proposed legislation.

New Enforcement Powers and Financial Punishments for Contraventions to the Act

The CPPA expands the federal Privacy Commissioner of Canada’s (the Commissioner) enforcement powers. Following investigation and inquiry into a contravention of the CPPA, the Commissioner can issue orders to ensure that organizations comply with the CPPA.[1] Contravening a compliance order is an offense subject to financial punishment, as set out below.[2]

The Commissioner can also recommend to the newly established Personal Information and Data Protection Tribunal (the Tribunal) that it should impose financial penalties if an organization has contravened the CPPA.[3] The Tribunal presides over hearings related to financial penalties recommended by the Commissioner and non-penalty-related appeals.[4] The Tribunal can impose a maximum financial penalty for contraventions of the CPPA of the higher of $10 million and 3 percent of the organization’s gross global revenue in its financial year before the one in which the penalty is imposed.[5]

As alluded to above, the CPPA introduces new offenses, with heavy financial punishments. Any party found guilty of an indictable offense and liable may pay a fine not exceeding the higher of $25 million and 5 percent of the organization’s gross global revenue in its financial year before the one in which the organization is sentenced, or $20 million and 4 percent for summary judgment, respectively.[6] These offenses include:

• if an organization fails to report to the Commissioner any breach of security safeguards involving personal information under its control where the breach may result in a reasonable risk of significant harm to an individual,[7]
• if a service provider fails to notify the organization that controls the personal data of a data breach involving personal information,[8]
• if an organization attempts to re-identify individuals using de-identified information,[9] and
• if an organization disposes of personal information after an individual has requested access to it and the individual has not exhausted the individual’s recourse under the CPPA.[10]

Private Right of Action

The CPPA establishes a new cause of action for individuals who are affected by an act or omission by an organization that constitutes a contravention of the CPPA against the organization for damages for loss or injury that the individual has suffered as a result of the contravention. To commence this action, the Office of the Privacy Commissioner and the Tribunal must have made findings that the organization has contravened the CPPA, and the finding was not appealed to the Tribunal or the Tribunal has denied the appeal.[11]

Codification of the 10 Privacy Principles and New Requirements

The CPPA codifies the Ten Data Privacy Principles of the Personal Information Protection and Electronic Documents Act (PIPEDA) into law[12] and introduces new requirements on organizations, including:

• requiring every organization to establish, implement, and make available a privacy management program, which, among other requirements, must be attuned to the volume and sensitivity of the personal information being collected, used, and stored,[13] and
• restricting how an organization can make use of de-identified information to prescribed circumstances.[14]

The CPPA also explicitly prescribes how organizations acquire valid consent. In most cases, an organization must obtain express consent from an individual and disclose in plain language:

• the purposes for the collection, use, or disclosure of personal information determined by the organization,
• the way in which the personal information is to be collected, used, or disclosed,
• reasonable foreseeable consequences of the collection, use, or disclosure of personal information when obtaining consent from an individual,
• the specific type of personal information that is to be collected, used and disclosed, and
• the names or types of third parties to which the organization may disclose personal information when obtaining consent from an individual.[15]

Additionally, organizations that use personal information to inform their automated decision-making tools to make predictions about individuals (such as certain AI systems) are required to:

• deliver a general account of the organization’s use of any automated decision system to make predictions, recommendations, or decisions about individuals that could have significant impacts on them,[16] and
• retain the personal information related to the decisions for a sufficient period of time to permit the individual to make a request for access[17] (as described below in New Rights for Individuals).

Service Providers

Under the CCPA, organizations are deemed to have control over personal information even when such organizations outsource or otherwise deploy a service provider that collects, uses, and discloses on the organization’s behalf.[18] Accordingly, organizations must ensure, by contract or otherwise, that the service provider provides substantially the same protection of the personal information as the organization is required to under the CPPA.[19] Service providers have an obligation to maintain adequate security safeguards to protect personal information and inform the organization that controls the personal information of any breach of its security safeguards in accordance with the requirements of the CCPA.[20]

Codes of Practice and Certification Programs

The CPPA also allows the Commissioner to approve and certify codes of practice and certification programs designed by nongovernmental entities. These codes and certifications must offer the same or substantially the same or greater protection of personal information under the CPPA. However, the organizations that comply with these codes of practice or certification programs must still meet their obligations under the CPPA.[21]

New Rights for Individuals

In addition to codifying the access rights discussed in the PIPEDA’s Ten Data Privacy Principles,[22] CPPA establishes three new rights for individuals regarding their personal information:

• Data mobility rights: Individuals can request an organization to directly transfer their personal information from one organization to another (subject to both organizations being part of a data portability framework).[23]
• Transparency and explanation rights: Individuals can request an organization that uses automated decision making based on the individual’s personal information to provide them with an explanation of the prediction, recommendation, or decision and of how the personal information that was used to make the prediction, recommendation, or decision was obtained.[24]
• Disposal rights: Individuals can request an organization dispose of their personal information.[25]

Next Steps

While this is only the first reading of Bill C-11, the second reading will take place shortly, and debates and committee will follow. The proposed amendments to Canada’s federal private-sector framework as described in Bill C-11 are significant and meaningful and will likely require many organizations to tighten up their existing privacy and security practices.

[1] CPP, s. 92.

[2] CPP, s.125.

[3] CPPA, s.93,

[4] PIDPTA, s. 5.

[5] CPPA, s. 94.

[6] CPPA, s.125.

[7] CPPA, s. 58(1) and 125.

[8] CPPA, s. 61 and 125.

[9] CPPA, s. 75 and 125.

[10] CPPA, s. 69 and 125.

[11] CPPA, s. 106.

[12] Accountability, identifying purposes, consent, limiting collection, limiting use disclosure and retention, accuracy, safeguards, openness, individual access, and challenging compliance.

[13] CPPA, s. 9.

[14] CPPA, s. 20, 21, 39(1), 74, and 75.

[15] CPPA, s.15(3).

[16] CPPA, s. 62(2)(c).

[17] CPPA, s.54.

[18] CPPA, s. 7(2).

[19] CPPA, s.11(1).

[20] CPPA, s. 57(1) and 61.

[21] CPPA, s. 76-81.

[22] The right to withdraw consent from a provider to collect, use, and disclose their personal information, and to access and correct their personal information.

[23] CPPA, s. 72.

[24] CPPA, s. 63(3).

[25] CPPA, s. 55(1).

Lisa R. Lifshitz