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If you have any questions regarding this advisory, please contact Amie V. Colby or Christopher R. Jones.

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On July 18, 2019, the Federal Energy Regulatory Commission (“FERC” or “Commission”) issued Order Nos. 860 and 861, in which FERC revised the requirements for sellers authorized or seeking authorization to make sales of energy, capacity, or ancillary services at market-based rates (“Sellers”). Order No. 860 rolled out longer-term changes to the way the Commission tracks affiliate relationships, and Order No. 861 eliminated the screen analyses for certain Sellers in regional transmission organization (“RTO”)/independent system operator (“ISO”) markets.

In Order No. 860, FERC revised its requirements to require Sellers to provide certain information about corporate relationships and affiliations through a “relational database” the Commission will be rolling out. Among other things, FERC (1) reduced and clarified the scope of information provided in market-based rate filings; (2) changed the information to be included in an asset appendix; (3) required market-based rate Sellers to update the relational database on a monthly basis; (4) changed the notice of change in status filing requirement to a quarterly basis; and (5) eliminated the requirement that Sellers submit corporate organizational charts adopted in Order No. 816. FERC declined to require Sellers and entities trading virtual or holding financial transmission rights to submit Connected Entity information and instead transferred the record on this proposal to Docket No. AD19-17-000 for possible future consideration. Order No. 860 will become effective October 1, 2020.

In Order No. 861, FERC relieved Sellers of the requirement to submit indicative screens to obtain or retain authority to sell energy, ancillary services, and capacity at market-based rates in markets with RTO/ISO administered energy, ancillary services, and capacity markets that are subject to FERC-approved RTO/ISO monitoring and mitigation. FERC also eliminated the rebuttable presumption that FERC-approved RTO/ISO market monitoring and mitigation is sufficient to address any horizontal market power concerns regarding the sales of capacity in RTOs/ISOs that do not have an RTO/ISO-administered capacity market. Order No. 861 will become effective 60 days after publication in the Federal Register.

II. Summary of Order No. 860

A. Overview

FERC revised its regulations to require market-based rate Sellers to provide certain information in a consolidated and streamlined manner through a relational database that FERC will establish over the next year and half. According to the Commission, the new “relational database construct modernizes the Commission’s data collection processes, eliminates duplications, and renders information collected through its market-based rate program usable and accessible for the Commission.”

Amongst the changes, FERC adopted rules to reduce and clarify the scope of ownership information provided by Sellers in their market-based rate filings, change the information to be included in a Seller’s asset appendix, and require market-based rate Sellers to update the relational database on a monthly basis to reflect any changes that have occurred. In addition, FERC changed the notice of change in status filing requirement from a rolling 30-days basis to a quarterly basis and eliminated the requirement that Sellers submit corporate organizational charts. FERC declined to adopt its proposal to collect Connected Entity data from market-based rate Sellers and entities trading virtual or holding financial transmission rights. Because these reforms will require significant changes to the systems used to report corporate affiliations, the regulatory changes in Order No. 860 will not become effective until October 1, 2020.

B. Submission of Information Through a Relational Database

FERC adopted its proposal to create a relational database that would collect market-based rate information,[1] where a relational database is a database model that contains multiple data tables which relate to one another via unique identifiers.[2] FERC clarified that there will be a two-step process for the data submission process.[3] Sellers will first submit information in XML into the relational database, which will produce a retrievable asset appendix and indicative screens that will be accessible via serial numbers.[4] Sellers can then submit market-based rate filings through eFiling, identifying its asset appendices and indicatives screens in its transmittal letter through the usage of the generated serial numbers.[5]

C. Obtaining a Legal Entity Identifier (“LEI”)

In order to track each unique public utility and each discrete affiliate, FERC will require that each entity have a unique identifier. FERC had proposed to have each entity register using an LEI.[6] FERC declined to require Sellers to obtain and maintain LEIs and adopted instead the proposal put forth by commenters to allow Sellers to use their Company Identifiers (“CID”) in the relational database.[7] FERC stated that because Sellers are already required to obtain and maintain CIDs, requiring Sellers to obtain and maintain LEIs was unnecessarily burdensome and duplicative.[8] However, FERC did maintain that Sellers may identify their affiliates through LEIs, as some affiliates may not have CIDs.[9] For affiliates without a CID or an LEI, the Commission created a new “FERC generated ID” to serve as their form of identification. The system will allow Sellers to obtain unique FERC generated IDs for their affiliates.

D. Substantive Changes to Market-Based Rate Requirements

1. Asset Appendix                 

a. New Format

FERC adopted the Data Collection NOPR’s proposal to require that Sellers submit asset appendix information in XML format instead of the excel format used currently.[10] FERC also adopted the proposals that while Sellers would no longer be required to report assets owned by its affiliates with market-based rate authority, Sellers would be required to include in their relational databases any assets owned by their affiliates that do not have market-based rate authority.[11] FERC noted that it was not changing existing policy regarding exempt Qualifying Facilities and behind-the-meter generation.[12]

b. Reporting of Generation Assets                      

FERC adopted the Data Collection NOPR’s proposal to require that Sellers report each generator separately into the relational database, with Sellers being required to report each generator’s Plant Code, Generator ID, and Unit Code (if applicable) (collectively, “EIA Code”), as gathered from the EIA-860 database.[13] For generators that do not appear in the EIA-860 database, FERC is creating a new “Asset Identification” number that can be obtained by Sellers prior to their relational database submissions to FERC.[14]

FERC also adopted the Data Collection NOPR’s proposal to require Sellers to report the telemetered market/balancing authority area of their generation in the relational database.[15] However, Sellers will not be required to report the telemetered region of their generation.[16]

c. Power Purchase Agreements

FERC adopted the Data Collection NOPR’s proposal to require Sellers to include information on long-term firm sales in the relational database,[17] with long-term firm sales being defined as sales for one year or longer that are not interruptible for economic reasons.[18]

d. Providing EIA Codes for Unit-Specific Power Purchase Agreements

FERC adopted the Data Collection NOPR’s proposal that, for unit-specific power purchase agreements, Sellers must provide the unit’s associated EIA Codes or Asset ID in the relational database,[19] with such requirement applying to both unit-specific sales and unit-specific purchases.[20]

e. Vertical Assets

FERC adopted the Data Collection NOPR’s proposal to require Sellers to signify in the relational database whether they have transmission facilities covered by a tariff in a specific balancing authority area.[21] For natural gas pipelines and/or storage facilities, Sellers need only indicate if they own such facilities and in which balancing authority area the facilities are located.[22] FERC also eliminated the requirement for Sellers to file specific details about their transmission facilities.[23]

2. Ownership Information

FERC adopted its proposal to require Sellers to identify their ultimate upstream affiliates when submitting their market-based rate applications or baseline submissions.[24] Sellers must also inform FERC of new “ultimate upstream affiliates” as part of their change in status reporting obligations.[25] FERC will also remove the requirement for Sellers to file corporate organizational charts, as the requirement to identify ultimate upstream affiliates will allow FERC to create such charts.[26] FERC will continue to require narrative descriptions of Sellers’ ownership structures that should capture any ownership or affiliate relationship information that has a bearing on Sellers’ horizontal and vertical market power analyses.[27]

FERC chose to not adopt the Data Collection NOPR proposal under which the first time an entity is identified as an ultimate upstream affiliate by Seller in an XML Submission, a unique identifier would be created for such entity.[28] However, a list of unique identifiers for Sellers’ ultimate upstream affiliates will be published on FERC’s website.[29]

3. Passive Owners

FERC adopted its proposal to require Sellers to affirm in their market-based rate narratives their owners who have a passive ownership interest.[30] Sellers must identify the owners and affirm that such ownership interests consist of passive rights that do not confer control over the Seller.[31]

4. Foreign Governments

FERC opted to not adopt the Data Collection NOPR’s proposal requiring Sellers to identify relationships with specific foreign governments.[32] However, Sellers must still identify all ultimate upstream affiliates, regardless of whether such affiliates are owned or controlled by a foreign government.[33]

5. Indicative Screens                               

FERC adopted its proposal to require Sellers to submit indicative screen information in XML format, thereby enabling the indicative screens to be included in the relational database.[34] However, because the relational database will not have the capability to populate indicative screens into the eLibrary record, Sellers must instead include the serial number of the indicative screens in their associated market-based rate filings.[35] Such serial numbers will be assigned to each indicative screen after a Seller submits its indicative screen-related XML data into the relational database.[36]

6. Other Market-Based Rate Information           

FERC adopted its proposal to require each Seller to submit the following information into the relational database as set forth in the MBR Data Dictionary:

• Information about its operation reserves;

• Category status for each region in which it has market-based rate authority; and

• Mitigation, if any.

E. Change-in-Status Filings and Ongoing Reporting Requirements

FERC adopted new rules requiring Sellers to submit monthly relational database updates on the 15th day of each month following the occurrence of any reportable change to relational database information.[37] FERC also changed the required timing for filing notices of change in status so that Sellers will only need to file notices of change in status on a quarterly basis, instead of 30 days after the change in status occurs.[38]

F. Connected Entity Information

FERC declined to adopt the Data Collection NOPR’s proposal requiring Sellers and Virtual/FTR Participants to submit Connected Entity Information.[39] FERC instead transferred the record on this proposal to Docket No. AD19-17-000 for possible future consideration by FERC.[40] This decision drew a dissenting opinion from Commissioner Glick.

G. Initial Submissions/Implementation and Timing

The effective date of the final rule will be October 1, 2020, but submitters will have until close of business on February 1, 2021 to make their initial baseline submissions into the relational database. As of February 1, 2021, prior to filing an initial market-based rate application, a new Seller will be required to make a submission into the relational database. According to the Commission, this will allow the relational database to create the asset appendices and indicative screens and provide the Seller with the serial numbers that it needs to reference in its transmittal letter as discussed above. FERC stated, “We affirm that after January 31, 2021, no asset appendices or indicative screens are to be submitted as attachments to filings through the eFiling system.”[41]

H. Data Dictionary

FERC adopted the Data Collection NOPR’s proposal to post on FERC’s website a dictionary that would define the framework for Sellers to follow when submitting information (the “MBR Data Dictionary”) and made numerous changes to MBR Data Dictionary entries.[42]

I. Confidentiality

FERC provided clarity that certain aspects of Sellers’ market-based rate filings will appear in eLibrary as either public or non-public, with Sellers being able to request privileged treatment of their filings they believe to be exempt.[43] However, FERC noted that much of the information submitted into the relational database will likely not qualify for privileged treatment, including the relationship between the Seller and its ultimate upstream affiliates. [44]

J. Due Diligence

FERC provided clarity that it will not seek to impose sanctions for inadvertent errors, misstatements, or omissions in the data submission process.[45] FERC added that any necessary corrections to a submission under the final rule should be submitted on a timely basis, as soon as practicable after the discovery of the inadvertent error or omission.[46] However, FERC also stated that certain circumstances could result in a violation and the imposition of sanctions, including if there are systemic or repeated failures to provide accurate information and a consistent failure to ensure the accuracy of the information submitted through due diligence.[47]

FERC declined to adopt a “safe harbor,” a “presumption of good faith,” a “good faith reliance on others defense,” or a standard where FERC would limit bringing enforcement actions only when there is evidence of an entity intentionally submitting inaccurate or misleading information to FERC.[48] Instead, FERC will rely on looking at extraneous circumstances and whether the entity submitting the information exercised due diligence.[49]

III.        Summary of Order No. 861

A. Overview

In Order No. 861, FERC modified its regulations regarding the horizontal market power analysis required to obtain authorization to sell energy, capacity, or ancillary services at market-based rates. In order to sell energy, capacity, or ancillary services at market-based rates, FERC requires the Seller and its affiliates to demonstrate that they do not have, or have adequately mitigated, both horizontal and vertical market power.[50] FERC previously adopted two indicative screens—the pivotal supplier screen and the wholesale market share screen—for assessing horizontal market power within a geographic area, often the RTO/ISO that the Seller is a member of and located in.[51] Order No. 861 relieves market-based rate Sellers that study RTO/ISO markets of the obligation to submit indicative screens as part of the horizontal market power analysis in any organized wholesale power market that administers energy, ancillary services, and capacity markets subject to Commission-approved monitoring and mitigation.[52]

The rule contains two caveats: First, Sellers will continue to be required to submit indicative screens for authorization to make capacity sales at market-based rates in markets that lack an RTO/ISO administered capacity market subject to FERC-approved monitoring and mitigation—at present, California Independent System Operator Corp. (“CAISO”) and Southwest Power Pool, Inc. (“SPP”). However, Sellers in these markets would still be relieved of the requirement to submit indicative screens if they sought market-based rate authority limited to sales of energy and/or ancillary services. Second, while FERC previously adopted a rebuttable presumption that existing, FERC-approved market power mitigation measures by RTOs/ISOs are sufficient to address market power concerns when a Seller fails the indicative screens, Order No. 861 holds that such mitigation mechanisms are no longer presumed sufficient to address any horizontal market power concerns regarding sales of capacity in RTOs/ISOs that do not have an RTO/ISO-administered capacity market.[53]

B. Arguments Regarding Assurance of Just and Reasonable Rates

FERC rejected concerns that relieving Sellers in RTO/ISO markets of the obligation to submit indicative screens would deprive FERC and other parties of the data necessary to assess market power and to meet the evidentiary burdens required to challenge market-based rate filings.[54] FERC explained that Sellers continue to be required to submit ownership information, vertical market power analysis, asset appendix, market monitor reports, and Electronic Quarterly Reports (“EQR”).[55] A successful challenge to a Seller’s market-based rate requires demonstrating that: (1) the Seller has market power, and (2) such market power is not addressed by existing FERC-approved RTO/ISO market monitoring and mitigation. To the extent that a complainant successfully rebuts the presumption of sufficiency of market monitoring and mitigation, FERC clarified that it retains its authority to require the Seller to submit indicative screens or other evidence to determine whether the Seller has market power.[56]

C. Capacity Sellers in CAISO and SPP

Order No. 861 requires Sellers to continue to submit indicative screens for capacity sales in CAISO and SPP, and eliminates the rebuttable presumption that FERC-approved RTO/ISO market monitoring and mitigation is sufficient to address any horizontal market power concerns regarding capacity sales in these markets.[57] FERC rejected objections that capacity sales in CAISO and SPP are subject to ISO- and state-level regulation that effectively mitigates market power.[58] FERC observed that neither CAISO nor SPP review, approve, or monitor capacity sales,[59] and found that there is no transparent market price for capacity sales in either market-determined under Commission-approved rules comparable to the price established by RTOs/ISOs with centralized capacity markets.[60] FERC also clarified that:

• In the event of indicative screen failures, the CAISO or SPP Seller’s evidentiary burden is limited to demonstrating that it lacks market power in capacity markets, or to proposing a satisfactory mitigation plan that is specific to capacity sales.[61]

• A CAISO or SPP Seller may still rely on the rebuttable presumption that it lacks market power in energy and ancillary services markets as a result of FERC-approved monitoring and mitigation.[62]

• An RTO/ISO Seller that would normally study CAISO or SPP as a relevant market and that seeks to offer capacity at market-based rates in those markets must submit indicative screens to demonstrate that it will not have market power in capacity sales.[63]

D. EIM

Some parties proposed that indicative screens should not be required to obtain or retain market-based rate authority in the Western Energy Imbalance Market (“EIM”) because the EIM is part of CAISO’s real-time energy market and is subject to FERC-approved market monitoring and mitigation.[64] FERC rejected this proposal, finding that such market monitoring and mitigation is not sufficient to address market power concerns.[65]

E. Bilateral Sales

FERC rejected arguments that ISO/RTO monitoring and mitigation measures would not ensure just and reasonable rates for bilateral sales of electricity in ISO/RTO markets[66] and affirmed that FERC-approved RTO/ISO monitoring and mitigation would enable it to retain sufficient oversight of bilateral sales in RTO/ISO markets.[67] FERC acknowledged that centralized markets may be imperfect substitutes for long-term bilateral contracts, but found that prices set in centralized auctions provide a benchmark against which to compare prices in long-term bilateral contracts, and that buyers with access to centralized markets can always purchase from the short-term market if the Seller of a long-term contract tries to charge an excessive price.[68] FERC also pointed out that RTO/ISO Sellers engaged in bilateral sales remain subject to EQR reporting requirements.[69]

F. Current Status and Effectiveness of RTO/ISO Monitoring and Mitigation

FERC rejected requests to initiate a formal review of RTO/ISO monitoring and mitigation provisions, explaining that it has accepted these provisions as just and reasonable, and that removing the indicative screens would not affect an RTO/ISO’s application of market power monitoring and mitigation provisions its market.[70] FERC also noted that nothing in its final rule precludes an RTOs/ISO from filing to amend its existing market power mitigation provisions if improvement is needed.[71]

G. Other Issues

FERC also rejected requests to:

• eliminate requirement for change in status reporting;[72]

• reconsider the continued need for triennial market power updates;[73]

• remove the current stay of the requirement in 18 CFR 35.37(a)(2) that Sellers submit an organizational chart;[74]

• state that independent market monitors have the right to file FPA section 206 complaints;[75]

• establish corporate character reporting requirements for market-based rate applications;[76]

• defer action on the rulemaking until FERC acts on the related, pending Data Collection Notice of Proposed Rulemaking (Docket No. RM16-17-000) and Market Power Notice of Inquiry (RM16-21-000).[77]

H. Effective Date

The changes in Order No. 861 will become effective 60 days after the rule is published in the Federal Register.

 

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[1] Data Collection for Analytics and Surveillance and Market-Based Rate Purposes, Order No. 860, 168 FERC ¶ 61,039, at P 15 (2019) (“Order No. 860”).

[2] Data Collection for Analytics and Surveillance and Market-Based Rate Purposes, Notice of Proposed Rulemaking, 156 FERC ¶ 61,045, at n.7 (2016) (“Data Collection NOPR”).

[3] Order No. 860 at P 15.

[4] Id. at P 16.

[5] Id.

[6] According to FERC, “An LEI is a unique 20-digit alpha-numeric code assigned to a single entity. They are issued by the Local Operating Units of the Global LEI System.”

[7] Id. at P 23.

[8] Id.

[9] Id. at P 24.

[10] Id. at P 39.

[11] Id.

[12] Id. at P 47.

[13] Id. at P 64.

[14] Id.

[15] Id. at P 67.

[16] Id.

[17] Id. at P 85.

[18] Id. at P 86.

[19] Id. at P 104.

[20] Id.

[21] Id. at 110.

[22] Id.

[23] Id.

[24] Id. at 121.

[25] Id.

[26] Id. at 124

[27] Id. at 127.

[28] Id. at 128

[29] Id.

[30] Id. at P 137.

[31] Id. at P 138.

[32] Id. at P 146.

[33] Id.

[34] Id. at P 150.

[35] Id. at P 151.

[36] Id.

[37] Id. at 171

[38] Id.

[39] Id. at 184.

[40] Id.

[41] Id. at 308.

[42] Id. at 209.

[43] Id. at 284.

[44] Id.

[45] Id. at 291.

[46] Id. at 293

[47] Id.

[48] Id. at 294.

[49] Id.

[50] Refinements to Horizontal Market Power Analysis for Sellers in Certain Regional Transmission Organization and Independent System operator Markets, Order No. 861, 168 FERC ¶ 61,040, at P 5 (2019) (“Order No. 861”) (citing Market-Based Rates for Wholesale Sales of Electric Energy, Capacity, and Ancillary Services by Public Utilities, Order No. 697, 119 FERC ¶ 61,295, PP 62, 399, 408, 440 (2006) (“Order No. 697”), clarified 121 FERC ¶ 61,260 (2007), on reh’g, Order No. 697-A, 123 FERC ¶ 61,055, clarified, 124 FERC ¶ 61,055 (“Order No. 697-A”) , on reh’g, Order No. 697-B, 125 FERC ¶ 61,326 (2008), on reh’g, Order No. 697-C, 127 FERC ¶ 61,284 (2009), on reh’g, Order No. 697-D, 130 FERC ¶ 61,206 (2010), aff’d sub nom. Pub. Citizen, Inc. v. FERC, 567 U.S. 934 (2012)).

[51] Id. at P 6 (citing Order No. 697 at P 62). Passing both screens establishes a rebuttable presumption that the Seller does not possess horizontal market power, while failing either screen creates a rebuttable presumption that the Seller has horizontal market power. Id. (citing Order No. 697 at PP 33, 62–63).

[52] Id. at PP 1–4.

[53] Id. at P 6.

[54] Id. at PP 10, 16.

[55] Id. at PP 19, 22. EQRs show the volumes and prices at which Sellers are transacting and can be used to determine a Seller’s market share of sales and relative prices. Id. at P 19.

[56] Id. at PP 25–27.

[57] Id. at PP 32, 46.

[58] Id. at PP 33–35, 47. While CAISO does not have a centralized capacity market, CAISO and the California Public Utilities Commission have established a Capacity Procurement Mechanism and a Reliability-Must-Run process to set a ceiling on resources’ bilateral capacity contract compensation. Id. at PP 35–36. In SPP, capacity costs are recovered in the rate bases of franchised public utilities and are therefore subject to state regulatory review. Id. at P 47.

[59] Id. at PP 39, 48.

[60] Id. at PP 39, 47.

[61] Id. at P 51.

[62] Id.

[63] Id. at P 52.

[64] Id. at P 53.

[65] Id. at P 56.

[66] Id. at PP 57–58.

[67] Id. at P 59.

[68] Id. (citing Order No. 697-A at P 285).

[69] Id. at P 62.

[70] Id. at P 65.

[71] Id. at P 66.

[72] Id. at P 71.

[73] Id.

[74] Id. at P 72.

[75] Id. at P 71.

[76] Id. at P 78.

[77] Id. at PP 79–80. FERC explained that any action taken in those proceedings will not impact the implementation of the removal of the screen requirement. Id. at PP 79–80. After noting its concurrent issuance of Order No. 860 in Docket No. RM16-17-000, FERC stated that it would continue to monitor RTO/ISO mitigation provisions on an ongoing basis and take necessary action, as appropriate. Id. at P 80.

Over the years many banks, particularly community banks, have formed bank holding companies to take advantage of certain additional permitted activities and other practical benefits. More recently, certain community banks, including Bank of the Ozarks, have determined to terminate the bank holding company structure in order to achieve certain efficiencies and other practical benefits. Set forth below is a list of certain advantages and disadvantages of a bank holding company structure.

Advantages of a Bank Holding Company Structure

• Greater Flexibility with Regulatory Capital – Greater flexibility includes the ability to repurchase capital without regulatory approval within certain limits and operating conditions (Federal Reserve Reg. Y permits stock redemptions of up to 10% of holding company consolidated net worth in the preceding 12 months without prior approval, assuming the company and subsidiary bank will be well managed, well capitalized, and have no other significant supervisory issues both before and after the stock repurchase), and the ability to issue trust preferred securities and hold grandfathered trust preferred securities assumed in an acquisition.  In addition, a holding company may issue debt securities and contribute the proceeds as equity capital to the subsidiary bank, and the interest paid on these debt securities is tax deductible for the holding company. 

• Greater Flexibility for Restricted Stock Awards – A bank holding company has more flexibility than a bank in providing employee-friendly tax withholding provisions in restricted stock awards. Federal banking regulations limit the ability of banks to reduce permanent capital without prior approval. A holding company may issue equity awards, including restricted stock awards, without impacting the permanent capital of a subsidiary bank. Accordingly, holding companies may permit employees to satisfy tax withholding triggered by vesting events by returning or surrendering shares of holding company stock to the company rather than by paying cash. For national banks and banks chartered in states that do not recognize the corporate concept of treasury shares (including Virginia), returning or surrendering shares of bank stock in this manner is treated as a repurchase that reduces the bank’s permanent capital. Absent prior regulatory approval, which would likely be difficult to obtain, returning or surrendering shares to satisfy tax withholding obligations is impermissible, and these banks must explore other methods to help employees manage the tax consequences of vesting in a restricted stock award. 

• Better Investor Relations – Bank holding companies with securities registered under federal securities laws file SEC reports on the SEC’s EDGAR System, providing greater transparency and disclosure of financial and other significant corporate information; whereas banks without holding companies with securities registered under the federal securities laws file similar reports on the FDICconnect system, which is not as visible to the public. However, banks without holding companies can make voluntary filings with the SEC and self-publish reports on their public websites to maintain investor and analyst visibility.

• Greater Flexibility Regarding Activities – A bank holding company may engage in certain additional permissible activities not possible for a bank, such as holding certain problem assets purchased from a subsidiary bank and owning up to 5% of any class of voting securities of any entity without prior regulatory approval. In addition, eligible bank holding companies may elect financial holding company status, which permits certain non-bank activities that are incidental to banking and/or financial in nature, including securities underwriting, insurance underwriting, and merchant banking. 

• Structural Flexibility with M&A – A bank holding company structure provides organizational flexibility when merging or integrating an acquired bank with an existing subsidiary bank. If a holding company acquires another bank, it can merge the subsidiary banks at any time after the acquisition, while in a bank-to-bank merger banks must be fully integrated on day one of the acquisition, which may create timing problems with core processor conversion, increase integration risks, and increase costs. 

• Flexibility for Small Bank Holding Companies – Bank holding companies with less than $3 billion in assets may take advantage of the Federal Reserve’s Small Bank Holding Company and Savings & Loan Holding Company Policy Statement. Traditionally, the Federal Reserve has disfavored the use of debt in bank mergers and acquisitions. However, the Federal Reserve recognizes that the transfer of ownership of small banks often requires the use of acquisition debt and, thus, permits the formation and expansion of small bank holding companies with debt levels higher than would be permitted for larger bank holding companies. 

Disadvantages of a Bank Holding Company Structure

• Enhanced Regulatory Burden – A bank holding company is regulated by the Federal Reserve and State regulatory authorities. For a national bank or a state non-member bank, this creates an additional set of regulators. In addition, a bank holding company is subject to periodic examination by the Federal Reserve and is required to be a source of financial strength for its insured subsidiary bank.  

• SEC Costs – A bank holding company with securities registered under federal securities laws typically incurs higher costs for SEC reporting and pays registration fees for non-exempt issuances of new securities. 

• No Federal Registration Requirement for State Bank Securities Offerings – Without a holding company, the public offering of bank stock by a state bank is exempt from registration under the Securities Act of 1933, allowing the use of an offering circular that is shorter than a public company registration statement/prospectus. This not only saves in registration fees, but also other costs associated with securities registration and offering document preparation. A national bank without a holding company, while exempt from SEC registration for securities offerings, is subject to comparable registration requirements imposed by the OCC.

• Multiple Governance and Organizational Structures for Both the Holding Company and the Bank – A bank with a holding company will have separate sets of articles, bylaws, policies, procedures, and risk management guidelines. It will also have two boards of directors with certain actions required to be approved by the holding company board and certain actions required to be approved by the bank board.  This burden may be eased by having the same individuals serve on the holding company board and the bank board.

• More Financial Reporting – Financial reporting is at the holding company and bank level, requiring the need to maintain separate books for the bank and holding company, including with regard to filing Call Reports, making SEC filings, and related activities.

• Affiliate Transaction Considerations – Sections 23A and 23B of the Federal Reserve Act (and Federal Reserve Reg. W) impose quantitative and market-terms restrictions on a bank’s loans to, purchases of assets from, and certain other transactions with, affiliates, including its bank holding company. By contrast, these provisions are largely inapplicable to transactions between banks without holding companies and their direct subsidiaries (although loan-to-one borrower rules and restrictions on the transfer of low-quality assets remain applicable).

Conclusion

While there are certain advantages to a bank holding company structure, there are certain disadvantages as well.  Because each bank and bank holding company structure is unique, as are their business plans, executives and boards addressing this issue should carefully analyze their unique circumstances. We are pleased to assist executives and boards explore structural alternatives. 

The Pennsylvania Supreme Court has adopted a new, expanded standard for preserving the protections of the attorney work-product doctrine, codified at Pennsylvania Rule of Civil Procedure 4003.3. This decision has implications for Pennsylvania companies and others employing nonlawyer consultants — including public relations experts — to help manage crises.

In BouSamra v. Excela Health, No. 5 WAP 2018 (Pa. June 18, 2019), the Court’s majority held that the attorney work-product doctrine is not waived by disclosure to a third party “unless the alleged work product is disclosed to an adversary or disclosed in a manner which significantly increases the likelihood that an adversary or anticipated adversary will obtain it.” The decision partially reversed the Pennsylvania Superior Court, which had found that work-product protections were waived when information from an attorney was forwarded to an outside public relations consultant.

Background

The dispute grew out of a defamation lawsuit filed by Dr. George BouSamra, a cardiologist, against his former employer, a Westmoreland County hospital owned by Excela. The hospital had hired a peer-review consultant to determine whether any cardiology procedures performed there were medically unnecessary. Excela then hired a public relations consultant to manage anticipated negative publicity.

While the review was ongoing, Excela’s outside counsel sent legal advice to Excela’s senior vice president and general counsel, who then forwarded the email to the public relations consultant. Excela decided to publicly disclose the results of the peer review during a press conference on the matter, naming BouSamra as one of two doctors who allegedly performed medically unnecessary procedures. BouSamra filed his defamation suit the following year and, during discovery, sought information provided to the public relations consultant.

The lower courts held that the information was not protected, reasoning that Excela waived its right to prevent disclosure of the email in question when it was forwarded to an outside PR consultant who was not a hospital employee.

Supreme Court’s Decision

The Pennsylvania Supreme Court agreed with the lower courts’ decisions regarding waiver of attorney-client privilege. In affirming that decision, the Court reasoned that the attorney-client privilege is meant to protect confidential communications between an attorney and client, and that this privilege is generally waived when those communications are shared with a third party. The PR consultant in BouSamra was an employee of a third-party firm, and, as such, attorney-client privilege was waived when the communication was shared outside of Excela.

In contrast, the Pennsylvania Supreme Court reasoned that the attorney work-product doctrine is not founded on the type of enhanced confidentiality considerations implicated by the attorney-client privilege. Instead, the work-product doctrine aims to protect “the mental impressions and processes of an attorney acting on behalf of a client.” The Court also stressed that work-product protections belong to the attorney, not to the client, and that the doctrine applies to an attorney’s work “regardless of whether the work product was prepared in anticipation of litigation.”

That latter point was based on differences between how Pennsylvania has codified work-product protections versus the work-product doctrine as defined in the Federal Rules of Civil Procedure. The majority explained that Pennsylvania Rule of Civil Procedure 4003.3 includes documents prepared “in anticipation of litigation” as an example of material that may be protected by the work-product doctrine, but that such materials are not automatically protected, and other materials not prepared in anticipation of litigation may also be protected. The majority went on to explain that Federal Rule of Civil Procedure 26(b)(3)(A), which codifies the version of the work-product doctrine applicable in federal court, uses different language that generally protects “documents and tangible things prepared in anticipation of litigation or for trial.”

After analyzing the purpose of the work-product doctrine, the Court reasoned that attorney work product can sometimes be disclosed to third parties without waiving the doctrine’s protections. It held that work product protections would be waived when the material is shared with an opponent, or shared in a way that “significantly increases the likelihood” that an opponent or a potential opponent would discover the information.

The Court noted that this new rule has a “fact intensive structure [that] requires evaluation on a case-by-case basis.” In making such a determination, it said, courts should consider “whether the disclosure was inconsistent with the maintenance of secrecy from the disclosing party’s adversary.” (Citation and internal quotation marks omitted.) However, that standard “should not be conflated with the heightened level of confidentiality required under the attorney-client privilege.” In other words, the majority reasoned, attorney work product must “be kept confidential only from the adversary,” not necessarily from all third parties.

The Court went on to find that the factual record had not been developed sufficiently to determine whether Excela waived the protections of the work-product doctrine. It remanded the case to the trial court for factual findings involving the work-product considerations laid out by the majority opinion.

Two concurring opinions agreed with the majority’s ultimate decision, but stressed factors that should be considered when a court rules on potential waiver of work-product protections.

Justice Donohue wrote that the trial court should look at whether the disclosing party “took any or all of the necessary and available precautions to reduce or eliminate the likelihood that the information could be obtained” by an adversary. Justice Wecht cited persuasive authority from the D.C. Circuit that suggested courts should evaluate “whether the disclosing party had a reasonable basis for believing that the recipient would keep the disclosed material confidential.” For example, he reasoned that work product protections may be maintained when the disclosing party has a formal confidentiality agreement with the party to whom the information is disclosed.

Implications

While the BouSamra decision expands the zone of protection afforded by Pennsylvania’s version of the attorney work-product doctrine, subsequent decisions evaluating different factual scenarios will be needed to flesh out how far that protection now extends. That said, the case does provide guidance for companies and individuals wishing to maximize attorney work-product protections. To prevent a finding that those protections have been waived, the party disclosing attorney work product should take explicit, demonstrable steps to maintain the secrecy of that information, such as:

• entering into a formal confidentiality agreement or similar written pact with the third party receiving the information

• explicitly stating when transmitting the information that it is confidential and should not be shared

• writing “Confidential Attorney Work Product” or some similar disclaimer on the information being disclosed.

The Supreme Court recently clarified that third-party counterclaim defendants — parties who were not defendants in the original action, but were brought in as third-party defendants by virtue of the original defendant’s counterclaims — lack the authority to remove their class claims from state to federal court. Home Depot U.S.A. Inc. v. Jackson, No. 17–1471, slip op. at 1 (U.S. May 28, 2019). Justice Thomas, writing for a five-Justice majority that included Justices Ginsburg, Breyer, Sotomayor and Kagan, noted that neither the general removal statute nor the removal provision of the Class Action Fairness Act (CAFA) provides any support for the theory that the term “defendant” in those statutes also encompasses “counterclaim defendant.” Id.

The key takeaways from the case are:

• Those forced to defend class claims brought by the original defendants via counterclaims cannot remove their claims to federal court under CAFA.

• The Court’s opinion is not limited to class actions — it applies to individual claims asserted via counterclaim in state court as well.

• While the opinion may have far-reaching consequences for counterclaim defendants, the majority has punted to Congress to remedy any fallout by amending the text of the relevant removal statutes, if it chooses.

• The opinion did not alter removal options for traditional defendants in any way. If a party faces class or individual claims by virtue of the claims that started a suit, it can still remove under the general removal statute and CAFA if it meets the relevant removal requirements.

Background

Plaintiff Citibank, N.A., filed a debt-collection action against George Jackson in a North Carolina state court. Slip op. at 3. In response, Jackson filed a class action counterclaim against Citibank, the original plaintiff, and two additional parties: Home Depot and Carolina Water Systems. Id. In his class counterclaim, Jackson alleged that a scheme between the three entities induced consumers to purchase products at inflated prices in violation of North Carolina law. Id. at 3-4. Citibank soon thereafter dismissed its claims against Jackson, the original defendant, and Home Depot promptly removed the case from state court to federal district court. Id at 4. Jackson moved to remand, arguing a third-party counterclaim-defendant like Home Depot did not have the authority to remove the case to federal court. Id. The federal district court granted Jackson’s motion to remand, and the Fourth Circuit affirmed. Id. Home Deposit successfully petitioned the Supreme Court for certiorari to determine whether a new party, impleaded by the original defendant as a counterclaim defendant, qualifies as a “defendant” with removal rights under either 28 U.S.C. § 1441(a), the general removal statute, or CAFA.

Majority Opinion

The five-Justice majority first looked to whether the general removal statute, 28 U.S.C. § 1441(a), permitted removal by a third-party counterclaim defendant. Id. at 5. Home Depot argued that because it is a “defendant” to a “claim,” it qualified as a defendant under this statute. Id. The majority disagreed, emphasizing that while the term “defendant” itself was broad, the term must be read in context with the statute. Id. “Considering the phrase ‘the defendant or the defendants’ in light of the structure of the statute and our precedent, we conclude that § 1441(a) does not permit removal by any counterclaim defendant, including parties brought into the lawsuit for the first time by the counterclaim.” Id. at 5-6.

The Court’s statutory interpretation analysis unfolded in three parts. First, the Court stressed that the removal statute refers to “civil action[s]” and not “claims,” notwithstanding Home Depot’s argument to the contrary. Id. at 6. Second, the Court pointed to the language of the Federal Rules of Civil Procedure, noting that Rules 12 and 14 distinguished between plaintiffs, defendants, third-party plaintiffs and third-party defendants, making it difficult to interpret “defendant” in § 1441(a) to also cover “third-party defendant.” Id. at 7. Finally, the Court noted that Congress has, in other removal statutes, explicitly provided for broader removal rights, and that it did not do so here. Id. For example, 42 U.S.C. § 1452(a) allows any party in a civil action to “remove any claim or cause of action” over which a federal district court would have bankruptcy jurisdiction, and 42 U.S.C. §§ 1454(a) and (b) provide that any party may remove a civil action related to “patents, plant variety protection, or copyrights.” Id. These rationales led the Court to affirm and broaden its 1941 decision in Shamrock Oil & Gas Corp. v. Sheets, 313 U.S. 100 (1941), where it held that a counterclaim defendant that was the original plaintiff had no right of removal under a predecessor statute to § 1441.

The Court also concluded that CAFA’s removal provision, codified at 28 U.S.C. § 1453(b), cannot be interpreted to allow for removal of class claims by third-party counterclaim defendants when traditional claims could not be removed under § 1441. Id. at 9. CAFA was only meant to modify the circumstances in which removal of class claims is appropriate, the Court held, not alter the limit on who can remove in the first instance. Id. CAFA broadened removal options in two ways: (1) it eliminated the prohibition on removal if the defendant was a citizen of the state in which the action was brought and (2) it removed the requirement that every defendant must consent to removal. Id. at 10. Neither of these provisions altered the definition of “defendant,” meaning that “defendant” under CAFA cannot encompass more parties than “defendant” under § 1441(a). Id.

Dissent

In his dissent, Justice Alito, joined by Chief Justice Roberts and Justices Gorsuch and Kavanaugh, began by stressing the importance of the removal process as a tool to help defendants avoid the perceived prejudices of state court. Slip op. at 1 (Alito, J., dissenting). The dissenting justices noted that, regardless of their procedural status, counterclaim defendants “are defendants to legal claims” indistinguishable in any meaningful respect from traditional defendants:

Neither chose to be in state court. Both might face bias there, and with it the potential for crippling unjust losses. Yet today’s Court holds that third-party defendants are not “defendants.” It holds that Congress left them unprotected under CAFA and §1441. This reads an irrational distinction into both removal laws and flouts their plain meaning, a meaning that context confirms and today’s majority simply ignores.

Id. at 2. Justice Alito examined the history of CAFA and noted that several federal district courts have described a removal prohibition for counterclaim defendants as a “loophole” or litigation “tactic.” Id. at 7. According to the dissent, there is no evidence that Congress intended this result when it passed CAFA and that the majority’s “uncharitable reading” has led to a “bizarre result.” Id. at 8.

Justice Thomas summarily dismissed the concerns raised by the dissenting Justices, noting that “if Congress shares the dissent’s disapproval of certain litigation ‘tactics’ it certainly has the authority to amend the statute. But we do not.” Id.

Implications

Perhaps the most obvious implication of the Court’s opinion is that it has, to some extent, undermined the purpose of the Class Action Fairness Act. In enacting CAFA in 2005, Congress specifically noted that certain class action practices by state and local courts over the course of the previous decade “undermine[d] the national judicial system” by “keeping cases of national importance out of Federal court; sometimes acting in ways that demonstrate bias against out-of-State defendants; and making judgments that impose their view of the law on other States and bind the rights of the residents of those States.” Class Action Fairness Act of 2005, S. 5, 109th Cong. § 2(a)(4).

CAFA was enacted to make it easier for defendants to avoid these state court abuses by easily removing class actions to federal court. The Court’s opinion in Home Depot effectively denies CAFA protections to parties who, throughout no fault of their own, face class claims in a state court by virtue of the original defendant’s counterclaims.

Ultimately, while this opinion will force counterclaim defendants to litigate class claims in state court for the immediate future, Justice Thomas took care to explain the limited nature of the Court’s rationale. At the end of the majority opinion, Justice Thomas noted that the Court’s opinion may very well result in unsavory litigation tactics designed to trap parties in state court. Justice Thomas simply noted that those concerns were not the Court’s to resolve; rather, the Court’s role was limited to interpreting the statutory text. Justice Thomas went on to point out that if Congress shared the concerns of Justice Alito and his fellow dissenters regarding the policy implications of the Court’s opinion, then Congress can easily remedy the situation by amending the relevant removal statutes.

At bottom, this opinion turns on the relatively limited jurisdiction of the federal courts, which only have the authority to hear a case when a statute grants that authority. Congress thus has substantial power to determine the types of cases eligible for removal from state court, and the parties that may effect removal. Here, Justice Thomas has explicitly called on Congress to act if it is not satisfied with the Court’s opinion. Given the consequences of this opinion, and its obvious conflict with the purpose of CAFA, Congress may very well effectively overrule or at least modify this opinion via legislative action.

Jan P. Levine and Lindsay D. Breedlove are partners in Pepper Hamilton’s Health Sciences Department, a team of 110 attorneys who collaborate across disciplines to solve complex legal challenges confronting clients throughout the health sciences spectrum. Dennie B. Zastrow is an associate in the firm’s Trial and Dispute Resolution Practice Group, a seasoned and trial-ready team of advocates who help clients analyze and solve their most emergent and complex problems through negotiation, arbitration and litigation.

Reprinted with permission from the April 2019 issue of Alternatives to the High Cost of Litigation, the newsletter of the International Institute for Conflict Prevention & Resolution. (Vol. 37, No. 4).

The U.S. Supreme Court has demonstrated with increasing frequency over the past 20 years a particular fascination with arbitration. There have been at least 20 Scotus cases in the past decade on arbitration, including three cases in the current term—two in the first week in October.

By contrast, even though there remains far more cases in federal court than in arbitration, and even though personal jurisdiction is both a frequently litigated issue and an evolving concept in our Internet age of virtual “presence,” there have been only three cases expanding on federal jurisdictional issues.

One might think that by this point all that is required to be said from the Supreme Court about arbitration has been said.

But one would be wrong. The Supreme Court’s seeming obsession with arbitration is a mile deep but only an inch wide.

Most of the cases of the past decade are concerned exclusively with arbitration jurisdiction—so-called questions of arbitrability—and, in particular, with whether arbitration clauses can exclude any form of class action even though some states are virulently opposed to these exclusions and some federal statutes arguably are adversely affected by them. See Epic Systems Corp. v. Lewis, 138 S. Ct. 1612 (2018); DIRECTV Inc. v. Imburgia, 136 S. Ct. 463 (2015); Am. Express Co. v. Italian Colors Rest., 570 U.S. 228 (2013), AT&T Mobility LLC v. Concepcion, 563 U.S. 333 (2011); Rent-A-Center, West Inc. v. Jackson, 561 U.S. 63 (2010).

Left virtually uncommented upon by the Supreme Court have been particular questions of arbitration procedure. The Court has shown itself to be far more concerned with the dog’s chase of the arbitration car than with what the dog does once it gets there.

Nowhere has the absence of guidance been felt so acutely and painfully as on the subject of third-party discovery in arbitration. This is not an esoteric topic. Any litigator reading this article knows how critical, and frequently dispositive, the testimony and documents of a non-party to the dispute can be to the outcome.

Third-party witnesses usually do not have a stake in the result of the case and so can emerge to the finder of fact as the most credible witnesses in the case. They also may have documents unavailable to any of the parties.

U.S. civil procedure recognizes this and makes it easy for a party to access evidence from third parties. Federal Rules of Civil Procedure Rule 45 was amended in 2013 to make third-party discovery more straightforward. At the state level, a significant majority of states have adopted some form of the Uniform Interstate Depositions and Discovery Act, which simplifies the process for state courts in enforcing out-of-state subpoenas.

The result is that third parties can be subpoenaed and then served virtually anywhere in the United States; they can be made to show up for depositions and produce documents, and they can be called to give evidence at trial. Third-party testimony is a core element of civil litigation.

Not so in arbitration. The rules of third-party evidence in arbitration are a mess. At first blush, it might not appear so, since Federal Arbitration Act Sec. 7 provides in plain terms that the arbitrator has the power to summon third-party witnesses to give testimony and provide documents at the hearing:

The arbitrators selected either as prescribed in this title or otherwise, or a majority of them, may summon in writing any person to attend before them or any of them as a witness and in a proper case to bring with him or them any book, record, document, or paper which may be deemed material as evidence in the case.

Notwithstanding this seemingly clear language in the statute, little is clear in practice. The confusion and uncertainty involves three variables: when, where, and what court will enforce a subpoena, if any?

1. When? Fifteen years after the Third U.S. Circuit Court of Appeals’ restrictive reading of the FAA in Hay Group—a case discussed full below and one that provoked substantial commentary—there remains a growing and substantial circuit court split as to whether pre-hearing discovery from third-party witnesses is allowed at all—and if so, with what parameters and what participation from the arbitrator(s).(On the circuit split, see Heather L. Heindel, Third-Party Document Discovery in Arbitration? Do Not Count On It, ABA Forum on Construction Law (Dec. 5, 2018) (available at https://bit.ly/2H6gPat); on the Hay Group commentary, see Third Circuit Says Arbitrators Cannot Force Non-Parties to Provide Documents for Review, Michael R. Triplett, BNA (March 15, 2004); Second Circuit Adds to Circuit Split on Arbitration Discovery, Holding that Third Parties Cannot be Compelled to Produce Discovery Documents Under 7 of the Federal Arbitration Act, Cleary Gottlieb (Dec. 4, 2008) (available at https://bit.ly/2HqWyf0); Rolling With Hay: Compelling Third-Party Discovery in Arbitration Proceedings, David J. McLean and Vincent Mekles, N.J. Law Journal, Vol. CXCV-No. 13 (March 30, 2009).)
2. Where? There is disagreement as to the territorial reach of arbitral subpoenas in compelling a witness to give testimony and/or produce documents when the witness and/or the documents are located outside of the arbitral seat.
3. What court? There is disagreement over whether the federal courts have exclusive jurisdiction on actions to compel compliance with an arbitral subpoena and how jurisdiction of that court is properly determined.

The result is that even though arbitration takes place under a federal statute, and even though the Supreme Court has repeatedly claimed that courts should construe arbitration decisions with a decided preference toward arbitration (FAA “Section 2 is a congressional declaration of a liberal federal policy favoring arbitration agreements.” Moses H. Cone Mem’l Hosp. v. Mercury Const. Corp., 460 U.S. 1 (1983); see also Perry v. Thomas, 482 U.S. 483, 489 (1987)), there is at present no consistent body of precedent that serves as a guidepost to practitioners.

There are no set standards. The “when” and the “where” questions are very much localized; make predictions impossible; raise costs; and, most of all, affect arbitration adversely. The result is higher costs: despite choosing arbitration as a supposedly more efficient process, parties may have to fight pitched battles within the arbitration or in related court proceedings to secure access to evidence.

This article examines the confusion in each of these “when,” “where,” and “what court” areas; analyzes competing arguments in favor of the present chaos—primarily that burdens on third-party discovery make arbitration more “efficient”—and finally, proposes a needed procedural amendment to the Federal Arbitration Act to eradicate the confusion.

I. When during the Course of an Arbitration Can a Party Obtain Third-Party Evidence?

As compared to the issues of territoriality (Section II below) and what court (Section III), the issue of “when” is comparatively straightforward, because the outcomes of any given court are somewhat predictable thanks to the federal appeals courts.

The result is that many circuit practitioners can predict what will happen, but the prediction can depend on the fates of fortune in dictating the location of the third-party evidence.

Luck, not consistency, dictates success here. There remains a substantial need for clarification by the Supreme Court or, failing that, for the type of amendment proposed below.

The Sixth and Eighth Circuits both take the expansive view that the policies underlying the FAA require that parties to an arbitration should be able to take discovery from third parties in advance of any arbitration hearing.

The Second, Third, and Ninth Districts have issued decisions making it clear that courts will not enforce arbitral subpoenas for documents and testimony prior to any hearing and outside of the arbitrators’ presence. While those courts generally do not permit discovery, some of them have accepted and even encouraged a loophole practice whereby the arbitrators can hold a “mini-hearing” prior to the main merits hearing in order to obtain the necessary third-party evidence.

The Fourth Circuit comes out in the middle and permits discovery “under special circumstances.” Those cases and the policies supporting them are discussed below.

A. Courts Taking a Permissive View of Third Party Discovery: The Eighth U.S. Circuit Court of Appeals in Security Life Ins. Co. of Am. v. Duncanson & Holt Inc., 228 F.3d 865, 870–71 (8th Cir. 2000), explained that the efficient resolution of disputes through arbitration “is furthered by permitting a party to review and digest relevant documentary evidence prior to the arbitration hearing.” It enforced an arbitrator’s subpoena for documents on a third party without regard to where the witness possessing the documents resided. Id. at 872. The Sixth Circuit took the same approach in Television and Radio Artists v. WJBK-TV, 164 F.3d 1004, 1010 (6th Cir. 1999).

B. Decisions Prohibiting Pre-Hearing Discovery from Third Parties: The Third Circuit in Hay Group Inc. v. E.B.S. Acquisition Corp. 360 F.3d 404 (3d Cir. 2004), rejected the Sixth and Eighth Circuits’ analysis, holding that the FAA did not give arbitrators subpoena power to require third parties to produce documents in advance of any hearing.

Then-Circuit Judge Samuel A. Alito Jr. reasoned that “[t]his slight redistribution of bargaining power is unlikely to have any substantial effect on the efficiency of arbitration. Moreover … the rule we adopt in this case may in fact facilitate efficiency by reducing overall discovery in arbitration.” The Second Circuit agreed with the Hay Group decision in Stolt-Nielsen SA v. Celanese AG, 430 F.3d 567 (2d Cir. 2005).

More recently, the Ninth Circuit joined the Second and Third Circuits and held that “Section 7 of the FAA does not grant arbitrators the power to order third parties to produce documents prior to an arbitration hearing.” CVS Health Corp. v. Vividus LLC, 878 F.3d 703, 708 (9th Cir. 2017).

C. The “Mini Hearing” Method: In a concurring opinion in the Hay Group case, then- Circuit Judge Michael Chertoff stated that the court’s opinion should not completely foreclose a party from obtaining the sought evidence in advance of the prime merits hearing:

Under section 7 of the Federal Arbitration Act, arbitrators have the power to compel a third-party witness to appear with documents before a single arbitrator, who can then adjourn the proceedings. This gives the arbitration panel the effective ability to require delivery of documents from a third-party in advance, notwithstanding the limitations of section 7 of the FAA. In many instances, of course, the inconvenience of making such a personal appearance may well prompt the witness to deliver the documents and waive presence. See David M. Heilbron, The Arbitration Clause, the Preliminary Conference, and the Big Case, 45 Arb. J. 38, 4344 (1990).

360 F.3d at 413. The Second Circuit joined with approval in this approach in Stolt-Nielsen v. Celanese, holding that the arbitration panel had the authority to compel a third party to testify and produce documents in advance of the full merits hearing so long as the evidence was taken before the arbitration panel:

Any rule there may be against compelling non-parties to participate in discovery cannot apply to situations, as presented here, in which the non-party is “summon[ed] in writing … to attend before [the arbitrators] or any of them as a witness and … to bring with him … [documents] which may be deemed material as evidence in the case.” 9 U.S.C. § 7.

Stolt-Nielsen v. Celanese, 430 F.3d at 577-578; see also Life Receivables Trust v. Syndicate 102 at Lloyd’s London, 549 F.3d 210 (2008).

For some courts, the Hay Group and Stolt-Nielsen v. Celanese decisions left open the question of whether the tribunal members needed to be physically present for the third-party testimony or document production, or whether testimony of a distant third party could be heard by the arbitrator via phone or videoconference.

The court in Westlake Vinyls Inc. v. Cooke, No. 3:18-MC-00018, 2018 BL 491532 (W.D. Ky. Aug. 20, 2018) (Magistrate recommendation accepted in 2018 BL 491535 (W.D. Ky. Oct. 16, 2018)), addressed that issue and held that an arbitrator can order pre-hearing discovery of a third party, but that discovery must occur in the context of an actual hearing with live participation by at least one arbitrator. Id. (“Due to lack of physical presence of at least one arbitrator at the hearing described by the subpoena, the Court lacks authority to enforce it pursuant to FAA, Section 7.”)

D. Discovery Available Only Under Special Circumstances: The Fourth Circuit has taken a slightly different approach, which while it has some facial appeal appears difficult to implement in practice and provides insufficient guidance for lower courts. In COMSAT Corp. v. Natl. Science Foundation, 190 F.3d 269, 275 (4th Cir. 1999), the court held that Section 7’s plain meaning did not empower an arbitrator to issue prehearing discovery subpoenas to nonparties. 190 F.3d at 275.

In dicta, however, the COMSAT court suggested that an arbitration panel might be able to subpoena a nonparty for prehearing discovery “under unusual circumstances” and “upon a showing of special need or hardship.” Id. at 276.

II. What are the territorial limits on obtaining third-party evidence?

Location of the witness, and the documents controlled by that witness, is the second variable affecting availability of third-party evidence in arbitration.

Courts must grapple with their authority over third parties outside of the court’s district. This in turn leads to questions regarding the proper interpretation of Fed. R. Civ. P. 45, the federal rule for subpoenas.

While Rule 45 has been amended to make taking discovery from third parties easier—the 2013 amendments to Rule 45 included requiring that subpoenas issue from the court where the underlying dispute is pending and permitted nationwide service of process (Fed. R. Civ. P. 45(a)(2), (b)(2))—the arbitration decisions have apparently ignored these amendments and have done little to aid practitioners in obtaining necessary third-party evidence.

Uncertainty remains. In Amgen Inc. v. Kidney Ctr. of Delaware County Ltd., 879 F. Supp. 878 (N.D. Ill. 1995), an arbitrator sitting in Chicago issued a subpoena for a deposition of a Pennsylvania company, KCDC. Amgen then sought to enforce the subpoena in Pennsylvania’s Eastern District, where KCDC is located, but the court transferred the matter to Illinois’ Northern District, the proper venue under FAA Section 7. 9 U.S. Code § 7 (“[U]pon petition the United States district court for the district in which such arbitrators, or a majority of them, are sitting may compel the attendance of such person or persons before said arbitrator or arbitrators.”).

KCDC then objected to the subpoena on the basis that “the arbitrator has no authority to subpoena persons who are located outside of the district in which he sits or beyond 100 miles of the site of the arbitration.” Id. at 880.

The court rejected this argument and held that it must be possible for parties to obtain evidence located outside of the judicial district where the arbitration is taking place:

To find that the wording of the FAA precludes issuance and enforcement of an arbitrator’s subpoena of a witness outside the district in which he or she sits, particularly where, as here, such discovery is agreed upon by the parties to the arbitration, would likely lead to rejection of arbitration clauses altogether.

Id. at 882. The Amgen court “gap-filled” the FAA by relying on the portion of Rule 45 that permits an attorney to issue subpoenas for depositions under the courts where the deposition is to take place and that a court sitting in another jurisdiction could then enforce the subpoena. Id. at 883. See also Ferry Holding Corp. v. GIS Marine LLC, No. 4:11-MC-687, 2012 BL 6546 (E.D. Mo. Jan. 11, 2012) (following Amgen and permitting counsel to issue subpoenas for documents located in the Eastern District of Louisiana).

Many years later, another Northern District of Illinois court rejected this analysis and refused to enforce an arbitration subpoena when it did not comply with Rule 45’s territorial limitations. Alliance Healthcare Servs. Inc. v. Argonaut Private Equity LLC, 804 F. Supp. 2d 808 (N.D. Ill. 2011). The court explained that FAA Section 7 limits the court’s “arbitration subpoena enforcement authority to the authority it has under existing law,” meaning the power conferred by Rule 45. Id. at 813. The court acknowledged this created a gap, “[b]ut it is up to Congress, not a court, to fill such gaps.” Id.

Similar to Alliance Healthcare, the Second Circuit in Dynegy Midstream Servs. LP v. Trammochem, 451 F.3d 89 (2d Cir. 2006) addressed the situation of arbitrators issuing a subpoena for out-of-state evidence. The court held that the FAA did not provide the arbitrators with nationwide service of process and that the arbitrators were limited as if they were a district court sitting in New York. Id. at 95. The court refused to follow the Amgen gap-filling role because Section 7 only permits arbitrators to issue subpoenas, not lawyers. Id. at 96.

Finally, turning back to one of the first discussed cases above, the Eighth Circuit apparently does not consider the territoriality to be an issue at all. The court in Security Life Ins. Co. of Am. v. Duncanson & Holt Inc., 228 F.3d 865, 870–71 (8th Cir. 2000), did not mind at all that the arbitral subpoena for the production of documents did not comply with Rule 45’s territorial limitations. Id. at 872 (“Whether or not Transamerica is correct in insisting that a subpoena for witness testimony must comply with Rule 45, we do not believe an order for the production of documents requires compliance with Rule 45(b)(2)’s territorial limit.”)

III. Does a Federal Court have Jurisdiction over a Section 7 Action?

The final frustrating factor for arbitration lawyers is that even in jurisdictions where there may be good answers as to “when” and “where,” there might not be an available court to enforce the subpoena.

Despite federalizing arbitration procedure and codifying that arbitration is enforceable, the FAA does not confer subject-matter jurisdiction on federal district courts. See Stolt-Nielsen v. Celanese at 572 (“parties invoking Section 7 must establish a basis for subject matter jurisdiction independent of the FAA”); Amgen at 567 (7th Cir. 1996) (holding that the FAA “itself does not create subject matter jurisdiction for independent proceedings, whether they involve § 4 or § 7”); see also American Federation of Television and Radio Artists, AFL-CIO v. WJBK-TV, 164 F.3d 1004, 1007-08 (6th Cir. 1999) (holding that FAA Section 7 did not bestow jurisdiction but finding federal jurisdiction pursuant to the Labor Management Relations Act of 1947).

To get into federal court, an arbitration must qualify for diversity jurisdiction just as any other federal court case. A $50,000 arbitration between citizens of different states, or a $1 million arbitration between Pennsylvanians, will generally not provide the federal court with jurisdiction. 28 U.S. Code § 1332.

This collides with the FAA’s requirement that any action to enforce a subpoena be brought in federal district court. The cases below show how arbitration parties have struggled to address this issue.

In Beck’s Superior Hybrids Inc. v. Monsanto Co., 940 N.E.2d 352 (Ind. Ct. App. 2011) Monsanto and Dupont were parties to a New York arbitration. To obtain documents from third party Beck’s, the arbitral tribunal issued a subpoena to Beck’s, ordering Beck’s to appear at a preliminary hearing, in Indiana.

The arbitration panel and the parties took this approach because they were presumably aware that they could not order Beck’s, an Indiana company with no New York contacts, to appear in New York. And under Stolt-Nielsen v. Celanese, a New York court would not enforce a documents-only subpoena outside of an arbitrator’s presence.

Beck’s refused to produce documents and Monsanto filed suit in Indiana state court to enforce the subpoena. Monsanto brought suit in Indiana because it admitted that New York’s Southern District did not have jurisdiction because of a lack of diversity (both Dupont and Monsanto are Delaware corporations).

The Indiana Court of Appeals held that it was preempted from enforcing the subpoena because Congress was clear in enacting FAA Section 7: “This limited federal jurisdiction for enforcement is a reflection of Congress’ desire to keep arbitration simple and efficient, ‘to protect non-parties from having to participate in an arbitration to a greater extent than they would if the dispute had been filed in a court of law,’ and not to burden state courts with incidental enforcement procedures.” Id. at 362-63.

Monsanto argued that for Section 7 purposes, the tribunal would be sitting in Indiana when one of the arbitrators convened a hearing for obtaining the documents from Beck’s. The court, however, rejected this argument because a majority of the arbitrators would never leave New York City. Id. at 364, citing Section 7 (“the arbitration panel, or a majority of its members”).

While the Beck’s court focused on the citizenship of the arbitration parties, rather than focusing on the citizenship of the parties seeking the evidence and the relevant third party, that is not always the case. In Federal Ins. Co. v. Law Offices of Edward T. Joyce, No. 08 C 0431, 2008 BL 61782 (N.D. Ill. Mar. 13, 2008), the party to the arbitration initiated an action to compel compliance with an arbitral subpoena. The court held it had jurisdiction because the party to the arbitration and the third party were from different states.

Similar to diversity, determining the amount in controversy is not settled. The court in Chi. Bridge & Iron Co. v. TRC Acquisition LLC, No. 14-1191, 2014 BL 208908 (E.D. La. July 29, 2014), determined that while there was diversity, the plaintiff failed to satisfy the amount-in-controversy requirement and could not rely upon the amount at stake in an underlying arbitration because that amount was not sought from the defendant in the federal case, which was a third party to the arbitration.

In contrast, the court in Next Level Planning & Wealth Mgmt. LLC v. Prudential Ins. Co. of Am., No. 18-MC-65, 2019 BL 47933, at *3 (E.D. Wis. Feb. 13, 2019), addressed the problem differently and held that the amount in controversy should be assessed based on the value of the arbitration.

Another recent set of cases all arising from the same single California arbitration further demonstrates the problem. Similar to the Beck’s court, the court in Gilead Sciences Inc. v. Roche Molecular Sys. Inc., No. 1777 CV01626, 2017 BL 487247 (Mass. Super. Ct. Nov. 27, 2017) rejected a party’s attempt to make a Section 7 compliance action in state court.

A New York state court reached the opposite conclusion as part of the same arbitration. In Matter of Roche Molecular Sys. Inc. v. Gutry, 76 N.Y.S.3d 752 (Sup. Ct. 2018), Roche requested that the tribunal authorize Roche to seek a commission—a common step in obtaining an out-of-state subpoena for a state court action—from a California Superior Court to take a former employee’s deposition in New York. After the tribunal provided authorization, the California Superior Court issued the commission. New York counsel for Roche then served the former employee with a subpoena directing him to appear for a deposition.

The court held that a California Civil Procedure Rule permits tribunals “to authorize a party to seek the assistance of a California court in granting a subpoena for the taking of a deposition.” (Illinois has a similar statute as California’s. See 710 Ill. Comp. Stat. § 30/20-55 [“Court assistance in taking evidence. The arbitral tribunal or a party with the approval of the arbitral tribunal may request from a court assistance in taking evidence. The court may execute the request within its competence and according to its rules on taking evidence.”])

The New York Roche Molecular opinion also said that the commission issued by the California court satisfied the meaning of “out of state subpoena” provided by New York’s version of the Uniform Interstate Depositions and Discovery Act.

Finally, the court rejected the argument that the FAA prohibits pre-hearing depositions, because state law could provide parties with greater rights in arbitration than those provided by the FAA:

While the substantive rules of the FAA apply in state court as well as in federal court, in Southland Corp. v Keating (465 U.S. 1 , 104 S Ct 852 , 79 L Ed 2d 1 [1984]), the U.S. Supreme Court explained that the purpose of the preemption of state substantive rules regarding arbitration was “to foreclose state legislative attempts to undercut the enforceability of arbitration agreements” (465 U.S. at 16 ), but it went on to clarify that it did not intend such preemption to extend to state rules of civil procedure that are applicable in state proceedings (465 U.S. at 16 n. 10).

Id. at 757.

The New York Roche Molecular court further explained that cases prohibiting discovery subpoenas were inapplicable because (1) the case does not involve an arbitral subpoena, but rather a New York subpoena based on a California commission and (2) a prior New York appellate court decision held that depositions of nonparties may be directed in an FAA arbitration where there is a showing of ‘special need or hardship,’ such as where the information sought is otherwise unavailable.” ImClone Sys. Inc. v Waksal, 22 A.D.3d. 387, 802 N.Y.S.2d. 653 [1st Dept. 2005]).

The Matter of Roche court distinguished itself from the related Massachusetts action by noting that Massachusetts has not adopted the “Uniform Interstate Depositions and Discovery Act, so the procedure employed in the dispute before this court was not available there. The analysis employed by the Massachusetts court is inapplicable here.” Matter of Roche Molecular Sys. Inc. v. Gutry, 76 N.Y.S.3d at 759.

What Are the Possibilities?

Having examined the issues of “when” “where” and “what court,” we will now explore how these issues play out with the following hypothetical:

JoJo Enterprises and Fultz Inc., both Philadelphia companies, enter into a contract in 2017 that includes an arbitration clause, calling for American Arbitration Association in Philadelphia. In 2019, Fultz is sold to Magic Co., after which the Fultz executive who negotiated the contract with JoJo leaves Fultz/Magic Co. After operating the business for a month, Magic, as the new owner of Fultz, alleges that JoJo breached the sale of business contract. It demands arbitration under the contract’s dispute resolution clause. Three months thereafter, the parties convene for the initial arbitration conference, but right before the conference occurs, the executive who negotiated the initial contract between JoJo and Fultz on behalf of JoJo moves to California. At this point in time, the individual who negotiated the contract for Fultz has retired but remains in Philadelphia. It becomes clear in the initial conference that a key issue in the case will be the proper construction of ambiguous terms in the contract—but now neither party has an employee on its payroll who negotiated the agreement.

The following applies the when, where and what court questions considered above to the hypo.

First, when is the evidence available to the parties? Because the arbitration is seated in Philadelphia and the former employees are located in Philadelphia and California, Hay and Vividus control, and so the only means of obtaining relevant documents and testimony will be through a live hearing before a majority of the arbitrators.

Second, as to the where, there is no dispute that the arbitration panel could order Fultz’s former employees to appear at a Philadelphia hearing, but the majority of decisions would prevent the parties from enforcing an arbitral subpoena against the JoJo executive in California.

Third, as to what court, because the arbitration is seated in Philadelphia, most courts would agree that the Eastern District of Pennsylvania is the exclusive venue for enforcing an arbitral subpoena.

If one of the parties attempts to enforce a subpoena against the Fultz employee—a Philadelphia resident—there would not be diversity. In contrast, if one of the parties attempts to enforce a subpoena against the JoJo employee, who is a California resident, there would be diversity.

A court, however, could also independently have jurisdiction over an FAA Section 7 action as a result of a prior action relating to a dispute between the underlying parties. See, e.g., Shasha v. Malkin, No. 14-cv-9989 (AT) (RWL), 2018 BL 239435, at *2 (S.D.N.Y. July 05, 2018) (“This Court had federal question jurisdiction when Plaintiffs filed this lawsuit and retains jurisdiction over any subsequent application involving the same agreement to arbitrate.”). The result is a litigation minefield of uncertainty with a significant possibility of an uneven playing field where one party is able to obtain its desired evidence and the other is left defending a claim with one arm tied behind its back.

As discussed below, this type of result should not be tolerated and requires change.

An Immodest Proposal

The FAA’s third-party discovery provision needs to be amended to address the situation that the hypo above illustrates.

The Federal Arbitration Act has been in effect since 1925. During that time, and with increasing rapidity over the last generation, arbitration has become more widely used, precisely as the drafters of the FAA intended.

And during the decade since the Supreme Court’s rejection of class-action waivers in arbitration clauses in AT&T Mobility v. Concepcion (and its multiple progeny), arbitration has become more and more controversial, with calls mounting for more consumer-friendly changes to the process. See “Senate Strikes Down CFPB Arbitration Rule,” Matthew H. Adler, et al., (Oct. 25, 2017) (available at https://bit.ly/2SRRlPA), and “Garden State Says #MeToo: Bill Barring Non-Disclosure Clauses Passes in Both Chambers,” Blank Rome (Feb. 4, 2019) (available at https://bit.ly/2TCbUnF).

But this article has little to do with social policy, important though those questions are to arbitration’s future. Instead, this article focuses on basic logistics.

Arbitration right now is not working to achieve the full exposition of the facts necessary in complex cases requiring third-party evidence. That is a fact. Whether that is worth it—whether the intent of arbitration is an incomplete record—is a question worth pondering.

But given that most institutional arbitration rules now swing sharply in favor of more discovery, including electronic discovery, that seems a difficult proposition to maintain. AAA Commercial Arbitration Rules and Mediation Procedures (effective Oct. 1, 2013) (R.-23 empowers the arbitrator to enforce its rules relating to “imposing reasonable search parameters for electronic and other documents)”; JAMS Comprehensive Arbitration Rules & Procedures, (effective July 1, 2014) (R-17: “The Parties shall cooperate in good faith in the voluntary and informal exchange of all non-privileged documents and other information (including electronically stored information (‘ESI’)) relevant to the dispute or claim immediately after commencement of the Arbitration.”) But see CPR Institute Administered Arbitration Rules (effective March 1, 2019) (Rule 11—Discovery: “The Tribunal may require and facilitate such discovery as it shall determine is appropriate in the circumstances, taking into account the needs of the parties and the desirability of making discovery expeditious and cost-effective. The Tribunal may issue orders to protect the confidentiality of proprietary information, trade secrets and other sensitive information disclosed in discovery.”).

The solution, which should not be controversial, is to amend the FAA. It should provide for (a) the right to take third-party document and deposition discovery and (b) means to enforce any arbitral subpoena. The following changes to Section 7 reflected in the below redline would achieve both of these goals:

Upon a showing of good cause, the arbitrators selected either as prescribed in this title or otherwise, or a majority of them, may summon in writing any person to attend before them at a hearing or for a pre-hearing deposition outside the presence of any arbitrators or any of them as a witness and to order any witness in a proper case to bring with him or them any book, record, document, or paper which may be deemed material as evidence in the case. The fees for such attendance shall be the same as the fees of witnesses before masters of the United States courts. Said summons shall issue in the name of the arbitrator or arbitrators, or a majority of them, and shall be signed by the arbitrators, or a majority of them, and shall be directed to the said person and shall be served in the same manner as subpoenas to appear and testify before the court.; if any person or persons so summoned to testify shall refuse or neglect to obey said summons, upon petition the United States district court for the district in which such arbitrators, or a majority of them, are sitting may compel the attendance of the witness and/or evidence resides shall have jurisdiction to hear any petition to compel such person or persons to comply with the subpoena and before said arbitrator or arbitrators, or punish said person or persons for contempt in the same manner provided by law for securing the attendance of witnesses or their punishment for neglect or refusal to attend in the courts of the United States.

On March 25, the U.S. Department of Justice (DOJ) announced that Duke University agreed to settle a False Claims Act qui tam action alleging widespread misconduct in federally funded research.

A former Duke researcher brought the whistleblower action, alleging that a Duke colleague knowingly submitted falsified research results to the National Institutes of Health (NIH) and the Environmental Protection Agency (EPA) in grant applications and progress reports to obtain tens of millions of dollars in federal grant funding. The whistleblower further alleged that, upon discovering the research fraud, Duke laboratory directors did not disclose the fraud to the government agencies and continued to submit the falsified data to support the university’s research funding. The whistleblower will receive 30 percent of the settlement, or $33.75 million.

These unprecedented allegations of research misconduct rising to a level that violates the False Claims Act, and the sizeable settlement paid by Duke underscore the stakes of alleged noncompliance with the many requirements attached to receiving public research funding. While allegations of research misconduct in federally funded research have increased in recent years, lawsuits and enforcement actions alleging that this misconduct violates the False Claims Act have remained rare. With this high-profile settlement, and huge financial windfall earned by the whistleblower, the looming specter of increased False Claims Act actions should cause research institutions to be more attentive than ever to their research misconduct compliance and reporting obligations.

The Allegations Against Duke University¹

Generally speaking, the federal False Claims Act imposes civil and, in some instances, criminal liability on individuals or institutions that knowingly present false or fraudulent claims for payment to the government. Although not traditionally used to pursue alleged research fraud, the submission of false or fraudulent documentation to federal agencies that administer research grants can fall within the scope of the False Claims Act when that documentation includes false or fraudulent research data or otherwise violates applicable rules, policies or certifications.

Here, the whistleblower’s allegations focused on the conduct of Erin Potts-Kant, the clinical research coordinator in Duke University’s Airway Physiology Laboratory, and Dr. William Foster, a research professor in the Division of Pulmonary, Asthma, and Critical Care at Duke and a principal investigator of the Airway Physiology Laboratory. Potts-Kant was responsible for collecting and interpreting clinical data on the effects of pathogens, chemicals and environmental factors on the airways of laboratory mice, with the goal of treating human pulmonary diseases. Foster was the principal investigator who supervised Potts-Kant and bore ultimate responsibility for the laboratory’s research and for applying for and securing grant funding.

During Potts-Kant’s almost eight-year tenure, Foster’s laboratory secured more than $120 million in public grant funding from the NIH and EPA. These extensive research efforts culminated in Potts-Kant and Foster co-authoring more than 38 scientific papers and journals articles, all of which cited federal grant support.

In the qui tam complaint, however, the whistleblower alleged that Potts-Kant’s research results supporting these publications were false and/or fabricated. Specifically, the whistleblower alleged that Potts-Kant deliberately manipulated the cited data or based it on experiments that she intentionally completed incorrectly. In some instances, the whistleblower alleged that there was no raw data at all to support Potts-Kant’s results and that some of the experiments had never been conducted.

The whistleblower also argued that Duke bore False Claims Act liability because it included Potts-Kant’s false and fabricated data in grant applications and progress reports it submitted to the NIH and EPA. The whistleblower alleged that faculty leadership at Duke learned of the extent of Potts-Kant’s research misconduct in March 2013, but did not take appropriate steps to disclose Potts-Kant’s fraud to the government, and also continued to include data obtained by Potts-Kant in grant applications.

Finally, the whistleblower alleged that, before learning about Potts-Kant’s misconduct in March 2013, principal investigators in the Pulmonary Division received warnings of research misconduct by Potts-Kant in Foster’s laboratory but did not take appropriate steps to investigate and address those warnings, as required by federal law and Duke’s internal policies, and in accordance with Duke’s obligations as a grant recipient.

Key Takeaways for Research Institutions

Duke’s settlement of this whistleblower action with DOJ highlights the need for strict compliance and vigilant oversight of research activities by any institution that applies for and/or receives public grant money. Given the outcome here, it would not be surprising to see a spate of similar allegations and qui tam suits in the coming months and years. Federally funded research institutions would be wise to take the following steps to protect themselves from similar allegations and False Claims Act exposure.

1. Increased Oversight of Employees. Research institutions can face significant civil legal exposure for the misconduct of their employees — even if the conduct is isolated to a single researcher or department. Indeed, the Duke case may provide future whistleblowers with a roadmap for bridging the gap between employee and institution. The Duke whistleblower alleged that Potts-Kant acted within the scope of her employment and that any knowledge of her actions possessed by Foster and other principal investigators should be imputed to Duke. Given these stakes, research institutions should consider implementing policies and conducting training aimed at increasing oversight of individual employees. These efforts may deter rogue individuals from taking liberties with research results, and will also help institutions identify questionable research data before it is included in publications or grant proposals, thereby raising the potential for False Claims Act liability.

 

1. Increased Knowledge and Awareness of Certification Obligations. As the Duke case illustrates, the process by which institutions apply for and obtain federal research grants is rife with opportunities to make a false certification and thereby violate the False Claims Act. For example, to obtain federal research funds, institutions are repeatedly required to certify their ongoing compliance with numerous terms, conditions, laws and policies during all stages of the public grant process — from application, to award, to progress reports, to close-out. A lack of understanding of, or appreciation for, the legal risks and compliance obligations that attach when an institution signs such certifications can trigger False Claims Act exposure, and increase the risk that an institution will be the subject of a whistleblower lawsuit and/or government enforcement action. Institutions must understand the consequences of their certifications, and should consider conducting training for principal investigators on the scope and meaning of these certifications, as well as implementing policies that require appropriate inquiries to confirm an institution’s compliance with all requirements before any certification is submitted to the government.

 

1. Prompt and Thorough Investigations of Allegations of Misconduct. Federal law, not to mention granting agencies and grant applications, requires institutions to have a procedure for evaluating and, if necessary, investigating allegations of research misconduct. It is critical that institutions ensure their compliance with those obligations by taking appropriate investigatory action whenever they suspect or receive reasonable allegations of research misconduct, especially when the research is federally funded. Most institutional policies utilize the two-tiered investigation approach suggested by federal regulations. Because the first tier (i.e., an “inquiry”) can usually be completed quickly and with little disruption to the laboratory, institutions should err on the side of caution and look into most allegations or suspicions of research misconduct — even if only to clear the alleged perpetrator. Failure to investigate allegations of research misconduct that later turn out to be substantiated can open the door to additional liability for the institutions, especially if the failure to investigate resulted in the continued submission of false data to the government. As an extra measure of precaution, depending on the severity and extent of the alleged/suspected misconduct, institutions should consider engaging legal counsel to conduct a privileged investigation. 

 

1. Evaluate and Mitigate False Claims Act Exposure. If an institution learns that research misconduct has occurred, it should quickly evaluate the scope of exposure and take appropriate remedial action. In the wake of the Duke settlement, this evaluation should include an analysis of potential False Claims Act liability when the falsified research implicates federal funds. An institution’s failure to take appropriate action or inform the grant originator may result in separate and significant liability for concealing or avoiding an obligation to repay money to the government. Given this new but critical wrinkle in research misconduct cases, institutions should involve legal counsel early in the investigation and evaluation process and, at the very least, should consult legal counsel immediately upon learning that misconduct occurred in order to ascertain whether the misconduct could implicate the False Claims Act, and to determine what reports and remedial steps need to be taken to mitigate potential liability to the government or in a whistleblower suit.

It is incumbent on research institutions to appreciate and address the significant risks that are implicated by malfeasance committed by their employees in federally funded research. The Duke settlement presents, perhaps, an extreme example of how things can go wrong when fraud occurs, but the settlement illustrates that a research institution’s liability under the False Claims Act is very real when there is falsification of federally funded research.

Given the severe penalties imposed by the False Claims Act, and the ability for whistleblowers to reap significant financial benefits by pursuing qui tam cases on behalf of the government, research institutions should learn from the Duke case and make every effort to protect themselves from future liability by taking appropriate preventive action and consulting with legal counsel the moment research fraud issues arise.

Endnote

On February 22, 2019, the Third Circuit Court of Appeals issued a precedential ruling affirming a district court’s finding that Crown Asset Management LLC is a debt collector under the Fair Debt Collection Practices Act. In doing so, the Third Circuit interpreted the Supreme Court’s recent ruling in Henson v. Santander, Consumer USA Inc., 137 S. Ct. 1718 (2018), and held an entity is a debt collector if its “important aim” and the reason for its existence is obtaining payment on the debts that it acquires.

In Mary Barbato v. Crown Asset Management LLC, et al., No. 18-1042 (3d Cir. Feb. 22, 2019), the lawsuit arose out a credit card debt Barbato incurred and defaulted on prior to 2010. Following various other assignments and sales, Crown purchased Barbato’s account, then referred it to Greystone for collection. After receiving collection letters and telephone calls from Greystone attempting to collect on the debt, Barbato filed a complaint alleging violations of the FDCPA. Crown and Barbato filed cross-motions for summary judgment on the issue of whether Crown and Greystone were debt collectors under the FDCPA.

Crown argued it was not a debt collector under the FDCPA because the principal purpose of its business is the “acquisition” of debts, rather than the “collection” of debts that it outsources to other companies. Further, Crown was not collecting the debt on behalf of another because it owned the debt. As such, Crown argued it does not fall under the definition of a debt collector in the FDCPA. Indeed, Crown had no contact with Barbato during the time period Greystone was attempting to collect the debt at issue.

In 2017, the district court issued an opinion denying Crown’s motion for summary judgment, concluding that because Crown acquired Barbato’s debt after default and its “principal purpose” was debt collection, it was a debt collector under the FDCPA. However, the court also denied Barbato’s motion for summary judgment because there was insufficient evidence to find that Greystone was likewise a debt collector under the FDCPA. The court granted both parties leave to file renewed motions for summary judgment on the issue of Greystone’s status as a debt collector.

Shortly thereafter, the Supreme Court issued its opinion in Henson v. Santander, in which it found that an entity that seeks to collect a debt that it owns is not a debt collector under the FDCPA’s “regularly collects” definition. That provision of the FDCPA defines a debt collector as “any person . . . who regularly collects or attempts to collect, directly or indirectly, debts owed or due or asserted to be owed or due another.” Crown filed a motion for reconsideration with the district court based on the decision in Henson, arguing that because it owned Barbato’s debt, it was a creditor, not a debt collector, per Henson. Further, since the Supreme Court’s decision in Henson rejected Third Circuit precedent that took into consideration the default-status of the debt when determining if an entity is a debt collector under the FDCPA, Crown argued the district court should reverse its decision because of its reliance on faulty legal grounds. The district court rejected Crown’s argument and found that Crown was still a debt collector under the FDCPA’s “principal purpose” definition. Crown filed for interlocutory appeal and the district court certified its decision on the issue of “whether Henson requires a finding that Crown is not a debt collector in this case when it was a third-party buyer of the debt, and the debt was in default at the time it purchased it.”

The Third Circuit agreed with the district court and found that Crown was a debt collector under the FDCPA’s “principal purpose” definition. In doing so, the Court focused on the meaning of the phrase “principal purpose” in the FDCPA, holding that “an entity that has the ‘collection of any debts’ as its ‘important’ ‘aim’ is a debt collector under [the principal purpose] definition . . . . [a]s long as a business’s raison d’etre is obtaining payment on the debts that it acquires, it is a debt collector.”

The Third Circuit expressly rejected Crown’s interpretation that the definition of debt collector was limited to those entities that are actually engaged in the “collection” of debts. Specifically, the Court determined that:

[i]n contrast to the ‘regularly collects’ definition, where Congress explicitly used the verb ‘to collect’ in describing the actions of those it intended the definition to cover, in the ‘principal purpose’ definition, Congress used the noun ‘collection’ and did not specify who must do the collecting or to whom the debt must be owed.

Thus, in the Third Circuit’s view, the fact that Crown used Greystone to collect on the debt was of no-consequence because the noun “‘[c]ollection’ by its very definition may be indirect.” Turning back to the “principal purpose” part of the definition of debt collector, the Court opined that a company purchasing debts specifically for the purpose of forgiving the debts or even re-selling the debt to other entities for a profit would not fall under the “principal purpose” definition. However, since the record reflected Crown’s only business was the purchase of debts for the purpose of collecting on them, it fell well within the “principal purpose” definition.

This decision is significant because it limits the Supreme Court’s decision in Henson to the interpretation of the “regularly collects” definition of a “debt collector” in the FDCPA. Entities whose principal purpose is the purchase and collection of consumer debts may still be subject to the requirements of the FDCPA regardless of who is actually engaged in collection activity with a consumer. In other words, while the Third Circuit’s opinion was decided in the context of traditional debt buying, i.e., third-party debt collectors, it does raise important considerations for any entity whose business model relies on the purchase and collection of consumer receivables. Finally, this decision did not speak to the “creditor as a debt collector under a different name” definition that is the third way in which an entity can fall under the purview of the FDCPA as a “debt collector.”

Troutman Sanders will continue to monitor this area of law and report accordingly.

This article was published in Law360 on January 16, 2019. © Copyright 2019, Portfolio Media, Inc., publisher of Law360. It is republished here with permission.

Starting in 2019, public companies will need to adopt the new lease accounting rules set forth in the new Financial Accounting Standards Board (FASB) standard ASC 842 (Leases).

The new rules eliminate the defined term “capital leases,” which many credit agreements rely on to distinguish leases that will be treated as indebtedness from those that will not, and requires all leases to be reflected on the balance sheet of the lessee company. These changes affect both the general business covenants restricting indebtedness and liens, as well as many financial covenants that are based on debt levels. Surprisingly, many credit agreements still fail to specifically anticipate this change. As a result, lenders and borrowers alike will need to evaluate whether changes are required to their existing credit facilities and will need to take a new approach to drafting credit agreements going forward.

Summary of the Changes to Lease Accounting

Under existing accounting rules, leases are mostly divided into “capital leases” and “operating leases.” Capital leases are capitalized — an asset and liability are entered on the balance sheet, and the leased asset is then amortized, with interest expense recognized over the life of the lease.

The result is essentially the same as if the lease were a loan secured by the leased asset. Operating leases are entirely off-balance sheet — no asset or liability is reflected on the balance sheet; the payments on the lease are expensed as they are paid.

Under the new accounting rules, all leases will appear on a company’s balance sheet. However, there are still two kinds of leases that are treated somewhat differently.

Leases that historically would have been “capital leases” will now generally be known as “finance leases.” The accounting associated with finance leases is virtually identical to existing capital lease accounting.

The big change is that operating leases will now also be reflected on the lessee’s balance sheet. Instead of the separate interest and amortization expense components attributable to a finance lease, there will be a single lease expense (usually on a straight-line basis) flowing through the income statement in connection with operating leases.

Common Credit Agreement Provisions and Impact of the New Rule

Capital leases defined as “leases required to be capitalized in accordance with GAAP”

Most credit agreements define “debt” or “indebtedness” to include capital lease obligations. A common definition of capital lease obligations is “obligations in respect of leases that are required to be capitalized in accordance with GAAP.”

Since the new rules will require all leases to be capitalized, all leases will be included in such definitions, resulting in operating leases being treated as “debt,” with the potential for breaches under negative covenants restricting indebtedness or under financial covenants that also tie to these defined terms.

Capital leases defined as “capital leases as defined in accordance with GAAP”

Some credit agreements will cross-reference to the definition of capital leases in GAAP, rather than referring to the general concept of a lease being required to be capitalized. The problem here, of course, is that there will no longer be any such definition under GAAP.

Static GAAP approach

The change in lease accounting has been coming for some time now, and, in anticipation of the change, many credit agreements lock in the existing accounting rules for purposes of determining whether a lease will be treated as a capital lease, and therefore as “debt” or “indebtedness.”

In theory, this would require the borrower to maintain separate books accounting for leases under the previous rules. In practice, however, it should generally work to treat leases that constitute “finance leases” (and only the leases that constitute “finance leases”) under the new GAAP rules as covered by the definition of “capital leases” in a credit agreement with this type of static-GAAP provision.

Also, attention must be paid to the exact wording of the credit agreement. The default wording of some lenders specifically references financial covenants only, and does not necessarily cover the categorization of leases for purposes of operating covenants like restrictions on indebtedness.

General provisions addressing changes in GAAP

Many credit agreements include a generalized provision addressing potential changes in GAAP.

There are many variations of this wording, but, as a rule, these provisions provide a mechanism for making amendments with just the agreement of the administrative agent and the borrower (i.e., without the need to obtain consent of the other lenders in a syndicated facility) to restore the original intent as closely as possible if there is a change in GAAP.

By their nature, these provisions require negotiation of an amendment so, if there is not a “static GAAP” provision that addresses the issue, administrative agents and borrowers should promptly discuss the issue so that any changes required to accommodate the new lease accounting rules can be implemented before the first reporting date under the credit agreement.

And again, attention needs to be paid to the exact wording of the provision to confirm that it allows all of the required amendments. If, for example, the applicable language only references the impacts on financial covenants due to a change in GAAP, then it might not cover impacts on operating covenants restricting indebtedness.

Going Forward

Going forward, we would expect that the concept of a “finance lease” will simply be substituted in place of a “capital lease” in most credit agreements. Some (though surprisingly few) have already taken this approach.

Alternatively, in recognition of the reasons behind the change in GAAP, some lenders may actually want to treat all leases as indebtedness and have baskets or other carve-outs to accommodate the business needs of the borrower within agreed-on limits. Restricting operating lease obligations is already common in certain credits (especially retail), and this may be expanded more generally under the new standard.

With stock prices generally down in the current bearish market, financial institutions may see an increase in unsolicited acquisition offers. Fortunately, well-prepared boards that fulfill their fiduciary duties should be able to safely conclude that their institution should remain independent. 

When a company receives a bona fide unsolicited written bid – whether ostensibly friendly or more overtly hostile – management must inform its board of directors and the board must consider the merits of the offer and respond in an informed manner. The board’s fiduciary requirements have a number of important implications:

• Waiting until an unsolicited offer is received puts the board at a substantial disadvantage. Boards and their institutions can take actions in advance of receiving an offer to improve their ability to deal with an unsolicited bid, including maintaining and periodically reviewing a strategic plan for long-term success, establishing “on the shelf” anti-takeover defenses, and maintaining a plan for assessing and responding to unsolicited offers.
• Assessing an unsolicited offer will require the board to become reasonably informed as to the merits of the bid relative to the company’s long-term prospects as an independent entity. To do so, the company should engage an independent financial advisor and legal counsel, and the board should also seek input from management. A proper assessment will not occur overnight but should not be unduly delayed. The board should be kept informed and up to date with respect to any developments while gathering information from management and the company’s advisors and carefully considering the proposal and the appropriate response.
• The board, along with legal counsel, should consider possible conflicts of interest on the board. This could include non-independent board members whose employment might be impacted by the completion of a sale transaction. Depending on the nature of any conflicts, it may be appropriate for decisions to be made by a special committee of non-conflicted board members, though the views of excluded directors could be considered as long as the rest of the board is informed of the conflict.
• Depending on the nature of the bidder and the Board’s intended response, the company may also wish to engage a public relations advisor and/or a proxy solicitor. Unsolicited offers can include overt or veiled threats of making the offer publicly known if the target

is unwilling to negotiate and it is important to be ready in case the process goes in that direction. In such cases, it is important that communications regarding the offer and the company’s evaluation and response are carefully managed and consistent.

While the specific nature of the board’s fiduciary duties and the requirements for the protection of the business judgement rule may vary somewhat from state to state, in general courts will be reluctant to second-guess a board’s decision where the board (or special committee) is free from conflict, has become reasonably informed with respect to the financial, legal and other merits of the offer and the company’s standalone prospects, and otherwise acts in good faith in accordance with a reasonable process. These important touchstones should be memorialized in the minutes of board meetings and related documentation in connection with the evaluation of and response to the unsolicited offer. Legal counsel can provide guidance regarding both substance and procedure with respect to an institution’s particular jurisdiction of incorporation.

Ultimately, boards can take comfort in their ability to resist unsolicited acquisition proposals where they properly exercise their fiduciary duties and business judgment to conclude that the company’s stockholders will be better off if the company remains independent to execute on its long-term strategy. While unsolicited offers are not to be taken lightly and ultimately could lead to a company’s sale, it is worth remembering the views of the Delaware Court of Chancery in its important decision upholding the use of poison pills to resist hostile tender offers. Asking itself who gets to decide when and if a corporation is for sale, the court concluded that the power ultimately lies with the board of directors.[1]

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Troutman Sanders’ Financial Institutions attorneys are available to help you and your institution with M&A matters from the initial strategic planning stages through the closing of a transaction

 

[1] Air Products and Chemicals, Inc., v. Airgas, Inc., C.A. No. 5249 (Del. Ch. Feb 15, 2011).

 

 

When a taxpayer is considering purchasing a foreign corporation, tax planning must be part of the process in order to mitigate unwanted tax consequences. For example, an election under section 338(g) of the Code has been a longstanding tax-planning tool for taxpayers considering the purchase of a foreign target.

Overview

In general, a 338(g) election allows an acquiring corporation to treat what would otherwise be a stock acquisition as an asset acquisition, solely for tax purposes. If the election is made, the target entity is deemed to sell its assets to a “new” target entity in a fully taxable asset sale. This deemed sale happens on the seller’s watch and results in a stepped-up basis in the assets of the target and eliminates the historic tax attributes, including earnings and profits, of the target corporation.

The many planning opportunities associated with making a 338(g) election, including considerations in light of the Tax Cuts and Jobs Act of 2017, are beyond the scope of this article, as are certain planning issues associated with a 338(g) election. This article focuses on when a 338(g) election is available and, in particular, targets one, sometimes overlooked, limitation when selling shareholders reinvest in the acquiring entity or its indirect owners into the acquisition chain (sometimes referred to as “roll”). In particular, this article focuses on the requirement that stock of the target company be acquired by “purchase” from unrelated persons, and how a potential roll into the acquisition chain might impact the ability to make a 338(g) election.

Requirements of a 338(g) Election

To make a 338(g) election for a target corporation, the purchasing corporation must acquire the target’s stock in a qualified stock purchase (QSP). A QSP is any acquisition or series of acquisitions in which, during a 12-month period, a corporate acquirer “purchases” target corporation stock possessing at least 80 percent of the target’s voting power and value.

The acquiring corporation “purchases” the target’s stock only if (1) the target stock is acquired in a transaction that does not result in the purchaser taking a carryover tax basis (in whole or part) from the target’s former shareholders; (2) the target stock is not acquired in an exchange to which sections 351, 354, 355 or 356 of the Code apply; and (3) the target stock is not acquired from a person the ownership of whose stock would, under section 318(a) of the Code (other than an option attribution rule therein), be attributed to the person acquiring such stock.¹

The application of the first two tests, while seemingly straightforward, will raise red flags when more than 20 percent of the stock of the target is acquired via a tax-free rollover or some other tax-free transaction. The third test, however, is more difficult to work through because its wording is awkward and can lead to unexpected results.

Frequently, item 3 is cited for the proposition that an acquiring corporation cannot purchase stock from a “related party.” Whether the purchaser is related to the seller is tested immediately after the acquisition of the target stock or, when the purchase is part of a series of transactions pursuant to an integrated plan, immediately after the last transaction in such a series. Rollovers are often part of the overall acquisition plan.

“Roll” Issues in Section 338(g)

The meaning of the language in item 3 is not intuitive. The question it poses is whether the purchaser would be treated as owning stock owned by the seller under the constructive ownership rules of section 318 of the Code. At least one commentator (Ginsburg and Levin) agrees with this interpretation.²

The application of this rule can lead to surprising results in seller rollovers. In a case where the rolling sellers own less than 20 percent of the stock of the target corporation, item 3 generally should not make a 338 election unavailable (assuming no other affiliation).

However, in the case of any roll (even a very small percentage) by a seller that owns 80 percent or more of the target, there is a chance that a 338(g) election will be unavailable because the seller is treated as related to the purchaser after the roll under item 3.

Many acquisition structures, particularly in the private equity context, involve a chain of wholly owned entities that are established for various legal and economic reasons. For example, an aggregating partnership may own a chain of a few flow-through entities (partnership or disregarded entities) that own one or two corporations, with the last corporation in the chain being the purchasing corporation. Often, management, and sometimes one or more of the sellers (e.g., a private equity fund seller where the buyer wants them to keep some economic interest), will obtain a co-invest interest in one of the entities in the acquisition chain.

If the seller is acquiring an interest in an entity in the acquisition chain that is a corporation for U.S. income tax purposes, this generally presents little risk of invalidating a QSP, as the seller would need to own more than 50 percent of the entity under section 318(a) (2)(C) in order for stock that it owns to be attributed into the acquisition chain and down to the purchaser, thus running afoul of item 3.

A more inclusive set of constructive ownership rules apply, however, under section 318(a) (3)(C), where the seller acquires a continuing interest in the acquisition chain in an entity that is a partnership. In this case, even if the seller only acquires a small interest (no percentage threshold at all, unlike the 50 percent threshold for corporations) in an acquisition chain entity that was a partnership (or becomes one upon the seller’s investment), stock owned by the seller would be attributed to the acquisition chain partnership under section 318(a)(3)(A). Assuming that a partnership (or another flow-through entity down the chain that the partnership invested in) owns more than 50 percent of the acquiring corporation (or another corporation that owns more than 50 percent of the acquiring corporation), the stock attributed to the partnership from the seller would, in turn, be attributed down the chain via sections 318(a)(3)(C) and 318(a)(2)(C). Thus, because stock owned by the seller is attributed (through the flow-through entities in the acquisition chain in which the seller invests) to the purchaser, the purchaser’s acquisition of any target stock from the seller does not qualify as a “purchase” because it does not satisfy item 3 and no QSP of the target occurs.

This means that, even if the roll amount is very small (e.g., 1 percent), if an 80 percent or more owner sells interests in the target and rolls into a partnership in the acquisition chain, it may be treated as a related party if the stock it owns is attributed to the purchaser under section 318. Note that this remains true regardless of whether the seller roll is taxable or tax-free, as the test is not whether there is a section 351 or some other carryover basis transaction, but only whether the parties are “related” immediately after the purchase (and all related transactions pursuant to the same integrated plan).

Pepper Perspective

A taxpayer considering making a 338(g) election should carefully review the ownership structure if a seller intends to roll a portion of their ownership interest as part of the overall acquisition transaction. This is particularly true when a seller that owns a large portion of the target is taking a continuing interest in the acquisition chain. If an issue arises, there may be mitigating steps that can be taken, and, thus, advance planning and consideration of these issues are critical to achieving the desired tax results that a 338(g) election can provide.

Endnotes