Reprinted with permission from the January 2018 issue of Alternatives to the High Cost of Litigation, the newsletter of the International Institute for Conflict Prevention & Resolution. (Vol. 36, No. 1).

Arbitration may end sooner and more efficiently than litigation, but it is slower to begin. A courthouse is just sitting there waiting for a complaint to be filed. An arbitrator, by contrast, has to be appointed, and it can take time for the process to get going. And when a case does not present issues that must be resolved immediately, that may not be a problem.

But where a case has emergency features—the dissemination of trade secrets, the raiding of a party’s customers, the destruction of its facilities—arbitration can be particularly ill-suited. Parties who need relief now cannot tolerate being imprisoned in the cage of a drawn-out arbitrator-selection process.

For precisely this reason, the common law has long recognized an exception to the general rule in favor of enforcing the exclusive nature of arbitration clauses. Even when parties state that “any and all issues under this contract shall be resolved by arbitration,” courts have found that a party can seek injunctive relief to prevent irreparable injury, so long as the court is not deciding the core issue committed by the parties to arbitration. Merrill Lynch, Pierce, Fenner & Smith Inc. v. Bradley, 756 F.2d 1048, 1053 (4th Cir. 1985)(“where a dispute is subject to mandatory arbitration under the Federal Arbitration Act, a district court has the discretion to grant a preliminary injunction to preserve the status quo pending the arbitration of the parties’ dispute if the enjoined conduct would render that process a ‘hollow formality.’”); Alliance Consulting Inc. v. Warrior Energy Res. LLC, No. 5:2017-cv-03541, 2017 BL 283376 (S.D. W. Va. Aug. 14, 2017)(addressing a preliminary injunction when the dispute resolution clause did not specifically provide a court with jurisdiction to hear such a dispute).

For that same reason, parties electing arbitration frequently insert into their clauses a provision allowing for temporary and emergent equitable relief, which makes clear to the court that arbitration is not the exclusive remedy in these situations. Such a provision may read “provided that, nothing in this clause shall bar a party from seeking injunctive relief in emergent circumstances, including but not limited to the dissemination of its intellectual property.”

But what happens when parties intending to preserve their right to seek emergency relief in court instead safeguard their right to seek all equitable relief? All emergency relief is, to be sure, equitable—but not all equitable relief is emergent. Consider the following clause:

Any controversy or claim arising out of or relating to this Agreement or the breach, termination, or validity thereof, except for temporary, preliminary, or permanent injunctive relief or any other form of equitable relief, shall be settled by binding arbitration … (Emphasis added.)

A strict textual reading of this arbitration clause reveals an inherent tension: on the one hand, the clause gives the arbitrator the power to hear “any controversy or claim arising out of or relating to this Agreement.”

Yet, at the same time, the clause pulls away from the arbitrator the power to hear claims for “temporary, preliminary, or permanent injunctive relief or any other form of equitable relief.” What did the parties intend? Should all non-emergent merits issues be arbitrated? Or just non-equitable issues?

This tension is exacerbated by the leading doctrinal underpinnings of arbitration law—namely, that (1) arbitration agreements are a creature of contract and should be enforced as written, (2) enforcing arbitration agreements promotes efficiency, and (3) contracts should generally be interpreted so as to promote arbitration.

This puts courts in a bind. Presented with a non-emergent equitable claim stemming from an agreement with an equitable carve-out like the provision above, a court may adopt a strictly textual approach and bar the arbitrator from considering the equitable claims.

This may especially be the case where a party either has second thoughts about arbitrating, or simply wants to slow down the case. The arbitration’s defendant—that is, the respondent—can file a motion before the arbitrator attempting to strip the tribunal from jurisdiction over the equitable claims.

If that party is a plaintiff (“claimant”), it can simply tack on a specific performance claim, which sounds in equity, to its core breach of contract claims. And presto! At least some of the claims are now in court. The “mandatory” arbitration clause is no longer exclusive, and instead has been defeated by a court interpreting literally the above equitable carve-out, notwithstanding the principles of efficiency and promoting arbitration.

This cannot be right. The exception should not swallow the rule. Parties should not be saddled with piecemeal procedures. Parties should be permitted to make emergent exceptions to their mandatory arbitration clauses, but that is all they should be permitted to do once they commit to arbitration.

Literal enforcement here is bad policy. Courts should be encouraged to favor the Federal Arbitration Act’s pro-arbitration policy, not to mention the mandate of Rule 1 of the Federal Rules of Civil Procedure that courts should seek “to secure the just, speedy, and inexpensive determination of every action and proceeding.”

It is a daunting thing to tell a commercial court not to follow clear contract language crafted by sophisticated parties. That flies in the face of basic contract law.

This article nevertheless takes the position that in this situation, that is precisely what courts should do. Courts should only enforce the equitable carve-outs to confer jurisdiction when there is an actual emergency requiring a quick decision or when a decision is otherwise necessary to preserve or in aid of the ultimate arbitration.

Any other result violates public policy, the Federal Arbitration Act, and can result in ridiculous and unintended outcomes in practice. The tension must be resolved in favor of efficiency and promoting arbitration.

Doctrinal Foundations

The inherent tension at the source of this article arises from three—and here, opposing—doctrinal foundations of arbitration.

Arbitration Agreements Should Be Enforced: The first of these core principles is that courts will generally enforce agreements to arbitrate as they are written. This is because the policy behind the FAA is not to enforce arbitration, but rather to enforce agreements to arbitrate. See Volt Info. Sciences Inc. v. Bd. of Trustees of Leland Stanford Junior University, 489 U.S. 468, 478 (1989) (“The FAA[’s] … passage was motivated, first and foremost, by a congressional desire to enforce agreements into which parties had entered.”)(internal citations and quotations omitted).

As a result, courts hold repeatedly that following the FAA’s liberal policy toward enforcing agreements to arbitrate, “a private agreement to arbitrate should be enforced according to its terms.” UHC Mgmt. Co. v. Computer Sciences Corp., 148 F.3d 992, 998 (8th Cir. 1998).

Following this policy and the FAA’s mandate, courts often view the matter simply and directly. Ninth Circuit courts, for example, ask just two questions: (1) Does a valid agreement to arbitrate exist? and (2) Does the arbitration agreement encompass the parties/present dispute? If the answer is “yes” to both, then the FAA requires that the court enforce the agreement according to its terms. Monster Energy Co. v. Wil Fischer Distrib. of Kan. LLC, No. 5:14-cv-02081-VAP(KKx), 2015 BL 490541 (C.D. Cal. Jan. 23, 2015); see Weyerhaeuser Co. v. W. Seas Shipping Co., 743 F.2d 635 (9th Cir. 1984).

The Ninth Circuit is by no means alone or an outlier on this point. The U.S. Supreme Court emphasized that the FAA “leaves no place for the exercise of discretion by a district court, but instead mandates that district courts shall direct the parties to proceed to arbitration on issues as to which an arbitration agreement has been signed.” Dean Witter Reynolds, Inc. v. Byrd, 470 U.S. 213, 218 (1985)(emphasis in original). The Supreme Court more recently recognized this point in Am. Express Co. v. Italian Colors Rest., 133 S. Ct. 2304 (2013).

Because courts take it as their mandate to enforce agreements to arbitrate strictly according to their terms, this line of cases and the FAA’s policy of enforcing arbitration agreements to their terms presents a significant hurdle to the central tenet of this article that certain arbitration clauses should not be enforced by their strict terms. But while at odds with the “strictly enforce” mandate, the authors’ position is well supported by the other policies underlying the FAA.

Arbitration Is Meant to Be Efficient: The Supreme Court has explained that the FAA’s overarching purpose is “to ensure the enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings.” AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 344 (2011)(emphasis added). The presumed efficiency of arbitration, while subject to increasing debate as arbitration takes on more of the trappings of discovery and motion practice, is still put forward in case and commentary. See Radvany, “Recent Trends in Discovery in Arbitration and in the Federal Rules of Civil Procedure,” 34 Rev. Litig. 705 (2015); Brian S. Harvey, “Speech,” 8 J. Bus. & Tech. L. 385 (2013).

Inherent in this thinking is that even if arbitration is not “efficient,” it is at least more efficient than court litigation, however low a bar or generous a measuring rod that may be. A policy that in effect searches for ways to take a dispute out of arbitration and in the process saddles parties with multiple, overlapping and potentially duplicative proceedings is the opposite of efficiency. It manages to offend both arbitration and litigation principles.

Federal Pro-Arbitration Policy: There is a strong federal policy that favors arbitration. Congress enacted the FAA in 1925 to counter judicial hostility to arbitration agreements. See AT&T Mobility, 563 U.S. at 339.

FAA Section 2 is the “primary substantive provision of the Act,” Moses H. Cone Mem’l Hosp. v. Mercury Constr. Corp., 460 U.S. 1, 24 (1983), and it renders a written provision in a contract to settle a controversy by arbitration “valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” 9 U.S.C. § 2.

The Supreme Court has explained that FAA Section 2 represents “a congressional declaration of a liberal federal policy favoring arbitration agreements.” Moses H. Cone Mem’l Hosp., 460 U.S. at 24. And in this regard, “any doubts concerning the scope of arbitrable issues should be resolved in favor of arbitration, whether the problem at hand is the construction of the contract language itself or an allegation of waiver, delay, or a like defense to arbitrability.” Id. at 24-25.

Federal courts have followed suit and repeatedly reaffirmed the presumption of arbitration, particularly when faced with contractual ambiguity. See, e.g., Fleetwood Enters. v. Gaskamp, 280 F.3d 1069, 1073 (5th Cir. 2002); Verducci v. Coda, 743 F. Supp. 2d 1182, 1185 (S.D. Cal. 2010)(“A court interpreting an arbitration agreement must resolve ambiguities as to the scope of the arbitration clause in favor of arbitration.”); Stein v. Burt-Kuni One LLC, 396 F. Supp. 2d 1211, 1214 (D. Colo. 2005)(“Unlike the general rule that ambiguities in a contract must be construed against the drafter, ambiguities in an arbitration agreement must be construed in favor of arbitration.”); Sacco v. Prudential-Bache Securities Inc., 703 F. Supp. 362, 366 (E.D. Pa. 1988)(“in light of the Supreme Court’s counsel to favor arbitration where the scope of the agreement is ambiguous, we will read the language of the agreement broadly, and direct the parties to arbitrate the claims”).

In addition to violating the FAA’s pro-arbitration policy, the hypothetical arbitration carve-out considered in this article should be unenforceable as a matter of contract law and public policy. See Fields v. Thompson Printing Co., 363 F.3d 259, 268 (3d Cir. 2004)(“It is axiomatic that a court may refuse to enforce a contract that violates public policy.”); Kaplan v. Pavalon & Gifford, 12 F.3d 87, 89 (7th Cir. 1993).

The Carve-Out Problem

Let’s consider how these arbitration principles apply in the following hypothetical. Assume that Company A manufactures washing machines, but has no sales force. It enters into an exclusive five-year distribution agreement with Company B. Things go well in year 1, but in year 2, Company B sees greener pastures, stops selling Company A’s machines and instead signs an exclusive distribution agreement with better-selling washing machine Company C. Company A is not only without a distributor, but its sales slow to a standstill and it is without valuable inventory that remains sitting in Company B’s warehouse.

Company A decides to take action against Company B for both legal damages—alleged sales that would have occurred had Company B not breached exclusivity—and for an equitable order that Company B return all of the Company A inventory in Company B’s warehouse. The parties’ distribution agreement contains the same arbitration provision that appears in the introduction to this article:

Any controversy or claim arising out of or relating to this Agreement or the breach, termination, or validity thereof, except for temporary, preliminary, or permanent injunctive relief or any other form of equitable relief, shall be settled by binding arbitration. … (Emphasis added.)

Look at the problem created by the emphasized language: under a strict and literal interpretation of those words, Company A must arbitrate its claim for money damages against Company B, but its equitable claim for return of its inventory (“or any other form of equitable relief ”) is not arbitrable and therefore must be resolved in court. The strict reading deprives the arbitration panel of jurisdiction over the equitable claim.

This can lead to inconsistent results, since both the court and the arbitrator will be required to address the central question of the case: whether Company B breached the distribution agreement. The client is now paying not just for two procedures but, given the potential inconsistency, two procedures which may not resolve the dispute if their results are in opposition.

Unfortunately, this is the result under much of the existing caselaw. For example, in a case involving an arbitration clause similar to our example, the University of Pennsylvania Hospital brought claims for damages and equitable relief against Aetna in court. Trustees of the Univ. of Pa. v. Aetna Inc., No. 3023 EDA 2012, 2013 Pa. Super. Unpub. LEXIS 2781 (Pa. Super. Ct. 2013). Specifically, the hospital brought breach of contract, tortious interference and declaratory claims that Aetna breached the contract by not paying fully on the claims submitted, and sought damages and specific performance for Aetna to stop the practices alleged. The arbitration agreement provided in relevant part as follows:

Any Dispute arising out of or relating to this Agreement or the breach, termination, or validity thereof, except for temporary, preliminary, or permanent injunctive relief or any other form of equitable relief, shall be settled by binding arbitration and administered by the American Arbitration Association (AAA) or American Health Lawyers Association (AHLA) and conducted by a sole Arbitrator [] in accordance with the AAA’s Commercial Arbitration Rules.

The Superior Court affirmed the trial court’s exercise of jurisdiction over the claims for equitable relief, rejecting Aetna’s argument that the hospital only included the equity claims to avoid the arbitration clause. The court noted that the contract “contains a valid agreement to arbitrate” and “[t]he arbitration agreement expressly excludes claims for equitable relief ” and found that the trial court’s equity jurisdiction was proper on the facts of that case. See also, e.g., Pbs Coal v. Hardhat Mining, 429 Pa. Super. 372, 377, 632 A.2d 903, 905 (Pa. Super. Ct. Oct. 20, 1993)(“if the agreement or contract clearly includes or excludes particular issues or remedies from arbitration, a court may so hold without submitting these matters to arbitration”); Haldeman v. Towers, Perrin, Forster & Crosby, 23 Phila. 427, 432-433, 1992 Phila. Cty. Rptr. LEXIS 3, *10-12, 1992 WL 1071350 (Pa. C.P. 1992)(“Arbitrators are limited to the fashioning of those remedies which the agreement itself permits.”).

Courts outside of Pennsylvania similarly enforce arbitration provisions similar to the hypothetical in this article according to their literal terms. See e.g. Starnes v. Harrell Indus. Inc., No. 0:13-cv-01109-JFA-KDW, 2013 BL 424063 (D.S.C. Aug. 30, 2013)(recommending that an arbitrator rule on the legal claims and that the plaintiff should file a motion in court following the arbitration proceeding to seek any equitable remedies); KWD River City Invs. LP v. Ross Dress for Less Inc. 288 P.3d 929 (Okla. 2012)(denying a motion to compel arbitration where the provision excluded equitable remedies from arbitration); Weiner v. Firm Inc., No. B166766, 2004 BL 14241 (Cal. App. 2d Dist. May 07, 2004)(denying a motion to compel arbitration because the court interpreted a claim for restitution as an equitable claim that was excluded from arbitration).

Supporting Arbitration

Carve-outs should be interpreted in favor of arbitration.

While many courts have concluded that they are obligated to enforce the literal terms of an arbitration agreement regardless of the consequences of that decision, other courts have acknowledged this inherent tension.

In doing so, some courts, in particular the District Court for the Southern District of New York, have reached the conclusion advocated in this article, that equitable carve-outs to arbitration clauses should only be enforced to carve out temporary and emergent equitable relief.

“[W]here a contract has both a broad arbitration clause and a clause permitting the parties to seek injunctive relief before a court, courts in this District have construed the latter clauses as permitting the parties to seek ‘injunctive relief … in aid of arbitration, rather than … transforming arbitrable claims into nonarbitrable ones depending on the form of relief prayed.’” Baldwin Tech. Co. v. Printers’ Serv., Inc., No. 15 Civ. 07152 (GBD), 2016 BL 22555, at * 3, n. 4 (S.D.N.Y. Jan. 27, 2016)(quoting Remy Amerique Inc. v. Touzet Distribution, S.A.R.L., 816 F. Supp. 213, 218 (S.D.N.Y. 1993)) (emphasis added).

In WMT Investors v. Visionwall Corp., the parties’ License Agreement contained an arbitration clause that provided that “any dispute or controversy arising under, out of, in connection with or in relation to this Agreement shall be resolved by final and binding arbitration…” and also contained a provision that “in the event of a breach or threatened breach … [the party] shall have the right to equitable relief, including but not limited to the issuance of a temporary or permanent injunction or restraining order, by any court of competent jurisdiction.” 2010 U.S. Dist. LEXIS 65869 *4, (S.D.N.Y. June 28, 2010).

WMT filed a complaint in New York’s Southern District seeking declaratory and injunctive relief, and Visionwall moved to compel arbitration. The court found that the gateway question of arbitrability should be decided by the arbitrator but that even assuming that the question of arbitrability was before the court, it would likely find that WMT’s claims should be arbitrated.

In so finding, the court explained that “if there is a reading of the various agreements that permits the arbitration clause to govern, the court will choose it.” Id. (citations omitted). The court also pointed to case law in which parties were prohibited from attempting to circumvent a broad arbitration clause by disguising their claims as seeking equitable relief. Id. at *10.

The court reasoned that the agreement is susceptible of the interpretation that the equitable relief provision relates to preserving the status quo between the parties pending the outcome of the arbitration. Id. The court found that its conclusion was “buttressed by Plaintiff ’s … assertion that an arbitrator should determine the validity and enforceability of the License Agreement.” Id. at *11. The court ultimately compelled arbitration. Id.

In DXP Enters. v. Goulds Pumps Inc., the Texas Southern District federal court concluded that the parties’ agreement and use of the word “notwithstanding” in the carve-out created an ambiguity that warranted a decision in favor of arbitrating the Plaintiffs’ claims for permanent injunctive and declaratory relief. DXP Enters. v. Goulds Pumps Inc., 2014 U.S. Dist. LEXIS 156158 (S.D. Tex. Nov. 4, 2014). There, the agreement and carve-out read:

Any controversy or claim arising out of or related to this Agreement or the breach thereof shall … be finally settled by conciliation or arbitration … Notwithstanding the foregoing, either Manufacturer or Distributor may apply to a court of competent jurisdiction for the imposition of an equitable remedy (such as a Restraining Order or Injunction) upon a showing of the elements necessary to sustain such a remedy.

The court found that “[t]he injunction provision, while stating that a party may apply to a court of competent jurisdiction to obtain equitable relief ‘notwithstanding’ the requirement to arbitrate, does not explicitly except claims for equitable relief from the scope of the broad arbitration clause.” Id. at *10-11.

In the court’s view, there was not a “positive assurance that the parties’ arbitration clause is not susceptible of an interpretation that covers the asserted dispute.” Id. at *11 (quotation marks and citation omitted; emphasis in original).

The court distinguished between the use of the word “notwithstanding” in the clause before it and cases that it perceived to involve more forceful language. Id. at *15-18. It ultimately concluded that the “notwithstanding” language “is closer to the provisions courts have held allow litigation only of applications for [a] temporary restraining order or preliminary injunctions needed to preserve the status quo pending arbitration of the merits, not attempts to displace the arbitration by allowing litigation of the merits through a permanent injunction.” Id. at *18. According to the court, “[t]he strong policy and presumption favoring arbitration weigh [heavily] against such a result.” Id.

Two recent decisions also reached the same conclusions that the equitable carve-outs are only to be interpreted to aid in arbitration and not to remove a case or claims from the proper jurisdiction of the arbitrator. In Davis v. SEVA Beauty LLC, the arbitration agreement was broad, and carved out many claims from arbitration: “any action for declaratory or equitable relief, including, without limitation, seeking preliminary or permanent injunctive relief, specific performance, [or] other relief in the nature of equity to enjoin any harm or threat of harm to such party’s tangible or intangible property, brought at any time, including, without limitation, prior to or during the pendency of any arbitration proceedings initiated hereunder.” No. C17-547 TSZ, 2017 BL 322579, at *3-4 (W.D. Wash. Sept. 13, 2017).

The court held that even though the plaintiffs brought equitable claims seeking rescission, those claims belonged in arbitration because they were not brought “in aid of arbitration.” Id. at *4. “A party may not, however, circumvent the arbitration clause by simply seeking equitable remedies for claims that are squarely within the scope of matters to be arbitrated. This interpretation brings the arbitration provision and the exception at issue into harmony with each other and the federal policy favoring arbitration.” Id.

Similarly, in Info. Sys. Audit & Control Ass’n v. TeleComm. Sys. Inc. the court interpreted a facially broad carve-out to only except from arbitration claims for “temporary equitable relief once a dispute has been submitted to arbitration” or “as authorizing courts to enforce arbitral awards once arbitration is complete.” No. 17 C 2066, 2017 BL 216900, at *5-6 (N.D. Ill. June 23, 2017).

The court also explained that interpreting the clause in any broader way “would permit a party to obtain from a court essentially the same relief as that otherwise reserved for the arbitrator.”

DXP Enters., Davis and Info. Sys. get to the right result, but have to work too hard to get there.

Those courts feel compelled to state that they are “interpreting” the arbitration clause in such a way as to permit the arbitrator to hear the equitable claims. They should not have to so strain. They could, and should, have focused on (1) the lack of any emergency or (2) that the equitable claims were not brought somehow in aid of the arbitration. As a result, they should have held that the parties have to arbitrate all of their claims.

Where parties have a mandatory arbitration clause and a non-emergent situation, cases should not be split, irrespective of whether the case presents a non-emergent equitable claim.

The most that courts should be permitted to do in cases with a mandatory arbitration provision is enter an injunction that freezes the status quo ante in order to prevent irreparable injury until such time as the merits are determined by the arbitrator.

A party that agreed to arbitrate its disputes should not be able to circumvent that very agreement by artfully pleading its claims to include equitable relief. Any other result compromises arbitration, increases party expense, and overburdens the court system—all in favor of enforcing a contract term contrary to public policy.

The Court of Appeals of New York in Carlson v. American Intl. Group, Inc., 2017 N.Y. LEXIS 3280, No. 47, (N.Y. Nov. 20, 2017) overturned the lower court’s determination that N.Y. Insurance Law § 3420, governing certain liability insurance “issued or delivered” in New York and authorizing judgment creditors to sue the insurer to satisfy a covered judgment (among other things), did not apply to a policy issued to and received by the insured outside of New York. New York’s high court held that the phrase “issued or delivered” in New York “encompasses situations where both insureds and risks are located” in New York, as found here, even if the policy was physically issued and delivered elsewhere.

This case addresses several issues bearing on whether the husband of a woman killed in a traffic accident in New York by the driver of a delivery van painted with DHL’s logo (running a personal errand during a scheduled break at the time of the accident) could bring a direct action against DHL’s liability insurers under N.Y. Insurance Law § 3420(a)(2) after securing a judgment against the van’s owner and driver. As pertinent to this alert, the lower court held, among other things, that because the statute applies to policies “issued or delivered” in New York, it, therefore, did not apply to an excess policy that was issued in New Jersey, delivered to DHL’s predecessor in Washington, and then later assumed by DHL, headquartered in Florida.

A majority of the Court of Appeals of New York viewed the lower court’s interpretation of the phrase “issued or delivered in this state” as too restrictive, relying on Preserver Ins. Co. v. Ryba, 10 NY3d 635 (N.Y. 2008), which held that the phrase “issued for delivery in this state,” as it formerly appeared in N.Y. Insurance Law § 3420(d) (requiring written notice in certain instances when an insurer disclaims liability or denies coverage for death or bodily injury), refers to “where the risk to be insured was located – not where the policy document itself was actually handed over or mailed to the insured. [The Court there] interpreted section 3420 to provide a benefit – deliberately in derogation of the common law – to New Yorkers whenever a policy covers ‘insureds and risks located in this state’.” Applying that standard to the facts at hand, the majority of the Court of Appeals reasoned that: “it is clear that DHL is ‘located in’ New York because it has a substantial business presence and creates risks in New York. It is even clearer that DHL purchased liability insurance covering vehicle-related risks arising from vehicles delivering its packages in New York, because its insurance agreements say so.”

Additionally, the majority emphasized that its interpretation is consistent with the overall intent behind the statute’s enactment “to protect the tort victims of New York State,” which could otherwise be easily side-stepped. Unlike the lower court (and dissent), the majority did not find a meaningful difference between the “issued for delivery” language addressed in Preserver and the “issued or delivered in this state” language at issue, noting that “[i]nterpreting ‘issued or delivered in this state’ to apply exclusively to policies issued by an insurer located in New York or by an out-of-state insurer who mails a policy to a New York address would undermine the legislative intent of Insurance Law § 3420. It would require an assumption that the legislature intended to remove coverage benefitting injured New York residents if the policy was mailed from another state, but to increase coverage for foreign victims injured elsewhere so long as the policy was mailed to New York or underwritten by a New York-based insurer – hardly plausible in light of the express purposes of section 3420 and the 2008 Amendments.”

Acknowledging that the phrase “issued or delivered in this state” appears in other parts of the Insurance Law, the majority stated: “we do not here purport to judge the meaning of the words ‘issued or delivered’ in any context other than section 3420. Identical words may be used in different contexts with different meanings and different legislative histories, and we do not foreclose any such interpretations by our decision here.” 

In a dissenting opinion, Justice Garcia expressed support for the lower court’s arguably more literal interpretation of “issued or delivered in this state,” among other things, concluding that the phrases “issued or delivered” (as used in section 3420(a) at issue) and “delivered or issued for delivery” (as formerly used in section 3420(d)(2) and addressed in Preserver) are “two distinct phrases in the Insurance Law that, our cases make clear, have quite different meanings.”

Published in the December 2017 issue of INSIGHTS (Volume 31, Number 12). INSIGHTS is published monthly by Wolters Kluwer, 76 Ninth Avenue, New York, NY 10011. For article reprints, contact Wrights Media at 1.877.652.5295. Reprinted here with permission.

Being a corporate director or officer can be risky business, especially for those involved with public companies. Directors and officers (Ds&Os) are exposed to lawsuits by the company, corporate successors, shareholders, debt holders, employees, bankruptcy trustees and governments. The building blocks of asset protection for Ds&Os are outlined in this article, as well as basic securities and fiduciary liability principles, updates on relevant government enforcement policies under the Trump Administration, and implications for D&O liability insurance coverage.

As discussed here, private securities claims and derivative suits against public company directors and officers are on a powerful upswing, with an unprecedented number of new lawsuits filed in 2017. Meanwhile, under the Trump administration, there are signs of a possible easing of government enforcement actions as the Department of Justice and SEC review prior policies governing corporate cooperation credit and the pursuit of individuals responsible for corporate wrongdoing. In these changing and challenging times, it is important for directors, officers and companies to review their corporate articles, bylaws, contracts and insurance to assure that corporate commitments and policies for protecting Ds&Os fit the needs of the company for balance sheet protection, flexibility and the exercise of discretion, and also satisfy the needs of Ds&Os for reliable and adequate sources of indemnity and advancement.

Asset Protection Overview

Lawsuits and demands against Ds&Os often materialize as claims for alleged violations of securities laws or breaches of fiduciary duties owed to the company or its stockholders. Directors and officers have several potential layers of protection for out-of-pocket expenses and losses, including legal costs, settlements and even judgments.

Statutory Corporate Indemnity and Advancement

State corporations laws permit or require companies to indemnify directors, officers, and employees who are forced to incur costs to defend or protect themselves in lawsuits or proceedings involving their work. Delaware and California law require indemnification of directors and officers who succeed in defending themselves—in Delaware “on the merits or otherwise” and in California “on the merits.”¹

Delaware and California law also permit (but do not require) indemnification for defense costs, judgments, fines and settlements incurred by directors, officers and employees who acted “in good faith and in a manner reasonably believed to be in and or not opposed to the best interests of the corporation” or, in a criminal matter, “had no reasonable cause to believe the conduct was unlawful.”²

These are known as the “minimum standards of conduct” for permissive corporate indemnification. A corporation is not legally permitted to indemnify an individual for expenses resulting from conduct that fails to meet these standards. Nor may a corporation indemnify an individual for a judgment of monetary liability to the corporation itself.

Rather than face a potential non-indemnifiable liability, cases against Ds&Os generally settle, if they are not dismissed on pre-trial motions. Corporate laws permit a corporation to advance legal expenses prior to any final determination of whether an individual met the minimum standards of conduct for indemnification. In Delaware and California, corporations may advance defense costs if the individual promises to repay the money if he or she is later found not to have met the minimum standards of conduct for indemnification.³

In order to attract high quality Ds&Os to serve, many companies commit to indemnification and advancement of their Ds&Os in the articles of incorporation or bylaws “to the greatest extent permitted by law.” This language effectively makes permissive indemnification and advancement mandatory.

Contractual Indemnity and Advancement

Directors and officers can strengthen their rights to corporate indemnity and advancement by requiring, as a condition of employment, that the company enter into a private contract stating the terms of its obligation to indemnify and advance.⁴ Then, if later changes in the articles, bylaws, ownership, key decision-makers or policies are disadvantageous to a director or officer, the company is bound by its contractual agreements to them. These private agreements usually contain presumptions, burdens of proof, timetables and other terms that favor individuals and generally continue in force after the employment relationship or directorship ends.

Exculpation

Many states also permit companies to limit the personal liability of directors (but not of officers) to the corporation and its stockholders with an “exculpation” provision in the articles of incorporation. These provisions excuse directors from personal monetary liability to the company and its shareholders for breach of the fiduciary duty of care. Corporate laws do not permit exculpation, however, for breach of the fiduciary duty of loyalty, bad faith, intentional misconduct, knowing violations of law, transactions resulting in an improper personal benefit, or improper payment of corporate dividends.⁵

Third-Party Insurance

The final layer of asset protection is D&O liability insurance purchased by the company to protect corporate assets and provide coverage for Ds&Os when the company cannot or will not indemnify them. D&O liability insurance is designed to pay losses (including legal fees) for defending against allegations of “wrongful acts,” such as violations of securities laws or breaches of fiduciary duty, that result in damages to the company, its stockholders or investors.

Most D&O liability policies contain multiple products in a single policy. A traditional “ABC” policy covers personal asset protection and corporate balance sheet protection. Side A covers directors and officers when the corporation cannot or will not indemnify them—such as when it is insolvent, chooses to withhold indemnity, or concludes that an individual failed to meet the minimum standards of conduct. Side B reimburses the corporation for indemnification paid to directors and officers. Side C covers the corporation when it is named in a securities action. Finally, excess Side A DIC (difference in conditions) coverage is dedicated coverage for directors and officers that is not “shared” with the corporation. Side A DIC provides coverage in excess of a tower of primary and excess policies and, among other attributes, “drops down” to replace an underlying insurer if it becomes insolvent.

Although D&O policies provide coverage for claims alleging “wrongful acts,” they exclude coverage for willful or intentional misconduct, which is uninsurable as a matter of law and public policy. That said, insurance can provide coverage for conduct that would not be indemnifiable by the corporation, such as non-exculpable failure of oversight or forms of “bad faith” that do not rise to the level of intentional misconduct. Corporate laws generally allow companies to buy D&O insurance for non-indemnifiable claims.⁶

Liability Standards—Securities Laws

Corporate directors and officers have potential exposure under both state and federal laws for securities law violations, which commonly are based on allegedly misleading disclosures to investors or illegal sales of securities. Liability for securities violations ranges from mere negligence to intentional wrongdoing. Federal law preempts state law in securities fraud class actions.⁷

Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) is the work horse most often invoked against directors and officers in private securities litigation. Federal courts have exclusive jurisdiction over Section 10(b) cases, and most federal circuit courts have concluded that “recklessness” satisfies the mental state required to prove liability—although the U.S. Supreme Court has never determined whether “reckless” conduct is sufficient.⁸

Federal securities fraud class action filings hit a record pace in 2017, with the most new case filings since enactment of the Private Securities Litigation Reform Act of 1995 (PSLRA). The PSLRA set up legal hurdles and protections for companies, directors and officers, designed to weed out meritless claims at the pleading stage, often filed on little more than accusations of prior disclosure fraud when disappointing news results in a stock price decline.⁹

Sections 11 and 12 of the Securities Act of 1933 (Securities Act) are invoked against Ds&Os less frequently than Section 10(b) because they apply in narrower circumstances.¹⁰ Section 11 is designed to redress material misstatements in a registration statement, and most often invoked following a public offering, when stockholders can trace their purchases to a particular registration statement. Section 12 is designed to redress the illegal sale of unregistered securities and material misstatements in prospectuses and other offering materials. Ds&Os can defend themselves against misrepresentation claims under Sections 11 and 12 by demonstrating their due diligence and that they “had no reasonable ground to believe and did not believe” that the challenged statements were untrue when made.¹¹

In 2017, the United States Supreme Court took up an important issue in Cyan Inc. v. Beaver County Employees Retirement Fund,¹² about whether state courts have jurisdiction over claims filed under the Securities Act. From the mid-1990’s until recently, plaintiffs brought Section 11 and Section 12 claims in federal court, where many of the PSLRA’s protections operate through the federal rules of civil procedure.¹³ However, federal courts in California parted company with other jurisdictions by holding that state courts retain jurisdiction over 1933 Act claims. If the Supreme Court agrees, then public companies—especially new companies following an IPO—will face the prospect of securities class actions in state courts that lack familiarity with the federal securities laws and are not obliged to enforce some of the procedural protections contemplated by the PSLRA—thus, increasing D&O liability risk.

Liability Standards—State Fiduciary Duties

The liability of directors and officers for breach of fiduciary duties owed to the corporation or its stockholders is governed by state law—usually the state of incorporation.¹⁴ In Delaware, gross negligence violates the fiduciary duty of care.¹⁵ In California, directors and officers are held to a standard of ordinary negligence, except that directors, unlike officers, have no liability if they act in good faith and in reasonable reliance on others.¹⁶

Duty of Care: The Business Judgment Rule

The first line of defense in a breach of fiduciary duty case is the business judgment rule (BJR). By statute or common law, depending on the state, the BJR immunizes directors for decisions made in good faith and on an informed business basis, even if those decisions result in losses to the company or its stockholders. In Delaware, it is unsettled whether the BJR protects both directors and officers; in California, it protects only directors.¹⁷

Many states, including Delaware and California, recognize a presumption that disinterested directors acted in good faith and on an informed basis, and put the burden on plaintiffs to rebut the presumption that the BJR applies to a given board decision.

Where the BJR applies, courts are expected to defer to a board’s decision about managing corporate affairs.¹⁸ Even if a board’s business judgment is “substantively wrong, or degrees of wrong extending through ‘stupid’ to ‘egregious’ or ‘irrational,’ ” no court should second-guess it and no director should have liability for it as long as “the process employed was either rational or employed in a good faith effort to advance corporate interests.”¹⁹

Business judgments that result in waste of corporate assets, however, are not recognized as valid and could expose directors to personal liability. However, “waste” is a transaction “so one-sided that no business person of ordinary, sound judgment could conclude that the corporation has received adequate consideration.”²⁰

Duty of Loyalty and Good Faith

Directors are not entitled to corporate indemnification—nor exculpated from personal liability—for breaches of the duty of loyalty or bad faith. “Bad faith” and the absence of good faith are “two sides of the same coin.”²¹ Bad faith in its “most extreme form” involves “the conscious doing of a wrong because of [a] dishonest purpose,” or “intentionally fail[ing] to act in the face of a known duty to act, demonstrating a conscious disregard for [his or her] duties.”²² In order to win a money judgment against directors, plaintiffs must allege and prove a non-exculpable breach of the duty of loyalty or bad faith. Accordingly, plaintiffs often allege that directors “consciously disregarded” a duty to intervene in events that are harmful to the company or its stockholders, or that they approved or engaged in transactions for self-interested reasons, knowing that their actions were not in the best interests of the company or its stockholders.

A transaction is self-interested when a director stands on both sides of it or is influenced by someone whose interests are across the table from the corporation’s interests. It is important to note that Ds&Os engage in business transactions with their companies not infrequently. These transactions are not inherently wrongful. Rather, the transaction will be subject to heightened judicial scrutiny, and the burden rests on the self-interested director to prove that the transaction was “entirely fair” to the corporation.²³ This heightened scrutiny and burden expose the director to the risk of a finding that the director obtained a personal benefit that he or she knew was opposed to the best interests of the corporation or its shareholders—i.e., non-exculpable, non-indemnifiable conduct.

Liability for Failure of Oversight Under Caremark

Directors also face non-exculpable, non-indemnifiable liability exposure for a failure of corporate oversight that amounts to breach of loyalty. Under the Delaware Court of Chancery’s Caremark decision, directors face liability for breach of loyalty when “a loss eventuates not from a [business] decision but, from unconsidered inaction.”²⁴ Directors may be liable if they knew or should have known that violations of law were occurring within the corporation and yet failed to take steps to prevent or remedy the situation. Directors must assure themselves that “information and reporting systems” exist that are reasonably designed to provide timely and accurate information sufficient to allow them to make informed judgments “concerning both the corporation’s compliance with law and its business performance.”²⁵ “[A] sustained or systematic failure of the board to exercise oversight—such as an utter failure to attempt to assure a reasonable information and reporting system exists—will establish the lack of good faith that is a necessary condition to liability.”²⁶

Because liability under Caremark is based on bad faith amounting to breach of the duty of loyalty, the company cannot indemnify a culpable director or officer. This narrows the potential source of indemnity to D&O insurance. A company may indemnify and advance legal fees and settlement costs, however, before a final determination of liability—which naturally tends to drive failure of oversight cases to settlement.

Government Investigations Focusing on Individual Wrongdoing

The federal titans of securities law enforcement—the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC)—have policies that encourage aggressive pursuit of individuals, both as sources of information and targets of enforcement action. These policies have negative implications for D&O defense.

The DOJ Policy

In a September 2015 memorandum by then-Deputy Attorney General Sally Yates, the DOJ announced a policy to more aggressively pursue individuals.²⁷ This announcement followed an uptick in the number of individuals charged under the Foreign Corrupt Practices Act (FCPA) and the False Claims Act. Statements out of the DOJ under the new administration have raised some uncertainty about whether the policy will continue in full force.

The Yates Memo gave federal prosecutors and investigators guidance on “key steps” to strengthen pursuit of individuals for corporate misconduct. In order to gain “any” credit for cooperation, companies must turn over “all relevant facts” relating to conduct of individuals responsible for corporate misconduct. Both civil and criminal enforcement attorneys are to focus on individuals at the inception of an investigation and share information with each other. Enforcement attorneys may not agree to a settlement that protects individuals or resolves a corporate case without a clear plan to resolve individual cases. Finally, civil attorneys must consider actions for monetary recovery against culpable individuals regardless of ability to pay.

While the impact of the Yates Memo is still playing out, some commentators have noted a counterintuitive drop in FCPA enforcement actions against individuals.²⁸ In a speech at New York University Law School in October 2017, Deputy Attorney General Rosenstein stated that while the Yates Memo is “under review” and subject to change, the policy of focusing on individual accountability for corporation wrongdoing will continue under the current administration.²⁹ On the other hand, in a November 17, 2017 press release, Attorney General Sessions may have been alluding to the Yates Memo in declaring an end to the DOJ “practice” of blurring regulations and “guidance,” stating that the DOJ “will proactively work to rescind existing guidance documents that go too far.”³⁰

The Yates Memo policies of targeting individuals responsible for corporate wrongdoing presents challenges to the protective use of corporate indemnity and third-party insurance. The criteria for obtaining cooperation credit pit companies against directors and officers in positions of oversight. Those potentially in harm’s way will want separate legal counsel early in any internal or government investigation, for which they will look to the company for immediate advancement. Third-party insurance may not be available to defray the cost because coverage generally is triggered by a claim for money and often provides only limited coverage, if any, to cover an investigation.

This dynamic increases the importance of careful consideration of potential conflicts that may require separate counsel for various corporate actors, which can spiral into a full-employment-act for lawyers unless carefully managed. At the same time, companies seeking to curry favor with the government may wish to maximize flexibility to refuse advancement to individuals perceived by the DOJ as potential wrongdoers. Of course, there may be legal limitations on a corporation’s ability to refuse advancement.

The impact of the DOJ’s cooperation program tends to make government investigations more complex, extend over a longer period of time, and foster more tension between and among Ds&Os who are under scrutiny and boards of directors or committees that are leading internal investigations. If an investigation leads to self-reporting of a violation of law, or an enforcement action based on, for example, information provided by a whistleblower, it may take longer for companies to settle while individual culpability remains under consideration. To assess the adequacy of D&O defense and protection, companies should reevaluate their indemnification and advancement bylaws, as well as insurance coverage, retention limits, excess coverage, policy language and exclusions, and Side A coverage for individuals.

SEC Policy

The SEC’s policies of pursuing individuals responsible for corporate securities violations have been endorsed under the Trump administration and raise many of the same challenges discussed above. A more recent SEC policy of requiring companies and individuals to admit wrongdoing in some cases as a condition of settlement further negatively impacts the D&O safety nets of indemnity and insurance.

Pursuit of individuals. SEC initiatives launched in 2010 and 2011 encourage individuals to cooperate and report corporate wrongdoing. The 2010 “Enforcement Cooperation Initiative” offers deferred prosecution agreements and non-prosecution agreements in exchange for cooperation,³¹ while the 2011 Whistleblower Program, implemented pursuant to the Dodd Frank Wall Street Reform and Consumer Protection Act, provides life-changing bounty awards for tips leading to successful enforcement actions, including against compliance officers and other gatekeepers.³²

These programs operate in tandem with the SEC’s longstanding policy of encouraging corporate cooperation with SEC enforcement through self-reporting, self-remediation, and punishing and turning over individuals responsible for corporate wrongdoing. The 2001 Seaboard Guidelines, published in an SEC report of investigation, articulate the framework by which the SEC evaluates corporate cooperation, including factors considered in determining whether, and to what extent, the SEC will grant leniency for cooperating.³³

These programs appear to be here to stay under the Trump administration, although details may be tweaked. The Whistleblower Program has continued to generate large rewards. An October 2017 SEC report announced that the total awards under the program have reached $162 million to 47 whistleblowers.³⁴ A co-director of the SEC’s Division of Enforcement recently confirmed that the Seaboard Guidelines also will remain in effect, while acknowledging that the SEC should be more specific about the exact benefits of cooperation and provide greater transparency about why cooperation credit is granted or denied.³⁵

Admissions of wrongdoing. In June 2013, then-SEC Chair Mary Jo White announced a shift in policy to seek more admissions of wrongdoing in settlements—a departure from the SEC’s longstanding practice of permitting settling parties to “neither admit nor deny” wrongdoing. According to a March 2015 article in The New York Times, the SEC had generated admissions of culpability in at least 18 different cases involving 19 companies and 10 individuals. In 2017, however, a co-director of the SEC Enforcement Division stated that, while the SEC supports having companies and individuals that admit wrongdoing to other agencies make similar admissions to the SEC, the “harder piece” is deciding whether to continue a policy of departing from the SEC’s “neither admit nor deny” practice.

The SEC’s policies of pursuing individual wrongdoers and seeking corporate cooperation raise the same issues discussed above regarding the DOJ policies of targeting individuals—i.e., more requests for separate counsel, advancement and indemnification, longer investigations, heightened tension between internal investigators and the subjects of investigation, and greater importance of Side A D&O insurance coverage.

Further, an admission of wrongdoing in an SEC settlement limits the ability of a settling director or officer to access corporate indemnity if the admission is deemed to establish non-indemnifiable conduct. Insurance may not be available to fill the gap because coverage for SEC investigations (as opposed to money damages claims) often is not covered or is limited, and there is no coverage for intentional wrongdoing. Ds&Os who admit liability also risk inability to access corporate or insurance funds for defense in parallel or follow on securities litigation, derivative suits and criminal proceedings.

Corporate D&O Litigation

M&A Lawsuits

Until 2016, whenever a public company was sold, the selling company’s board invariably found itself on the receiving end of a class action lawsuit for breach of fiduciary duty to the selling stockholders. So-called “merger objection” lawsuits typically were filed by stockholders of the selling company claiming that the directors and officers breached their fiduciary duties in negotiating the merger price and terms, agreeing to a price that was too low, and approving deficient proxy disclosures. As of the end of 2014, a leading research firm reported that more than 90 percent of merger and acquisition (M&A) transactions above $100 million had ended up in litigation since 2009.³⁶

Historically, most M&A cases were resolved by settlement before the merger closed based on the defendants’ agreement to make additional disclosures or minor adjustments in the deal terms, along with a negotiated fee to the plaintiff ’s attorneys, in exchange for a broad release of D&O liability. Those settlements, until recently, were routinely approved.³⁷ In these early settlements, directors never face a real prospect of out-of-pocket liability exposure.

Recently, however, more M&A cases are being litigated as traditional class actions for money damages after the merger closes.³⁸ This trend has serious liability implications for directors. In order to obtain a judgment for money damages, plaintiffs must prove non-exculpable conduct. This requires proof of self-dealing, bad faith or breach of the duty of loyalty—all of which expose directors to out-of-pocket, non-indemnifiable loss, leaving directors to rely on Side A insurance to fill a potential corporate indemnity gap. It is often unclear exactly what degree of wrongful conduct, however, may be insured.

Two factors are driving the trend toward post-closing merger class actions. First, the Delaware Court of Chancery has taken a stand against broad releases in exchange for “a peppercorn and a fee,” refusing to approve pre-closing nonmonetary settlements. In January 2016, the Court of Chancery embraced the mounting criticism of these settlements and rejected a disclosure-only settlement in In re Trulia Inc. Securities Litigation.³⁹ Trulia echoed the analysis in Acevedo v. Aeroflex Holding Corp., where the Court of Chancery harshly criticized “disclosure-only” settlements stating that they “do not provide any identifiable much less quantifiable benefit to stockholders” and that “ubiquitous merger litigation is simply a deadweight loss.”⁴⁰ The Court in Aeroflex gave the plaintiffs three choices: (1) declare the claims moot based on the enhanced disclosures and seek attorneys’ fees; (2) propose a settlement limiting release of the directors to Delaware fiduciary duty claims; or (3) litigate the case.⁴¹ None of those choices would provide the defendants with broad releases from personal liability.

Second, the trend toward post-closing merger class action cases is fueled by the high potential dollar recovery. Plaintiffs now are filing many of these cases in federal court (to avoid Delaware).⁴² Although the cases are subject to a high dismissal rate, the rewards of surviving a motion to dismiss are potentially considerable. But again, in order to win a judgment against corporate directors, plaintiffs must establish non-exculpable liability—such as breach of loyalty—which is not indemnifiable by the company. Individual defendants, who usually have parted ways with the company under new ownership, are highly motivated to encourage a class-wide settlement with insurance dollars rather than face risk of personal liability at trial, even on weak or patently unmeritorious claims.

Derivative Suits

Derivative suits against corporate officers and directors historically have presented a low risk of liability for Ds&Os and low returns for plaintiff’s firms. Generally, cases are filed in the wake of securities class actions and settled for minor prophylactic measures, such as corporate governance improvements, and a relatively small fee award. Recently, however, derivative suits have gained traction after high-profile cases resulted in large settlements, including $275 million for Activision Blizzard (2014), $139 million for News Corp. (2013), $137.5 million for Freeport-McMoRan (2015), and $62.5 million for Bank of America Merrill Lynch (2012), among others.⁴³

Stockholders seeking to sue on behalf of a company must establish their standing to assert the company’s claims, which normally are controlled by the board. Stockholders must first make a demand on the board to bring the desired action, or else establish that demand would be futile because a majority of the directors are too conflicted to exercise valid business judgment on a demand.⁴⁴ In response to a demand, the board must investigate and make a business decision about whether it is in the best interest of the company to take the action demanded. If the demand is refused, courts should defer to the board’s business judgment and dismiss the case without considering the underlying merits of the claims.⁴⁵

While the odds that plaintiffs will get past the pleading stage in a derivative suit are low, the potential payoff is high, as the settlements cited above suggest. As in the merger litigation context, plaintiffs must prove that defendant directors engaged in nonexculpable wrongdoing (bad faith, breach of loyalty), which generally cannot be indemnified by the company. Further, companies cannot indemnify directors and officers for a judgment of monetary liability in favor of the company, regardless of the theory. Thus, defendants face theoretical out-of-pocket liability in derivative suits. The primary defense strategy is to obtain dismissal based on plaintiffs’ lack of standing, regardless of the underlying merits of the claim. All equal, a settlement funded by D&O insurance is preferable to trial.

Plaintiffs have gained leverage in derivative suits based on recent Delaware decisions that allow more expansive pre-suit stockholder access to “books and records,” enabling plaintiffs to investigate D&O wrongdoing and file better complaints.⁴⁶ Delaware courts have long encouraged stockholders to use Section 220 of the Delaware General Corporate Law to obtain nonpublic books and records before bringing derivative actions.⁴⁷ To obtain corporate records, a would-be stockholder plaintiff need only show a “credible basis from which fiduciary misconduct could be inferred.”⁴⁸

In 2014, the Delaware Supreme Court upheld a Court of Chancery decision enforcing a “books and records” demand by Wal-Mart stockholders to investigate an ongoing Wal-Mart internal investigation of alleged FCPA violations in Mexico. The court required Wal-Mart to comply with demands to search back-up tapes and to produce lower-level officer documents that were never seen by the board and certain privileged attorney-client communications.⁴⁹ With such extensive information, plaintiffs in theory are better able to craft derivative complaints that stand a chance of survival at the pleading stage.

Coverage and Indemnity Implications

D&O coverage typically is triggered by a demand for money—not by a demand for corporate “books and records” or a demand that a board of directors investigate and bring suit on behalf of a company. Yet, these demands are serious precursors to derivative litigation against D&O defendants. Some D&O policies provide limited coverage to defray corporate costs of the board’s investigation in response to a demand. But this is only part of the cost. Individual Ds&Os who are questioned in the board investigation may seek separate counsel and request corporate advancement and indemnification. If the derivative suit were to result in a judgment in favor of the company, the culpable Ds&Os could not look to the company to defray the cost, and would need to call upon Side A insurance coverage.

Conclusion

If you are a director or officer of a public company, or considering a board position with a public company, it is a good idea to invest in a legal checkup on the company’s indemnification and advancement articles, bylaws, policies and agreements, and a review of its D&O liability coverage.

Endnotes

This article was published in the Fall 2017 issue of Real Estate Finance Journal. © 2017 Thomson Reuters. Reprinted with permission.

New York City is home to Broadway, Times Square, the New York Yankees — and some of the most expensive real estate in the country. As a result, commercial leases in New York City tend to be difficult to navigate and negotiate for tenants — particularly for startups and small companies. This article will discuss several common pitfalls for tenants to avoid, and some local nuances for tenants to be aware of, when negotiating New York City commercial leases.

REBNY Form

Depending on the landlord and the size/type of the building, some landlords use an antiquated standard form of office lease, loft lease or store lease prepared by the Real Estate Board of New York (the REBNY Form). This dual-column “boilerplate” form is rarely, if ever, used on its own and is often supplemented by a lease rider that amends and supersedes most, if not all, of the provisions in the REBNY Form. This begs the question of why the REBNY Form is still used. Nevertheless, many landlords in New York City continue to prepare leases using the REBNY Form. If a tenant is presented with the REBNY Form, there are several provisions to look out for, including:

• The obligation to remove all tenant improvements and alterations in the leased premises at the end of the lease term. As drafted, all fixtures, paneling, partitions, railings and other like installations shall, upon installation, become the property of the landlord and shall be surrendered with the leased premises at the end of the term “unless Owner, by written notice to Tenant no later than twenty days prior to the date fixed as the termination of this lease, elects to relinquish Owner’s right thereto and to have them removed by Tenant, in which event the same shall be removed from the demised premises by Tenant prior to the expiration of the lease, at Tenant’s expense.”

  This restoration obligation could result in a tremendous expense and burden on a tenant at the end of the term and should be removed, if possible. As an alternative, most landlords will agree to either (1) notify the tenant at the time the landlord approves an alteration whether the alteration will need to be removed at the end of the term (as opposed to notifying a tenant shortly before the end of the term), which would give a tenant the opportunity to decide if the alteration is worth installing if it must then be removed at the end of the term, or (2) limit the restoration obligation solely to “specialty alterations” or alterations that are nonstandard alterations for an office space, such as internal staircases, raised flooring and supplemental air conditioning units, and which may cost more to remove than ordinary office installations.
   

• The obligation to comply, at the tenant’s sole cost and expense, with all present and future laws which shall impose a violation, order or duty upon the landlord or tenant with respect to the demised premises, “whether or not arising out of tenant’s use or manner of use thereof (including tenant’s permitted use).” This seemingly innocuous provision can have tremendous ramifications if not revised properly. For example, if a new law requires an owner to install a sprinkler system in a building that, when initially constructed, predated the city’s sprinkler code, then, based on this provision, a tenant could be required to install, at its expense, a sprinkler system within the premises.

  Instead, tenants should only be required to perform such alterations within the premises or to the building necessary to comply with law if such compliance is required by reason of their specific or particular manner of use in the premises, as opposed to the permitted use under the lease (which, in most cases, is general office use). The theory here is that tenants should not be responsible for compliance obligations merely based on being a tenant in a building, but rather they need to be doing something (other than simply leasing the space) that results in such violation, order or duty.

• The prohibition on assignments, subleases and transfers of stock or other ownership interest in the tenant. Without any modifications to this provision, a tenant would be hamstrung in its ability to find other space (whether to downsize or grow its business), to sell or transfer control of its business, or to undertake other corporation transactions because any of these transactions would be prohibited without obtaining the landlord’s consent. Therefore, it is important to make sure that this provision is modified to permit assignments, subleases, licenses and other occupancy arrangements with the landlord’s prior consent, not to be to unreasonably withheld. Further, tenants should also negotiate the right to transfer the lease in connection with certain corporate transactions without the landlord’s consent, such as (1) assignments or subleases to affiliates or subsidiaries of the tenant (or the parent of the tenant, as the case may be), (2) mergers, consolidations or reorganizations of the tenant and (3) the sale of all or substantially all of the tenant’s assets, stock or other ownership interest. Most often, landlords will permit these corporate transactions without their consent provided that certain conditions are met, which may include a net-worth test and prior notice of such transactions.

• Default for the nonpayment of rent. As drafted in the REBNY Form, if a tenant fails to pay any rent required under the lease when due, the landlord may, without notice, reenter the demised premises either by force or otherwise and dispossess the tenant by summary proceedings. While this rarely, if ever, happens in practice, a landlord is still entitled to terminate the lease if the rent is not received when due. Generally, landlords are amenable to giving some period of written notice to the tenant before nonpayment of rent is deemed to be a default under the lease entitling the landlord to terminate the lease. At the very least, landlords may agree to give one or two written notices per year or lease term as a courtesy so that a tenant is not facing eviction if they are late in paying rent on occasion.

Base Years for Real Estate Taxes and Operating Expenses

In addition to base rent, most landlords will require tenants to pay additional rent in the form of real estate tax and operating expense escalations. Instead of annual percentage increases in base rent, tenants may be obligated to pay their proportionate share (i.e., the ratio that the rentable square footage of the premises bears to the total rentable square footage of the building) of the real estate taxes and/or operating expenses for the building. Often, the tenant’s proportionate share is based on the excess of the building’s real estate taxes and/or operating expense over the real estate taxes and/or operating expenses for an agreed-on “base year.”

For example, if operating expenses for the building are $200,000 during the “base year” and $250,000 during the subsequent lease year, then a tenant who occupies 10 percent of the building would be required to pay its proportionate share of the increase in operating expenses over the base year, or $5,000 (i.e., $50,000 x 10 percent). It is important to negotiate for the most current base year (or even a future base year) in order to realize the most savings over the life of a lease. In addition, payments for real estate taxes and operating expenses should not begin until the year following the base year — or, if possible, for a year after the lease commencement date.

• Real Estate Tax Base Years: Tenants in a newly constructed building or a building that is currently undergoing (or recently underwent) substantial renovations must be careful that their base year properly reflects a fully assessed building, as these buildings will be reassessed to reflect the value of the construction or renovations. If the base year is artificially low (i.e., the increased value is not reflected in the base year), tenants could be exposed to enormous increases in real estate tax escalations when the building is reassessed in later lease years. Therefore, it is critical that real estate taxes are based on the building as if it were fully leased and assessed or to select a later base year when the construction or renovation is completed and the building is fully assessed.

• “Gross Up” for Operating Expenses: Similar to protections for real estate tax escalations, tenants must also protect themselves against potentially large operating expense escalations by negotiating “gross up” provisions in the lease. If the building has a low occupancy rate during the tenant’s base year, then, as the occupancy rate increases, the tenant’s operating expense escalations may increase exponentially. However, if the lease states that the operating expenses for the building are based on a fully occupied building (i.e., 95 percent or 100 percent occupancy rate) and the amount by which operating expenses would have increased had the building been fully occupied and operational and had all services been provided to all tenants, then the operating expenses will be regulated in an equitable manner for the tenant and the landlord. To fully benefit from this concept, the “gross up” language must apply to the base year, as well as to all future lease years.

Security Deposits

Depending on the creditworthiness of the prospective tenant, a landlord may require a security deposit equal to several months of base rent. If a landlord is requesting a high security deposit to overcome financial solvency issues, a tenant should try to negotiate for a reduction or a “burn down” in the amount of the original security deposit after a certain period of time, provided the tenant has been current in its rental payments.

While most landlords require the security deposit in the form of a letter of credit (to protect the security deposit from being clawed back into a bankrupt tenant’s estate), landlords that accept cash security deposits are permitted by law to keep up to 1 percent of the interest earned on the security deposit as an administrative fee. In some instances, such as with startups, small businesses or single-purpose entities, a landlord may also require a personal or corporate guaranty (depending on the tenant entity), which means that the guarantor will make the rent payments if the business fails. A less onerous form of guaranty is a “good guy” guaranty created to incentivize good behavior in tenants and to avoid the expensive and difficult process of remarketing the space while obtaining possession from the holdover tenant. The good-guy guaranty typically contains (1) a guaranteed period of time, (2) a limited and specified amount of payment, such as base rent and additional rent, and (3) specified scope of performance obligations other than payments. A tenant should try to limit the good-guy guaranty in the following ways:

• Guaranty Period: The guaranty should only cover the period of time that the tenant is in possession of the premises. Provided that the tenant has paid all rent and performed other specified obligations through the date it vacates the premises (albeit a date before the lease expiration date), then the guaranty terminates. Landlords typically require that tenants give a certain amount of advance notice before vacating the premises (anywhere between 30 and 90 days), and, if this notice is not given, the vacate date is extended for the same amount of time as the notice period. A tenant will want to limit the notice period to the shortest amount of time possible, if not eliminate the notice period entirely.

• Guaranty Obligations: The guaranty should only cover the payment of base rent and monthly recurring additional rent — as opposed to any and all charges and performance obligations under the lease. The guarantor should not step in the shoes of the tenant under the lease (as it would with a standard guaranty), but rather agree to be a “good guy” and pay the rent while the tenant is occupying the space. If the landlord is opposed to removing all performance-based obligations from the guaranty entirely, these obligations should be limited to very specific obligations, such as completion of work projects, removal of liens and surrender condition.

Use/Compliance With Law

Tenants leasing space in New York City must determine the permissible uses of a space under local zoning ordinances and the certificate of occupancy for the building to ensure that their intended use is permitted in the premises. For example, a financial services company leasing office space in midtown Manhattan has little to worry about in terms of using the premises for its intended use because most buildings in this area have certificates of occupancy for general office use. However, in lower Manhattan, many of the older buildings have outdated certificates of occupancy for warehouse, retail or other non-office uses or do not have certificates of occupancy at all. In these cases, a tenant will need the landlord to either amend the certificate of occupancy or represent that the tenant’s use will not be deemed a violation under the lease. In some cases, depending on the negotiating power of the tenant, a landlord may agree to give the tenant a termination right if the tenant is prohibited from obtaining work permits or conducting its business in the premises as a result of the existing certificate of occupancy or the lack thereof. Further, if the premises lies within a historic district or is in a landmarks building, a tenant may also need to comply with the rules of the New York City Landmarks Preservation Commission for certain alterations and improvements (including storefronts and exterior signage for retail tenants).

Local Taxes

Tenants may also be subject to a local use and occupancy tax on rents. Tenants leasing property for commercial activity are subject to the Commercial Rent or Occupancy Tax (CRT) if (1) the property is located in the borough of Manhattan, south of the center line of 96th Street, and (2) the annual or annualized gross rent paid is at least $250,000, unless the tenants meet certain exemption criteria (such as short rental periods, residential subtenants, theatrical productions, not-for-profit status or properties located in the World Trade Center Area). See Title 11, Chapter 7, NYC Administrative Code.

Currently, the tax rate for the CRT is 6 percent of the base rent. All taxpayers are granted a 35 percent base rent reduction, which reduces the effective tax rate to 3.9 percent. In addition, tenants with annualized base rents between $250,000 and $300,000 before the 35 percent rent reduction are eligible for a sliding-scale credit that partially offsets the CRT. Tenants subject to the CRT must file annual CRT returns with the NYC Department of Finance on or before June 20 covering the prior year. Every landlord of taxable property and every tenant of taxable property must keep the following records:

• identification of each tenant or subtenant

• the rent required to be paid

• the rent paid and received

• the location of each premises

• the period of each occupancy

• all leases or agreements that fix the rents required to be paid and/or the rights of the tenants.

Leases stating rents required to be paid should be kept for a period of three years after the expiration of the lease. Other records must also be kept for a three-year period after the annual return is filed (unless written permission is granted to destroy them before that time).

We are here to assist you in negotiating your lease in New York City to protect your interests.

On September 20, 2017, a group of construction union trusts that operate in the New York City metropolitan area successfully obtained a $76 million award from a midtown construction firm and a major real estate developer after a three-year court battle. In a decision with potentially widespread implications for the city’s construction and development firms, the United States District Court Southern District of New York found that a construction company subject to multiple collective bargaining agreements (CBAs) fraudulently established an alter ego company in an attempt to divert work away from several major city construction unions in violation of the “work preservation clauses” contained in the related CBAs. [1]

The scale of the Navillus court’s verdict is considered one of the largest of its type in the United States and is a strong warning to New York construction and development firms seeking to avoid union requirements. In this article, we provide an overview of double-breasted operations and discuss the implications of Moore v. Navillus Tile, Inc.

Double-Breasted Operations

In New York City and elsewhere in the US, many contractors engage construction workers pursuant to a CBA negotiated with the workers’ unions. These CBAs often require that the employer (and its progeny) utilize union workers for all specified work covered by the agreement in the specified geographic area; those employers are required among other things to pay union scale wages and make contributions to jointly administered pension and welfare funds. Specific projects can be all union, open shop (mix of union and nonunion trades) or nonunion.

Nonunion workers generally receive lower wages and fewer benefits than union workers for the same services. Therefore, contractors may have a financial incentive to use nonunion labor when possible. Additionally, developers may have a preference whether or not to mix union and nonunion trades on the jobsite to promote efficiencies – some developers believe that mixing union and nonunion trades in an open shop atmosphere can lead to disputes and lack of coordination between the trades that can be detrimental to efficiencies and timelines. As a result, some employers subject to CBAs operate “double-breasted” operations in which the unionized employer creates a second, separate firm with a nonunion workforce. We note that in Navillus, the defendants claimed that nonunion help was significantly less effective than union (seventeen percent or so), and therefore, the discrepancy in wages and benefits was somewhat justified. The court, however, dismissed the defendant’s argument in its application to mitigate damages.

Double-breasted operations do not violate the National Labor Relations Act (NLRA) per se. However, if improperly managed, double-breasted operations may violate certain protections set forth in those statutes as well as CBA contractual provision that prohibit employers from using nonunion labor for covered work in a unionized employers’ CBA. They may also violate the Labor Management Relations Act of 1947 (LMRA) and the Employee Retirement Income Security Act of 1974 (ERISA), which provide federal remedies for certain violations of CBAs to parties to covered CBAs and participants and beneficiaries of covered benefit funds, respectively.

The determination of whether two distinct divisions or companies comprise a double-breasted operation is generally determined based upon the following tests (i) single employer or (ii) alter ego. [2] For the purposes of this article, our discussion focuses on the alter ego doctrine, because the Navillus court relied on the alter ego doctrine to determine that two contractors were subject to the union shop’s CBA even while operating parallel companies.

Typically, the single employer test is used when commonly controlled entities run parallel operations, and the alter ego test is predominant when a new nonunion entity replaces the union shop. The single employer test has two parts which includes the finding of a single employer and a single bargaining unit. Factors that determine whether two entities or division are a single employer include (i) centralized control of labor relations; (ii) interrelation of operations; (iii) common management; and (iv) common ownership or financial control. The factors used to find a single bargaining unit include: (i) bargaining history; (ii) functional integration of operations; (iii) differences in types of work and skills of employees; (iv) extent of centralization of management and supervision, particularly with regard to labor relations, (v) hiring, discipline and control of day-to-day operations; (vi) and extent of interchange and contact between the two groups. [3]

While similar to the single employer doctrine, the alter ego doctrine does not require the finding on a single bargaining unit. The alter ego doctrine is primarily applied in situations involving successor companies, where the successor is merely a disguised continuance of the old employer. [4] As described below, the alter ego doctrine for purposes of finding two entities to be subject to a CBA is more akin to a standard “pierce the corporate veil” test for corporations. In Navillus, the court found that the nonunion operations “borrowed” management, finances, employees, operations and equipment so heavily from the predecessor (and continuing) union shop that the nonunion businesses were indeed alter egos of the union shop established for the purpose to avoid the constraints of the union shop’s CBA obligations. Note that under both doctrines, direct or indirect common ownership or control between the union and nonunion operations is essential but not alone dispositive.

The Alter Ego Doctrine

The alter ego provides “an analytical hook to bind a non-signatory to a collective bargaining agreement.” [5] The test to determine alter ego status is “flexible” and dependent upon the “circumstances of the individual case.” [6] Generally, the “hallmarks of the alter ego doctrine include whether the two enterprises have substantially identical management, business purpose, operation, equipment, customers, supervision, and ownership.” [7] A finding of alter ego status does not require all of these factors to be present nor is a single factor dispositive. [8] Further, although a company’s intent to evade union obligations is a factor in determining alter ego status, it is not a necessary factor.

The alter ego doctrine was developed in the context of the NLRA, but it also applies to claims brought under ERISA. [9] In the ERISA context, the purpose of the alter ego doctrine is to prevent an employer from evading its funding obligation under the labor laws ‘through a sham transaction or technical change in operations.’ [10] In order to protect employee benefits, courts observe “a general federal policy of piercing the corporate veil when necessary.” [11] In Navillus, the court applied the alter ego doctrine despite the fact that the controlling persons continued to operate a union contractor in parallel to the new, non –union businesses. [12] Accordingly, two companies can be found to be alter egos where both companies “exist simultaneously.” [13] The key factors of the alter-ego doctrine break down as follows:

1. Ownership

In determining common ownership, courts consider whether one entity holds interest in the other entity and whether the entities are under common ownership by a third entity, either directly or indirectly. Common ownership can also be inferred where businesses are held by close family members [14] or friends [15].

Although common ownership is typically the least important factor in challenging a double-breasted operation, it is thoroughly discussed in Navillus. To be clear, while common ownership/financial control is a requirement for the finding of a single employer or alter ego, common ownership/financial control alone will not suffice. The Navillus court distinguished the facts of its case from prior cases where the only alter ego factor present was a family connection between the two entities. [16]

In Navillus, two brothers founded a union company and later incorporated a second, nonunion company. In addition to being related, both brothers formally owned both the union and nonunion companies through part of a construction project at issue and only disaggregated their ownership in order to undercut the alter ego claims made against them by backdating contracts to appear that the separation occurred months earlier.

2. Management

The common management factor is broadly interpreted by the National Labor Relations Board (NLRB) and courts to include a wide range of personnel, including company directors. Courts consider the following questions in determining its presence: whether one entity exercises control over the other entity’s day-to-day operations; whether the same individuals serve as officers, directors and key managers for the entities; and whether the same individuals serve in lower management positions, such as regional managers, plant managers, supervisors, etc.

The Navillus court distinguished the facts of its case from those in cases where no common management was found. [17] In United Union of Roofers, Waterproofers, Allied Workers, Local No. 210, AFL–CIO v. A.W. Farrell & Son, Inc. , the court found that the manager of the union company provided “limited business advice and operational support” during the nonunion company’s “early stages” and that this was insufficient to establish substantially identical management. [18]

In the present case, the management team for the nonunion company’s construction project was comprised almost entirely of people who had worked for the union company or were doing so immediately prior to working on the project. The nonunion company’s bid was prepared by a project manager employed by the union company. Additionally, an individual, who was a former engineer for the union company led the contract negotiations for the nonunion company, which the president and CEO of the union company participated in and served as the final decision maker. Further, there were employees who worked on the nonunion company’s project while still employed by the union company. Most importantly, the court focused on (i) the participation and actions of the the controlling brother who purportedly remained with the union company while negotiating contracts, fixing problems, appearing at job sites, financing, and securing property and equipment for the nonunion businesses; (ii) the union company’s provision of visas for workers for the nonunion operations, sharing of management and provision of union insurance to persons on the nonunion companies’ payroll; and (iii) the nonunion company’s leveraging of union company’s track record to win contracts, and secure insurance and bonds.

The court also discerns its facts from those in Local 812 GIPA v. Canada Dry Bottling Co. of New York which held that “the mere transfer of low and middle managers does not establish” common management. [19] The court rejected this argument, because the relevant “low and middle managers” included all of the individuals responsible for negotiating the nonunion construction contract and overseeing its day-to-day operations. [20]

3. Supervision

Common supervision is another factor considered in a finding of alter ego status. The Navillus defendants only cited one case in its rebuttal that there was no common supervision. In Amalgamated Lithographers, the court concluded that three “isolated facts” were insufficient to establish alter ego status against a backdrop of other contrary evidence: (1) that the owner of one company had once signed a litter identifying her as “President” of the other; (2) that said owner had check-signing authority at the other company for two years; and (3) that she had once declared (inside the two companies’ shared office) that she was “in charge here.” [21]

The Navillus court distinguished the Amalgamated Lithographers facts from those in its case, because the President and CEO of the union company was a co-owner of the nonunion company during the period of contract negotiations over a nonunion company’s contract and was the point-person who communicated on behalf of the nonunion company when issues regarding the project arose. In its verdict, the court also noted that the president of the nonunion company was rarely copied on emails in which problems regarding the nonunion company project were discussed and resolved.

4. Business Purpose

“In the ordinary case, two entities have the same ‘business purpose’ if they deal in the same product or service.” [22] As such, companies have been found to share substantially identical business purposes where both companies, for example, are “involved in the heating, air conditioning and ventilation industry,” [23] or perform “masonry construction.” [24]

Minor distinctions in the work performed are not dispositive. For example, differentiating among entities by pointing out that one entity performs union work and the other entity does not perform union work will not defeat a finding of common business purpose. Likewise, that one entity performs a type of job or project that its alleged alter ego does not is insufficient to uncouple companies with an otherwise common business purpose. The NLRB and the courts have found that entities that do the same work “a large percentage of the time, even if not exclusively” to have a common business purpose. [25]

However, courts have found companies to have “completely different” business purposes where, for example, one company manufactures clothing and another markets and sells clothing [26] or where the companies “were engaged in different, though related, lines of business within the freight transportation industry.” [27]

Although the union and nonunion company in Navillus operated the same line of business on the project at issue (serving as a concrete foundation and superstructure subcontractor), the court added that aside from the nonunion construction project at issue, the union and nonunion company operated different lines of businesses and as a result, ceased being alter egos.

5. Customers

Sharing of clients and customers is indicative of an alter ego relationship. For example, the NLRB and courts have found alter ego status based in part on: common vendors and at least one long-time customer in common; [28] two companies servicing substantially the same customers; [29] companies sharing twenty percent of the same customers; [30] and sharing of “at least some of the same customers.” [31]

However, in Navillus, the court concluded that this factor is not “terribly relevant to the alter ego analysis,” [32] reasoning that contractors on major construction projects in New York City all deal with a common set of customers – with some projects (including all publicly funded projects) being unionized and an increasing number of projects (including most private residential high rise construction projects) being nonunionized. Similarly, the same developers appear to operate in both spheres and developers are the ultimate source of business for both general and subcontractors.

6. Operations

The common operations factor is generally a significant factor in challenging a double-breasted operation. The NLRB and courts pay greater scrutiny to two entities when they share the same administrative staff, office space, bank and payroll accounts, marketing and advertising materials and file joint taxes.

However, the Navillus court gave little weight to the fact that the nonunion company leased office space from the union company for six months and the union and nonunion companies used the same accountants, attorneys, and insurance brokers in determining alter ego status. More relevant was the fact that the union president and CEO was contacted regarding issues on the nonunion company project and the union and nonunion companies used adjoining storage yards that were jointly owned by both companies’ presidents.

Nonetheless, the court concluded that the nonunion company had largely independent operations, because they maintained separate offices, telephones, computer systems, books and records, insurance policies, bank accounts, human resources, payroll systems, and professional services. The companies further filed their own taxes and did not comingle funds.

7. Equipment

Companies may also be found to be alter egos when they share equipment, tools, supplies or other resources in connection with their operations

In Navillus, the nonunion company purchased equipment from the union company. However, the court held that there was no evidence of shared equipment, because the items were paid for at fair market value and were not for purposes of the nonunion company project at issue. As such, the court weighed this factor against its finding of alter ego status. That said, for one particular contract, the Court focused on the fact that the nonunion operation need a tower crane to complete a project. Since the nonunion business could not afford the crane and did not have sufficient assets to finance it, an equipment rental company owned by the union side purchased the required crane then rented it to the nonunion shop to finish the project. The equipment provided never had a tower crane in its inventory prior and only acquired the crane after the nonunion company told the developer that it was “buying” the crane.

8. Anti-Union Animus

Although a company’s intent to evade union obligations is a factor in determining alter ego status, it is not a necessary factor.

The court in Navillus held that there was no evidence that the president and CEO of the union Company or the union company harbored anti-union animus. Here, the controllers kept a union shop for those jobs that required union labor. The court noted that it may have been the developer’s animus to an open shop that drove the union contractor to form a nonunion operation in the first place to win work.

Conclusion

Despite the court’s finding of a lack of shared operations, equipment or anti-union Animus, it held that the factors, overall, weighted in favor of concluding that the nonunion companies were alter egos of the union company during the nonunion company project.

The rules governing how litigants conduct written discovery changed substantially on December 1, 2015, when major amendments to the Federal Rules of Civil Procedure took effect. Adherence to those changes, however, has been sporadic, as counsel struggle to abandon two ingrained practices that may never have been advisable, but were nonetheless commonplace: (1) serving unfocused, overreaching document requests and (2) responding to these requests with nonspecific, generalized boilerplate objections. As we approach the two-year anniversary of the amendments, courts are growing increasingly annoyed with practitioners who behave as if the amendments did not exist. Southern District of New York Magistrate Judge Andrew Peck has been among the most vocal, issuing a strongly worded “wake-up call” to counsel that “[m]ost lawyers who have not changed their ‘form files’ violate one or more (and often all three)” of the amendments to Rule 34. Fisher v. Forrest, No. 1:14-cv-01307, 2017 WL 773694, at *1 (S.D.N.Y. Feb. 28, 2017).

What were those three amendments exactly? First, parties responding to a request for documents must now state their objections “with specificity.” Second, they must indicate whether any responsive materials are being withheld on the basis of that objection (although describing the search conducted may be sufficient). Third, they must state when documents will be produced (including the start and end date of a rolling production). Fed. R. Civ. P. 34, Advisory Committee Note, 2015 Amendment.

In recognition of the need for more detailed guidance, the Sedona Conference — an influential e-discovery think tank composed of jurists, lawyers (from both sides of the aisle), experts and academics — has once again stepped in to fill the void, publishing its “Federal Rule of Civil Procedure 34 Primer” for public comment. The Primer provides attorneys with five practice pointers on how to comply with the requirements of amended Rule 34, each of which is summarized below.

Conferences by the Parties

To comply with the amended discovery rules and reduce the likelihood of downstream discovery disputes, the Sedona Primer advises outside counsel to schedule an early, substantive discovery conference. But doing so only works if each side comes prepared to discuss the claims and defenses underlying the matter as well as the types and locations of potentially relevant information in their clients’ possession, custody or control. Other topics for negotiation at the conference could include the potential phasing of discovery, the contours of an ESI protocol, and how to reduce the burden of identifying and logging privileged information.

Rule 34 now permits the exchange of document requests much earlier than was previously permitted, just 21 days after service of the complaint. Parties can take advantage of this opportunity to focus the discussion at discovery conferences. Indeed, the Sedona Primer encourages responding counsel to share document requests with their clients before any conference so they can better inform potential objections. Early requests may also narrow the scope of the obligatory preservation discussion. As the parties reach agreements at these conferences, Sedona recommends, as has always been best practice, that they memorialize them in correspondence or by issuing revised requests or responses.

Requests for Production

In drafting requests for production, parties should consider what is actually needed to litigate the operative claims and defenses, and what is proportionate under Rule 26(b)(1). Sedona recommends that requesting parties do their part to reduce extensive objections by avoiding blanket requests for “any and all documents,” omitting overbroad definitions and instructions, and defining reasonable date ranges when possible. Requests for specific documents or for documents “sufficient to show” a particular point are preferable to unbounded requests, which instead should be tied to specific factual allegations or defenses and refined in discovery conferences.

Responses to Requests for Production

Outside counsel should meet with their clients as early as possible to determine (1) what documents exist, (2) what documents are going to be withheld and why, (3) what will be produced, and (4) the timing of production. Doing so will give counsel the information needed to comply with the mandates of Rule 34 within 30 days of service. The Rules do not contemplate that production of documents will be completed within that same timeframe. However, Rule 34(b)(2)(B) does require parties to include a date in their responses by which at least a partial production will have been made, even if certain objections have yet to be resolved.

Given Rule 34’s requirement that objections (1) be stated with specificity and (2) indicate whether responsive materials are being withheld on the basis of that objection, general objections will rarely be appropriate. The Sedona Primer sets forth three examples in which general objections may still be appropriate: privilege, confidentiality and overbreadth. Even in those instances, boilerplate objections, included those made out of an abundance of caution, are out of bounds and may lead to sanctions. Using the phrase “to the extent that” in an objection (e.g., objecting to a request “to the extent that it is overbroad”) is almost always indicative of boilerplate. Reservation-of-rights-style objections likewise have no effect and are impermissible under the new rubric.

Sedona provides several helpful tips regarding specific objections to individual requests. For instance, the oft-used phrase, “subject to and without waiving these objections, [responding party] will produce responsive, non-privileged documents responsive to this request,” should no longer be used. Rather, when a party intends to produce a more limited scope of documents than was requested, it can either state so directly or indirectly — the latter typically by describing the search parameters (e.g., custodians, date ranges and search terms) it is willing to use. And when the time of production cannot reasonably be determined yet, a party can provide an estimated date of substantial completion and/or expected starting and ending dates of a rolling production.

Court Involvement

While discovery disputes are best resolved without court intervention, objections should be written in a manner that can withstand judicial scrutiny. The Sedona Primer suggests that, when the parties do seek a court ruling, they should each present the judge with specific, alternative language to consider, rather than asking the court to craft its own language. Sedona also recommends that parties request informal discovery conferences to resolve disputes, ideally after requesting that the judge include that option in the Rule 16(b) scheduling order.

Parties’ Obligations Under Rule 26(g)

While rarely invoked, Rule 26(g) authorizes — even mandates — that courts sanction parties and their counsel for seeking disproportionate discovery, attempting to cause needless delay, or increasing the cost of litigation without justification. Before any document request or response is certified, both outside and in-house counsel should heed that warning by ensuring that the content of the discovery document is consistent with the Rules, including the Rule 26(b)(1) proportionality requirement, and has not been interposed for any improper purpose.

*          *          *

Attorneys by their nature can be resistant to change and are likely to grapple with these amendments for some time. Fortunately, the Sedona Primer goes a long way to giving litigators the guidance they need to avoid incurring the discovery ire of an adversary or court.

Matthew Hamilton is a partner 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. Jason Lichter is Pepper’s director of discovery services and litigation support.

Often a real estate developer will encounter a zoning ordinance that does not permit the developer’s desired use or physical structure on the property. In these circumstances, the developer may pursue a rezoning of the property or a text amendment to the municipality’s zoning ordinance. Under the Pennsylvania Municipalities Planning Code (MPC), rezonings and text amendments in Pennsylvania have similar, but not identical, procedural requirements. However, both are political in nature and are at the legislative discretion of the municipality’s elected officials.

A rezoning is an ordinance adopted by the municipality’s governing body (e.g., city council, borough council, township commissioners or township supervisors) amending the zoning map to redesignate one or several lots from one zoning district to another. For example, under the applicable statutory procedures, a municipality may rezone a property from a district that generally only allows for residential uses to one that permits commercial uses.

A text amendment, on the other hand, is an ordinance amending the text of a zoning ordinance without any facial effect on the zoning map. Text amendments can add or remove permitted uses within a zoning district or change the dimensional requirements applicable to buildings and other structures. Sometimes a rezoning and text amendment are done simultaneously to create an entirely new zoning district within a municipality to allow for a specific type of unique development in a certain location.

Rezonings and text amendments differ from zoning variances. A variance, which is essentially an authorization to violate a provision of the zoning ordinance, is granted by a zoning hearing board following a quasi-judicial hearing in which the applicant satisfies the statutory criteria to be granted a variance, including a demonstration of hardship. Conversely, a rezoning or a text amendment is a legislative change as to what is permitted under the zoning ordinance. Requests for rezonings and text amendments should not be confused with petitions for curative amendments, which are challenges to the legal validity of zoning maps and ordinances.

In most situations, a landowner or a developer initiates the rezoning or text amendment process by requesting that the municipality’s governing body take legislative action. Many zoning ordinances include a rezoning and text amendment application process, which may include submitting a prescribed form and an application fee to cover the municipality’s costs. The municipality’s planning commission may also initiate the process, and the Commonwealth Court of Pennsylvania has even held that a municipality may consider a request for a rezoning of a property presented by a person or an entity that does not own the property at issue.

Following the initial request from a landowner or a developer, the governing body, if it chooses to proceed (which it is not required to do), must refer the proposed ordinance to the municipality’s planning commission and the county’s planning commission. The proposed ordinance may not be voted on and adopted by the municipality’s governing body until after the governing body has held a public hearing on the proposed ordinance. The public hearing may not occur before the municipality’s planning commission and the county’s planning commission have had at least 30 days to review and provide comments to the proposed ordinance, and the public hearing must be advertised two times in a newspaper of general circulation in the municipality. If a rezoning is being requested, notices of the public hearing must be sent to the owners of the property within the area being rezoned, and a notice of the public hearing must be conspicuously posted at points deemed sufficient by the municipality along the tract to notify potentially interested citizens. The Commonwealth Court of Pennsylvania has recently ruled that some text amendments must be noticed in a manner similar to rezonings when the proposed ordinance, while not amending any portion of the zoning map, clearly limits the practical effect of the ordinance to only one property or a small group of properties.

During the public hearing, the governing body receives comments and presentations from the requesting party and interested persons who may be in favor of or opposed to the proposed ordinance. While the public hearing does not often resemble a formal judicial hearing, many municipalities create a stenographic record of the public hearing, and documentary evidence is often received and indexed for a record to be created. If changes are made to the draft of the proposed ordinance as a result of the review and comments of the planning commissions or comments received by the governing body during the public hearing, the revised proposed ordinance must be referred again to the municipality’s and the county’s planning commissions, and a subsequent public hearing pursuant to public notice must be held.

Assuming that there are no additional changes to the draft of the proposed ordinance, it is ripe for adoption. The proposed ordinance must be voted on during an advertised public session of the governing body, and notice of the proposed enactment of the ordinance must be advertised in a newspaper of general circulation within the municipality. An attested copy of the proposed ordinance must be filed in the county’s law library for public inspection. Following adoption of the ordinance, the municipality or any resident or landowner in the municipality has the option of advertising a notice of the adopted ordinance twice to limit the time period within which a challenge to the procedure in adopting the ordinance may be filed with the applicable court of common pleas. This limits the time period to 30 days from the date of the second notice being advertised.

Although the municipality is generally responsible for the procedural aspects of a rezoning or text amendment request, it is very important for the applicant, especially a developer, to monitor the procedure to ensure that it is done correctly. This will help applicants avoid procedural challenges to the rezoning or text amendment and the resulting project that is developed in accordance with the rezoning or text amendment in the future. Also, the applicant must consider the substance of its arguments to support the rezoning or text amendment. Keeping in mind that the adoption of the proposed ordinance is within the governing body’s broad legislative discretion, and generally not subject to judicial review, the following should be considered in fashioning a rezoning or text amendment request:

• Is the proposed ordinance consistent with the municipality’s comprehensive plan?

• Will the proposed ordinance, if adopted, constitute impermissible “spot zoning,” which is generally the creation of a small island of property zoned inconsistently with its surrounding properties?

• In the context of a text amendment, will the proposed ordinance allow for noxious or other objectionable uses of property that are wholly unrelated to the applicant’s property?

• Will the rezoning and subsequent development of the rezoned property create objectionable traffic or environmental conditions, and will those conditions be remedied through the land development plan approval process?

• How will the rezoning or text amendment and subsequent development of the property affect the municipality’s tax revenue?

In sum, rezonings and text amendments are very effective procedures to increase the development rights on, and the value of, a property. However, due to the strict procedures in adopting these ordinances and their legislative nature, it is paramount for a developer to focus on both the procedural and substantive aspects of the adoption to ensure both legal and successful adoption of its proposed ordinance.

It is nearly inevitable that at some point every company will receive an internal allegation of wrongdoing that will require the company to conduct an investigation. This primer on internal investigations raises key issues and concerns that both in‑house and outside counsel should consider both before starting, and while conducting, an internal whistleblower investigation.

Take All Complaints Seriously

Anonymous whistleblower tips often include information that may be somewhat vague, and the allegations could, at first, appear baseless. It is crucial, however, to take every complaint seriously because an allegation that seems unfounded could actually be just the tip of the iceberg.

Corporate stakeholders are now demanding thorough internal investigations. Shareholders of public corporations view credible and timely investigations as something that brings value to a company. Statutes, like Sarbanes-Oxley, require internal investigations in certain instances. An effective and objective internal investigation can also be looked on favorably by government agencies, such as the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC), in their consideration of whether to assess a company with civil or criminal penalties.

Avoid Retaliation

It is crucial to maintain a strict prohibition on retaliating against the whistleblower, particularly in situations where the whistleblower is known to the company. Retaliation can take the form of an adverse employment action, such as termination or demotion of the employee, or the creation of a hostile work environment. Often, whistleblowers will already be disgruntled employees who are more sensitive to any type of negative treatment. Whistleblowers who were retaliated against can bring statutory claims against the company.

Develop an Investigation Plan

Both adaptability and flexibility to appropriately scale an investigation relative to the allegations are necessary in order to take every complaint seriously. Once a complaint is received and the decision is made to investigate, in-house counsel must lay out a plan, from start to finish, that will ensure the investigation will be thorough, efficient, objective and credible.

Consider the Scope of the Investigation

The investigation’s scope may be influenced by a number of factors, such as criminal or civil exposure to the company (both domestically and globally), seriousness and nature of the allegations, possibility of shareholder litigation, or potential breach of company policy. Scope may be determined after consultation with outside counsel.

Should Outside Counsel Be Brought On?

There are a number of benefits to utilizing in-house counsel to conduct the investigation. In-house counsel are more likely to be familiar with the company and its people. Management would likely be more receptive to being investigated by a familiar face, particularly because of the cost savings.

Retaining outside counsel, however, brings greater assurance that the investigation will be independent. Outside counsel may bring expertise and a depth of knowledge that can help guide the company through an array of unknowns. Agencies, such as DOJ and SEC, may also look more favorably on an investigation that has greater assurances of objectivity and thoroughness. Company officials should also be sure to consider whether outside counsel is too connected to the company in a way that distorts the investigation’s independence. Familiar outside counsel may be able to perform a more efficient investigation, but government officials may be more persuaded by an investigation that is truly objective.

What Are the Investigation’s Goals?

The nature of the allegations is likely to determine the desired outcome of the investigation. An investigation into a violation of internal company policy, for example, may be geared towards gathering enough information to decide whether to terminate the subject’s employment. Allegations of illegal or improper behavior, however, may generate multifaceted investigation goals, such as determining whether the alleged conduct occurred, figuring out whether the conduct was widespread, or gathering sufficient information to highlight weak points in internal controls.

What Is the Investigation’s Timetable?

The timing of the investigation may be crucial if the company is facing an impending government investigation or a qui tam lawsuit was just unsealed. An investigation may need to conclude before a company makes a filing with the SEC to avoid any material misstatements. The investigation plan must be realistic enough to meet a potentially strict timeline but must also build in enough time to thoroughly interview witnesses and review relevant documents.

Keep Costs in Mind

Many general counsel still report that business-focused managers are resistant to investing in thorough investigations. In-house counsel should strive to sell prophylactic legal solutions as a value-based investment that pays long-term returns. Data comparing the costs and risks to a company that chooses not to seriously investigate damaging allegations versus one that prioritizes it can convince management to commit resources to an investigation.

Preserve Relevant Documents

A specific document preservation and retention policy must be implemented once an investigation is initiated. A notice should be sent out to all relevant employees warning them not to destroy, alter or conceal documents. Document preservation and retention policies should be put in place regardless of whether a subpoena has been issued because the credibility of any investigation can be impaired by document destruction. In-house counsel should also be sure to work closely with the IT department to suspend any regular document deletion program and to create backups of all documents collected.

Assemble the Investigation Team

The composition of the investigation team will largely depend on whether outside counsel is retained. An investigation team should have a diverse group of talent that is capable of handling each portion of the investigation in a professional and thorough manner.

Reporting Lines and Supervision

An internal investigation may alter established modes of supervision and reporting. Upper management may be implicated in the allegations, and looping them in on the investigation’s progress may be improper. If general counsel is implicated in any allegation, then it may be appropriate to have investigation staff report directly to the CEO or board of directors. Care must be taken to wall off an investigation from those implicated in order to preserve its independence.

Privilege Considerations

Investigations conducted by either in-house or outside counsel will likely be protected by the attorney-client privilege, work-product doctrine or both. It is important to remember that the company is the client during an investigation, and the company holds the authority to waive privilege. Company officials may not have sufficient information to decide whether to waive privilege until the conclusion of the investigation. Thus, it is crucial for the investigation team to maintain privilege. Failure to do so may allow for the release of sensitive company information into the hands of the government, litigation opponents, shareholders or competitors.

Investigators must be well-versed with the U.S. Supreme Court’s Upjohn decision. Before every witness interview, the investigator should administer an Upjohn warning that makes clear:

• Counsel represents the corporation, not the employee

• Communications are privileged, but the privilege belongs to the company

• The company may waive the privilege and share information with third parties, including the government

• To maintain the privilege, the subject should keep the information discussed in the interview confidential.

Courts distinguish between “factual” and “opinion” work product produced by investigations. Factual work product merely recounts objective facts learned in the investigation, while opinion work product contains legal analysis and mental impressions. Factual work product could be discoverable through a showing of “substantial need” by the government or litigation opponent. Conversely, opinion work product enjoys stronger protections. For example, instead of producing a verbatim transcript of a witness interview, counsel should intersperse legal analysis and mental impressions about the witness’s testimony in the transcript.

Utilize the IT Department

The IT department can be an immensely helpful resource in collecting and preserving documents and analyzing data. Experienced investigators enlist IT staff to further their fact‑finding mission.

Witness Interviews

Witness interviews are an indispensable source of information pertaining to an allegation. Due care should be given to preparing the strategy and process for witness interviews because of their critical importance. It is best to begin the process early on in the investigation in order to lock in the narrative and to prevent witnesses from being influenced.

Often, the best practice is to interview lower-level employees first to gather facts, then speak to upper management. Counsel will often only have one chance to speak to senior officials, so the more robust the conversation can be, the better. Investigators should take into account the possibility of resignations, government requests or internal disciplinary action that could complicate the order in which witnesses are interviewed.

Witness interviews should start by administering an Upjohn warning, as described above. Ideally, two lawyers should staff each interview — one who conducts the interview, while the other takes notes. Privilege considerations may dictate whether the interview is recorded or transcribed.

An in-person interviews is best because it can be insightful to read the body language of the witness. This allows the interviewer to gauge the witness’s demeanor and make judgments about the approach that are likely to elicit the most information.

Reporting

A final report represents the culmination of the investigation and is likely the first time the client will be apprised of all the facts and the investigation team’s conclusions. The client’s initial decision to receive an oral or written report is critical due to the implications each carry.

Weighing an Oral Versus a Written Report

A written report provides the client all the key facts based on the witnesses interviewed and documents reviewed, allowing the investigators to make conclusions about how the company should respond to their findings. Written reports are proof that the investigation was handled in a credible and thorough manner. This evidence could be crucial if advocating for leniency from DOJ or SEC.

On the other hand, written reports can codify damaging information about the company. Oral reports can control who receives the findings of the investigation and better fortify privilege. To be sure, even oral reports come with drawbacks, such as the appearance that the company is trying to conceal the findings.

Counsel should advise their client of the various alternatives and propose creative solutions, such as a limited written report followed by an extensive oral report.

Structure of the Report

Reports should be structured in a way that best protects the client. A report should also follow a logical path that lays a basis in fact for the conclusions the investigators make.

Robust reports will have the following components:

• Summary of the issues raised or mandate from client

• An executive summary

• Relevant facts and documents

• List of witnesses interviewed

• Specific methodology used

• Findings

• Recommendations.

Counsel must pay close attention to the recommendations made and must tailor them to the capabilities and culture of the company. Proposing unrealistic reforms may open the company up to future scrutiny by regulators. At the same time, investigators should be forthright in identifying changes the client should make to mitigate the issues examined.

Special thanks to Jason A. Kurtyka, a law clerk and a member of the Villanova Law School class of 2018.

Starting a lawsuit against defendants outside the United States just got cheaper and easier. On May 22, the U.S. Supreme Court settled a dispute as to whether the Hague Convention on the Service Abroad of Judicial and Extrajudicial Documents in Civil or Commercial Matters (Hague Service Convention) authorizes service of process by certified mail. In holding that mail service is authorized, the Court removed a judicially created barrier to efficient service in international litigation and brought the United States’ interpretation of the Hague Service Convention into agreement with the practices of many other developed nations. Water Splash, Inc. v. Menon, No. 16–254, slip op. at 12 (U.S. May 22, 2017).

Article 10 of the Hague Service Convention

Prior to Water Splash, multiple circuit courts distinguished between initial service of process and service of all post-complaint documents under the Hague Service Convention, concluding that only the latter was authorized by certified mail. See Nuovo Pignone v. Storman Asia M/V, 310 F.3d 374 (5th Cir. 2002); Bankston v. Toyota Motor Corp., 889 F.2d 172 (8th Cir. 1989). The relevant section of the convention, Article 10, states:

Provided the State of destination does not object, the present Convention shall not interfere with—

(a) the freedom to send judicial documents, by postal channels, directly to persons abroad,

(b) the freedom of judicial officers, officials or other competent persons of the State of origin to effect service of judicial documents directly through the judicial officers, officials or other competent persons of the State of destination,

(c) the freedom of any person interested in a judicial proceeding to effect service of judicial documents through the judicial officers, officials or other competent persons of the State of destination.

Convention of the Service Abroad of Judicial and Extrajudicial Documents in Civil and Commercial Matters, Nov. 15, 1965 (Hague Service Convention), 20 U.S.T. 361, T.I.A.S. No. 6638 (emphasis added).

The circuit courts that concluded initial service of process could not be effected by mail, focused on the fact that Article 10(a) — which addresses the use of postal channels — uses only the word “send,” while Articles 10(b) and 10(c) explicitly use the term “service of process.” In those courts’ view, this distinction demonstrated that the Article 10(a) was not meant to apply to service of process. The practical effect of this distinction was to limit plaintiffs in these jurisdictions to service through time-consuming formal Hague Service Convention processes.

The Water Splash Decision

In Water Splash, the Supreme Court rejected this narrow construction of Article 10, and instead looked to the structure of the Hague Service Convention as a whole. In an opinion authored by Justice Alito, the Court relied on the language of the Convention’s preamble, which states that its purpose is to facilitate and encourage the efficient “service” of judicial documents, and Article 1, which states it “shall apply in all cases . . . where there is occasion to transmit a judicial or extrajudicial document for service abroad.” Water Splash, Inc. No. 16–254, slip op. at 4 (emphasis added).

With respect to Article 10, the Court reasoned that the word “send” is a broad term and could encompass service of a complaint, even if Article 10(a) itself does not use the word “service.” Id. at 6-7. Further, Articles 10(a), 10(b) and 10(c) all use the term “judicial documents” such that there is no reason to believe that Article 10(a) applies only to a subset of those documents (i.e., post-complaint documents). Id. at 6. Moreover, in an effective turnaround of the Fifth and Eighth Circuit’s reasoning, Justice Alito stated that, if the writers of the Convention intended Article 10(a) to be limited to documents served after the complaint, they could have included that limiting language. Id. at 6.

Additionally, the Court looked to how both the U.S. executive branch and the rest of the world have interpreted the provision. See id. at 8. Soon after the Eighth Circuit‘s decision in Bankston, the Department of State issued a letter outright disagreeing with the holding and arguing that Article 10(a) allowed for service of complaints through the mail. Today, even, the Department of State website “takes the same position.” Id. at 10. The Court also gave “considerable weight” to the interpretation of the Hague Service Convention afforded by other parties to the Convention, citing courts in Canada, the United Kingdom and Italy that have held that Article 10(a) “encompasses service by mail.” Id. at 10-11.

The Effect of the Water Splash Decision

Water Splash removes one barrier to the efficient service of complaints on foreign adversaries. However, other barriers remain. As the Court concluded, service by mail is authorized only so long as (1) “the receiving state[] has not objected to service by mail; and (2) service by mail is authorized under otherwise-applicable law.” Id. at 12. Of these barriers, the first is the most significant. Parties to the Hague Service Convention may opt out of Article 10(a) altogether, and some countries — such as Germany, India and China — have done so.

As a result, service of process by mail in these countries is not an option. At the same time, there are many signatories that have not opted out of Article 10, including Canada, France and the United Kingdom. There, Water Splash has removed any barrier to effective service of a complaint by certified mail when applicable state or federal law authorizes such service on defendants outside the jurisdiction. This will save U.S. plaintiffs time and expense in initiating a case and also remove a basis for foreign defendants to contest judgments against them.

This is the third article in our five-part series on PTE.

Calculating a drug’s regulatory review period seems like it should be simple. The FDA even states that its regulatory review period determination is “straightforward and largely ministerial in nature.” But recent court decisions coupled with prior FDA determinations demonstrate that the calculation is not so easy. Identifying the testing phase — from the effective date of the investigational new drug (IND) exemption to the filing date of the new drug application (NDA) — and the approval phase — from the filing date of the NDA to its approval date — can be tricky in certain circumstances.

Drug, biologic and medical device manufacturers should remember the following:

• If multiple INDs have been filed for a product, the first IND for the product should be used.

• If no investigational device exemption (IDE) was submitted for a device, the testing phase begins on the date on which the applicant began the first clinical investigation for the device.

• The filing date of the NDA is the date when the NDA is initially submitted.

• The approval phase may not begin until the user fees have been paid.

The regulatory review period (RRP) forms the basis for determining the length of a patent term extension (PTE). The RRP is simply the time from the date on which the IND or IDE became effective until the date on which the NDA, biologic license application (BLA) or pre-marketing authorization (PMA) was approved.¹ This period of time is broken into two phases: the testing phase and the approval phase. The length of a PTE award is equal to the sum of one-half of the time in the testing phase and the time in the approval phase, after the date the patent is issued, less any period during which the applicant was not diligent.² The equation is:

Period of Extension (PTE) = RRP – PGRRP – DD – ½(TP-PGTP).³

The FDA has jurisdiction over the calculation of the RRP.

Testing Phase Determinations

When a product is initially developed for one indication, fails that indication, and is transitioned to a new indication, the product often will have multiple INDs. In this situation, the FDA will consider the testing phase to have begun when the first IND for the approved drug product became effective.⁴ Although the indication, the dose or the dosage form noted in the first IND may not be the same as when the product is approved, often there is information from the first IND — such as safety or manufacturing information — that is relevant or necessary for product approval.⁵

For a medical device, if an IDE was submitted, the testing phase begins on the effective date of the IDE. If an IDE was not submitted, the testing phase begins on the date on which the applicant began the first clinical investigation for the device.⁶

Approval Phase Determinations

The end of the testing phase and the beginning of the approval phase is “the date an application was initially submitted for such drug product under section 351, 505 or 507.”⁷ Under the FDA regulations for determining PTE, an application for approval of a product is initially submitted “on the date it contains sufficient information to allow FDA to commence review of the application.”⁸

In the case of a rolling submission (in modules) of an NDA, the initial submission is usually considered the date on which the final module of the NDA is submitted to the FDA.⁹ However, if the FDA responds to the applicant that the application submitted is not sufficiently complete to permit a substantive review, then the application for approval of the product is not yet “initially submitted,” and the approval phase has not commenced.¹⁰

Another requirement of an application being “initially submitted” is that the filing fees must be paid, since the FDA may not review “until the correct amount of User Fee money has been received by the agency from the sponsor of the NDA.”¹¹

Determining the end of the approval phase is critical because it directly affects PTE calculation and starts the clock for the deadline for submitting the PTE application to the USPTO. A PTE application must be submitted to the USPTO “within the 60 day period beginning on the date the product received . . . permission for commercial marketing.”¹² The date of approval of a product is not always clear. For example, if the product is a controlled substance and cannot be commercially marketed at the time of its approval due to domestic drug scheduling activities, when does approval occur for purposes of the PTE statute? Pursuant to a 2015 act, the date of approval of an NDA or BLA for a controlled substance awaiting a Drug Enforcement Administration scheduling determination is the later of the approval date and the date of issuance of the interim final rule controlling the drug.¹³

It is important for applicants to work with both patent and regulatory counsel to ensure that the RRP is calculated correctly and that the application for PTE is timely submitted. Applicants should not embark on such an analysis once their product is approved. Rather, the analysis should be started as soon as the application for approval is submitted to the FDA, if not sooner.

Endnotes

Nicole Stakleff is a partner 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. Kyle Dolinsky is an associate in the Health Sciences Department.