Posted by Gale Burns on Mon, Jan 23, 2012 @ 03:15 PM
The Lawletter Vol 36 No 6
Brad Pettit, Senior Attorney, National Legal Research Group
A recent advisory issued by the Chief Counsel's Office of the Internal Revenue Service ("IRS") sets forth the IRS's position on the procedures that its agents must follow in order to obtain a taxpayer's e-mails from his or her Internet service provider ("ISP"). In I.R.S. Chief Counsel Advisory ("I.R.S. C.C.A.") 2011-41-017 (July 8, 2011), the IRS interpreted provisions of the Internal Revenue Code relating to examination of a taxpayer's records, the Stored Communications Act ("SCA"), and a decision by the U.S. Court of Appeals for the Sixth Circuit, and concluded that there are certain restrictions on the ability of an IRS agent to issue a summons to a taxpayer's ISP, seeking the contents of a taxpayer's electronic communications.
The Internal Revenue Code provides that
For the purpose of ascertaining the correctness of any return, making a return where none has been made, [or] determining the liability of any person for any internal revenue tax . . . , the Secretary [of the Treasury] is authorized—
(1) To examine any books, papers, records, or other data which may be relevant or material to such inquiry;
(2) To summon the person liable for tax or required to perform the act, or any officer or employee of such person, or any person having possession, custody, or care of books of account containing entries relating to the business of the person liable for tax or required to perform the act, or any other person the Secretary may deem proper, to appear before the Secretary at a time and place named in the summons and to produce such books, papers, records, or other data, and to give such testimony, under oath, as may be relevant or material to such inquiry[.]
I.R.C. § 7602(a)(1)–(2). The federal SCA states that
[a] governmental entity may require the disclosure by a provider of electronic communication service of the contents of a wire or electronic communication, that is in electronic storage in an electronic communications system for one hundred and eighty [180] days or less, only pursuant to a warrant issued using the procedures described in the Federal Rules of Criminal Procedure (or, in the case of a State court, issued using State warrant procedures) by a court of competent jurisdiction.
18 U.S.C. § 2703(a). The Sixth Circuit, relying on the Fourth Amendment to the U.S. Constitution, recently held that since an Internet "subscriber enjoys a reasonable expectation of privacy in the contents of emails that are stored with, or sent or received through, a commercial ISP[, t]he government may not compel a commercial ISP to turn over the contents of a subscriber's emails without first obtaining a warrant based on probable cause." United States v. Warshak, 631 F.3d 266, 288 (6th Cir. 2010) (emphasis added) (citations omitted) (internal quotation marks omitted), reh'g and reh'g en banc denied, 2011 U.S. App. LEXIS 5007 (6th Cir. Mar. 7, 2011). The Warshak court also ruled that "to the extent that the SCA purports to permit the government to obtain such emails warrantlessly, the SCA is unconstitutional." Id. However, the Warshak court applied the so-called "good-faith reliance by an officer" exception to the exclusionary rule and determined that the IRS had not violated the taxpayer's constitutional rights by obtaining the e-mails at issue in that case. Id. (citing Illinois v. Krull, 480 U.S. 340, 349-50 (1987)).
In I.R.S. C.C.A. 2011-41-017, the IRS Chief Counsel advised that since an agent must obtain a warrant in order to gain access to the "contents" of a taxpayer's electronic communications that are less than 180 days old from the taxpayer's ISP, the summons issued by the IRS to an ISP in that case should have been withdrawn. I.R.S. C.C.A. 2011-41-017 concl. 1. However, the Chief Counsel also advised that with respect to the "contents" of a taxpayer's e-mails or other electronic communications that are more than 180 days old, there is a "warrantless" administrative summons procedure described in 18 U.S.C. § 2703(c)(2) that can be followed by an IRS agent in order to obtain such communications from the taxpayer's ISP. Id. Furthermore, the Chief Counsel noted that various federal courts "have recognized that a warrant is not required by the Constitution for a government entity to require an electronic communications provider to produce a customer's non‑content information regarding an electronic communication." Id. concl. 3 (emphasis added). In addition, the Chief Counsel advised as follows:
Pursuant to 18 U.S.C. § 2703(c)(2)(F), the Service may continue to use an administrative summons upon an ISP (with no "notice" to the affected customer) to request, inter alia, the "means and source of payment" for the ISP's electronic communication services to the customer, "including any credit card or bank account number." Through follow‑up requests based on this ISP customer payment information, if sought in a new summons, the revenue officer may indirectly obtain some of the potential collection asset leads he is interested in pursuing further in this case.
Id.
The above-described rulings by the IRS provide up-to-date guidance as to the IRS's position on the procedures that an IRS agent must follow in order to review the content of a taxpayer's e-mails or other electronic communications. However, it should be noted that under I.R.C. § 6110(j)(3), the Chief Counsel's Advisory "may not be used or cited as precedent." For additional discussion of I.R.S. C.C.A. 2011-41-017 and the issues surrounding the IRS's right to review a taxpayer's e-mails, see Chief Counsel Nixes IRS Agent's Attempt to Get Taxpayer Emails from Internet Service Provider, 57 Fed. Taxes Weekly Alert (RIA) art. 9 (Oct. 20, 2011).
Posted by Gale Burns on Mon, Dec 05, 2011 @ 03:57 PM
In a civil lawsuit against a close corporation, it is relatively common for the plaintiff to allege that the corporate veil should be pierced and the corporate officers or shareholders be held personally liable for the corporation's wrongful actions. If the corporation files a bankruptcy petition in the midst of the proceedings, the civil action against it is automatically stayed pursuant to 11 U.S.C. § 362(a). The question then arises as to whether the automatic stay in bankruptcy extends to the alter ego claims against the corporate officers or shareholders.
Generally speaking, the automatic stay provided by § 362(a) does not extend to third parties such as officers of the debtor corporation. However, courts have carved out certain important exceptions to this general rule. Because state law determines whether a specific claim belongs to the bankruptcy estate or to an individual creditor, these exceptions are not uniformly recognized but, rather, vary from state to state.
In a recent illustrative case, Shaoxing County Huayue Import & Export v. Bhaumik, 120 Cal. Rptr. 3d 303 (Ct. App. 2011), the California Court of Appeal addressed the effect of a corporation's bankruptcy filing upon a creditor's alter ego claims against an individual who controlled the corporation's business operations. In that case, a corporate creditor filed a state court complaint for breach of contract against both the corporation and the company's general manager. In regard to the manager, the creditor alleged that the corporate veil should be pierced because the manager was responsible for the corporation's actions and he used the company as a device to "avoid individual liability and for purposes of substituting a financially insolvent entity in place of himself." Id. at 306. After suit had been commenced, the corporation filed a Chapter 7 bankruptcy petition, and the creditor voluntarily dismissed the corporation from the action. The manager then moved for a stay, arguing that the creditor's alter ego claims belonged to the bankruptcy estate and that the bankruptcy trustee had exclusive standing to pursue the action against him.
In addressing this issue, the court acknowledged that the line separating claims of the debtor, which the bankruptcy trustee has exclusive standing to assert, and claims of an individual creditor against a third party is not always clear. To determine the nature of the claim, the focus of the inquiry must be on whether the injury to be redressed is one that was suffered by the debtor corporation. Id. at 309. If the corporation has not sustained an injury but, rather, the creditor alone has been injured by the alleged conduct, then the claim does not belong to the bankruptcy estate and, by extension, the bankruptcy trustee. Id.
Even if the corporation has sustained some injury, it does not necessarily follow that the alter ego claims against the corporate officer will be stayed. Id. at 310. Instead, the Shaoxing court ruled that under California law, the bankruptcy trustee will have standing to maintain an action against the corporate officer on an alter ego theory of liability only if the allegation of injury to the corporation "gives the corporation a right of action against the defendant." Id. This may occur where the bankruptcy trustee seeks to "recover property or pursue a right of action belonging to the bankrupt corporation, including an action to set aside fraudulent transfers or an action for conversion to recover assets of the bankrupt corporation." Id.
If the corporation has not sustained an injury that gives rise to a cause of action against the corporate officer, "the asserted cause of action belongs to each creditor individually." Id. (internal quotation marks omitted). Because the corporate manager in question had not argued that the alter ego allegations seeking to hold him liable for the corporation's breach of contract constituted a substantive right of action belonging to the corporation, the court held that the alter ego claims were not the property of the corporation's bankruptcy estate. Id. at 311. As a result, the creditor's action against the corporate manager was not subject to the automatic stay, and the creditor was free to pursue its claims against the manager in state court. Id.
As Shaoxing demonstrates, whether a creditor may pursue civil claims against a corporate officer or shareholder of a bankrupt corporation turns upon the nature of the alleged injury and, specifically, whether the alleged wrongful conduct gives rise to a right of action by the corporation against the officer or shareholder. This determination is not an easy one to make, as it turns upon rather subtle distinctions. In any event, whenever a corporation files a bankruptcy petition after the commencement of a civil lawsuit, careful reference should be had to governing state law in order to determine the exact nature of the creditor's claim and the probable effect of the corporation's bankruptcy filing on any alter ego claims asserted against corporate officers or shareholders.
Posted by Gale Burns on Mon, Nov 28, 2011 @ 03:04 PM
The Lawletter Vol 36 No 4
Tim Snider, Senior Attorney, National Legal Research Group
The Supreme Court recently rendered a decision that may rival the impact of Northern Pipeline Construction Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), which had declared aspects of the then newly enacted Bankruptcy Code unconstitutional. In Stern v. Marshall, 131 S. Ct. 2594 (2011), the notorious Anna Nicole Smith ("Vickie") had married tycoon J. Howard Marshall II, Pierce Marshall's father, approximately one year before the former's death. Shortly before J. Howard died, Vickie had filed a suit against Pierce in Texas state court, asserting that J. Howard had meant to provide for Vickie through a trust and that Pierce had tortiously interfered with that gift. After J. Howard died, Vickie filed for bankruptcy in federal court. Pierce filed a proof of claim in that proceeding, asserting that he should be able to recover damages from Vickie's bankruptcy estate because Vickie had defamed him by inducing her lawyers to tell the press that he had engaged in fraud in controlling his father's assets. Vickie responded by filing a counterclaim for tortious interference with the gift she had expected from J. Howard.
The bankruptcy court granted Vickie's motion for summary judgment on the defamation claim and eventually awarded her hundreds of millions of dollars in damages on her counterclaim. Pierce objected that the bankruptcy court lacked jurisdiction to enter a final judgment on that counterclaim because it was not a "core proceeding" as defined by 28 U.S.C. § 157(b)(2)(C). As set forth in § 157(a), Congress has divided bankruptcy proceedings into three categories: those that "aris[e] under title 11"; those that "aris[e] in" a Title 11 case; and those that are "related to a case under title 11." District courts may refer all such proceedings to the bankruptcy judges of their district, 28 U.S.C. § 157(a), and bankruptcy courts may enter final judgments in "all core proceedings arising under title 11, or arising in a case under title 11," id. § 157(b)(1). In noncore proceedings, by contrast, a bankruptcy judge may only "submit proposed findings of fact and conclusions of law to the district court." Id. § 157(c)(1). Section 157(b)(2) lists 16 categories of core proceedings, including "counterclaims by the estate against persons filing claims against the estate." Id. § 157(b)(2)(C).
The bankruptcy court held that the counterclaim was a core proceeding, but the district court reversed, concluding that to hold all counterclaims to be core proceedings would be unconstitutional under Northern Pipeline. The court of appeals vacated the district court's judgment, concluding that because the subject matter of the counterclaim was not so closely related to the underlying core proceeding, the bankruptcy court should not have entertained it but instead should have given the Texas state court judgment preclusive effect. The Supreme Court affirmed, but on different grounds. The Chief Justice, writing for a 5-4 majority, concluded that while § 157(b)(2)(C) permitted the bankruptcy court to entertain the counterclaim, Article III of the Constitution does not.
Bankruptcy courts are creatures of Congress, while Article III courts have powers conferred by the Constitution. After Northern Pipeline, some thought Congress might resolve doubts about the jurisdictional limits of the bankruptcy courts by conferring Article III status on those courts. Congress was disinclined to do so, in part because it dreaded the partisan political battle that reconfirming hundreds of bankruptcy judges would have provoked. Instead, it created the jurisdictional muddle that is 28 U.S.C. § 157, which enables bankruptcy courts to hear some, but not all, of the categories of cases that may be decided by the district courts. The majority in Stern reasoned that while Article III forbids Congress to withhold or withdraw from Article III courts the authority to decide matters historically within the scope of their jurisdiction, neither can Congress confer on non-Article III courts jurisdiction that can be exercised only by an Article III court.
The majority's reasoning is hard to follow, since the district courts (which are, of course, Article III courts) can confer or withhold jurisdiction from the bankruptcy courts over which they have supervisory authority. Because the bankruptcy courts frequently decide substantive questions of state law, Stern places in doubt the scope and extent of the jurisdiction of the bankruptcy courts to decide the many issues that they have historically heard and resolved and that arise under state law, a matter that Congress presumably had resolved. See Things Remembered, Inc. v. Petrarca, 516 U.S. 124, 132 n.2 (1995) ("After the Court held inconsonant with Article III the Bankruptcy Act's broad grant of jurisdiction to bankruptcy judges, see Northern Pipeline Constr. Co. v. Marathon Pipe Line Co., 458 U.S. 50, 87, 102 S.Ct. 2858, 2880, 73 L.Ed.2d 598 (1982), Congress transferred supervisory jurisdiction over bankruptcy cases to Article III courts and retained for the district courts the broad removal/remand authority the Act initially gave to bankruptcy courts. See Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub.L. 98-353, 98 Stat. 333.").
Stern has managed to muddy even further the already murky issues surrounding the jurisdictional scope of the bankruptcy courts' authority to decide nonbankruptcy issues.
Posted by Gale Burns on Tue, May 24, 2011 @ 02:14 PM
May 25, 2010
Charlene Hicks, Senior Attorney, National Legal Research Group
Most ordinary citizens who enter into written contracts with the federal Government take for granted the fact that such agreements are valid and enforceable. Horn v. United States, No. 07-655 C, 2011 WL 1663598 (Fed. Cl. May 3, 2011), however, sounds a resounding warning against such blithe assumptions.
Jullie Horn is a dental hygienist who entered into a written contract with the U.S. Federal Bureau of Prisons (the "BoP") in 2005 to provide dental hygiene services at an Illinois federal prison. The contract stated that Horn would provide a maximum of 1,560 one-hour dental hygiene sessions over the term of the agreement, at the unit price of $32 per session. Horn was awarded the contract for the fixed price of $49,920.
In accordance with Federal Acquisition Regulations ("FAR") 52.216-21, the contract specifically designated itself as a requirements contract and stated that the "quantities of supplies or services specified in the Schedule are estimates only." 2011 WL 1663598, at *1. The agreement further provided that if the Government's requirements did not result in orders equivalent to the maximum number of sessions in the Schedule, "that fact shall not constitute the basis for an equitable price adjustment." Id.
One month after Horn was awarded the contract, the BoP dental supervisor informed her that BoP would no longer utilize her services but would instead obtain the services of an in-house dental hygienist. Id. at *2. At that time, Horn had completed only 130 one-hour sessions, which was approximately 8% of the contract estimate. Id. Horn submitted a claim to the BoP contracting officer, alleging that the early termination of the agreement constituted a material breach of contract. Id. The BoP disagreed, taking the position that it was not bound by the estimated number of hours provided in the contract.
In response, Horn filed a breach-of-contract action in the U.S. Court of Federal Claims, seeking damages for lost wages of over $30,000 plus interest. The Government filed a motion for summary judgment, which was granted by the court. Id.
In so ruling, the court first determined that despite the express contract language incorporating the boilerplate FAR provision and designating the agreement as a requirements contract, no enforceable requirements contract actually existed. "[T]he plain language of the contract is misleading." Id. at *4. As a general rule, a requirements contract involves the conferral of an exclusive right upon the contractor to perform a given service at a fixed price and for a fixed duration. Id. The contract between Horn and the BoP, however, lacked the required element of exclusivity. Id. Rather, the contract provided that the BoP would utilize Horn's services only in the event that the BoP could not fulfill its need for dental hygiene services in-house. Id. Although it appeared that "both parties entered into the contract with the intent to form a requirements contract, that fact cannot overcome the plain language of the contract." Id. at *5.
Next, the court ruled that Horn's contract was unenforceable as an indefinite-quantities contract. Id. One essential element of such a contract is that the agreement must expressly state a minimum quantity of supplies or services to be purchased. Id. Because Horn's contract lacked a minimum-quantity term, the contract lacked consideration and mutuality. Id. at *5-6. Accordingly, the contract was unenforceable. Id. at *6.
Although the contract between Horn and the BoP was unenforceable at its inception, the court allowed Horn to retain the compensation she had already received for the 130 hours of services she actually rendered. Id. Given the lack of an enforceable contract, however, Horn was not entitled to recover any additional costs or lost profits. Id.
As an aside, the court lamented the unfortunate fact that "the Government has continued to use this standard form document that appears to the non-legal reader as a binding contract, but is in fact not." Id. The court found it "particularly troublesome" that even the Government officials with whom Horn dealt "did not seem to understand the document's lack of enforceability." Id. According to the court, the Government has been on notice since 1929 that "this type of contractual language created an unenforceable instrument. . . . Yet . . . these FAR provisions are still rendering contracts unenforceable and unsuspecting contractors are being denied the opportunity to pursue what may be meritorious claims." Id. The court went on to opine that "[i]n the future, the Government's contracting offers should make [the] point much clearer [that this kind of agreement is not a requirements contract] and disclose the fact that this type of agreement is not a legally binding contract." Id.
Although the Horn court explicitly acknowledged the inequities resulting from its decision, the court insisted upon interpreting the contract and the applicable law in a narrow, inflexible manner. This reading does not portend well for potential future employees and contractors who wish to enter into services contracts with the federal Government. Through its continued use of legally unenforceable service provisions, the Government may have what amounts to absolute discretion to terminate the services of such persons at will.
Even so, it may be noted that Horn is at odds with other decisions from the Court of Federal Claims. In several instances, the court has construed similar form clauses as "limited form" requirements contracts, wherein the court implies a term of good faith into the contract. This implied term precludes the Government from expanding its in-house capabilities during the contract period at the expense of the contractor. See, e.g., District of Columbia v. Org. for Envtl. Growth, Inc., 700 A.2d 185, 200-02 (D.C. 1997); Appeal of Dynamic Sci., Inc., ASBCA No. 29510, 85-1 BCA ¶ 17,710, 1984 WL 13911. In these cases, the court has recognized that the "limitation of the requirement to that portion that the Government did not choose to meet from its own capabilities did not render the promise illusory particularly because the Government was precluded from expanding its capabilities during contract performance at the expense of the contractor." Id.
Posted by Gale Burns on Tue, Feb 15, 2011 @ 11:53 AM
February 15, 2011
Charlene Hicks, Senior Attorney, National Legal Research Group
In recent months, embattled homeowners striving to fend off mortgage foreclosures have increasingly turned to the courts for relief. This has resulted in an emerging body of law involving the validity of the underlying loans. Because virtually all mortgages are assigned by the original lender soon after execution, questions concerning the validity of the assignment often arise. Thus, one particular avenue in which homeowners have enjoyed particular success in defending against foreclosure proceedings involves contesting the current noteholder's standing to maintain a foreclosure action.
This point is well illustrated in Wells Fargo Bank, N.A. v. Ford, No. A‑3627‑06T1, 2011 WL 250561 (N.J. Super. Ct. App. Div. Jan. 28, 2011), a case recently decided by the Superior Court of New Jersey, Appellate Division. In that case, Sandra Ford executed a negotiable note on March 6, 2005 to secure repayment of $403,750 she had borrowed from Argent Mortgage Company and a mortgage on her New Jersey home, a transaction in connection with which Ford was alleging that Argent had engaged in fraudulent and predatory acts.
On March 11, 2005, Argent assigned the mortgage and note to Wells Fargo Bank, N.A. Ford defaulted on the loan, and, in July 2006, Wells Fargo instituted foreclosure proceedings. After various proceedings in the lower courts, Wells Fargo was granted summary judgment, and a final judgment of foreclosure was entered. The appellate division granted a stay on a scheduled sheriff's sale of the property pending the outcome of Ford's appeal.
Holding that Wells Fargo had "failed to establish its standing to pursue this foreclosure action," the appellate division reversed the trial court's order of summary judgment in Wells Fargo's favor and remanded the case to the lower court. Id. at *3. In reaching this decision, the appellate division noted that in order to have a right to foreclose on a mortgage, the party seeking to foreclose "must own or control the underlying debt." Id. (internal quotation marks omitted). Ford's debt was evidenced by a negotiable note made payable to Argent. This note had originally been owned and controlled by Argent. Thus, the case turned upon the question as to "whether Wells Fargo established that it subsequently acquired ownership or control of the note from Argent." Id.
Because the note Ford signed was a negotiable instrument, "the answer to this question is governed by Article III of the Uniform Commercial Code (UCC)[.]" Id. Under the 2002 version of U.C.C. § 3-301, three categories of persons are entitled to enforce a negotiable instrument: (1) the holder of the instrument; (2) a nonholder in possession of the instrument who has the rights of the holder; and (3) a person not in possession of the instrument who is entitled to enforce the instrument pursuant to § 3-309 or § 3-418(d). Wells Fargo did not fall into any of these three classifications. Id. at *3-5.
To begin with, although Wells Fargo argued that it was the "holder" of Ford's note within the meaning of the first classification, U.C.C. § 3-201(a) expressly provides that a person other than the one to whom a negotiable instrument is made payable may become a "holder" only if a "negotiation" of the instrument is made. The U.C.C. further specifies that "negotiation" requires both the transfer of possession of the instrument and its indorsement by the holder. U.C.C. § 3-201(b). Wells Fargo was unable to provide any evidence that the note had been properly indorsed by Argent. Wells Fargo Bank, 2011 WL 250561, at *3. As a result, Wells Fargo was not a "holder" within the first category of persons entitled to enforce a negotiable instrument. Id.
Wells Fargo also did not fall within the third category. Id. at *4. Section 3-309 concerns the enforcement of instruments which have been lost, destroyed, or stolen. Section 3-418(d), in turn, focuses on situations in which an instrument has been paid or accepted by mistake and the payor or acceptor recovers payment or revokes acceptance. Neither of those circumstances was involved in the Wells Fargo Bank case. Id.
Finally, under the circumstances, Wells Fargo could not be classified within the second category of persons entitled to enforce a negotiable instrument under U.C.C. § 3-301. Id. To support its right of foreclosure, Wells Fargo submitted a certification by attorney Josh Baxley, which stated that Wells Fargo "is still the holder and owner of the said Note/Bond and mortgage," with a copy of the mortgage and note attached to the certification. Id. In addition, "Wells Fargo submitted a document that purported to be an assignment of the mortgage, which stated that it was an assignment of 'the described Mortgage, together with certain note(s) described therein with all interest, all liens, and any rights due or to become due thereon.'" Id. The court found that if these documents had been properly authenticated, they might have been sufficient to establish that Wells Fargo did, in fact, fall within the second category of persons entitled to enforce an instrument. Id. Baxley's certification, however, was not properly authenticated, because it did not allege that he had personal knowledge that Wells Fargo was the holder and owner of the note, nor did it indicate how he had obtained this alleged knowledge. Id. In addition, the purported assignment of the mortgage "was not authenticated in any manner; it was simply attached to a reply brief." Id. at *5. The document should not have been considered in evidence "unless it was authenticated by an affidavit or certification based on personal knowledge." Id.
Because Wells Fargo did not fall within any of the three classes of persons entitled to enforce a negotiable instrument under U.C.C. § 3-301, the appellate division concluded that Wells Fargo had not established its standing to pursue the foreclosure action by competent evidence. Id. Hence, the court reversed the grant of summary judgment and remanded the case to the trial court. Id.
Although in dicta, the appellate division then went on to provide some "guidance for the trial court in the event Wells Fargo is able to establish its standing on remand." Id. In this respect, the court noted that even if Wells Fargo were to produce an indorsed copy of the note from Argent on remand, it would not necessarily follow that Wells Fargo would become a "holder in due course" under U.C.C. § 3-203. Id. Only a holder in due course could avoid any defenses Ford would have to a claim by Argent to enforce the note. Id. To be classified as a holder in due course, Wells Fargo could not have known of Ford's defenses against Argent. Id. This, in turn, would mandate that the indorsement have occurred near the date the original note was executed. Id.
As Wells Fargo Bank demonstrates, courts will not allow an assignee of a mortgage note to foreclose upon the property unless the assignee is able to show that it falls into one of the three categories of persons entitled to enforce a negotiable instrument under U.C.C. § 3-301. In most cases, the original mortgage note is payable to a specific lender. For such a note to be validly negotiated, that lender must properly indorse the note either in blank or specially to the assignee. In addition, the indorsement should have been executed at or near the time the original note was executed. Moreover, in several states, the indorsement must also be affixed to the original note. Unless each of these requirements is satisfied, the assignee lacks standing to pursue a foreclosure action. See, e.g., In re Weisband, 427 B.R. 13, 18-21 (Bankr. D. Ariz. 2010); In re Willhelm, 407 B.R. 392, 402-03 (Bankr. D. Idaho 2009).
Posted by Gale Burns on Wed, Jan 12, 2011 @ 03:06 PM
November 30, 2010
Charlene Hicks, Senior Attorney, National Legal Research Group
Because Delaware is the predominant state in which most U.S. businesses choose to incorporate, it is not surprising that Delaware statutory and case law are also the primary authorities governing alternative business entities, such as limited liability companies ("LLCs") and limited partnerships ("LPs"). In early November, the Delaware Court of Chancery issued an important opinion involving the interpretation of the Delaware Limited Liability Company Act ("LLC Act") and the rights of a creditor to assert a derivative claim against members of the board of managers of an insolvent LLC.
In CML V, LLC v. Bax, C.A. No. 5373 VCL, 2010 WL 4517795 (Del. Ch. Nov. 3, 2010), CML V ("CML") loaned large sums of money to JetDirect Aviation Holdings, LLC ("JetDirect"), an LLC. After JetDirect became insolvent, CML filed a derivative claim for breach of fiduciary duty against the various members of JetDirect's board of managers, claiming that the board members had approved four major acquisitions by JetDirect without informing themselves of critical information about the company's financial condition. The individual defendants moved to dismiss on the ground that CML lacked standing as a creditor to sue derivatively under the LLC Act, Del. Code Ann. tit. 6, § 18‑1002. This statute provides that "[i]n a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action[.]" Id.
CML was clearly not a member or an assignee of JetDirect. However, in the context of insolvent corporations, Delaware courts have recognized that creditors have an equitable right to maintain derivative actions against directors on behalf of the corporation for breaches of fiduciary duties. CML V, 2010 WL 4517795, at *2; see N. Am. Catholic Educ. Programming Found. v. Prod. Res. Group, L.L.C., 863 A.2d 772, 776 (Del. Ch. 2004). When a corporation is insolvent, creditors become "the principal constituency injured by any fiduciary breaches that diminish the firm's value." CML V, 2010 WL 4517795, at *2 (internal quotation marks omitted). Hence, creditors may effectively step into the shoes of a stockholder and assert a derivative claim on behalf of the corporation.
CML argued that the court should apply by analogy in the LLC setting a corporate creditor's equitable right to maintain a derivative action when an insolvent corporation is involved. To most observers, CML's argument had a certain intuitive appeal. Indeed, the court acknowledged that "the standing provisions in the alternative entity statutes have not been widely understood as barring derivative claims by creditors of an insolvent entity. To the contrary, many have assumed that creditor standing exists." Id.
Although the court recognized the compelling force of this argument, it nevertheless ruled that "the literal terms of the LLC Act control, and they bar a creditor of an insolvent LLC from suing derivatively." Id. Declining any invitation to depart from a literal reading of the statute, the court ruled that CML lacked standing to pursue its derivative claim for breach of fiduciary duty against JetDirect's former board members. Id.
In reaching this conclusion, the court emphasized that the "exclusive language of [LLC Act] Section 18‑1002 contrasts with the non‑exclusive language of the Delaware General Corporation Law (the "DGCL"), 8 Del. C. § 327." Id. at *4. Section 327 of the DGCLC—the only Delaware Code provision that addresses derivative actions—"does not create the right to sue derivatively and, by its terms, does not say that only stockholders can sue derivatively." Id. Instead, the DGCL requires only that a stockholder plaintiff satisfy a contemporaneous ownership requirement. This open‑ended statutory language does not expressly preclude a derivative action brought by someone other than a stockholder.
According to the CML V court, the open nature of DGCL § 327 "demonstrates that the General Assembly can readily adopt a non-exclusive limitation on derivative standing." Id. Whereas DGCL § 327 is nonexclusive in nature, LLC Act § 18‑1002 "uses exclusive language." Id. The exclusive terms employed by LLC Act § 18‑1002 literally "den[y] derivative standing to creditors of an insolvent LLC." Id.
Although the court found that this conclusion was compelled by the clear language of the LLC Act, it conceded the "awkward fact" that the result causes LLC derivative actions "to differ markedly from their corporate cousins." Id. Even so, "any apparent tension between the plain language of the LLC Act and the commonly held understanding of the provisions" had to be resolved in favor of the statutory language. Id. at *6. Moreover, the court found there was nothing inherently absurd "about different legal principles applying to corporations and LLCs." Id. at *10. Rather, because the "conceptual underpinnings" of Delaware corporations law differed from that of Delaware's alternative entity law, "courts should be wary of uncritically importing requirements from the DGCL" into the LLC context. Id. (internal quotation marks omitted).
Unlike the DGCL, the "overarching policy" of the LLC Act is to "give maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements." Del. Code Ann. tit. 6, § 18‑1101(b). Creditors generally may be presumed to be entities capable of protecting themselves in a bargained‑for contract. CML V, 2010 WL 4517795, at *10. Accordingly, the court concluded that limiting "creditors to their bargained‑for rights and deny[ing] them the additional right to sue derivatively on behalf of an insolvent entity comports with the contractarian spirit created by the LLC Act." Id. Further, the LLC Act provides "expansive contractual and statutory remedies" to creditors. Id. at *14. As a result, it was neither absurd nor unreasonable for the court to interpret the LLC Act as denying derivative standing to creditors of an insolvent LLC. Id.
As the
CML V court itself acknowledges, the conclusion that the LLC Act does not grant standing to creditors of an insolvent LLC "might surprise wizened veterans of debates over corporate creditor standing."
Id. at *1. The mere fact that a specific practice or remedy has been approved under established precepts of Delaware corporations law is no guarantee that the same practice or remedy will be available in the context of newer, alternative forms of business entities, such as LLCs and LPs.
Posted by Daniel Lynton on Wed, Sep 22, 2010 @ 04:20 PM
August 10, 2010
Paul Ferrer, Senior Attorney, National Legal Research Group
It is surprising how much business continues to be done between relatively sophisticated commercial entities based on a casual exchange of forms, despite the potentially ruinous consequences for a buyer of terms contained in an invoice or packing slip sent by the seller along with the item purchased. Consider the following scenario: An engine repair facility (the "buyer") is hired to repair a $1 million race car engine. The buyer needs a $10,000 part to fix the engine. The part consists of multiple blades. If any one of the blades breaks off while the engine is operating, it is likely that the entire engine will be completely destroyed, thus potentially subjecting the buyer to $1 million in liability, at least (assuming no additional damage to the race car). The buyer purchases the necessary part from the manufacturer (the "seller") by faxing a purchase order identifying the part and the price, with no terms concerning warranties or remedies upon a breach of warranty. The seller sends the part to the buyer along with an invoice or packing slip that sets forth, on the reverse side, a series of "terms and conditions," including provisions excluding the implied warranties of merchantability and fitness for a particular purpose, limiting the buyer's remedies to repair or replacement of the defective part, and excluding consequential damages. Do all of these terms become part of the parties' contract? If the part fails and destroys the $1 million engine, is the buyer limited to recovering the value of a $10,000 part from the seller?
Here is how these questions would typically be handled under Article 2 of the Uniform Commercial Code (the "U.C.C."), which applies to transactions in goods and has been adopted in all 50 states: The parties' "battle of the forms" is initially governed by § 2-207 of the U.C.C., which deals with additional terms in acceptance or confirmation of an offer. The buyer's purchase order would be considered an offer, which was accepted when the seller shipped the part. The additional terms in the seller's invoice excluding warranties and consequential damages and limiting the buyer's remedies to repair or replacement would be "construed as proposals for addition to the contract." U.C.C. § 2-207(2). Between merchants such as the buyer and the seller, such terms automatically become part of their contract unless "(a) the offer expressly limits acceptance to the terms of the offer; (b) they materially alter it; or (c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received." Id. In this scenario, the buyer's purchase order did not expressly limit acceptance to the terms of the offer, nor did the buyer object to the terms set forth on the back of the seller's invoice. In fact, like most purchasers, the buyer probably did not even look at the terms until the part failed, the engine was destroyed, and the race car's owner looked to the buyer to recover $1 million in damages. Accordingly, the terms on the seller's invoice became part of the contract unless they "materially alter[ed] it."
The U.C.C. specifically provides "[e]xamples of typical clauses which normally 'materially alter' the contract and so result in surprise or hardship if incorporated without express awareness by the other party," including "a clause negating such standard warranties as that of merchantability or fitness for a particular purpose in circumstances in which either warranty normally attaches." Id. § 2-207 cmt. 4. As such, the seller's attempt to exclude the implied warranties of merchantability and fitness for a particular purpose was probably unsuccessful. See, e.g., Distinctive Cabinetry, Inc. v. Home Depot U.S.A., Inc., No. Civ. 08-10233, 2009 WL 1448954, at *8 (E.D. Mich. May 22, 2009); Tacoma Fixture Co. v. Rudd Co., 174 P.3d 721, 724 (Wash. Ct. App.), review denied, 190 P.3d 55 (Wash. 2008). But it is unlikely that the seller is overly concerned about the existence of these warranties compared to its attempt to limit remedies and exclude consequential damages, which are the real battlegrounds in this instance. As the Illinois Supreme Court has explained:
The two provisions—limitation of remedy and exclusion of consequential damages—can be visualized as two concentric layers of protection for a seller. What a seller would most prefer, if something goes wrong with a product, is simply to repair or replace it, nothing more. This "repair or replacement" remedy is an outer wall, a first defense. If that wall is breached, because the limited remedy has failed of its essential purpose, the seller still would prefer at least not to be liable for potentially unlimited consequential damages, and so he builds a second inner rampart as a fallback position. That inner wall is higher, and more difficult to scale—it falls only if unconscionable.
Razor v. Hyundai Motor Am., 854 N.E.2d 607, 619 (Ill. 2006), cert. denied, 549 U.S. 1181 (2007).
With regard to these two more important lines of a seller's defense, the U.C.C. also provides "[e]xamples of clauses which involve no element of unreasonable surprise and which therefore are to be incorporated in the contract unless notice of objection is seasonably given," including "a clause . . . limiting remedy in a reasonable manner (see Section[] . . . 2-719)." U.C.C. § 2-207 cmt. 5. Section 2-719 specifically states that the parties' agreement "may provide for remedies in addition to or in substitution for those provided in this Article and may limit or alter the measure of damages recoverable under this Article, as by limiting the buyer's remedies to . . . repair and replacement of non-conforming goods and parts." Id. § 2-719(1)(a). In addition, "[c]onsequential damages may be limited or excluded unless the limitation or exclusion is unconscionable."Id. § 2-719(3). Under this subsection, limitation of consequential damages is not prima facie unconscionable "where the loss is commercial." Id. Taken together, §§ 2-207 and 2-719 seem to indicate that the terms in the seller's invoice limiting the buyer's remedies to repair or replacement and excluding consequential damages did not "materially alter" the parties' agreement and became part of their bargain under § 2-207(2), which would likely come as quite a surprise to the unwitting buyer. Note, however, that not all courts agree on this reading of the U.C.C. See, e.g., Distinctive Cabinetry, 2009 WL 1448954, at *12 (noting that courts are split on this issue, but concluding that the courts "finding that an exclusion of all consequential damages is a material alteration have the better view").
In a state holding that an exclusion of consequential damages is not a material alteration of the parties' bargain, the buyer would be left with only two arguments. First, the buyer could claim that the seller's attempt to alter the terms of their bargain through the inclusion of an invoice or packing slip with the items being shipped to the buyer came too late in the contracting process. Some, though not all, courts have agreed that, in such a case, the parties' contract consists only of those terms on which the parties' forms agree, plus any additional terms supplied by the U.C.C., including those relating to implied warranties and consequential damages. See, e.g., Tacoma Fixture Co., 174 P.3d at 724 (discussing U.C.C. § 2-207(3)).
Second, the buyer could also argue that the limited remedy provided by the seller failed of its essential purpose, thus allowing the buyer to have "remedy . . . as provided in this Act," U.C.C. § 2-719(2), including consequential damages, see id. § 2-715(2)(b) (consequential damages include injury to property proximately resulting from the seller's breach of warranty). There was a time when the majority of courts to consider the issue had held that if a limited remedy failed of its essential purpose, then the seller's attempt to exclude consequential damages failed as well. See Razor, 854 N.E.2d at 616. That is no longer the case, however, and the modern trend is to adopt the so-called "independent" approach, which views subsections (2) and (3) as independent provisions, such that even if a limited remedy is deemed to have failed of its essential purpose, a term excluding consequential damages can still be enforced so long as it is not unconscionable. See id. at 616-17. Arguing unconscionability in a contract between two commercial parties, with no consumers involved, is a tall order. Cf. id. at 622-23.
Returning to our scenario, all of this means that the buyer may well be limited to recovering from the seller only the $10,000 value of the part, while being on the hook for $1 million in damages to the owner of the race car. The lessons are clear. From the seller's perspective, carefully drafted provisions limiting remedies and excluding consequential damages are worth their weight in gold. On the other hand, the buyer, who would ordinarily be entitled to recover its substantial consequential damages in this situation under the rule of Hadley v. Baxendale, must protect itself either in its dealings with the race car's owner or by being more careful in forming a contract with the seller of the part that ultimately destroyed the engine. The buyer can do so either by expressly limiting acceptance to the terms of its offer or by objecting to the additional terms proposed by the seller immediately upon receiving the seller's invoice. See U.C.C. § 2-207(2). It may even be prudent for the buyer to include in its purchase order an express term purporting to nullify any attempt by the seller to exclude warranties or consequential damages or to limit remedies. In that case, the buyer's and seller's conflicting terms would not become part of the contract, which would then consist of those terms upon which there was agreement between the parties, plus any supplementary terms supplied by the U.C.C., including its provisions on warranties and consequential and other damages. See id. § 2-207(3).