April 3, 2012

Brad Pettit, Senior Attorney, National Legal Research Group

Corporate and tax law attorneys frequently are asked to assist clients who have formed or want to create an organization that will serve the public good.  Section 501 of the Internal Revenue Code recognizes the desirability of such organizations by according tax-exempt status to "[c]orporations, and any community chest, fund, or foundation" that is "organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, or to foster national or international amateur sports competition . . . , or for the prevention of cruelty to children or animals."  I.R.C. § 501(c)(3) (emphasis added).  The Treasury Regulations further indicate that in order to be exempt from taxation under § 501(c)(3), an organization must be both "organized and operated exclusively for one or more of the purposes specified in such section."  Treas. Reg. § 1.501(c)(3)-1(a)(1).  According to the Regulations, "[i]f an organization fails to meet either the organizational test or the operational test, it is not exempt [from taxation]."  Id.

A.         Organizational Test

The Treasury Regulations provide that an organization is organized exclusively for one or more exempt purposes only if its articles of organization (1) limit the purposes of the organization to one or more exempt purposes, and (2) do not expressly empower the organization to engage, other than as an insubstantial part of its activities, in activities which in themselves are not in furtherance of one or more exempt purposes.  Treas. Reg. § 1.501(c)(3)-1(b)(1)(i).  The Regulations go on to caution that

     An organization is not organized exclusively for one or more exempt purposes if its articles expressly empower it to carry on, otherwise than as an insubstantial part of its activities, activities which are not in furtherance of one or more exempt purposes, even though such organization is, by the terms of such articles, created for a purpose that is no broader than the purposes specified in section 501(c)(3).

Id.  § 1.501(c)(3)-1(b)(1)(iii).  As part of an organization's application to the IRS for tax-exempt status, it must submit a detailed statement of its proposed activities.  Id. § 1.501(c)(3)-1(b)(1)(v).

B.         Operational Test

Charlene Hicks, Senior Attorney, National Legal Research Group

The always thorny topic of mandatory arbitration provisions in consumer sales contracts has recently developed a new layer of legal complexity.  Prior to July 2009, many businesses routinely inserted into their consumer sales contracts arbitration clauses that required consumers' complaints to be resolved through binding arbitration administered exclusively by the National Arbitration Forum ("NAF").  At that time, the NAF was the largest administrator of consumer arbitrations in the United States.  A 2009 investigation of the NAF conducted by the Minnesota Attorney General, however, revealed that the supposedly neutral body of the NAF actually held a strong anticonsumer bias.  See Arbitration or "Arbitrary":  The Misuse of Mandatory Arbitration to Collect Consumer Debts:  Hearing Before the H. Domestic Policy Subcomm. of Comm. on Oversight & Gov't Reform, 111th Cong. 3-5 (July 22, 2009).  The NAF routinely "represented to corporations that it would appoint anti-consumer arbitrators and discontinue referrals to arbitrators who decided cases in favor of consumers."  Khan v. Dell, Inc., No. 10-3655, 2012 WL 163899, at *8 (3d Cir. filed Jan. 20, 2012) (Sloviter, J., dissenting).  The NAF's "various deceptive practices" had the effect of unfairly disadvantaging consumers in the arbitral forum.  Id. at *2 (majority opinion).  As a result of the Minnesota Attorney General's investigation, the NAF entered into a consent judgment wherein it agreed to cease administering and participating in all consumer arbitrations.

Because the NAF is no longer available to serve as an arbitral forum in consumer disputes, consumers in recent cases have moved the courts for orders setting aside mandatory arbitration clauses that name the NAF as the exclusive arbitrator of the consumers' complaints.  Courts confronted with this issue have reached differing conclusions as to whether the unavailability of the NAF to serve as arbitrator of consumer-related disputes renders the entire arbitration clause unenforceable.

The current, unsettled status of the law in this regard was well documented by the Third Circuit Court of Appeals in Khan.  In that case, Khan, a consumer, filed a putative class action on behalf of himself and other similarly situated purchasers and lessees of a certain Dell computer model that he claimed had been defectively designed.  Khan purchased his computer for $1,200 directly from Dell's website.  To complete the purchase, Khan was required to click a box that stated:  "I AGREE to Dell's Terms and Conditions of Sale."  Id. at *1.  The Terms and Conditions of Sale contained an arbitration clause that provided that any claim or dispute between the parties relating to the computer purchase

SHALL BE RESOLVED EXCLUSIVELY AND FINALLY BY BINDING ARBITRATION ADMINISTERED BY THE NATIONAL ARBITRATION FORUM (NAF) under its Code of Procedure then in effect. . . . This transaction involves interstate commerce, and this provision shall be governed by the Federal Arbitration Act[,] 9 U.S.C. sec. 1B16 (FAA).

Id. (citation omitted).

At the time Khan filed his lawsuit, the consent judgment entered into by the NAF barred the NAF from arbitrating Khan's complaint.  Even so, Dell moved to compel arbitration on the ground that the arbitration provision in the sales contract was binding and covered all of Khan's claims.  Khan objected by arguing that the arbitration provision was unenforceable because the NAF was no longer permitted to conduct consumer arbitrations, and that the NAF's designation as the arbitral forum was integral to the arbitration provision.  Id.

Finding that the contract language indicated that the parties had intended to arbitrate exclusively before a particular arbitrator that was no longer available, the district court denied Dell's motion to compel.  Id.  In addition, the district court refused to appoint a substitute arbitrator, finding that it could not compel the parties to submit to an arbitral forum to which they had not agreed.  Id.

The Lawletter Vol 36 No 9

Tim Snider, Senior Attorney, National Legal Research Group

The Supreme Court takes so few cases on writs of certiorari that it is remarkable that the Court in consecutive Terms has accepted and decided two cases involving arbitration of consumer disputes.  Last Term, the Court decided AT&T Mobility LLC v. Concepcion, 563 U.S. ___, 131 S. Ct. 1740 (2011), which held that the Federal Arbitration Act, 9 U.S.C. § 2, preempts California's judicial rule regarding the unconscionability of class arbitration waivers in consumer contracts.  This Term, the Court again took up arbitration, also in the context of consumer contracts, in CompuCredit Corp. v. Greenwood, 132 S. Ct. 665 (2012).

There, a group of consumers filed a class-action complaint in the U.S. District Court for the Northern District of California against the defendant credit card issuers, alleging, inter alia, violations of the Credit Repair Organizations Act ("CROA"), 15 U.S.C. §§ 1679–1679j.  The claims largely involved the defendants' allegedly misleading representation that the issuers' credit card could be used to rebuild poor credit and their assessment of multiple fees upon opening the accounts, which greatly reduced the advertised credit limit.  The defendants moved to compel arbitration in accordance with a provision in the consumers' contracts.  The district court denied the motion, and the Ninth Circuit affirmed.  Greenwood v. CompuCredit Corp., 615 F.3d 1204 (9th Cir. 2010). The Supreme Court reversed and remanded.

CROA sets out a statement that credit repair organizations must provide to consumers before any contract is executed.  15 U.S.C. § 1679c(a).  One sentence of the required statement reads, "'You have a right to sue a credit repair organization that violates the Credit Repair Organization Act.'"  Id.  CROA's nonwaiver provision states, "Any waiver by any consumer of any protection provided by or any right of the consumer under this subchapter—(1) shall be treated as void; and (2) may not be enforced by any Federal or State court or any other person."  Id. § 1679f(a).  The Ninth Circuit reasoned that the disclosure provision gives consumers the "right to sue," which "clearly involves the right to bring an action in a court of law."  Greenwood, 615 F.3d at 1208.  Because the nonwaiver provision prohibits the waiver of "any right of the consumer under this subchapter," the arbitration agreement—which waived the right to bring an action in a court of law—could not be enforced.

The Supreme Court rejected the premise that the disclosure provision affords consumers a right to bring an action in a court of law.  The Court concluded that the defendants were required only to provide consumers with the mandated statement, which referred to rights afforded elsewhere in the statute.  The statute provides for procedures that must be utilized if and when the case finds its way into court, but that does not mean that Congress intended to supplant the availability of arbitration under the Federal Arbitration Act ("FAA").  If Congress had intended to do so, it would have done so explicitly as it has done elsewhere, particularly inasmuch as arbitration is a favored means of resolving disputes.

The Lawletter Vol 36 No 9

Suzanne Bailey, Senior Attorney, National Legal Research Group

The antiretaliation provision of the Fair Labor Standards Act ("FLSA") makes it unlawful

to discharge or in any other manner discriminate against any employee because such employee has filed any complaint or instituted or caused to be instituted any proceeding under or related to this chapter, or has testified or is about to testify in any such proceeding, or has served or is about to serve on an industry committee[.]

29 U.S.C. § 215(a)(3) (emphasis added).  Whether "filed any complaint" includes complaints made to an employer or whether it is limited to complaints brought before an administrative agency or a court has been the subject of much litigation.  In Minor v. Bostwick Laboratories, Inc., No. 10-1258, 2012 WL 251926 (4th Cir. Jan. 27, 2012), the Fourth Circuit Court of Appeals recently joined the majority of circuits that have addressed the issue in holding that intracompany complaints may constitute protected activity within the meaning of § 215(a)(3).  See, e.g.,  Hagan v. Echostar Satellite, LLC, 529 F.3d 617, 626 (5th Cir. 2008); Lambert v. Ackerley, 180 F.3d 997, 1004 (9th Cir. 1999) (en banc); Valerio v. Putnam Assocs., 173 F.3d 35, 43 (1st Cir. 1999); EEOC v. Romeo Cmty. Sch., 976 F.2d 985, 989 (6th Cir. 1992); EEOC v. White & Son Enters., 881 F.2d 1006, 1011 (11th Cir. 1989); Brock v. Richardson, 812 F.2d 121, 124-25 (3d Cir. 1987); Love v. RE/MAX of Am., Inc., 738 F.2d 383, 387 (10th Cir. 1984); Brennan v. Maxey's Yamaha, Inc., 513 F.2d 179, 181 (8th Cir. 1975).

In reaching its conclusion, the Fourth Circuit rejected the employee's argument that the U.S. Supreme Court's decision in Kasten v. Saint‑Gobain Performance Plastics Corp., 131 S. Ct. 1325 (2011), compelled a holding that her intracompany complaint was protected under the FLSA.  The court observed that the sole issue resolved by the Supreme Court in Kasten was whether an oral complaint could be protected activity under the antiretaliation provision of the FLSA; the Court expressly declined to address whether an intracompany complaint could be protected activity.  Likewise, the Fourth Circuit rejected the employer's argument that the court's prior decision in Ball v. Memphis Bar‑B‑Q Co., 228 F.3d 360 (4th Cir. 2000), required a finding that intracompany complaints are not protected activity.  Ball was distinguishable on its own terms because it addressed only the "has testified or is about to testify in any such proceeding" clause of § 215(a)(3), not the "filed any complaint" clause under consideration in Minor.

The Lawletter Vol 36 No 9

Charlene Hicks, Senior Attorney, National Legal Research Group

On January 27, 2012, the Delaware Chancery Court issued a 75-page slip opinion in Auriga Capital Corp. v. Gatz Properties, LLC, No. C.A. 4390-CS, 2012 WL 361677 (Del. Ch. Jan. 27, 2012) (slip op.), which holds that managers of Delaware limited liability companies ("LLCs") owe fiduciary duties of loyalty and care to their investors unless an express contractual provision exists that waives or modifies those duties.  The opinion is notable for the broad and comprehensive scope of the court's analysis of the Delaware LLC Act and its application to common-law principles of fiduciary duty.

The facts of Auriga Capital Corp. involved various egregious acts committed by Gatz, the majority owner and manager of a Delaware LLC, against the minority members of the company.  Gatz had entered into a long-term lease with a management company to manage the golf course owned by the LLC.  The management company managed the golf course poorly, and Gatz soon saw that an opportunity would present itself for him to both buy back the property at a bargain price and simultaneously squeeze out the minority investors.  Gatz then exercised his management powers within the LLC in a manner that ultimately resulted in an auction in which he was the only bidder and in which the same counsel represented him in his dual capacities as both manager of the LLC and auction bidder.

In its analysis, the court first noted that the Delaware LLC Act, like the Delaware General Corporations Law ("DGCL"), does not plainly state that traditional fiduciary duties of loyalty and care apply by default to LLC managers or members.  Id. at *8.  However, section 18-1104 of the LLC Act does state that "[i]n any case not provided for in this chapter, the rules of law and equity . . . shall govern."  Del. Code Ann. tit. 6, § 18-1104.  Under traditional principles of equity, an LLC manager "would qualify as a fiduciary of that LLC and its members."  2012 WL 361677, at *8.  As a result, the court ruled that "the LLC Act starts with the default that managers of the LLCs owe enforceable fiduciary duties."  Id.  The court then conducted an extensive review of the history and statutory construction of the LLC Act and determined that the interpretation of the Act as imposing fiduciary duties on LLC managers by default "is confirmed by the Act's own history."  Id. at *9.

Although the LLC Act incorporates by default equitable principles, including fiduciary duty, the court emphasized that the statute also permits the parties to an LLC agreement "to entirely supplant those default principles or to modify them in part."  Id. at *9 & n.50.  If the LLC Agreement "clearly supplant[s] default principles in full," Delaware courts will give effect to the express contractual language.  Id. at *9 & n.52.

The court then cautioned that the implied covenant of good faith and fair dealing should not be confused with, or used as a replacement for, the principle of fiduciary duty.  "If, rather than well thought out fiduciary duty principles, the implied covenant is to be used as the sole default principle of equity, then the risk is that the certainty of contract law will itself be undermined."  Id. at *10.  This, in turn, would provide "room for subjective judicial oversight" and would therefore "inject unpredictability into both equity and contract law."  Id.  Moreover, "a judicial eradication of the explicit equity overlay in the LLC Act could tend to erode [Delaware's] credibility with investors in Delaware entities."  Id.

Under the LLC Agreement at issue in the case, Gatz had a fiduciary duty to manage the business loyally for the benefit of the company's members.  An affirmative aspect of the fiduciary duty of loyalty requires the fiduciary to take affirmative steps to protect the interests of the company committed to his charge.  A reasonable fiduciary in Gatz's position would have immediately searched for a replacement management company, assessed whether the LLC could operate the golf course profitably itself, or looked for a buyer to acquire the golf course or its assets.  Under the circumstances, Gatz's inaction amounted to a breach of fiduciary duty.

The Lawletter Vol 36 No 8

Jim Witt, Senior Attorney, National Legal Research Group

After the enactment of the Employee Retirement Income Security Act of 1974 ("ERISA"), a conflict developed among the U.S. Circuit Courts of Appeal as to whether the antialienation provision, 29 U.S.C. § 1056(d)(1) (benefits under an ERISA plan may not be assigned or alienated), applied to void an ex-spouse's waiver of ERISA plan benefits under a divorce decree.  The theory was that the waiver would result in a prohibited alienation of the benefits to the decedent's estate.  The Fourth Circuit Court of Appeals in Altobelli v. IBM Corp., 77 F.3d 78 (4th Cir. 1996), found no conflict between common-law waiver and the antialienation rule.  The Third Circuit Court of Appeals in McGowan v. NJR Serv. Corp., 423 F.3d 241 (3d Cir. 2005), held that common-law waiver in a divorce decree was barred by the antialienation rule.

In Egelhoff v. Egelhoff ex rel. Breiner, 532 U.S. 141 (2001), the U.S. Supreme Court, although not dealing with a spousal waiver of ERISA benefits or the antialienation rule, set the stage for the resolution of the conflict as to common-law waiver.  In reversing the Supreme Court of Washington, the U.S. Supreme Court ruled that ERISA preempted a Washington statute, Wash. Rev. Code § 11.07.010(2)(a), providing for automatic revocation upon divorce of any designation of a spouse as the beneficiary of a nonprobate asset.  The decedent, David A. Egelhoff, while married to the petitioner, had designated her as the beneficiary of a life insurance policy and pension plan, with both plans subject to ERISA.  The petitioner and Egelhoff divorced, and Egelhoff died intestate without having removed the petitioner as the beneficiary of the insurance policy and pension plan.  The respondents, Egelhoff's children by a previous marriage, claimed the proceeds of both the insurance policy and pension plan as Egelhoff's heirs at law.  In holding that the Washington statute was preempted by ERISA, the Court ruled that the statute ran counter to ERISA's command that a plan fiduciary shall administer the plan "in accordance with the documents and instruments governing the plan."  29 U.S.C. § 1104(a)(1)(D).  The Supreme Court stated:

One of the principal goals of ERISA is to enable employers "to establish a uniform administrative scheme, which provides a set of standard procedures to guide processing of claims and disbursement of benefits."  Fort Halifax Packing Co. v. Coyne, 482 U.S. 1, 9, 107 S.Ct. 2211, 96 L.Ed.2d 1 (1987).  Uniformity is impossible, however, if plans are subject to different legal obligations in different States.

The Washington statute at issue here poses precisely that threat.  Plan administrators cannot make payments simply by identifying the beneficiary specified by the plan documents.  Instead they must familiarize themselves with state statutes so that they can determine whether the named beneficiary's status has been "revoked" by operation of law.  And in this context the burden is exacerbated by the choice‑of‑law problems that may confront an administrator when the employer is located in one State, the plan participant lives in another, and the participant's former spouse lives in a third. In such a situation, administrators might find that plan payments are subject to conflicting legal obligations.

The Lawletter Vol 36 No 8

Brett Turner, Senior Attorney, National Legal Research Group

Steven Walsh and Janet Schaberg were divorced in New York in 2006.  They had a substantial marital estate, which they divided in a property settlement agreement.  Given the size of her property award, Schaberg agreed to waive maintenance.

Several years after divorce, a federal investigation revealed that Walsh had been engaged in a long-standing scheme to defraud investors in various funds he managed.  In fact, much of the parties' marital estate was a product of Walsh's fraud.

Two federal agencies, the Commodity Futures Trading Commission and the Securities and Exchange Commission (hereinafter "the agencies"), filed suit in federal court, seeking to recover the proceeds of Walsh's fraud not only from Walsh, but also from Schaberg.  The Second Circuit held that the agencies could recover the proceeds from Schaberg if she "lacks a legitimate claim" to the funds.  Commodity Futures Trading Comm'n v. Walsh, 618 F.3d 218, 225 (2d Cir. 2010).

Schaberg, who had been entirely unaware of Walsh's wrongdoing, argued that she had such a legitimate claim under New York state marital property law.  Because state law was involved, the Second Circuit certified two questions to the New York Court of Appeals:  (1) whether "marital property" can ever include the proceeds of fraud, and (2) if so, whether the wife nevertheless had an obligation to return the funds because she had not paid fair consideration for them in good faith.

In a 2011 opinion, the New York court answered both questions.  Commodity Futures Trading Comm'n v. Walsh, 951 N.E.2d 369 (N.Y. 2011).  It answered the first question with a yes, holding that the proceeds of fraud can constitute marital property.  They are certainly property acquired during the marriage through the active, if dishonest, efforts of the guilty spouse.  They belong to the guilty spouse unless and until the victims take legal action to recover them.  If a postdivorce attempt to recover the proceeds of fraud retroactively erases those funds from the marital estate, property-division judgments will never be final, and the policy of finality of judgments is very strong.  The court therefore held that the proceeds of fraud can constitute marital property.

The second question defied a simple and easy answer.  The agencies argued that the wife had acquired her share of the proceeds of fraud in exchange for waiving her interest in the husband's share of the proceeds of fraud.  The New York court agreed that fair "consideration cannot be predicated on a spouse's relinquishment of a claim to a greater share of the proceeds of fraud."  Id. at 377.  In other words, fair consideration must be something beyond an interest in the proceeds of fraud themselves.