Wednesday, November 28, 2018

The Lowdown on Retirement Plans—How Does ERISA Protect Employees



Employment-based retirement plans offer significant advantages to employees over the options individuals might have on their own, with the ability to use otherwise taxable compensation for the purpose of saving for retirement.  With the amount of assets directed to employer-based retirement accounts, an important concern is the safe management of those assets and the ability of employees to understand how those assets are administered.   The Employee Retirement Income Security Act of 1974 (ERISA), along with various provisions of the Internal Revenue Code, are the primary laws regulating these plans.  This article provides an overview of ERISA and describes how the law regulates and helps protect employees’ retirement plans.

To understand the scope and importance of ERISA, it is helpful to consider how private pension plans were regulated prior to its passage.  Tax-favored status of employer-based retirement plans has deep roots. Early versions of the 1920s era Revenue Acts permitted employers to deduct pension contributions from income and allowed the funds to grow tax-free.  Over time, the law began to require certain disclosures and minimum employee coverage requirements.  The United State Department of Labor (DOL) eventually became an overseer of the plans, with legislation intended to prevent abuse and mismanagement of funds by employers and unions. 

Overview of ERISA

Compared to these early laws, ERISA represented an expansion in enforcement and investigatory powers.  ERISA requires an employer-sponsored plan to meet certain reporting and disclosure requirements.  In addition, it imposes fiduciary duties upon plan administrators.  Finally, it (along with other federal anti-discrimination laws) bans discrimination in who may participate in the plans and restricts an employer’s ability to impose eligibility requirements.  It is important to note that ERISA does not require that employers offer a retirement plan.  It simply sets forth minimum standards for such plans and offers remedies when those standards are violated.  Employers that choose to provide retirement benefits then must comply with ERISA in both the design and administration of the plans.

ERISA governs most employee-benefit plans that provide for either retirement income or a deferral of income until after termination of employment.  Retirement plans that meet the IRS definition of “qualified plans,” such as 401(k)s and traditional pension plans, are considered employee benefit plans subject to all aspects of ERISA.  Notably, 403(b) plans sponsored by public education employers, governments and religious organizations are generally exempt from ERISA.  Other “nonqualified” deferred compensation arrangements, such as plans that are designed only to benefit key employees, are mostly exempt from ERISA. 

The DOL takes a lead role in requiring compliance with ERISA’s required disclosures, fiduciary responsibilities and bans on prohibited transactions.  An array of causes of action exist under ERISA, allowing for private civil suits, criminal actions, civil penalties, sanctions and civil actions by the DOL.

ERISA’s Requirements for Employer-Sponsored Retirement Plans

ERSIA requires the use of a written plan document to establish an employee benefit plan.  The document must name one or more fiduciaries who will manage the plan.  Plan assets are held in a trust.  A system is required to provide plan documents and information to employees, keep accurate records of funds flowing to and from the plan and provide for an annual report to the Employee Benefits Security Administration, a division of the DOL.  This annual report provides detailed information on the assets and liabilities of the plan.

Determining whether a person or entity is a fiduciary is a threshold question in assessing whether a breach of a fiduciary duty has occurred under ERISA.  A plan administrator chosen by the employer, members of a board of directors and trustees of a retirement plan all may have fiduciary responsibilities to the plan participants.  An employer is usually the “plan sponsor” who designs the plan, but the employer may also act as a fiduciary in the implementation and administration of the plan.  If an employer hires someone else to provide fiduciary functions, the employer remains responsible for the choice of the fiduciary and monitoring the chosen fiduciary.  Determining whether a person or entity has a fiduciary responsibility to plan participants is a functional inquiry, which is determined by examining whether the person or entity has discretionary authority to administer or manage the plan or its assets or provides investment advice for compensation.  Fiduciaries have the responsibility to diversify investments, follow plan documents and act prudently and with sole loyalty to plan participants. In sum, an ERISA fiduciary must act in the interests of the plan participants or risk liability.  In addition to actions for breaches of fiduciary duty, plan participants can also seek remedies for improper denial of benefits and interference with their rights under ERISA.

Broadly speaking, employer retirement plans are either defined benefit plans or defined contribution plans.  With defined benefit plans, such as a traditional pension, there is a pre-established level of benefits that the retired employee will receive and the plan administrator normally has control over the invested assets.  In terms of investment of employees’ retirement assets, these plans must be fully funded by the employer.  The employer bears the risk of a decrease in value of invested assets and might be required to make additional contributions to satisfy its obligations.  Further, defined benefit plans must be insured by Pension Benefit Guaranty Corporation.  In addition, ERISA dictates that a plan may not engage in a “prohibited transaction.”  For example, there are limits on the amount of assets that can be invested in the securities of the employer.  Other prohibitions focus on potential conflicts of interest or regulating the plan administrator’s ability to engage in transactions that may be adverse to the interests of plan participants.

Investments in defined contribution plans, such as a 401(k), are chosen by plan participants.  While plan administrators are not liable for losses in defined contribution plans, they are still required to provide sufficient information to employees to allow them to make informed decisions and provide for an array of investments that allow an employee to choose a diversified investment portfolio.  While investment in securities of the employer are permitted in these plans, guidelines exist to allow employees to divest themselves of employer securities.  Employers must provide notice to employees to make them aware of when they are entitled to divest their account of employer securities.

There are also ERISA regulations regarding information that must be provided to employees regarding their rights and obligations, as wells as plan expenses and fees.  Employers must provide employees with a Summary Plan Description (SPD).  The SPD is a plain-language document providing detailed information regarding the benefits provided by the plan, when an employee is eligible to participate, when benefits becomes vested (owned) by the employee, and the remedies available to an employee.

Employees who are 21 years of age or older and have completed at least one year of service must be permitted to participate in a retirement plan if one is offered by the employer.  If the plan allows for 100% vesting after two years of service or less, the plan may extend the years of service requirement to two years.  There are also restrictions on accrual of benefits that are designed to prohibit age discrimination in the administration of retirement plans.

Summary

Due to the significant tax benefits offered by employer-sponsored retirement plans, as well as the societal interest in ensuring that employees have the opportunity to save for retirement, ERISA has evolved into a broad tool to regulate such plans and allow for enforcement of breaches of a fiduciary’s obligation to act in the interest of plan participants.  While the regulatory burden in complying with its requirements is significant, ERISA offers clear remedies and access to information for employees participating in employer-sponsored retirement plans and provides a safeguard against mismanagement of their retirement savings.

Reprinted with permission from the November 15, 2018 issue of The Legal Intelligencer. 
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. 
All rights reserved.

Thursday, October 25, 2018

Retirement Planning 101: The Differences Between a Pension, 401(k) & 403(b)



It seems many financial terms are known by shorthand that does not readily describe their purpose – 401(k), 403(b), SEPs, PSPs and MPPPs, for example.  On the other hand, a term such as “pension” seems easy to grasp but can include the above types of retirement plans or describe a distinct type of plan. When we meet with our estate planning clients, we need to drill down on these types of questions so that we can understand what our clients own and make sure we develop the best approach for wealth accumulation and preservation. Here, we provide an overview of the similarities and differences among pensions, 401(k) plans and 403(b) plans to clarify the various ways retirement plans are structured and how employees can benefit. 

Pension Plans

Pensions, 401(k) plans and 403(b) plans are all employer retirement plans that allow an employee to receive some form of financial benefit when they retire.  A pension can describe a range of different types of plans, but most people think of a pension as a “defined benefit plan”.  In a defined benefit plan, an employer sets aside a certain amount of money for an employee on a regular basis.  Essentially, the employer defers paying the employee a greater amount in wages while the employee is working in exchange for the promise of regular payments of benefits when the employee retires.  The amount of the promised benefit is usually tied to time of service with the employer and the employee’s salary and is paid out over a period of years during retirement in the form of an annuity. These types of plans are increasingly unusual in the private sector, but many public sector jobs and some unionized employees continue to participate in these types of plans. 

Traditional pension plans place the risk of underfunding or underperforming investments on the employer.  Because of the promised stream of retirement benefits over the retired employee’s lifetime, employees who live a long life after retirement benefit more than those who die soon after retirement.  Of course, some of these plans allow for the election of survivor benefits, in which the retiree can choose to take a reduced benefit during retirement in exchange for a continuing stream of payments to their spouse or designated beneficiary if the retiree dies before that spouse or designated beneficiary.  

401(k) & 403(b) Plans

401(k) plans and 403(b) plans are very similar to each other.  The main distinctions between these plans is that 403(b) plans are available to nonprofits and government institutions, while 401(k) plans are used by for-profit companies.  Both of these plans allow employees to voluntarily defer a portion of wages from their paychecks.  This deferred compensation is placed in an account earmarked for each employee, grows tax-free and usually allows the employee to invest in a range of investment options.  Some plans also provide that an employer will “match” a percentage of the employee’s contributions, which further leverages the employee’s ability to save for retirement.  Both of these plans place the risk of investment performance on the employee – poor investment performance can lead to a significant reduction in funds available at retirement.  Further, employees can outlive what they have saved if they live a long life after retirement

Employees who withdraw funds from their 401(k) plan or a 403(b) plan prior to turning 59.5 generally incur a penalty on the withdrawal.  Employees may, however, take loans from both types of plans.  Both plans also require that employees start taking withdraws from their plans the year after they reach 70.5 years of age.

Employees may defer up to $18,500 in compensation annually in either a 401(k) or 403(b) plan. Further, employees who are age 50 years or older can defer an additional $6,000 per year.  A distinction between the two types of plans is that some 403(b) plans allow for an additional $3,000 in annual deferrals for those who have at least 15 years of service.

The Takeaway

In sum, traditional defined benefit pension plans provide a pre-set lifetime benefit for their retirees while 401(k) and 403(b) plans put the onus on employees to save enough for retirement.  If an employee is a careful saver, however, the 401(k) or 403(b) can offer more benefits than those available in the traditional pension plan. Whether you are considering moving to a new job or just embarking on your career, it is important to understand the type of retirement benefits offered by your potential employer. If you are the type of person who enjoys the fresh challenge of frequent career moves, it is unlikely that you will stay long enough at any one employer to benefit from a traditional pension based on years of service.  You will need to take individual responsibility to save enough for retirement.  For others, a career path offering less in terms of salary might provide for a guaranteed pension benefit that makes up for lower earnings while working.  While traditional defined pension benefit plans are in decline, such plans and other hybrids that combine aspects of a pension plan with a 401(k) may be available and are worth investigating.   

Thursday, September 27, 2018

Make Business Divorce Easier—Spell Out Duties in Operating Agreement


Closely held companies are like marriages but without the sex or kids to hold things together. And just like some marriages, closely held companies can fall apart. Sometimes these “business divorces” and the painful litigation they generate are inevitable. Business partners have different personalities, expectations regarding finances and strategies for interacting with the world and one another. Some business divorce litigation involving limited liability companies might be resolved more easily or avoided altogether with the operating agreement’s inclusion of thoughtfully drafted provisions that address the owners’ fiduciary and other duties.

Many transactional practitioners devote significant time to drafting and refining complex capitalization structures and distribution waterfalls in their operating agreements. In our experience, nearly all business divorce litigation arises from alleged breaches of fiduciary duties. In such cases, the operating agreements typically are either silent as to what fiduciary or other duties govern the relationships between the parties or give the topic short shrift. These shortcomings may be the result of the mistaken belief among many practitioners that fiduciary duties are neatly defined by statute or caselaw and need not be spelled out in the agreements themselves.

Fiduciary duties generally, and within the context of limited liability companies more specifically, are subject to slippery rules and definitions. For years, Delaware courts have struggled with the concept. Pennsylvania’s jurisprudence, which is not nearly as well developed, has adopted a certain “I know it when I see it” method for identifying such duties. Given the limitless ways a manager can run a business without the requisite care or checks on self-dealing, defining the scope of fiduciary duties is perhaps an inherently fact-intensive exercise that necessitates this ad hoc approach.

Further complicating the landscape is that the duty of good faith and fair dealing is implied in most contracts. This duty is independent of other fiduciary duties. Although it is not clear under the pre-2016 version of the Pennsylvania LLC law whether an operating agreement is subject to the implied duty of good faith and fair dealing, the Pennsylvania Uniform Limited Liability Company Act of 2016 (the act) expressly imposes one (Section 8849.1(d)). The duty is often discussed as a “gap filler” that addresses conduct violating the spirit of a contract. We think of it, less formally, as a “don’t be a jerk” rule.

The transactional practitioner that defers to these foggy standards by not addressing them in the operating agreement is likely to invite litigation between the parties to the operating agreement. Fiduciary standards imposed by court decisions or statutes may conflict with the expectations of business owners. This disconnect between what an owner thinks they can do under the ill-defined terms of the operating agreement and what the court- or statutorily defined fiduciary duties permit is fodder for potential litigation should the parties’ business relationship go awry.

Given that limited liability companies are creatures of contract, there is no reason not to address fiduciary duties in a company’s operating agreement. Pennsylvania, like many states including Delaware, allows operating agreements to modify the traditional corporate fiduciary duties—i.e., the duty of care and duty of loyalty—and the duty of good faith and fair dealing. Modifying these provisions requires thoughtful and precise drafting. For example, while the act permits the alteration of the duty of care, the act ostensibly prohibits the elimination of this duty. In this regard, a generalized disclaimer that “all fiduciary duties are eliminated” or “the parties hereby disclaim the covenant of good faith and fair dealing” is unlikely to be effective. Moreover, modifications can be made only when they are not “manifestly unreasonable.” Thus, the only way to modify, or attempt to eliminate, these duties is to affirmatively and precisely state what they are and define their scope. Should a court ever inquire as to whether a modification is “manifestly unreasonable,” it may also be helpful to provide detailed recitals on the background of the owners’ relationship, the purpose of the company and the reasons for modifying any duties.

Well-drafted duty-of-care provisions should, at a minimum, address the applicable standard of care and the scope of the business judgment rule, exculpation from monetary damages for breach of the duty and the advancement litigation expenses. In crafting these provisions, practitioners should consider the following questions, among others: Is the standard for the duty of care negligence, gross negligence or something else? To what extent can a manger or controlling person rely on information provided by others? Should the managers or controlling members be liable to the company for the monetary damages that result from a breach of the duty of care? Should they receive indemnity or advancement of fees for litigation expenses in the event of an alleged beach?

The duty of loyalty is particularly important in the context of closely held businesses. If controlling owners are going to compete with the company, charge it a fee, cause it to deal with an affiliate or be employed by the business, those issues should all be addressed in the operating agreement. The act encourages this type of specificity by allowing an operating agreement to “identify specific types or categories of activities that do not violate the duty of loyalty.” The agreement should also identify a procedure by which the noncontrolling members can review activities that might otherwise violate a duty of loyalty.

The act allows the parties to prescribe the standards, if not manifestly unreasonable, by which performance of the contractual obligation of good faith and fair dealing is measured. As a practical manner, the obligation is so amorphous that it is difficult to articulate how it should be modified. The obligation, however, cannot contradict the express terms of an agreement. Therefore, careful drafting of the fiduciary duty sections helps to minimize the unexpected invocation of the duty of good faith and fair dealing. Practitioners should nevertheless codify this principal by making clear that whatever duty it creates, such duty cannot supplant the express terms or duties articulated elsewhere in the operating agreement.

Much like including certain provisions in a prenuptial agreement may give rise to awkward conversations between partners before getting married, including these provisions in an operating agreement may provoke uncomfortable discussions between owners at the outset of a new venture. Transactional practitioners should nevertheless encourage those discussions and address owners’ concerns head-on. Resolving these issues up-front will likely avoid punting them to litigators and courts in the back-end and prevent unnecessary or unnecessarily contentious litigation.

Reprinted with permission from the September 20, 2018 issue of The Legal Intelligencer. 
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. 
All rights reserved.

Thursday, August 30, 2018

Are Improvements to Retirement Savings Options on the Horizon?


News outlets recently flooded social media with headlines about the rise of “401(k) millionaires” in the wake of an analysis by Fidelity Investments which touted the increased number of its 401(k) plans with at least a $1 million balance. It is difficult to decipher whether this development is a sign of individuals taking increased responsibility for funding their retirement, the product of a strong investment market or some other combination of factors.  While it appears to show that more people are saving significant funds for retirement, some are questioning whether the government should be doing more to encourage retirement savings.

In March, the Senate introduced a bipartisan bill titled the “Retirement Enhancement and Savings Act of 2018” (RESA, S. 2526), an updated version of a similar bill from 2016.  While the likelihood of passing any important bill during the upcoming election cycle is uncertain, there are aspects of this bill that should be attractive to those on either side of the aisle.  Coupled with the House of Representative’s Ways and Means Committee’s release of “Tax Reform 2.0”, it appears that savings for retirement and other life events are on Congress’s radar.  

In my last article on beneficiary designations, I raised one potentially controversial provision of RESA around shortening the time period in which an account holder’s beneficiaries must withdraw funds from an inherited retirement account.  There are some additional RESA items, however, that may be more widely acceptable. 

Under current law, an individual cannot make a contribution to a traditional IRA after reaching age 70.5.  RESA would remove that limitation and allow individuals of any age to make deductible additions to their IRA, assuming they otherwise qualify.  With life expectancies increasing and individuals working well into their seventies, often due to inadequate retirement planning at an earlier age, encouraging continued contributions to a retirement plan makes sense.  RESA does not, however, include any change in the provision that requires such individuals to begin making withdrawals from their retirement accounts after reaching age 70.5.  If one of the purposes of the proposed change is to recognize that individuals are working longer to save for retirement, some wonder whether it makes sense to also acknowledge that these individuals working beyond traditional retirement age might not yet want to begin withdrawing from their retirement savings.

Another notable provision of RESA would give smaller employers the flexibility to band together to form multiple employer retirement plans (MEPs).  Factors such as the cost of setting up a plan and the ongoing compliance and maintenance of a plan are barriers or perceived barriers to entry for many employers who would like to sponsor a retirement plan. MEPs could significantly expand the number of employees covered by an employer sponsored retirement plan as each employer can have different plan designs and its own account within the pooled MEP.  A version of MEPs already exists, but is limited to those employers who share a characteristic such as membership in the same trade group or some degree of common ownership that is not sufficient for them to be treated as traditional “multiemployer” plans.  RESA would significantly expand the number of employers that could utilize a MEP, share administrative and compliance costs and benefit a greater number of employees working for smaller employers whose retirement planning options are limited.  While there are some complexities to MEPs, such as determining what type of data must be tracked among all participating employers versus data counted on an employer by employer level, the potential benefits may outweigh the costs. Employers who have avoided instituting their own plans due to concerns about ongoing investment decisions, tax filing requirements, potential audits and the cost of initiating the plan, now may have retirement offerings that are within reach. In turn, broader access to employer-based retirement plans would be a welcome benefit to those employees who work for smaller employers which previously lacked these resources.

While RESA is the most fleshed-out proposal on the table, there are other indications that retirement accounts and similar savings devices may get a facelift.  For some, there is tension between saving to start a family in the near future and the long-off goals of retirement.  Just when some individuals begin moving into a position of more responsibility and more pay, they are also thinking about saving for a house, saving for college or providing for children.  Such individuals are understandably concerned about earmarking and locking up money for retirement when there are more immediate concerns at hand. 

While lacking in details, House of Representatives Ways and Means Chair Kevin Brady (R-Texas) released Tax Reform 2.0 in late July which sought to address some of these concerns.  This bullet-point “listening framework” is a follow up to the Republican-sponsored tax bill passed in late 2017.  At least part of Tax Reform 2.0 is focused on expanding ways for individuals to save in a tax-advantaged manner while allowing increased flexibility in the ways those funds are used. 

One proposal included in Tax Reform 2.0 is a “baby-savings” option. This proposal would permit families to make penalty-free withdrawals from a retirement account to pay for expenses related to the birth or adoption of a child.  The individual could later replenish the amount withdrawn from the account.  Another provision would expand the breadth of tuition-savings 529 plans, permitting parents to use the saved funds for their children’s home schooling and apprentice fees if a child decides to learn a trade rather than attend a traditional college or university.

A more sweeping concept in Tax Reform 2.0 calls for “universal savings accounts”.  While retirement accounts, tuition-savings devices and health-insurance savings accounts offer tax advantages, they all come at a cost relative to the flexibility of accessing those funds.  Unlike these types of accounts, universal savings accounts would allow for deposit of after-tax money into accounts that grow tax free and permit withdraws to be made on a tax-free and penalty-free basis.  While the proposal makes these accounts available to anyone, it is likely that the benefits or use of such accounts would be phased out by income level, a cap on the amount that may be contributed and other criteria.  Similar plans have been instituted in other countries such as Canada and the U.K.  While Republicans are generally fans of such plans, others are critical of the concept.  One objection is that such accounts would merely result in those wealthy enough to save money in taxable accounts moving those funds into nontaxable accounts.  As a result, tax revenues might decrease.  Critics also fear that such accounts would make it easier for individuals to abandon retirement planning all together in order to use saved funds to take care of emergency items such as a new HVAC system or on luxury items such as vacations.

With concerns about the solvency of the social security system and healthcare costs associated with retirement, there is significant interest in encouraging Americans to save more. To many, the current retirement savings system is complex and has a language all its own: industry specific acronyms and terms such as SEPs, Roth-IRAs, 401k’s, profit sharing plans, defined benefit plans, Keough plans, 403b plans, SIMPLE IRAs, RMDs, RBDs, 10% penalties on early withdrawals, eligible rollover distributions, employer matches, vesting schedules, and qualified beneficiaries are not easy to understand and make retirement planning difficult to navigate. While it is important to consider the potential political and economic implications of revamping tax-advantaged accounts, a push for a greater level of simplicity in savings vehicles and encouraging broader access to employer-sponsored retirement are factors that could allow more Americans to work toward long-term financial security. 

Reprinted with permission from the August 27, 2018 issue of The Legal Intelligencer. 
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. 
All rights reserved.

Tuesday, June 26, 2018

Enough With Arbitration Provisions: Litigators Hate Them and GCs Should Too


Arbitration provisions are a common feature of commercial transactions for businesses trying to alleviate the burdens of litigation. In-house and transactional attorneys routinely include arbitration provisions in all flavors of commercial agreements. To put it bluntly: please stop. The professed benefits of arbitration in commercial cases are frequently overstated. Proponents of arbitration argue that it is cheaper and faster than litigation with “expert” arbiters rendering final decisions. Careful examination of these claims suggests that they are an unpersuasive justification for a process that should not be incorporated wholesale into every transaction. This article examines four of the most common justifications for arbitration and suggests examination of the knee-jerk impulse to include arbitration provisions in commercial agreements.

Arbitration is Cheaper

The first fallacy of arbitration proponents is the claim that arbitration is cheaper than litigation. Not true. For a nominal filing fee, litigants can access the full infrastructure of the state and federal court systems. The cost of the judges, law clerks, administrative staff and the court house are all subsidized by taxpayers. Arbitrators charge by the hour, the arbitration provider often charges by the size of the claim and the parties may have to pay a room charge. In practice, it is difficult to complete a single arbitrator arbitration of any size for less than $25,000 in costs. Despite the financial realities of arbitration, attorneys routinely include arbitration provisions that require a three-arbitrator panel in contracts even where the amount of the transaction is likely less than the costs associated with paying the arbitrators.

Proponents of arbitration also claim that legal fees are less when compared with the costs associated with a trial. There is nothing to suggest, however, that an attorney preparing to appear before an arbitrator can prepare any less thoroughly than an attorney representing a client at trial. Moreover, the “arbitration-is-cheap” folks also tend to overlook the possibility of significant litigation associated with getting a case into arbitration. Although courts favor arbitration, such preference must yield to the agreement of the parties as expressed in the arbitration provision. It is not uncommon to litigate the scope and validity of an arbitration clause as a prelude to submitting the case to arbitration. The Pennsylvania Rules of Appellate Procedure make an order denying a motion to compel arbitration or granting a stay of arbitration immediately appealable by right.  Arguing about whether a claim is subject to arbitration and the terms of such arbitration invites a sideshow that can easily dissipate any cost savings realized by the decision to arbitrate.

You Get a Highly Qualified Subject Matter Expert

A common justification for commercial arbitration is the notion that the arbitrator will be a “subject-matter expert” – one that will clearly do a better job than a judge or jury that has no similar expertise. The ideal “subject-matter expert” is a person experienced in deciding cases who can make intellectually honest, clear and decisive decisions. Most arbitrators are lawyers with little subject matter expertise except in the law. Lawyering skills are not necessarily congruent with judicial skills; claiming that they are overlooks the skills and temperament required of a judge and the time it takes to develop them. Crafting arguments and evaluating arguments are not the same thing.

While the “expertise” of lawyer-arbitrators may raise doubts, there are situations in which a specialized expertise – beyond familiarity with the law – may be warranted. It may be more efficient to resolve a dispute with a securities broker in front of a panel that already understands how securities work. Even if a specialized subject matter arbitrator is warranted, such experts may be difficult to find.  Successful industry specific experts are often working in their industries, not serving as arbitrators.

Most commercial litigation, however, does not fall into this category. Commercial litigation comes in a variety of flavors – contracts, fiduciary duties, “business torts” – with widely varying facts that are not easily susceptible to a standardized response. Such cases are commonplace in both the federal courts and Philadelphia’s Commerce Program and judges and juries have resolved them for hundreds of years. Judges and juries can provide a sense of the reasonable expectations or behavior of the parties in similar circumstances. Although there are always (usually well reported) examples of juries doing crazy things, juries get it right most of the time.  Commercial disputes can be complicated but the best litigators find the common-sense proposition in complicated fact patterns and convey it in a way that provides context and relevance.

Arbitrators are also subject to certain pressures that judges are not. Professional arbitrators make money by conducting arbitrations. Leaving one party totally defeated at an arbitration reduces the odds of any repeat business from the losing attorney or their friends. It also brands the arbitrator with being plaintiff or defendant friendly, further reducing the odds of future appointments. This is not fair to the arbitrator who has diligently applied the law to the facts but it is the state of the world. As a result, many arbitrators tend to “split the baby” when it should not be split.

Discovery is Less Painful

The next purported benefit of arbitration is that discovery is shorter and more efficient, thereby achieving cost savings and a prompt resolution. There is nothing about arbitration that suggests that the parties will employ “discovery lite.” Many commercial disputes simply require elaborate discovery. There is nothing inherent in the arbitration process that reduces the discovery grind. Discovery can be just as contentious in arbitration as it is in litigation, or perhaps even more so due to the lack of detailed rules of civil procedure.

In litigation, judges have the power to limit the scope of discovery to prevent undue hardship, harassment or delay. Even before the 2015 amendments to FRCP 26, both state and federal judges engaged in a “proportionality” analysis when evaluating discovery requests. Without the benefit of detailed rules of civil procedure, the scope of discovery in arbitration depends in large part on the discretion of the arbitrator.  In the event of a dispute between the parties on the scope of discovery, arbitrators may choose to look to the rules of civil procedure, his or her own experience or anything else. There is nothing to prevent an arbitrator from allowing wide-ranging, multi-round discovery, increasing costs for all parties.  

Attorneys in the “discovery-is-a-breeze-in-arbitration” group sometimes fail to appreciate the additional annoyance associated with compelling unwilling third-parties to produce information or dealing with an opponent’s unwarranted machinations. Arbitrators lack a court’s power to compel compliance with third-party subpoenas. As a result, extracting information from a third-party often requires the initiation of litigation anyway. Although arbitrators have some ability to punish parties who do not participate in discovery in good faith, many arbitrators are reluctant to do so. 

Forward thinking corporate counsel may try to avoid such discovery tsunamis by including parameters for discovery within the provisions authorizing arbitration. But limitations that seem like a good idea when drafting an agreement can backfire if your client is the one that needs the deposition or the e-discovery to advance or defend their case. Given the extremely liberal pleading procedures that the arbitration rules provide, there is often an enhanced need for discovery in arbitration that makes any contractual limitation on the scope problematic.

Arbitration is Final

The finality of arbitration is often touted as one of its benefits. This justification is based on the unsound premise that finality is always desirable. It is only desirable if you are happy with the result or the costs of continued litigation is likely to eclipse the eventual outcome of the litigation. A party that has lost because of an arbitrator’s error has cause for concern about the finality of the proceeding; elimination of a right to appeal merely adds salt to the wound. In recognition of the perceived unfairness of such an outcome, the AAA rules now contemplate that parties may agree to make an arbitration award appealable to another panel of arbitrators.

Even absent an explicit appeal provision, a disappointed party may attempt to set aside an arbitration award by showing arbitrator bias, fraud, obvious miscalculation and other narrow categories of complaints. Although overturning the arbitration decision may have poor odds of success, the appeal may be disruptive and costly to the non-appealing party. If a trial court elects not to set aside the arbitration decision, the disappointed party may seek to appeal from that decision. Thus, a disappointed party in arbitration has two chances to set aside an award – first to the trial court, then to the intermediate appellate court – before it reaches an appellate court with discretionary jurisdiction. Conversely, a party that began its litigation in the court system has typically only one appeal before it reaches a court with discretionary jurisdiction.

The Take Away

Arbitration is not always inappropriate for commercial disputes. Confidentiality, speed and other justifications may make it the preferred method of dispute resolution in certain circumstances. It is equally true, however, that arbitration does not always performed as advertised. It is sometimes more expensive, less efficient and less effective than it might initially be intuited. A thoughtful and deliberate comparison of the costs and benefits of both arbitration and litigation will lead to more efficient dispute resolution that better serves the interests of all parties. 

Reprinted with permission from the June 20, 2018 issue of The Legal Intelligencer. © 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.

Tuesday, April 24, 2018

'Pittsburgh History': Boring Name, Big Development for Attorney-Client Privilege


You represent a privately held corporation considering a restructuring. You believe that the proposed transaction would violate the securities laws and advise the board of directors accordingly. The board, however, disregards your advice and proceeds with the transaction anyway. It violates the securities laws as you advised and several shareholders initiate derivative claims against the board on behalf of the company. The plaintiffs propound discovery seeking your communications with the board related to the transaction. Can the company assert the attorney-client privilege against plaintiffs? Pennsylvania courts have been surprisingly quiet on this common issue until recently.

A company’s assertion of privilege against a derivative plaintiff creates the unusual problem of a client asserting privilege against those purporting to act on the client’s behalf. Moreover, the people invoking the privilege for the corporation are generally the same people whose conduct gave rise to the derivative claim. Allowing defendants to invoke the company’s privilege may deprive derivative plaintiffs of the information they need to vindicate the company’s interests.  A rule that allows a derivative plaintiff free access to otherwise privileged communications may impact the corporate client’s willingness to seek legal advice for fear that the request or the advice could later be used against it.

Any discussion of a corporation’s assertion of attorney-client privilege in the context of shareholder litigation begins with Garner v. Wolfinbarger, 430 F.2d 1093 (5th Cir. 1970). In Garner, a class of shareholders brought a derivative action on behalf of a corporation against various officers, directors and controlling persons. The plaintiffs sought communications between the corporation and its counsel relating to the conduct giving rise to the plaintiffs’ claims. The corporation asserted the attorney-client privilege seeking to prevent disclosure of the communications. Both the corporation and the American Bar Association, as amicus curiae, asserted that the corporation had an absolute right to assert attorney-client privilege in such circumstances. The plaintiffs took the equally extreme position that the privilege simply does not apply in the context of derivative claims.

The U.S. Court of Appeals for the Fifth Circuit rejected both positions and adopted a “goldilocks” approach that affirmed the applicability of the attorney-client privilege for a corporation involved in litigation with its shareholders, but allowed shareholder plaintiffs to pierce the privilege for good cause: The attorney-client privilege still has viability for the corporate client. The corporation is not barred from asserting it merely because those demanding information enjoy the status of stockholders. But where the corporation is in suit against its stockholders on charges of acting inimically to stockholder interests, protection of those interests as well as those of the corporation and of the public require that the availability of the privilege be subject to the right of the stockholders to show cause why it should not be invoked in the particular instance.

The court identified a nonexclusive list of “indicia” used to evaluate whether a derivative plaintiff has good cause for piercing the attorney-client privilege: the number of shareholders and the percentage of stock they represent; the bona fides of the shareholders; the nature of the shareholders’ claim and whether it is obviously colorable; the apparent necessity or desirability of the shareholders having the information and the availability of it from other sources; whether, if the shareholders’ claim is of wrongful action by the corporation, it is of action criminal, or illegal but not criminal, or of doubtful legality; whether the communication related to past or to prospective actions; whether the communication is of advice concerning the litigation itself; the extent to which the communication is identified versus the extent to which the shareholders are blindly fishing; and the risk of revelation of trade secrets or other information in whose confidentiality the corporation has an interest for independent reasons. Both the Restatement (Third) of the Law Governing Lawyers and the American Law Institute’s Principle of Corporate Governance: Analysis and Recommendations also adopted the substance of Garner.

There are two Pennsylvania cases addressing Garner. They reached contrary results and have not settled the law in this area. In Agster v. Barmada, 43 Pa. D. & C.4th 353, 359–60 (Com. Pl. 1999), Judge R. Stanton Wettick addressed a dispute among owners of a closely held business. A minority shareholder of a medical practice sued the majority shareholder for a variety of claims related to the majority’s diversion of business away from the practice. The minority shareholder plaintiff sought communications between the majority shareholder and the corporation’s counsel arguing that the attorney client-privilege does not apply to such communications. The court rejected this argument and prevented disclosure of the communication. Reasoning that the Pennsylvania Supreme Court had never recognized a conditional attorney-client privilege, the court expressly rejected Garner’s “good cause” analysis as inconsistent with Pennsylvania law.

The only Pennsylvania appellate court to address the attorney-client privilege in the context of derivative litigation did so on an unusual fact pattern. In Pittsburgh History & Landmarks Foundation, 161 A.3d 394 (Pa. Commw. Ct. 2017), a group of former board members of two related nonprofit corporations asserted derivative claims against the president and current board members alleging a variety of misconduct. In response to the lawsuit, defendants formed a committee to evaluate whether the derivative action was in the best interest of the nonprofit corporations. The committee determined that the litigation was not in the best interest of the corporations and defendants filed a motion to dismiss the derivative claims on that basis. The plaintiffs sought all the information provided to the investigative committee, including communications with counsel that would otherwise be privileged. The Commonwealth Court explicitly rejected the holding in Agster and adopted Garner’s “good cause” analysis. It emphasized that the possible exception to privilege only applied to communications that were “roughly contemporaneous with the events giving rise to the litigation,” presumably excluding communications that occur after a derivative plaintiff files suit.

The Pennsylvania Supreme Court granted cross-petitions for allowance of appeal from the Commonwealth Court’s decision and heard oral argument on April 11. If upheld, Pittsburgh History has obvious implications for both derivative plaintiffs and corporate counsel. For the derivative plaintiff, the case provides the potential to access a variety of highly relevant communications regarding the conduct that gave rise to their claims. For corporate counsel, the case injects uncertainty as to whether the attorney-client privilege will apply to communications with a corporation in the event of shareholder litigation. Counsel should advise their client of this possibility and, in the context of a closely held company, consider whether a majority owner should obtain personal counsel in circumstances where the majority owner wants to ensure the application of the privilege.

Reprinted with permission from the April 20, 2018 issue of The Legal Intelligencer. 
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. 
All rights reserved.

Wednesday, March 28, 2018

What You Need to Know When Representing a Minority Shareholder in a Corporate Dispute


You represent a minority shareholder of a closely-held corporation and the company is having an off year. The majority shareholder is the sole member of the board and serves in every officer position. She draws significant compensation. Without a business justification, she decides to double her salary and have the company pay the mortgage on her vacation home. Your client is the only other shareholder and likely the only person hurt by the majority shareholder’s self-declared raise. Although the minority shareholder suffers a clear injury, characterizing the injury as direct or derivative can have a significant impact on the outcome of the litigation.

Until recently, minority shareholders in closely-held companies could assert claims for breach of fiduciary duty and corporate waste directly against the majority owner. If the claimant was successful, a court could order the majority shareholder to disgorge the spoils of her behavior and pay them to the minority shareholder. This type of direct recovery is no longer permissible.  Since 2014, Pennsylvania courts have made clear that claims arising from breach of the duties owed to a corporation, even a closely-held one, belong to the corporation and must be asserted on a derivative basis. This requirement creates procedural and substantive complexities when compared to direct claims. Bringing such claims requires strategic and creative analysis and careful attention to detail.

Without a shareholder’s agreement, minority shareholders are largely at the mercy of the majority shareholder. Minority shareholders have no formal ability to direct how the company spends money, compensates employees or hires vendors. Some majority owners use their power to disadvantage the minority shareholder by excessively compensating themselves or causing the corporation to contract with vendors affiliated with the majority on unfair terms. Although the minority shareholder is the party ultimately damaged by this behavior, the Pennsylvania Business Corporation Law (“BCL”) makes clear that “[t]he duty of the board of directors … is solely to the business corporation … and may not be enforced directly by a shareholder.” To obtain redress for the majority shareholder’s misconduct, the minority shareholder is therefore required to assert their claims on a derivative basis on behalf of the corporation. 

In this regime, attorneys representing minority shareholders are required to look for opportunities to assert direct claims in lieu of derivative claims. The same facts that support a derivative claim may also be the basis of a direct claim. This is particularly common when the minority shareholder is involved in the operation of the business.  For example, claims arising from the wrongful termination of a minority shareholder’s employment may form the basis of a direct claim on behalf of the minority shareholder, as well as a derivative claim against the majority shareholder for the breach of duty of care owed to the company. 

Shareholder oppression claims are direct claims and may provide a viable method for a minority shareholder to obtain an individual recovery. Pennsylvania has long recognized that a majority shareholder has a quasi-fiduciary duty not to use their power in such a way as to exclude the minority shareholder from the “benefits accruing from the enterprise.” Carefully structured, a shareholder oppression claim can often address the same conduct that a court might otherwise classify as giving rise to a derivative claim. A claim that a majority shareholder increased their compensation to a level that leaves no profits available to be distributed to shareholders is likely a direct shareholder oppression claim. It may also be a derivative claim if the compensation is excessive by objective measure.

Fraud claims against majority shareholders may also be asserted directly if they arise from a misrepresentation made to the minority shareholder. The misrepresentation, however, must not be related to malfeasance in relation to the company. For example, misrepresenting the financial status of the business to induce a minority shareholder to invest additional capital that is subsequently lost is likely a direct claim. Falsely representing the terms of the majority shareholder’s excessive compensation is likely derivative because it is so closely related to the breach of the majority’s duty owed to the company itself.

When developing claims, keep in mind that counsel’s labeling of claims in pleadings as direct or derivative is not dispositive. Courts look to the substance of the allegations to determine the nature of the wrong.

The distinction between direct and derivative claims presents a variety of challenges in the context of closely-held business disputes. Recognizing the issue at that outset of the litigation and developing theories for asserting direct claims is critical to the successful representation of the minority shareholder.

Reprinted with permission from the February 28, 2018 issue of The Legal Intelligencer.
© 2018 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.