U.S. Supreme Court Rejects Gender Discrimination Class Action Against Wal-Mart

Posted earlier this week at the National Law Review by the Labor and Employment Group of Sheppard, Mullin, Richter & Hampton LLP a good overview of the implications of the Wal-Mart Stores, Inc. v. Dukes case. 

On June 20, 2011, the United States Supreme Court released its widely-anticipated decision in Wal-Mart Stores, Inc. v. Dukes, et al., 564 U.S. ___ (2011) (“Wal-Mart“). In Wal-Mart, the Supreme Court reversed the Ninth Circuit Court of Appeals and held that the proposed nationwide gender discrimination class action against the retail giant could not proceed. In a decision that will come as welcome news to large employers and other frequent targets of class action lawsuits, the Supreme Court (1) arguably increased the burden that plaintiffs must satisfy to demonstrate “common questions of law or fact” in support of class certification, making class certification more difficult, especially in “disparate impact” discrimination cases; (2) held that individual claims for monetary relief cannot be certified as a class action pursuant to Federal Rule of Civil Procedure 23(b)(2), which generally permits class certification in cases involving claims for injunctive and/or declaratory relief; and (3) held that Wal-Mart was entitled to individualized determinations of each proposed class member’s eligibility for backpay, rejecting the Ninth Circuit’s attempt to replace that process with a statistical formula.

The named plaintiffs in Wal-Mart were three current and former female Wal-Mart employees. They sued Wal-Mart under Title VII of the federal Civil Rights Act of 1964, alleging that Wal-Mart’s policy of giving local managers discretion over pay and promotion decisions negatively impacted women as a group, and that Wal-Mart’s refusal to cabin its managers’ authority amounted to disparate treatment on the basis of gender. The plaintiffs sought to certify a nationwide class of 1.5 million female employees. The plaintiffs sought injunctive and declaratory relief, punitive damages, and backpay.

The trial court and Ninth Circuit had agreed that the proposed class could be certified, reasoning that there were common questions of law or fact underFederal Rule of Civil Procedure 23(a), and that class certification pursuant to Rule 23(b)(2) – which permits certification in cases where “the party opposing the class has acted or refused to act on grounds that apply generally to the class, so that final injunctive relief or corresponding declaratory relief is appropriate respecting the class as a whole” – was appropriate because the plaintiffs’ claims for backpay did not “predominate.” The Ninth Circuit had further held that the case could be manageably tried without depriving Wal-Mart of its due process rights by having the trial court select a random sample of claims, determine the validity of those claims and the average award of backpay in the valid claims, and then apply the percentage of valid claims and average backpay award across the entire class in order to determine the overall class recovery.

The Supreme Court reversed. A five-justice majority concluded that there were not common questions of law or fact across the proposed class, and hence Federal Rule of Civil Procedure 23(a)(2) was not satisfied. Clarifying earlier decisions, the majority made clear that in conducting this analysis, it was permitted to consider issues that were enmeshed with the merits of the plaintiffs’ claims. The majority then explained that merely reciting common questions is not enough to satisfy Rule 23(a). Rather, the class proceeding needs to be capable of generating “common answers” which are “apt to drive the resolution of the litigation.” The four-justice dissent criticized this holding as superimposing onto Rule 23(a) the requirement in Rule 23(b)(3) that “common issues predominate” over individualized issues. The dissent believed that the “commonality” requirement in Rule 23(a) could be established merely by identifying a single issue in dispute that applied commonly to the proposed class. Because the trial court had only considered certification under Rule 23(b)(2), the dissent would have remanded the case for the trial court to determine if a class could be certified under Rule 23(b)(3).

The majority held that the plaintiffs had not identified any common question that satisfied Rule 23(a), because they sought “to sue about literally millions of employment decisions at once.” The majority further explained that “[w]ithout some glue holding the alleged reasons for all those decisions together, it will be impossible to say that examination of all the class members’ claims for relief will produce a common answer to the crucial question why was I disfavored.”

Addressing the plaintiffs’ attempt to provide the required “glue”, the majority held that anecdotal affidavits from 120 class members were insufficient, because they represented only 1 out of every 12,500 class members, and only involved 235 out of Wal-Mart’s 3,400 stores nationwide. The majority also held that the plaintiffs’ statistical analysis of Wal-Mart’s workforce (which interpreted data on a regional and national level) was insufficient because it did not lead to a rational inference of discrimination at the store or district level (for example, a regional pay disparity could be explained by a very small subset of stores). Finally, the majority held that the “social framework” analysis presented by the plaintiffs’ expert was insufficient, because although the expert testified Wal-Mart had a “strong corporate culture” that made it “vulnerable” to gender discrimination, he could not determine how regularly gender stereotypes played a meaningful role in Wal-Mart’s employment decisions, e.g., he could not calculate whether 0.5 percent or 95 percent of the decisions resulted from discriminatory thinking. Importantly, the majority strongly suggested that the rigorous test for admission of expert testimony (the Daubert test) should be applied to use of expert testimony on motions for class certification.

The Court’s other holdings were unanimous. For one, the Court agreed that class certification of the backpay claim under Rule 23(b)(2) was improper because the request for backpay was “individualized” and not “incidental” to the requests for injunctive and declaratory relief. The Court declined to reach the broader question of whether a Rule 23(b)(2) class could ever recover monetary relief, nor did it specify what types of claims for monetary relief were and were not considered “individualized.” The Court made clear, however, that when plaintiffs seek to pursue class certification of individualized monetary claims (such as backpay), they cannot use Rule 23(b)(2), but must instead use Rule 23(b)(3), which requires showing that common questions predominate over individual questions, and includes procedural safeguards for class members, such as notice and an opportunity to opt-out.

Lastly, the unanimous Court agreed that Wal-Mart should be entitled to individualized determinations of each employee’s eligibility for backpay. In particular, Wal-Mart has the right to show that it took the adverse employment actions in question for reasons other than unlawful discrimination. The Court rejected the Ninth Circuit’s attempt to truncate this process by using what the Court called “Trial by Formula,” wherein a sample group would be used to determine how many claims were valid, and their average worth, for purposing of extrapolating those results onto the broader class. The Court disapproved of this “novel project” because it deprived Wal-Mart of its due process right to assert individualized defenses to each class member’s claim.

Looking forward, the Wal-Mart decision will strengthen the arguments of employers and other companies facing large class action lawsuits. In particular, the decision reaffirms that trial courts must closely scrutinize the evidence when deciding whether to certify a class action, especially in “disparate impact” discrimination cases. Statistical evidence that is based on too small a sample size, or is not well-tailored to the proposed class action, should be insufficient to support class certification. Likewise, expert testimony that is over-generalized and incapable of providing answers to the key inquiries in the case (here, whether a particular employment decision was motivated by gender discrimination) should also be insufficient to support class certification. Finally, the Court’s holding that defendants have the right to present individualized defenses as to each class member, and that this right cannot be short-circuited through statistical sampling, will provide defendants with a greater ability to defeat class certification where such individualized determinations would otherwise prove unmanageable.

Copyright © 2011, Sheppard Mullin Richter & Hampton LLP.

U.S. Supreme Court: Federal Court Could Not Enjoin State Court from Addressing Class Certification Issue

Posted yesterday at the National Law Review by Scott T. Schutte of Morgan, Lewis & Bockius LLP a great overview of  the U.S. Supreme Court’s recent ruling  in Smith v. Bayer Corp.   

In a decision with implications for companies facing class action litigation, the U.S. Supreme Court ruled unanimously that a federal district court, having rejected certification of a proposed class action, could not take the additional step of enjoining a state court from addressing a motion to certify the same class under state law. In an opinion authored by Justice Kagan, the Court inSmith v. Bayer Corp.No. 09-1205, 564 U.S. ____ (June 16, 2011), held that principles of stare decisis and comity should have governed whether the federal court’s ruling had a controlling or persuasive effect in the later case, and the state court should have had an opportunity to determine the precedential effect (if any) of the federal court ruling.

Facts of Bayer

In Bayer, a plaintiff sued in West Virginia state court alleging that Bayer’s pharmaceutical drug Baycol was defective. After removal to federal court, the plaintiff moved to certify the action as a class action on behalf of all West Virginia purchasers of Baycol. The federal court rejected class certification because proof of injury from Baycol would have required plaintiff-specific inquiries and therefore individual issues of fact predominated over common issues. It then dismissed the plaintiff’s claims on independent grounds.

A different plaintiff, who had been a putative class member in the first action and was represented by the same class counsel in the federal action, moved to certify the same class in West Virginia state court. Bayer sought an injunction from the federal court in the first case, arguing that the court’s rejection of the class bid should bar the plaintiff’s relitigation of the same class certification question in state court. The district court granted the injunction, and the Circuit Court affirmed.

The Supreme Court’s Decision

The issues before the Court were (i) the district court’s power to enjoin the later state-court class action to avoid relitigation of the previously decided classcertification determination; and (ii) whether the federal court’s injunction complied with the Anti-Injunction Act, 28 U.S.C. § 2283, which permits a federal court to enjoin a state court action when necessary to “protect or effectuate its judgment.” The Court granted certiorari to resolve a circuit split concerning the application of the Anti-Injunction Act’s relitigation exception.

The Supreme Court overturned the injunction. It determined that enjoining the state court proceedings under the circumstances of the case was improperly “resorting to heavy artillery.” The Court noted that “[d]eciding whether and how prior litigation has preclusive effect is usually the bailiwick of the second court.” It observed that a federal court may under the relitigation exception to the Anti-Injunction Act enjoin a state court from relitigating an already decided issue-including whether to certify a case as a class action-when two conditions are met: “First, the issue the federal court decided must be the same as the one presented in the state tribunal. And second, [the party in the later case] must have been a party to the federal suit, or else must fall within one of a few discrete exceptions to the general rule against binding nonparties.” Notably, the Court commented that, in conducting this analysis, “every benefit of the doubt goes to the state court” being allowed to determined what effect the federal court’s prior ruling should be given.

The Court held that neither condition was met in Bayer. The issue of class certification under West Virginia’s Rule 23 (the language of which mirrored Federal Rule of Civil Procedure 23) was not “the same as” the issue decided by the federal court because the West Virginia Supreme Court had expressly disapproved of the approach to the “predominance” analysis adopted by federal courts interpreting the federal class action rule. In addition, the Court also held that unnamed persons in a proposed class action do not become parties to the case if the court declines to certify a class. By contrast, the Court affirmed the established rule that “a judgment in a properly entertained class action is binding on class members in any subsequent litigation.”

According to the Court, Bayer’s “strongest argument” centered on a policy concern that, after a class action is disapproved, plaintiff after plaintiff may relitigate the class certification issue in state courts if not enjoined by the original court. The Court suggested that these concerns were ameliorated by the Class Action Fairness Act of 2005, through which Congress gave defendants a right to remove to federal court any sizable class action involving minimal diversity of citizenship. The Court noted the availability of consolidating certain federal class actions to avoid inconsistent results and offered that the Class Action Fairness Act’s expanded federal jurisdiction should result in greater uniformity among class action decisions and in turn reduce serial relitigation of class action issues.

Implications of Bayer

Bayer exposes defendants to the potential for repetitive class action litigation by plaintiffs in state courts. Bayer does not alter existing standards for class certification, however, and its holding is a limited one: a defendant who has defeated class certification may not invoke the “heavy artillery” of an injunction against future state-court bids for class certification in a case raising the same legal theories unless that future bid is advanced by the same named plaintiff(s) (or a person who falls within one of the few discrete exceptions to the general rule against binding nonparties) and the defendant can establish that state standards for class certification are similar to Federal Rule 23. In this regard, the Court held that “[m]inor variations in the application of what is in essence the same legal standard do not defeat preclusion,” but if the state courts would apply a “significantly different analysis” than the federal court, an injunction will not be upheld. The Anti-Injunction Act analysis from Bayer applies directly only where the enjoining court is a federal court and the second court is a state court.

The Bayer opinion also highlights avenues for companies facing serial class actions to mitigate risk. The Court all but acknowledged that “class actions raise special problems of relitigation.” These relitigation problems in the class action context and beyond will remain after Bayer. But a number of strategic steps can be taken to reduce the burdens, expenses, and risks associated with multiple lawsuits. For example, the enactment of the Class Action Fairness Act provides expanded federal jurisdiction over many class actions and therefore permits enhanced removal opportunities for state court class actions. If subsequent class actions are filed and removed, the Court noted that multidistrict litigation proceedings may be available for coordination of pretrial proceedings to avoid repetitive litigation. Even if transfer and consolidation cannot be effectuated, the Court observed that “we would expect federal courts to apply principles of comity to each other’s class certification decisions when addressing a common dispute.”

Finally, the Court’s treatment of absent class members as nonparties to the class certification question in the first action may have significance to other issues in class actions, including often hotly disputed issues relating to communications with putative class members by the defendant before class certification.

Copyright © 2011 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

 

California and Florida Lead Trend of New State-Level Iran Sanctions

Posted this week at the National Law Review by Reid Whitten  of Sheppard, Mullin, Richter & Hampton LLP a good summary of recent  state legislation targeting potential contractors that deal with Iran.  

On June 2, 2011, Florida Governor Rick Scott signed a new state law prohibiting Florida government entities from contracting with companies invested in Iran’s petroleum energy sector.  Florida’s law, and a similar California law that went into effect on June 1, 2011, announce a coming trend of state laws targeting potential contractors that also deal with Iran.  These two laws, and several others on the horizon, present pitfalls for unwary companies as well as unique opportunities for informed, well-advised businesses.

On July 1, 2010, President Obama signed the Comprehensive Iran Sanctions, Accountability, and Divestment Act of 2010 (“CISADA”) into law.  CISADA targets companies invested in Iran’s petroleum sector through provisions prohibiting the U.S. Government from contracting with such companies.  CISADA also permits the states to enact similar prohibitions against state contracts with companies invested in the Iranian petroleum sector.  Within months of enactment of the U.S. law, California and Florida passed their own laws, citing the desire to put further economic pressure on such companies. The legislatures of Oregon, Kansas, and other states are considering similar actions. Arizona also has a prohibition on contracting with companies invested in Iran that became law as part of a 2008 divestment act. Companies, particularly non-U.S. companies, intending to bid on state government contracts need to pay close attention to individual state statues, and review their own investments for connections to Iran’s petroleum energy sector.  U.S.-organized companies are unlikely to have such investments because (except in very narrow circumstances) the pre-existing U.S. economic embargo against Iran prohibits them.

On September 30, 2010, California passed the Iran Contracting Act of 2010 (“California Act”) requiring, among other actions, that the California Department of General Services compile a list of persons or companies involved in business or investment activities in Iran.  The California Act also declares that any person identified as having business or investment activities of $20 million dollars or more in the energy sector of Iran “is ineligible to, and shall not bid on, submit a proposal for, or enter into or renew, a contract with a public entity for goods or services of one million dollars ($1,000,000) or more.”  See Cal. Pub. Contr. § 2203(a)(1) (West 2010). Companies that are notified of their designation as doing significant business in Iran’s petroleum energy sectors must demonstrate to the government’s satisfaction that they should not be so designated. If they fail to do so, they will be subject to the contracting prohibition.

Similarly, the Florida Scrutinized Companies law (“Florida Act”) will take effect July 1, 2011. Under a 2008 Iran divestment act, Florida’s State Board of Administration maintains a “Scrutinized Companies with Activities in the Iran Petroleum Energy Sector List” (“Scrutinized Companies List”). The Florida Act prohibits a Florida state agency or local governmental entity from contracting for goods and services of more than $1 million dollars or more with any company on the Scrutinized Companies List.

The Florida Act requires contractors to certify that they are not on the Scrutinized Companies List before submitting a bid for, entering into, or renewing a contract with, a state agency or local government entity. In addition, any contract entered into or renewed on or after July 1, 2011 must contain a provision allowing for termination of that contract if the company is found to have submitted a false certification. Further, the bill would require the Florida state government to bring a civil action against any company that does not disprove a determination of false certification within a specified time.

The state laws present both a concern and an opportunity for contracting companies. Concerns, in particular, arise because states lack substantial experience in administering international sanctions policy. As a result, Companies may be mistakenly designated as a business significantly invested in Iran’s energy petroleum industry. Individual state resources, already spread thin, may not provide the means accurately to designate the correct companies falling under the new laws’ prohibitions. States are likely to borrow names of possible target companies from Federal CISADA actions and from one another, sometimes without independently verifying the alleged reasons for designating a company. Additionally, we have seen instances of private groups (such as human rights and anti-nuclear activists groups) distributing inaccurate lists of companies alleged to be violating CISADA.

Contracting companies may be presented with an opportunity, however, to get ahead of this trend of state sanctions in a number of ways. If a company receives notice that it is under scrutiny from one state, that company and its counsel can prepare a response that is both tailored and general;  a response that not only answers the initial notice but that can also be repeated to respond to any other notices it might receive from other states in the future. Companies may also have opportunities to communicate with the state administrators of these new laws about their application. Many of these administrators may not have extensive substantive experience with international sanctions policy;  therefore, companies and their counsel, particularly counsel with experience in international sanctions work, would be in a strong position to discuss with state officials the laws and the means of implementation.

Companies intending to contract with any state agencies need to pay close attention to the changing landscape of state-level sanctions laws and remain aware of the continuing risks and opportunities that landscape presents.

Copyright © 2011, Sheppard Mullin Richter & Hampton LLP.

 

Comments to CMS’ 2011 IPPS Proposed Rule are due by June 20th

Posted this week at the National Law Review by Scott J. Thill of von Briesen & Roper, S.C. – a reminder about the comment deadline for  CMS’ 2011 Inpatient Prospective Payment System Proposed Rule  

 

Just a reminder, comments to CMS’ 2011 Inpatient Prospective Payment System Proposed Rule are due by June 20, 2011.  Several notable provisions in the Proposed Rule include:

  • Policies for several hospital quality initiatives, including policies related to the Hospital Readmissions Reduction Program and the Hospital Value-Based Purchasing Program.
  • The addition of contrast-induced acute kidney injury as a hospital acquired condition.
  • The removal of excisional debridement cases from the current MS-DRG and assignment of them to three new MS-DRGs that would provide more accurate, but lower, payment.
  • The creation of two new MS-DRGS for autologous bone marrow transplants.  One MS-DRG would apply to such transplants with complications or comorbidities, while another MS-DRG would apply to such transplants without any complication or comorbidity.
  • Revisions to the rules for determining pension costs for Medicare cost-finding and wage index purposes.
  • Clarification that Medicare’s 3-day/1-day payment window policy applies to both preadmission diagnostic and non-diagnostic services furnished at a physician practice wholly owned or wholly operated by the admitting hospital.
  • The exclusion of patient days and bed days for inpatient hospice services from the Medicare disproportionate share adjustment and indirect medical education adjustment.
  • Clarification of CMS’ “under arrangements” requirements.

You may access the Proposed Rule here.

A summary of the Proposed Rule is available from CMS here.

©2011 von Briesen & Roper, s.c  

IKEA’s Way to Eternal Life: A Deconstruction of the Furniture Giant’s International Tax Practices

Congrats to Julia W. Gin of Santa Clara University School of Law winner of the National Law Review’s Spring Legal Writing Contest!  Julia’s topic discusses IKEA’s Interational Tax Practices

Since its first store in Sweden in 1958, IKEA has rapidly become an international household name.  The large Swedish flag-inspired blue and yellow buildings are a beacon for anyone searching for a wide selection of affordable modern furniture for varying tastes.  On its face, IKEA appears as any other large corporation that has taken the world by storm but with a few notable exceptions.  Firstly, the physical IKEA stores and business operations are owned by an untaxed two-pronged nonprofit foundation in the Netherlands: the Stichting INGKA Foundation and the Stichting IKEA Foundation.  Secondly, the IKEA Concept and IKEA trademark rights are owned by Inter IKEA Systems B.V., which is operated through a variety of companies based in the Dutch Antilles, Luxembourg, and Liechtenstein that are all controlled by IKEA founder Ingvar Kamprad himself and his three sons through the untaxed Interogo Foundation.  Thirdly, Kamprad moved from his hometown in Sweden to Denmark and finally to Switzerland, successfully benefitting from ideal tax regulations, especially the generous Swiss tax breaks for wealthy foreigners.[1]  This is only a brief summary of what is so unique about IKEA, aside from its eccentric founder.

The intricate corporate structure was created to give IKEA eternal life through lessening the international tax impacts and maintaining the foundational IKEA corporate culture.  This paper will disentangle the numerous organizations within the IKEA system while delineating their interrelationships, and explore the current tax practices of IKEA and the tax-induced reasons for this particular setup.

International IKEA Business Structure and Tax Practices

Kamprad registered IKEA as a company in Sweden in 1943.  Soon after IKEA’s booming success within Sweden, Kamprad became concerned with the high Swedish inheritance and wealth taxes, and family squabbles that could potentially tear the company apart.[2]  In his own words, “as an emerging global company, I also had to ensure that we were structured in tax efficient ways to avoid the burden of double taxation.”[3]  Kamprad met with the National Tax Board in Stockholm to discuss IKEA’s departure from Sweden and then with Denmark’s tax board to clarify what the tax benefits would be if he moved IKEA across the Drogden Strait.[4]  In 1973, Kamprad moved the company to Denmark and began the plan to secure IKEA’s immortality.  In his own words:

When the family and I moved abroad, we automatically received permission from the National Bank [of Sweden] to take with us 100,000 kronor[5] per member of the family.  That half-million was enough to start a foundation in Switzerland, where real estate may not be owned by foreigners, and to found a whole series of companies in different countries with different tax regulations—from Switzerland and Holland to Panama, Luxembourg, and the Dutch Antilles.  Our many lawyers quite often had completed registration of companies in their back pockets in reserve, so the process was soon completed and not particularly expensive.  Many of the companies have never been used.[6]

It is unknown how many companies are still unused and in reserve, but there are many organizations currently active in IKEA operations.

The international IKEA business structure involves the following main entities:

  • Stichting INGKA and Stichting IKEA Foundation—will refer to as the IKEA Foundation (Netherlands)
  • INGKA Holding B.V. (Luxembourg)
  • Inter IKEA Systems B.V. (Netherlands)
    • Inter IKEA Holding S.A. (Luxembourg)
    • Inter IKEA Holding (Dutch Antilles)
    • I.I. Holding (Luxembourg)
  • IKANO Group (Liechtenstein)
  • Interogo Foundation (Liechtenstein)

More IKEA entities are involved within the main controlling bodies and there are likely additional IKEA related companies that have either ownership or an interest in IKEA business.[7]

IKEA Business and Ownership Structure

IKEA Foundation (Stichting INGKA and Stichting IKEA Foundation)

Formed in 1982 in Leiden, Netherlands, the IKEA Foundation, made up of the Stichting[8] INGKA and Stichting IKEA foundations, has been the world’s biggest charity since 1984 when Kamprad gave the Foundation the irrevocable gift of 100% of his equity in the company.[9]  

The Netherlands was chosen as an ideal country by a team of lawyers from Switzerland, Denmark, Sweden, France, and England because it had “the oldest and most stable legislation on foundations.”[10]  As an added incentive, Dutch foundations have loose regulations, little oversight, and “are not, for instance, legally obliged to publish their accounts.”[11]

The IKEA Foundation is based on the double Dutch foundation system.  The Stichting INGKA and Stichting IKEA are technically one foundation but operate as two, with Stichting INGKA as the owner foundation and Stichting IKEA as the charitable foundation.[12]  Stichting INGKA holds all the shares in the for-profit INGKA Holding B.V., which is the group of companies that controls all of the IKEA stores worldwide and will be discussed below.[13]  Stichting IKEA is to receive money from the Stichting INGKA arm for distribution towards the fulfillment of the IKEA Foundation’s mission: “to promote and support innovation in the field of architectural and interior design.”[14]  The IKEA Foundation must also “ensure ‘the continuity and growth’ of the IKEA Group” and is required to maintain INGKA Holding B.V.[15]  To ensure this mission is carried out, the IKEA Foundation is run by a five-person executive committee with two seats reserved for the Kamprad family[16] (which is chaired by Kamprad and has also included Kamprad’s wife, Margaretha Stennert) that appoints its own committee members and also appoints the board of directors of INGKA Holding B.V.[17]

The IKEA Foundation is registered in the Netherlands as an “Institution for the General Good”[18] charitable foundation, which is the equivalent of a 501(c)(3) in the United States.[19]  Qualification as a charitable foundation under Dutch law is relatively simple with only a few conditions that need to be met:

  • A request for charitable foundation status filed with the Dutch tax authority
  • The purpose of the foundation is not to generate profit and has a charitable purpose
  • An individual or entity may not use assets as if owned by the individual or entity
  • Board members may not receive remuneration other than costs
  • If dissolved, all funds must go towards a charitable purpose
  • The foundation’s assets must not exceed what is required for a reasonable fulfillment of the foundation’s charitable purpose.[20]

In addition, Dutch charitable foundations receive the following benefits:

  • Gifts are tax deductible for Dutch income and corporate income tax purposes, and are not subject to the Dutch gift tax,
  • Inheritances are not subject to Dutch inheritance tax, and
  • Are not subject to Dutch corporate income tax on any income.[21]

With the IKEA Foundation categorized as a Dutch charitable foundation, they are not required to pay taxes on any income from the IKEA business.  In 2010, IKEA earned almost $4.1 billion[22] and as of 2006 the IKEA Foundations net worth was at least $36 billion[23].  In order to fulfill the mission of “innovation in the field of architectural and interior design”, the IKEA Foundation gave one grant in 2005 to the Swedish Lund Institution for $1.7 million.[24] [25]  Additionally, IKEA’s new BoKlok flat-pack housing could be seen as a contribution to innovating architecture.[26]

Ultimately, any profit made from the INGKA Foundation through its ownership of INGKA Holding B.V. is not taxed in the Netherlands.

INGKA Holding B.V.

INGKA Holding B.V. may be owned by the IKEA Foundation, but is itself a private company registered in Leiden, Netherlands.[27]  INGKA Holding B.V. has physical ownership of the entire IKEA business.  This currently includes “more than 300 stores in 35 countries and more than 130,000 co-workers.”[28]  It is the parent company for the IKEA Group which includes, but is not limited to: IKEA Group Management[29], Swedwood[30], IKEA Services B.V. and IKEA Services AB[31], and IKEA of Sweden[32].[33]  To manage the IKEA Group, INGKA Holding B.V. assigns INGKA International A/S, headquartered in Humlebæk, Denmark, to run the executive functions of INGKA Holding B.V. and to manage international store business.  This includes “purchasing, product range, distribution, sales, and sometimes manufacturing.”[34]

INGKA Holding B.V.’s ownership and control of the physical IKEA stores and business operations is entirely separate from the IKEA Concept, which is exclusively owned by Inter IKEA Systems B.V.

Inter IKEA Systems B.V.

Inter IKEA Systems B.V. is registered in Delft, Netherlands.  It owns the IKEA concept and trademark, and controls the IKEA Concept franchise.[35]  This “Sacred Concept” controls the brand name, copyrights, regulations, and anything else related to the idea of IKEA.[36]  The root of the Concept can be found in Kamprad’s Testament of a Furniture Dealer[37], “to create a better everyday life for the many people by offering a wide range of well-designed, functional home furnishing products at prices so low that as many people as possible will be able to afford them.”[38]

Inter IKEA Systems B.V. is the entity that approves or denies a franchise permit to run any IKEA store.[39]  It also ensures that every franchisee follows the exact IKEA Concept with very specific store designs including the children’s playroom, the restaurant, and the set-up that leads the shopper around the store in a guided pathway.[40]  Store managers must send a written request to deviate from the IKEA Concept, and if the rules are broken without permission Inter IKEA Systems B.V. has the power to stop supplies and have the rogue store’s IKEA sign taken down.[41]

 For its efforts as the IKEA Concept franchisor, Inter IKEA Systems B.V. receives a generous 3% royalty from the global sales from all the IKEA stores worldwide[42], an income of 80 billion Swedish Kronor[43] in the last 20 years.[44]  This figure is expected to rise considering in 2010 “IKEA’s sales grew by 7.7% to 23.1 billion [Euros] and net profit increased by 6.1% to 2.7 billion [Euros].”[45]  Inter IKEA Systems makes large payments to another company registered in Luxembourg called I.I. Holding (unknown ownership and no website), and both companies paid 19 million Euros in taxes in 2004 of a combined profit of 328 million Euros.[46]

Inter IKEA Systems B.V. itself is owned by parent company Inter IKEA Holding S.A. which is registered in Luxembourg, and is also a part of the identically named Inter IKEA Holding S.A. that is registered in the Dutch Antilles.[47]  Until its liquidation in 2009[48], a “trust company” headquartered in Curaçao operated the Inter IKEA Holding S.A. of the Dutch Antilles[49].  Inter IKEA Holding S.A. had post-tax profits of $1.7 billion in 2004.[50]  Further details on Inter IKEA Holding S.A. are discussed below within the context of the Interogo Foundation.

 Inter IKEA Systems B.V. is assisted in preserving the IKEA Concept by the IKANO Group, which is a company owned and controlled by Kamprad’s three sons, Peter, Jonas and Matias.[51]

IKANO Group

The IKANO Group was founded in 1988 and is owned by the Kamprad family with fund assets of 3.4 billion Euros in 2009.[52] [53]  The IKANO Group is based in Liechtenstein, with the vision “to inspire our people to build profitable companies that dare to be different and are fun to work for.”[54]  The IKANO Group contains all of the Kamprad-owned companies that were not given to the IKEA Foundation[55]and is primarily concerned with managing the Kamprad family fortune[56].  Peter, Jonas and Matias are currently on the IKANO Board of Directors with Kamprad listed as a Senior Advisor.[57]  Kamprad gave IKANO to his sons to run as they see fit[58] as separate but in support of the IKEA entity.

 “IKANO fundamentally safeguards the same virtues—simplicity, thrift, and so on—that mark IKEA” through its activities in finance, insurance, retail and property.[59]  Though the finance division is most profitable, the property stock of the IKANO Group will ensure the Kamprad family’s economic security.[60]  Most notably, IKANO had made early investments in shopping centers near IKEA stores[61], which must be extremely lucrative at present day considering the rapid development of the surrounding areas that generally radiates from the opening of new IKEA stores.  Though IKEA and IKANO had absolute ties when Kamprad chaired both entities until 1998[62], it will be no surprise if the two continue a close business relationship.

Initially, it was believed that IKANO was the Kamprad family’s covert ownership and controlling interests in IKEA.  However, with the recent discovery of the Interogo Foundation, it appears that IKANO is indeed an independent and merely supporting entity of IKEA.

Interogo Foundation

According to Kamprad himself, the “Interogo Foundation, based in Liechtenstein, is the owner of the Inter IKEA Holding S.A., the parent company of the Inter IKEA Group…[and] is controlled by my family…”[63]  The Inter IKEA Group includes Inter IKEA Systems B.V. (controls and owns the lucrative IKEA Concept) and Inter IKEA Holding S.A. (which owns Inter IKEA Systems B.V.).  As discussed earlier, the identically named Inter IKEA Holding S.A. of the Dutch Antilles that was operating in Curaçao was liquidated, which can only be done by the owner of the company[64], now known to be the Interogo Foundation.

The Interogo Foundation was created by Kamprad in 1989[65] [66] with the purpose of investing in the expansion of IKEA to ensure its longevity as a method of financial security.[67]

Liechtenstein is a strategic choice for many companies because of its closed system of rules and regulations which lead to its reputation as an international tax-haven[68].  Furthermore, Liechtenstein has “liberal principles of [ ] foundation law” with the purpose of attracting lucrative investments.[69]  Some of the advantages of Liechtenstein foundations include:

  • Political and economic stability, and a central European location
  • A liberal and business-oriented legal system
  • Stringent professional secrecy regulations for banks and trustees
  • Effective methods of preserving family wealth over generations
  • Efficient protection of assets from third parties
  • Efficient international tax planning
  • Flexibility regarding the advancement of charitable purposes, and
  • Discretion and anonymity with regard to the founder’s wishes.[70]

These benefits create the perfect environment for the foundation envisioned by Kamprad to ensure his family would not be plagued by the high inheritance taxes in Sweden.

“[Interogo] Funds could also be used to support individual IKEA retailers experiencing financial difficulties and for philanthropic purposes”[71] as an additional safeguard to IKEA’s immortality.  Liechtenstein law governing charitable foundations follows a “Criterion of Preponderance” which allows a foundation to be classified as charitable if the majority of activities are dedicated to charitable versus private purposes.[72]  The current law defines “charitable” as:

…purposes which help fostering the public benefit… This is especially the case if the activities of the foundation foster the public benefit in the charitable, religious, humanitarian, scientific, cultural, moral, social, sporting or ecological field, even if the activities are only in favour of a determined circle of persons.[73]

A Swedish documentary aired on the Swedish public network SVT on January 26, 2011 by the Uppdrag granskning investigative news program[74] stated that the Interogo Foundation has $15.4 billion in funds.[75]  2010 was the first year in the last two decades of its existence that the foundation published detailed figures on sales, profits, assets, and liabilities.[76]

The Uppdrag granskning documentary further stated that the 3% of IKEA sales royalties from all IKEA stores worldwide that are supposed to go to Inter IKEA Systems B.V. for use of the IKEA Concept and franchise actually goes directly to the Interogo Foundation and is tax-free.[77]  Interogo’s purpose of ensuring IKEA’s prolonged existence and assisting in IKEA’s philanthropic ventures would seem to indicate a mixed family foundation[78] which supports the Kamprad family while also contributing to charitable institutions.  However, if the tax treatment of Interogo’s business venture through Inter IKEA Systems B.V. holds true, this would signify Interogo’s treatment as a purely charitable foundation under Liechtenstein law.  Liechtenstein law does acknowledge that that this is not a typical allowance for foundations:

Foundations, in principle, may not engage in commercial activities.  However, the foundation may pursue commercial trade when this serves the attainment of its non-commercial purpose, or the nature and extent of the foundation’s assets (e.g. the holding of participations) necessitates business operations.[79]

If Interogo’s goal of supporting IKEA’s possible philanthropic projects is upheld by Liechtenstein as its main non-commercial purpose and the ownership of Inter IKEA Systems B.V. necessitates business operations, Interogo would legally not be taxed. 

There is also a supreme focus for Liechtenstein foundations on the intent and purpose of the founder.  The founder provides the purpose of the foundation, which is fixed and unchangeable once the foundation has its own legal personality, and has the sole power to revoke the foundation.[80]  If the founder chooses to revoke the foundation, the assets of the foundation revert to the founder.[81]  The founder may name an “ascertainable class of beneficiaries”, be assisted by a family council, and manage the foundation’s assets personally.[82]  A Liechtenstein foundation may exist indefinitely or until the founder’s purpose is realized.[83]  With Interogo founder Kamprad’s goal of IKEA’s eternal life, Interogo will be in operation for as long as IKEA is in existence, aided by both IKANO and Interogo. 

Additionally, certain bylaws of the foundation leave little doubt that Interogo was intended to be left to its own devices:

  • Documents about the foundation are not allowed be shown to outsiders or foreign authorities
  • Proceeds may be paid in the form of grants to individuals or organizations related to architecture, interior design, and consumer products
  • The Kamprad family has “total control” over the executive board of the Inter IKEA Group[84]

The revelation of Interogo’s existence, control over IKEA, and ownership by the Kamprad family is unfortunate for the founder considering his consistent stance that “he and his family no longer controlled the global furniture giant.[85]”  He has further stated “that his influence over the company is limited and that a Dutch charitable foundation, Stichting INGKA Foundation, directed [IKEA].[86]” [87]

If the Inter IKEA Group owns the IKEA Concept, and the Kamprad-owned Interogo controls the Inter IKEA Group, it follows that Kamprad still has control over the essential part of the IKEA system.  This same ownership is what the public had been led to believe was gifted to the IKEA Foundation that still owns the physical IKEA business, which is arguably worthless without the IKEA Concept. 

Impact to the International Community

Despite the tax-free status of both the IKEA Foundation and the Interogo Foundation, according to Kamprad, the Inter IKEA Group (Inter IKEA Holding S.A. and Inter IKEA Systems B.V.) and the IKEA Group companies pay taxes like any other corporation in every country of operation.[88]  He emphasizes that those operations comply with relevant laws and regulations.[89]

The unique corporate structure of IKEA is likely one of a kind.  However, other companies that may have a similar complex and international configuration would be a challenge for the international community to identify.  Whatever the case, it is clear that international corporations are constantly operating in new and innovative ways leaving lawmakers in all countries racing to keep up.


[1] Kamprad is considered the richest man in the world and benefits from Switzerland’s lump-sum taxation that is only offered to a few thousand foreigners living in Switzerland.  With this taxation system, Kamprad pays 200,000 Swiss francs in taxes annually, which is approximately $215,933 USD according to XE Currency on April 5, 2011 with 1 Swiss franc worth a little over $1 USD. The Public Eye Awards, IKEA Group (2007), http://www.evb.ch/cm_data/
Ikea_e.pdf

[2] Bertil Torekull, Leading by Design 88 (ed. Wahlström & Widstrand 1998) (1999).

[3] IKEA, Ingvar Kamprad comments, (Jan 28, 2011), available athttp://www.ikea.com/at/de/about_ikea/newsitem/
statement_Ingvar_Kamprad_comments.

[4] Id. at 91.

[5] Would be around $15,816.95 USD according to XE Currency on April 4, 2011 with 1 Swedish Kronor worth almost 16 cents USD.

[6] Torekull at 89.

[7] For example, IKEA Catalogue Services AB which is based in IKEA birthplace Älmhult, Sweden is where the 300 plus page IKEA catalogue is created.  It is unknown who owns, controls, or pays IKEA Catalogue Services AB.
IKEA, The IKEA Catalogue – the world’s largest free publication (2003),http://www.ikea.com/ms/en_GB/
about_ikea/press_room/thecatalogue.pdf.

[8] Stichting is Dutch for “foundation”.

[9] IKEAFANS, IKEA Corporate Structure,available athttp://www.ikeafans.com/ikea/ikea-corporate/ikea-corporate-structure.html.

[10] Torekull at 92.

[11] Economist, Flat-pack accounting, (May 11, 2006), available athttp://www.economist.com/node/6919139/.

[12] Id. at 99.

[13] Id.

[14] Economist, Flat-pack accounting.

[15] Id.

[16] IKEA, Ingvar Kamprad comments.

[17] Economist, Flat-pack accounting.

[18] Algemeen nut beogende instelling, acronym ANBI, is Dutch for “institution for general benefit”.

[19] Rich Cohen, Nonprofit Newswire of The Nonprofit Quarterly: The biggest and stingiest foundation in the world, (October 19, 2009), available athttp://www.nonprofitquarterly.org/index.php?option=com_content&view=
article&id=1554:nonprofit-newswire-october-19-2009&catid=155:nonprofit-newswire&Itemid=986

[20] Spigthoff Law Firm, The Legal 500: The Use of Foundations in the Netherlands, (Aug 2008), available athttp://www.legal500.com/c/netherlands/developments/5049.

[21] Id.

[22] Deutsche Welle, Swedish documentary alleges tax fraud by Ikea founder, (Jan 27, 2011), available at http://www.dw-world.de/dw/article/0,,14799699,00.html.

[23] Economist, Flat-pack accounting.

[24] Cohen, Nonprofit Newswire.

[25] IKEA won a Public Eye Global Awards through nominations by SOMO (Stichting Onderzoek Multinationale Ondernemingen, literal English translation: Foundation Research Multinational Companies) in the Netherlands and the Berne Declaration (a corporate social responsibility NGO in Switzerland).  The award cites payment of taxes as a central element of corporate social responsibility and criticizes IKEA’s lack of tax payment for Kamprad’s individual gain and lack of contributions to charitable purposes. Id. and The Public Eye Awards, IKEA Group.

[26] The BoKlok venture is a joint-project between IKEA and the Skansa company to provide cost efficient, sustainable, and low energy consumption track apartments and housing at a low cost for the consumer based on the IKEA model of construction.  BoKlok housing is currently in operation in Sweden, Denmark, Norway, Finland, and the United Kingdom.
BoKlok, The Product Familyavailable at http://www.boklok.com/UK/About-BoKlok/The-BoKlok-Products2/.

[27] Economist, The secret of IKEA’s success: Lean operations, shrewd tax planning and tight control, (Feb 24, 2011), available athttp://www.economist.com/node/18229400.

[28] Inter IKEA Systems B.V., The IKEA Concept: How the IKEA Concept Began 2,http://franchisor.ikea.com/
showContent.asp?swfId=concept3.

[29] IKEA Group Management contains the executives of IKEA, including the President and CEO, Vice President, Head of Human Resources, and other corporate leadership positions.

[30] Swedwood is the group of industrial companies responsible for manufacturing all IKEA products.  This group has concentrated manufacturing in Poland, Slovakia, and Russia but have plants around the world.

[31] IKEA Services B.V. and IKEA Services AB are located in Sweden and the Netherlands and serve to support all the work of the IKEA Group companies.

[32] IKEA of Sweden is located at the birthplace of IKEA in Älmhult, Sweden and is the hub for all of the designers that create and develop the range of IKEA products.

[33] IKEAFANS, Ikea Corporate Structure.

[34] Torekull at 99.

[35] IKEA Fans, Ikea Corporate Structure.

[36] Torekull at 100.

[37] Kamprad wrote The Testament of a Furniture Dealer at the behest of the IKEA staff in Sweden before he emigrated to Denmark.  It includes nine “commandments”: 1. The Product Range is Our Identity, 2. The IKEA Spirit is Strong and Living Reality, 3. Profit Gives us Resources, 4. Reaching Good Results with Small Means, 5. Simplicity Is a Virtue, 6. Doing It a Different Way, 7. Concentration Is Important to Our Success, 8. Taking Responsibility Is a Privilege, and 9. Most Things Still Remain to Be Done—A Glorious Future.  These Kamprad principles serve as a textbook for manager training.  The Testament is published by Inter IKEA Systems B.V. and is given to all new employees.  Torekull at 111-114 and Bloomberg Businessweek, Ikea: How the Swedish Retailer became a global cult brand, (Nov. 14, 2005), available athttp://www.businessweek.com/magazine/content/05_46/b3959001.htm.

[38] Ingvar Kamprad, The Testament of a Furniture Dealer and A Little IKEA Dictionary 6(2007), http://www.emu.dk/
erhverv/merkantil_caseeksamen/doc/ikea/english_testament_2007.pdf.

[39] Torekull at 100.

[40] Id.

[41] Id.

[42] Economist,The secret of IKEA’s success.

[43] Would be over $12 billion USD according to XE Currency on April 4, 2011 with 1 Swedish Kronor worth almost 16 cents USD.

[44] Magnus Svenungsson, Svt.se: Uppdrag Granskning (Mission Review), Granskningen av Ikea ett brett samarbetsprojekt (The review of Ikea, a broad collaborative), (Jan 26, 2011), available at http://svt.se/2.150075/1.2304474/granskningen_av_ikea_ett_brett_samarbet….

[45] Economist, The secret of IKEA’s success.

[46] Economist, Flat-pack accounting.

[47] IKEAFANS, IKEA Corporate Structure.

[48]Magnus Svenungsson, Svt.se: Uppdrag Granskning (Mission Review).

[49] The Public Eye Awards, IKEA Group.

[50] Economist, Flat-pack accounting.

[51] Torekull at 103-4 and 107.

[52] IKANO, Facts & Figuresavailable at http://www.ikanogroup.com/the-group-facts-and-figures.html.

[53] The 1988 foundation date is according to the IKANO Group website, however, in Torekull’s book on IKEA Leading by Design IKANO is said to be one of the many companies founded by Kamprad and his lawyers before his departure from Sweden to Denmark in the 1950s.  Torekull at 104.

[54] IKANO, Our essenceavailable at http://www.ikanogroup.com/the-group-our-essence.html.

[55] Torekull at 104.

[56] IKEAFANS, Ikea Corporate Structure.

[57] IKANO, Group Boardavailable at http://www.ikanogroup.com/the-group-group-board.html.

[58] Torekull at 103-104.

[59] Id. at 105-106.

[60] Id. at 106.

[61] Id.

[62] Id.

[63] IKEA, Ingvar Kamprad comments.

[64] Magnus Svenungsson, Svt.se: Uppdrag Granskning (Mission Review).

[65] The Local: Sweden’s News in English, Ikea founder admits to secret foundation, (Jan 26, 2011), available at http://www.thelocal.se/31650/20110126.

[66] This date is different from the 1980 foundation date that was in a statement by Kamprad released ahead of the documentary according to Deutsche Welle inSwedish documentary alleges tax fraud by Ikea founder.

[67] IKEA, Ingvar Kamprad comments.

[68] Deutsche Welle, Swedish documentary alleges tax fraud by Ikea founder.

[69] Marxer & Partner Rechtsanwälte (Lawyers), The New Liechtenstein Foundation Law: An Overview on the Important Changes, available athttp://www.marxerpartner.com/fileadmin/user_upload/marxerpartner/pdf-dow…. Note: though there were revisions to Liechtenstein Foundation laws (Art. 552-570 Persons and Companies Act (PGR)) that entered into force on Apr 1, 2009, none of these revisions impact foundations created prior to that date.  Additionally, the changes were intended to clarify rules but in no way limit or initiate forceful regulations on Liechtensteiner foundations (ex. the new law necessitates the appointment of an auditor for charitable foundations, which does not apply to Interogo).  The intent was to maintain the country’s attractive laws.

[70] Kaiser Ritter Partner, The Liechtenstein Foundation: Responsibility in Wealth, available at http://www.kaiser-ritter-partner.com/uploads/media/Liechtensteinische_st….

[71] IKEA, Ingvar Kamprad comments.

[72] Marxer & Partner Rechtsanwälte (Lawyers), The New Liechtenstein Foundation Law: An Overview on the Important Changes.

[73] Id. (emphasis added)

[74] The Local: Sweden’s News in English, Ikea founder admits to secret foundation.

[75] Deutsche Welle, Swedish documentary alleges tax fraud by Ikea founder.

[76] Economist, The Secret of IKEA’s success.

[77] Deutsche Welle, Swedish documentary alleges tax fraud by Ikea founder.

[78] Kaiser Ritter Partner, The Liechtenstein Foundation: Responsibility in Wealth.

[79] Id.

[80] Kaiser Ritter Partner, The Liechtenstein Foundation: Responsibility in Wealth.

[81] Marxer & Partner Rechtsanwälte (Lawyers), The New Liechtenstein Foundation Law: An Overview on the Important Changes.

[82] Kaiser Ritter Partner, The Liechtenstein Foundation: Responsibility in Wealth.

[83] Id.

[84] The Local: Sweden’s News in English, Ikea founder admits to secret foundation.

[85] The Local: Sweden’s News in English, Ikea founder admits to secret foundation.

[86] Id.

[87] Despite this claim, it is known that the IKEA store managers are still “trained and groomed by Kamprad himself” at workshops in IKEA mecca, Älmhult. Bloomberg Businessweek, Ikea: How the Swedish Retailer became a global cult brand, (Nov 14, 2005), available athttp://www.businessweek.com/magazine/content/05_46/b3959001.htm.

[88] IKEA, Ingvar Kamprad comments.

[89] Id.

© 2011 Julia W. Gin

The Need for a Detailed Procedure of Judicial Review of Civil Rights Arbitration Awards after Rent-A-Center West, Inc. v. Jackson

Congrats to Nicole Farbes-Lyons of St. John’s University School of Law – winner of the National Law Review Spring Student Legal Writing Contest.  Nicole’s topic  explored several components underlying the Supreme Court’s recent Rent-A-Center decision and the subsequent need for clearer guidance per civil rights arbitration.  

Introduction

The November 17, 2010 New York Times article “Justices Are Long on Words but Short on Guidance” blasted the Supreme Court of the United States for its issuance of sweeping and politically polarized decisions, and criticized the quality of the Court’s “judicial craftsmanship” by positing that “[i]n decisions on questions great and small, the Court often provides only limited or ambiguous guidance to lower courts. And it increasingly does so at enormous length.” [1] The article continued that critics of the Court’s work “point to reasoning that fails to provide clear guidance to lower courts,” and described the Court’s recent rulings as “fuzzy” and “unwieldy.”[2]

In the past, the Supreme Court has been notably divided over issues such as abortion and the death penalty. But the “fuzziness” in many recent rulings is owed to an obvious ideological divide in the area of arbitration. Over the past decades, a significant number of controversial decisions have arisen from the considerable attention (and contention) the Supreme Court has given arbitration as it endeavors to counterbalance pro-arbitration rulings and assurances that arbitration does not erode sufficient, constitutionally proscribed judicial control.[3] However, these decisions have been largely criticized as providing, at best, a fuzzy blueprint for lower courts to design more specific rules.

Rent-A-Center v. Jackson [4] is the most controversial, ideologically split arbitration decision of the Supreme Court’s recent term. The central issue arose because Rent-A-Center requires employees to sign a two-part arbitration agreement as a condition of their employment, stipulating first that all disputes arising out of the employment relationship be settled by arbitration, and second, that an arbitrator must settle all challenges to the validity of the arbitration agreement.[5] When plaintiff Jackson, a Rent-A-Center account manager, brought a 42 USC § 1981(a) / 42 USC §§. 2000(e)(2) employment discrimination claim against the company, Rent-A-Center insisted that the claim be resolved through arbitration.[6]

Jackson argued that the arbitration agreement was unconscionable because it denied him meaningful and appropriate access to court for a satisfactory remedy in the exact way prohibited by federal statute. Rent-A-Center argued that this threshold question of whether there was a valid and fair agreement to arbitrate Jackson’s employment grievance was a matter for the arbitrator under the Federal Arbitration Act. Jackson asserted that because the unconscionability challenge went to both parts of the arbitration agreement, arbitrability of the agreement was a question for the court.

By a vote of five to four, the Supreme Court ruled in Rent-A-Center’s favor. Led by Justice Scalia, the Court held that if Jackson had solely questioned the second part of the contract – that the agreement must be arbitrated – then the challenge would have been proper before the court. But because the employee’s grounds for unconscionability applied equally to the agreement to arbitrate all employment disputes, the general question of unconscionability was no longer a “gateway issue” before the court, and was a matter for the arbitrator.[7]

Though it generated very little media attention, the majority decision in Rent-A-Center incited much sideline animosity. Critics of Rent-A-Center argued that the case is incorrectly decided and the latest, deadliest blow to consumers and employees in a trajectory of pro-arbitration rulings that are supplanting the constitutional right to court access with compulsory arbitration. Lawmakers have admonished the Court’s short-sightedness, and Senate Judiciary Committee Chairman Patrick Leahy referred to Rent-A-Center as “a blow to our nation’s civil rights laws”.[8] Throughout the blogosphere, commentators described Rent-A-Center as “audacious,” and, as Justice Stephens described in his dissent, “fantastic”.[9]

In addition to the political arguments arising from Rent-A-Center, critics also raised concerns about procedural challenges facing professional arbitrators in light of the Court’s holding. The recent case law culminating in Rent-A-Center has drawn criticism for its lack of guidance instructing either the courts or arbitrators about their respective roles within civil rights arbitration. Broad principles of arbitration and specific doctrines of the Supreme Court encourage but do not demand that the federal protections of civil rights statutes must be enforced in private arbitration. Though the Supreme Court gives assurance that courts may reject arbitral awards for “manifest disregard,” in regards to statutory protection, the courts do not agree as to whether a showing of manifest disregard is proper grounds for vacating an arbitration award.[10]

This conundrum is disturbing, and the doctrine culminating in Rent-A-Centercreates, at best, a blueprint for potential interpretations of arbitration agreements and judicial remedies for arbitrable disputes. The question left before the legal community is, then, whether the Supreme Court’s next step will be to clarify a specific process for civil rights arbitration. Until then, the courts will likely remain divided over the issue of whether, and under what circumstances, statute-created court access can be circumvented with compulsory arbitration agreements, without violating due process of law.

This paper will explore several components underlying the Rent-A-Centerdecision and the subsequent need for clearer guidance per civil rights arbitration. First, this paper will prepare the background and context of civil rights arbitration by exploring the legislative history and statutory framework of the Federal Arbitration Act (“FAA”) and the Civil Rights Acts, particularly focusing on 42 USC §1981(a) right to recovery under Title VII of the Civil Rights Act of 1964 (“Title VII”). Second, this paper will introduce problems of separability stemming from the Supreme Court’s efforts to increase the preemptive reach of the FAA under a broad definition of interstate commerce. Finally, this paper will assert potential remedies towards ameliorating the ambiguities that culminate in the Rent-A-Center decision, in light of this judicial and legislative history.

I. Background and Context of Civil Rights Arbitration

A. Statutory History of 42 USC § 1981

The civil right at issue in Rent-A-Center was Jackson’s right to protection against racial discrimination under 42 USC § 1981. During the Reconstruction Era, restrictive employment covenants were an acknowledged social evil used by former slave owners to deny freedmen any opportunity to exercise their rights to property and employment.[11] Recognizing the elements that impaired the emancipated slaves’ ability to obtain a fair trial in former Confederate states, Congress observed that, “To say that a man is a freeman and yet is not able to assert and maintain his right in a court of justice is a negation of terms.”[12]

The framers of the Civil Rights Acts had a specific legislative goal of rooting out discrimination. The Reconstruction Congress determined that the Civil Rights Acts would only have force if the statutes also created a clear mechanism of judicial enforcement, and delineated a remedy at law that would ensure all Americans the right to a fair tribunal.[13] Accordingly, this Congress created statutes providing a federal right to action as protecting against discrimination.[14]

The legislative history behind the Reconstruction Era Civil Rights Acts is not antiquated, and the Supreme Court has recognized that, “ameliorating the effects of past racial discrimination [is] a national policy objective of the highest priority.‟[15]A predominant effect of the Civil Rights Acts, particularly 42 USC § 1981(a), is that federal law prohibits discrimination in employment based on race, gender, disability, and sexual orientation. In 1991, the 102nd Congress expanded the provisions of 42 USC § 1981(a) and subsequent law to provide statutory basis for arbitration and alternative dispute resolution to “the extent available by law.”[16]

B. Statutory History of the Federal Arbitration Act

Formal arbitration practices can be dated to the Middle Ages, and many primary themes continue in modern arbitration: greater confidentiality, group amelioration, arbitrators with particularized commercial expertise, less formality than court proceedings, greater expedition, compromise, judgments that are final in merit, and the idea that, optimally, resolution of the dispute allows the parties to maintain favorable business relationships.

Despite this equitable premise, many difficulties hindered arbitration until the 20th century, such as difficulty in enforcing awards and judicial concern over jurisdictional ouster. In 1920, the New York State legislature enacted the first modern arbitration statute, which was followed in 1925 by enactment of the FAA and, subsequently, the advent of arbitrable statutes in most of the states.[17]Core principles of the New York statute were cloned in the FAA, particularly the idea that a pre-dispute agreement compelling arbitration is contractual, and therefore a litigant must assert a valid contract defense such as fraud, duress or unconscionability to prove the agreement is unenforceable.[18]Where a counter party to a pre-dispute agreement brings a case, a party can move to stay the court case by showing the agreement was arbitrable or, if there is general recalcitrance, move to compel arbitration.[19]

C. Common Criticisms of Modern Arbitration

These attributes of modern arbitration have been greatly criticized in the context of statutory arbitration, particularly in respect to Title VII claims.[20] In the legal discussions surrounding Rent-A-Center, Jackson’s supporters argued that he, and similarly situated employees, did not have a choice about whether to sign the Rent-A-Center mandatory pre-dispute arbitration agreement; Jackson had no opportunity to negotiate its terms, and the failure to sign would have precluded employment.[21] Additionally, supporters argued that Jackson should not have been expected to understand that his acceptance of the employment agreement was a waiver of his statutory right to court access.[22] Finally, supporters believed that, even in favorable arbitration circumstances, acceptance of all arbitration terms was likely to favor the employer with respect to fees, discovery, and procedures.[23] However, the Supreme Court has noted many times that these criticisms are not unique to civil rights arbitration but instead are inherent to the very nature of dispute resolution.[24]

The Court of Appeals has noted the issue of enforceability in employment contracts mandating employees’ waiver of court access with respect to all employment disputes relating to discrimination.[25] The court described an arbitrator who resolves statutory claims as a “private judge,” but noted that, unlike a judge, an arbitrator is not publicly accountable and the lack of public accountability may favor companies over individuals.[26] The court also acknowledged that confidentiality is won at the cost of binding precedent, which presents both a potential barrier to future plaintiffs’ ability to locate necessary information as well as reduced effectiveness of binding precedence.[27] The Court of Appeals also noted that the competence of an arbitrator to analyze and decide purely legal issues in connection with statutory claims might be questioned because arbitrators do not have to be legal professionals.[28] Nonetheless, the Court of Appeals dismissed all of these criticisms by stating that the Supreme Court has decided that, as a general rule, employment discrimination claims are fully subject to binding arbitration.[29]

The Supreme Court and Court of Appeals’ dismissal of these critical issues does little to assuage the valid concerns raised regarding civil rights’ arbitration.[30]Particularly in light of the legislative history substantiating 42 USC § 1981, the Court of Appeals’ deference, without meaningful underlying analysis behind its decision, is demonstrative of the enormous lack of guidance criticized by the New York Times.

II. The Preemptive Reach of the Federal Arbitration Act

A. Basic Principles of Federal Preemption in Arbitration

The FAA is something of an anomaly in the field of federal-court jurisdiction.[31]The FAA does not vest exclusive subject matter jurisdiction in the federal courts though it creates the body of federal substantive law establishing and regulating arbitration.[32] Unless there is either a federal question or complete diversity, it is up to the state courts to apply the FAA and the federal case law standards for its implementation in any cases involving interstate commerce.[33]

Some, including some Supreme Court Justices, take this to mean that the congressional intent was that the FAA should only apply in federal court as a federal remedy.[34] The disagreement between jurists of the correct application of the FAA is, at least, indicative of the lack of clarity in the congressional intention behind the Act. The FAA says that it applies to all matters involving “interstate commerce.”[35] However, interstate commerce of 1925 was a restricted concept, to the point that a business’ involvement in interstate activity did not create sufficient minimum contact to assert jurisdiction over it.[36] Therefore, it is questionable whether this statutory language should be imposed upon by a modern definition of interstate commerce.

B. Federal Preemption of the FAA and Substantive Law Under Erie

Additionally, the Supreme Court did not distinguish substantive diversity of state versus federal law until Erie v. Tompkins in 1938.[37] Under Erie, state contract law is applied to interpret the substantive meaning of the arbitration agreement.[38] Within the context of preemption – under which interstate commerce is broadly sweeping, without regard to its substantial impact – the Court has construed the FAA as broadly as the constitutional limit.[39] Under the constitutional provisions of the Supremacy Clause, the Supreme Court has held that state courts and legislatures cannot enact statutes restricting arbitration.[40]Likewise, states cannot ease the federal presumption of arbitrability.[41]

C. Restrictions to Separability

This imposition of preemption may be the most problematic because of its restrictions to common law contract defenses. In his dissent to Prima Paint Corp. v. Flood & Conklin Mfg. Co., Justice Black described the Court’s holding that the preemptive reach of the FAA compels a counter party to carry out his agreement to arbitrate even though the a court might find the agreement void because of fraud as “fantastic.”[42] Justice Black continued in his dissent that he was unconvinced that a broad preemptive application of the FAA is not a denial of a person’s rights to due process of law.[43]

Under contract law,undue influence, fraud, and unconscionability are remedies available to parties attempting to rescind a contractual clauses. Contract defenses may be ruled on separately or prior to arbitration. This makes sense because, as Justice Stevens suggested, there is no need to arbitrate an unenforceable agreement.[44] In Rent-A-Center, plaintiff Jackson presented a well-pleaded case of unconscionability, relying on the separability of contract and arbitration.[45]However, the Supreme Court’s decision in Rent-A-Center, that a defense of unconscionability should be heard by the arbitrator, entirely undermines the presumed separability of the arbitrable matter and the arbitration agreement.[46]

This ruling is unwieldy, at best. It does not make sense to compel arbitration of the validity of an arbitration agreement when a party claims to have contractual defenses to that arbitration agreement.[47] Nevertheless, the Rent-A-Centerdecision approves this conceptual change to separability. In light of the legislative intent of the FAA and Title VII, any denial of court access resulting from this faulty logic must be considered a lack of due process.[48]

III. Judicial Review of Arbitration Awards Post-Rent-A-Center

A. Lack of Guidance on Judicial Review of Civil Rights Arbitration

Jackson’s argument in Rent-A-Center was that the making of the arbitration agreement was unconscionable, and therefore required the court to make a determination of the agreement’s legality before compelling any arbitrable review of the dispute.[49] However, as illustrated in the previous sections, even those legal minds most versed in the FAA are unable to agree whether compulsory arbitration of employment discrimination suits can be forced on employees. The Court’s ruling in Rent-A-Center dramatically affects the ability of employees to challenge the enforceability of arbitration agreements, because it sends valid challenges to arbitration to the arbitrator.[50]

However, the Rent-A-Center decision provides little guidance on judicial review of contractual defenses to arbitration. The decision does not consider the obvious question that arises from its holding: in light of this decision, has the scope of review of arbitration awards changed such that the arbitrator’s determination of whether to arbitrate is a valid ground for judicial review?

The Rent-A-Center decision is premised on the assumption that an arbitrator’s ruling on unconscionability is still subject to post-award review under the FAA.[51]In fact, Justice Scalia was insistent that an arbitrator would not be able to disregard the law when determining whether an arbitration agreement is unconscionable.[52] However, the Rent-A-Center decision does not provide any guidance on the procedure of this scope of review.

B. The Doctrine of Manifest Disregard

Justice Scalia’s insistence that an arbitrator may not disregard the law hints at the doctrine of manifest disregard, and the validity of its application to the scope of review. The Supreme Court has ruled that, so long as the litigant may vindicate his or her statutory claim in the arbitral forum, the statute will continue to serve both its remedial and deterrent function.[53] However, actual judicial review of arbitration awards is strictly limited under section 10 of the FAA.[54] The award may be vacated only if the proceeding was tainted with corruption, misconduct or bias; if the arbitrator exceeded his or her authority; or if the arbitrator acted in “manifest disregard of the law.”[55]

Generally, manifest disregard means that the arbitrator knew the applicable law but purposefully chose to ignore it or refused to apply it.[56] Since the inception of the doctrine, there has been a great expansion of the arbitrator’s authority over disputes.[57] This expansion of power has been so broad that, under applicable arbitration rules, the arbitrator himself may not correct his award after release for substantive deficiencies.[58] Because judicial review of arbitration awards is rare, it seems a convincing argument that manifest disregard applies in circumstances where arbitrators have exceeded their powers.[59] However, the doctrine is also contested because the language of section 10 does not specifically refer to manifest disregard as an independent ground for vacating arbitration awards.[60]

A good deal of confusion around the extent of the arbitrator’s power and the applicability of manifest disregard is owed to the lack of guidance provided by recent Supreme Court decisions. Prior to Rent-A-Center, the Supreme Court held in Hall Street Assocs., LLC v. Mattel, Inc. that the statutory grounds for judicial review under section 10 are exclusive. This ruling indicated that manifest disregard was not valid grounds for review.[61] Shortly after the Hall Streetdecision, the court concluded, in dictum, that if an arbitration panel exceeds its powers, the courts are authorized by section 10(b) of the FAA to either direct a rehearing or review the question de novo.[62] The federal circuit courts have been diametrically opposed in their rulings, as they struggle to interpret the meaning of these conflicting Supreme Court writings.[63]

C. Post-Award Judicial Review after Rent-A-Center

Historically, courts have been reluctant to even review arbitration awards, let alone vacate or demand rehearing. However, Rent-A-Center may be an opportunity for a new post-award standard of review.

Consider the following: An arbitration panel is selected to hear an employment discrimination dispute. Though the panel members are all industry experts and well versed in employment discrimination issues, they are not lawyers. The employee asserts that not only have her Title VII rights been violated, but also that the arbitration agreement is invalid because it was fraudulently induced. In its misunderstanding of applicable contract law, the panel misinterprets the employee’s claim and decides that the arbitration agreement is enforceable. The panel proceeds with arbitration.

This example illustrates a potential conflict arising from the Supreme Court’sRent-A-Center and Hall Street decisions. Does the arbitrators’ incorrect determination manifest purposeful disregard of the law? Although section 10 of the FAA does not allow a court to set aside an award for an error of law per se, an argument could be made that, in such a case as the previous scenario, the arbitrator exceeded his or her powers under section 10(a)(4) by acting on an unfamiliar area of law. However, there is no precedent on how the court should proceed to review such a situation. As the Supreme Court continues to expand the scope of post-award judicial review, more guidance and clearer judicial intent will be required to direct both arbitrators and the courts.

Professional mediator and former Columbia University Negotiation and Conflict Resolution faculty member, Bathabile Mthombeni, vehemently agrees that the Supreme Court must put forth specific rules relating to civil rights arbitration claims. Professor Mthombeni is an enthusiastic supporter of mediation, including employment and statutory mediation. However, her wariness of compulsory arbitration has increased over the years in tandem with Supreme Court pro-arbitration rulings.

“I am very concerned about the way that Rent-A-Center was decided because of the impact this has on access to the courts – especially by people who are likely the most vulnerable,” Professor Mthombeni stated. “Do potential employees really have a choice? [In the future, will] this mean that an employee cannot file with the EEOC? And, as the dissent inRent-A-Center points out, how are the lawyers arguing these cases supposed to anticipate how thinly they must slice their arguments as to the seperability of various portions of the agreement to arbitrate?”

Professor Mthombeni’s concern about the Rent-A-Center case’s impact on employees and consumers is based in her extensive knowledge of both dispute resolution and civil rights statutes. She suggests that arbitrators should be held to the same standards of evidential and procedural rules that would pertain in court. “The framers of [42 U.S.C. § 1981(a)] did not anticipate those claims being investigated or decided in arbitration. My recollection of 1981 legislation is that it is especially articulated in order to allow individuals to act as attorneys general, recognizing the particular interest that society has in rooting out civil rights violations.

“It does not seem that arbitration is a forum that champions this end. I am at least concerned about the lack of protections afforded to litigants in arbitration – in particular… the rules of evidence and civil procedure not being strictly adhered to.”

Professor Mthombeni suggests that not only should post-judicial review standards be more defined but also that the Supreme Court should parallel its rulings with evidential and procedural rules of arbitration. “Some might argue that the rules of evidence and civil procedure are themselves flawed. But at least they are part of a commonly understood scheme that has evolved and been tested over several hundred years that puts everyone on level ground – so long as they all understand the rules.”

Conclusion

In their best light, the Supreme Court’s pro-arbitration rulings can be dense and confusing. The Court has upheld the validity of mandatory compulsory arbitration agreements that waive an employee’s right to court access as predicated by Title VII. The Court has held that this negation of the legislative intent of Title VII is still fair, so long as arbitration provides the same statutory remedy as the court system. The Supreme Court has previously held that, because arbitration agreements are separable contractually, a party may seek judicial review of defenses to the arbitration agreement.

However, the Supreme Court has now ruled in Rent-A-Center that the entire arbitration agreement, even the contractual defenses, may be removed to the arbitrator, for a determination of whether the agreement to arbitrate is valid. This ruling is not only a confusing departure, but also requires the Supreme Court to go further with an explanation of the scope of review for civil rights arbitration.

The Rent-A-Center opinion holds that judicial review of challenges to civil rights arbitration agreements is still available under the FAA, but does not address how this review should happen. Without guidance and procedure for post-award review, and without guidance of whether manifest disregard is applicable under the FAA, the criticism of the Supreme Court’s pro-arbitration rulings as “sweeping”, “politically polarized,” and “fuzzy” will likely continue.


[1]Liptak, Adam. “Justices Are Long on Words but Short on Guidance.” The New York Times Online. 17 November 2010, available athttp://www.nytimes.com/2010/11/18/us/18rulings.html?pagewanted=1&_r=1.

[2]Id.

[3]See Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 200-01 (2d. Cir. 1998).

[4]Rent-A-Center, West, Inc. v. Jackson, 130 S.Ct. 2772 (2010).

[5]Id.

[6]Id.

[7]See id.

[8]Marks, Clifford M. “Supreme Court’s Arbitration Ruling Draws Liberal’s Ire.” The Wall Street Journal Blogs. 21 June 2010, available athttp://blogs.wsj.com/law/2010/06/21/supreme-courts-arbitration-ruling-draws-liberals-ire/?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed:+wsj/law/feed+%28WSJ.com:+Law+Blog%29.

[9]Lithwick, Dahlia. “Justice by the Hour.” Slate.com. 26 April 2010. Accessed 10 November 2010. http://www.slate.com/id/2252001/pagenum/all/#p2.

[10]See Coffee Beanery, Ltd. v. WW, L.L.C., 300 F.3d 415 (6th. Cir. 2008) (holding that manifest disregard is an applicable standard of review). But see Citigroup Global Markets, Inc. v. Bacon, 562 F.3d 349(5th Cir. 2009) (holding that manifest disregard is not an applicable standard of review.)

[11]A common antebellum holding, reflecting Justice Taney’s decision in Dred Scott,was that freedmen did not have the right to exercise the same civil rights as white men. See e.g., Howard v. Howard, 51 N.C. 235 (1858).

[12]Cong. Globe, 39th Cong., 1st Sess. 41 (1866).  See generally Report of the Joint Committee on Reconstruction Pt. II, 240 (1866).

[13]See, e.g., Cong. Globe, 39th Cong., 1st Sess.1758 (1866) (statement of Sen. Trumbull).

[14]42 U.S.C. § 1981(a).

[15]Franks v. Bowman Transp. Co., 424 U.S. 747, 779 (1976).

[16]Pub. L. 102-166, Title I §118.  There has been consistent disagreement between the circuit courts whether this statutory language refers to the extent defined by Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (holding that an agreement to arbitrate employment claims could be binding even under the ADEA), versus Alexander v. Gardner-Denver Co., 415 U.S. 36 (holding that an employee’s suit under Title VII of the Civil Rights Act of 1964 is not foreclosed by the prior submission of his claim to arbitration).

[17]N.Y. C.P.L.R. § 7501.

[18]9 U.S.C. § 1-16.

[19]9 U.S.C. § 4.

[20]Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 203 (2d. Cir. 1998).

[21]Brief of Amicus Curiae Service Employees International Union, Legal Aid Society, Employment Law Center, National Employment Lawyers Association, National Employment Law Project, Women’s Employment Rights Clinic, and The Employee Rights Advocacy Institute for Law & Policy in Support of Respondent. Part I, p. 6.

[22]Id.

[23]Id.

[24]Rodriguez de Quijas v. Shearson/American Express, Inc., 490 U.S. 477, 481 (1989).

[25]Cole v. Burns Int’l Sec. Servs., 105 F.3d 1465, 1476 (D.C. Cir. 1997).

[26]Id. at 1477.

[27]Id.

[28]Id.

[29]Id. at 1478, see also Gilmer, 500 U.S. 26, 34-35.

[30]Id.

[31]Moses H. Cone Mem’l Hospital v. Mercury Constr. Corp., 460 U.S. 1, 26.

[32]Id.

[33]Id.

[34]Gilmer v. Interstate/Johnson Lane Corp., 500 U.S. 20 (J. Stevens dissenting).

[35]The Citizens Bank v. Alafabco, Inc., 539 US 52, 53 (2003).

[36]Gilmer,500 U.S. at 39-40 (J. Stevens dissenting).

[37]See Erie Railroad Co. v. Tompkins, 304 U.S. 64 (1938)

[38]Allied-Bruce Terminix Cos. v. Dobson, 513 U.S. 265, 271 (1995). “The Act’s provisions (about contract remedies) are important and often outcome determinative, and thus amount to “substantive”, not “procedural” provisions of law.”

[39]Id.

[40]Id.

[41]Prima Paint Corp. v. Flood & Conklin Mfg. Co.,388 U.S. 395, 400.

[42]Id.at 407 (J. Black dissenting).

[43]Id.

[44]Id.

[45]Id. As a matter of substantive federal law, a claim of fraud in the inducement of a contract containing an arbitration clause is for the arbitrator, but the issue of fraud in the inducement for the arbitration clause itself is a question for the court.Id.

[46]Id.

[47]130 S. Ct. at 2782 (J. Stevens dissenting).

[48]Gilmer,500 U.S. at 39-40 (J. Stevens dissenting).

[49]Brief of Amicus Curiae The American Federation of Labor and Congress of Industrial Organizations in Support of Respondent. Part I, p. 5-9.

[50]130 S. Ct. at 2782 (J. Stevens dissenting).

[51]9 U.S.C. § 10.

[52]130 S. Ct. at 2781.

[53]Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth, Inc., 473 U.S. 614 (1985).

[54]Halligan v. Piper Jaffray, Inc., 148 F.3d 197, 202 (2d. Cir. 1998).

[55]Merrill Lynch v. Jaros, 70 F.3d 418, 421 (6th. Cir. 1995).

[56]Halligan, 148 F.3d at 202.

[57]The concept of manifest disregard was first used by the Supreme Court inWilko v. Swan, 346 U.S. 427 (1953).

[58]A.A.A., Rule R-46.

[59]Stolt-Nielsen S.A. v. AnimalFeeds Int’l. Corp., 548 F.3d 85, 95 (2d. Cir.

2008), rev’d on other grounds, 130 S. Ct. 1758 (2010).

[60]9 U.S.C. § 10.

[61]Hall Street Assocs., LLC v. Mattel, Inc., 552 U.S. 579, 589 (2008). “[T]he statutory text gives us no business to expand the statutory grounds [of judicial review under the FAA].” Id.

[62]Stolt-Nielsen, S.A.,130 S. Ct. at 1772.

[63]Supra note 10.

Copyright © 2011 Nicole Farbes-Lyons

Tax Court Decision Subjects LLP Service Providers/Equity Partners to Self-Employment Tax

Posted last week at the National Law Review by Paul A. Gordon and Casey S. August of  Morgan, Lewis & Bockius LLP new developments concerning partners in a law firm established as a limited liability partnership (LLP) under state law  subject to Self-Employment Contributions Act (SECA) tax on their distributive share of LLP income received in respect of their services.

In a decision issued February 9, the U.S. Tax Court ruled, in part, that the partners of a law firm established as a limited liability partnership (LLP) under state law were subject to Self-Employment Contributions Act (SECA) tax on their distributive share of LLP income received in respect of their services. In doing so, the court determined that the LLP partners could not avail themselves of the exemption from SECA for nonguaranteed service payments to “limited partners.” This ruling illustrates the potential risk for service provider limited partners and limited liability company members of assuming that state law entity and limited liability classifications alone shield them from being subject to SECA tax.

Background

Generally, payments to service providers who are not classified as employees for federal payroll tax purposes are not subject to any payroll tax withholding or payment liability on the part of the payor. Instead, Section 1401 imposes SECA tax on “self-employment” income at the rate of 15.3%, a combination of a 12.4% old-age, survivors, and disability insurance (OASDI) tax and a 2.9% Medicare tax. The OASDI tax is only imposed on the first $106,800 of “net earnings” (which allows for offsets to gross earnings for deductible expenses associated with the creation of the income) for 2011. Subject to certain exemption rules, self-employment earnings include income derived by an individual from any trade or business carried on by such individual plus his or her distributive share of partnership income or loss from any trade or business carried on by a partnership in which he or she is a partner. One of the exemption rules, included in Section 1402(a)(13) of the Internal Revenue Code, excludes from self-employment earnings “the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in Section 707(c) to that partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services” (emphasis added). Unfortunately, Congress failed to provide a definition for limited partner in the statute.

In order to resolve this definitional ambiguity, the U.S. Treasury released temporary regulations in 1997 under which partners with either authority to contract on behalf of the partnership or who participate in the partnership’s trade or business for more than 500 hours during the partnership’s taxable year could not be limited partners for Section 1402(a)(13) exemption purposes. In addition, no service partner in a service partnership could be a limited partner. This guidance created political shockwaves so extensive that Congress imposed a 12-month moratorium on Treasury’s ability to issue further guidance under Section 1402(a)(13). Since that time, Treasury has not provided guidance on the limited partner exemption from SECA tax.

Confronted with the dearth of authority on this issue, many tax practitioners have taken the position that all partners in a tax partnership, who are limited partners or limited liability company members under state law, are per se eligible for the Section 1402(a)(13) limited partner exemption. Others, although not required by law, have followed the guidance under the proposed regulations.

Renkemeyer Decision

It was this definition of “limited partner” that was at issue before the Tax Court in Renkemeyer, Campbell & Weaver, LLP v. Commissioner, 136 T.C. No. 7 (2011). In that case, the Tax Court addressed an IRS challenge to both (1) the special allocation of the LLP’s (a law firm treated as a partnership for federal income tax purposes) distributive share of income to its partners and (2) the treatment of the LLP distributive share allocations of business income to its service partners (the law partners) as being exempt from SECA tax. After ruling in favor of the IRS on the allocation issue (the petitioner could not produce a partnership agreement supporting the challenged special partnership allocations), the court turned to the SECA tax issue.

The LLP partners argued that the limited partner exemption should apply because (1) the LLP organizational documents designated their interests as limited partnership interests and (2) they enjoyed limited liability under state law. The Tax Court disagreed, reaching the result that would have been required under the temporary regulations. Noting that Congress passed the limited partner exemption prior to the state law advent of LLPs and LLCs, the court reviewed the exemption’s legislative history and determined that the impetus for the exemption was not a limited partner’s individual protection from the partnership’s liabilities, but instead its status as a nonservice investment partner in a traditional limited partnership. In doing so, the court found that Congress did not intend for active service partners, such as the LLP partners, to be exempt from self-employment taxes. Specifically, the court referred to the partners’ minimal LLP capital contributions in exchange for their interests in LLP as indicating that the partners’ distributive share of income arose from the legal services performed on behalf of LLP and “not . . . as a return on the partners’ investments and . . . not [as] ‘earnings which are basically of an investment nature.'” (citing the Section 1402(a)(13) legislative history). Additionally, the Renkemeyer opinion hinted that the same rationale could be applied to prevent members of an LLC from qualifying as Section 1402(a)(13) limited partners.

Implications

Renkemeyer demonstrates the hazards of assuming that state law entity and limited liability classifications should control for purposes of determining eligibility for the Section 1402(a)(13) SECA tax limited partner exemption. That is, there may be danger in taking the per se limited partner exemption position described above. Service providers to tax partnerships (including LLCs treated as tax partnerships) in which they are also equity partners should thus be wary of whether both their service-related payments and guaranteed partnership equity allocations would be considered self-employment income subject to SECA tax.

Copyright © 2011 by Morgan, Lewis & Bockius LLP. All Rights Reserved.

A Four-Step Guide for Securing Patent Portfolios after Stanford v. Roche

Posted today at the National Law Review by Jason Miller of Lowndes, Drosdick, Doster, Kantor & Reed, P.A. some great tips on how to review patent portfolios after Staford v. Roche:  

 

 

On June 6, 2011, the U.S. Supreme Court issued its highly anticipated decision in the Stanford v. Roche case. The facts behind Roche are easily replicated on college and university campuses around the nation, forewarning institutions of the potentially problematic IP issues that lurk behind each of their patent and technology transfer agreements. Today, most major research universities boast of vast IP portfolios, including dozens of patents, which were invented by professors and the like during the course of their employment. Oftentimes, these patents allow universities to generate a critical revenue stream by licensing the patents through established licensing offices or policies. However, under Roche, the ownership of the patents may not be as clear as universities previously thought. Though a serious review of existing patent portfolios and potential modifications of boilerplate patent agreement language is likely necessary, first understanding the facts behind Roche will clarify why these steps are strongly advised for universities.

Research fellow, Dr. Holodniy, signed a Copyright and Patent Agreement with Stanford University agreeing to assign his “‘right, title and interest in’ inventions resulting from his employment at the University.” Stanford, like many institutions, received federal funding from the National Institutes of Health for the HIV measurement technique research that Dr. Holodniy participated in. Dr. Holodniy, in pursuit of developing an improved method for quantifying HIV levels in blood samples, later collaborated with Cetus, a California research company that worked with Stanford’s scientists. Equally wary of patent laws and eager to get the right to the findings, Cetus had Dr. Holodniy sign a Visitor’s Confidentiality Agreement stating he “‘will assign and do[es] hereby assign’ to Cetus his ‘right, title and interest in each of the ideas, inventions and improvements’ made ‘as a consequence of [his] access to Cetus.’”

Two research entities. Two patent right agreements. One patent. Who wins?

According to the majority opinion in Roche, authored by Chief Justice Roberts, Cetus prevailed. This opinion is by no means groundbreaking. Rather, the decision merely reinforces the historical rule that “rights in an invention belong to the inventor.” Any institution involved with research and potential IP issues traditionally has their employees sign copyright and patent agreements since an employer has no right to their employees’ inventions without an express grant. Barring such agreement, employee inventions “remain the property of him who conceived it.” Thus, Roche mirrors the general principle that inventors own their inventions by holding, “mere employment is [not] sufficient to vest title to an employee’s invention in the employer.”

Next, Roche is not fodder for major legislative change since it simply provides a straightforward reading of the Bayh-Dole Act. An undoubtedly landmark piece of legislation, Bayh-Dole recognized the need for the commercialization of inventions that federal money was heartily supporting. Bayh-Dole has promoted and facilitated federal collaboration with commercial and nonprofit organization research by specifying what rights each party has when federal funding is involved. The relevant part of the Act cited in Roche provides that federal contractors (which include individuals, small business firms or nonprofits that are a party to the funding agreement) may “elect to retain title to any subject invention.” “Subject invention” is then defined as “any invention of the contractor conceived or first actually reduced to practice in the performance of work under a funding agreement.” The Roche opinion begins to sound more like a grammar lesson than a ruling from the highest court as Roberts explains what the phrase “of the contractor” means. Just as it reads, an “invention of a contractor” would be an invention that a contractor owns. And for the contractor to own such invention in the university context, its employees who participated in the federally funded research would have had to sign an agreement transferring their ownership rights. Thus, the Act is simple: federal contractors can elect to retain title to any invention they own.

Thus, Roche does not change the fact that universities still need to obtain express agreement from employees in order to acquire the rights to any inventions of their employees. The case also does not change any of the traditional interpretations or precedents involving the Bayh-Dole Act. However, the case does clarify the technology transfer and related rights between universities with federally funded research and the private companies with which they collaborate. This clarification signals the need for a stricter approach that universities should take in terms of drafting and ensuring their rights under patent agreements. In light of Roche, an immediate four-step plan should be implemented by colleges and universities.

First, institutions must examine their existing patent portfolios. As the marketability of portfolios increases with the sheer volume of patents, many universities strive to possess a wealth of patented inventions. The value of portfolios thus is not generally linked to a single patent, but the number of patents that outside firms are willing to invest in or collaborate with. Universities therefore capitalize on their portfolios through technology transfers, facilitating the commercialization of research and incentivizing future research through income generation. Thus, examining existing portfolios requires universities to determine what patent rights they currently possess. For those universities that receive federal funding for research, verify whether such funding was acquired before or after the development of each patented invention. If the patent was developed under the funding, check to see whether the employee solely assigned their rights to the university and whether the university has elected to retain the rights to such patent. As Roche explicitly held, “the Bayh-Dole Act does not confer title to federally funded inventions on contractors or authorize contractors to unilaterally take title to those inventions; it simply assures contractors that they may keep title to whatever it is they already have.”

Further, determine which patents were developed collaboratively with outside research firms and institutions. Because academia, private firms and the government are the holy trinity for innovation, universities must be clear on which of their patents were developed by their sole efforts. Creating a framework of mutual benefit that technology transfer ultimately desires requires an examination of the actual benefits universities have afforded themselves through their existing patents.

Second, institutions should closely scrutinize their previously signed employment agreements. Begin by checking whether employees even had rights to transfer in the first place. If the employee came from other institutions or private firms, are they now conducting research at their current university employer that was started elsewhere? Are current employees starting from scratch or building upon existing inventions developed through the funding, efforts and resources of outside entities with which the university has no connection? Finding these answers may require a look into the backgrounds of employees who joined the university as experienced researchers and professors, since they are likely to have signed prior patent agreements. Speak with employees who raise concern and inquire about any past employment agreements they signed. As part of inspecting existing patent agreements, determine the scope of the agreement- does it cover only the original invention or does it extend to any other inventions developed based off the underlying research? Answering these questions is vital in guaranteeing that a university actually retains rights to the patents marketed in their portfolios.

Third, develop a plan for amending existing agreements, or obtaining written intellectual property agreements if none exist. Start by finding out which employees have not signed patent and copyright agreements. Of those employees who have not signed, determine whether any have, or are in the process of, researching and developing inventions. Work with an attorney to develop specific agreements that will assign all existing rights to the university and will also transfer the employee’s rights to future inventions developed during their employment to the university. Any professor who knows that if they invent it, they own it, may be reluctant to hand over such rights. However, patent marketability and the benefit of commercialization of inventions that comes with university technology transfers should leverage some bargaining power over a hesitant employee. Alternatively, incentive provisions may be warranted in certain instances.

Further, refine or amend existing assignments that do not operate under the assumption that the university owns the patent rights. As part of this change, determine whether there are any employees who have transferred departments since the original patent or copyright agreement was signed. If a professor is currently in a research capacity but was not previously, determine whether that departmental change necessitates a revision of their previous agreement or the execution of a new one. Also research and ensure that employees have not assigned their rights to underlying inventions elsewhere or at any previous point during their current employment. Develop a plan for handling employees who are unwilling to sign modified agreements, as reluctance from some employees should be expected. Finally, care should be given in regard to the potential tax implications of amendments to existing agreements and additional incentives offered in connection with any transfer of existing rights in an invention.

Fourth, institutions should draft future employment agreements with more stringent language to prevent the type of patent right quandary exhibited in Roche. The problem in Roche could have been solved by conforming the tense of the verbs to the intention of the university- had Dr. Holodniy’s agreement with Stanford read that he “does” assign his rights, the ownership would have immediately transferred to Stanford. However, the language that Dr. Holodniy “agree[d] to assign” his rights was only a promise to do something in the future. That expectancy did not vest, however, because the Dr.’s subsequent agreement with Cetus included language immediately transferring ownership rights. The “will assign and do[es] hereby assign” phrase gave priority of ownership to Cetus, serving as partial justification for Stanford losing the suit. Thus, it is not an exaggeration to say that each agreement signed with professors and research fellows must be ironclad and reviewed to make certain the existing agreement accomplishes its intended purpose. This may require terminating the old form of agreement and replacing them with individualized agreements that definitively establish a status quo transfer of rights. The use of present tense verbs is imperative to ensure that rights actually are assigned, rather than just promising to be assigned subsequently.

In addition, incorporate provisions within the new agreements to handle situations where researchers work with other institutions in order to prevent an inadvertent transfer of rights. Employ language that specifically requires consent from the university before any employee signs over their rights to an outside institution. Also, include provisions requiring the disclosure of previously signed patent agreements at the outset of employment so that universities will be aware of potential litigation arising from contract and patent disputes.

With a large enough patent portfolio, the process of reviewing and updating patent agreements may appear daunting. However, based on the undisputable message of inventor rights in Roche, a serious assessment of existing agreements and the need for heightened specificity in the future is paramount. The decision in Rocheencourages vigilance on the part of universities and requires steps to be taken to reduce liability to patent infringement and contract violation claims. The four above recommended steps above are not an exhaustive list of actions universities could take; instead, they provide a necessary starting point for universities in navigating patent portfolio review and reform.

*Jason Miller is admitted to the North Carolina and the US Patent bar. He is not yet a member of the Florida Bar.

*Co-author, Lara L. Tedro, is a summer clerk and a rising third year law student.

© Lowndes, Drosdick, Doster, Kantor & Reed, PA, 2011. All rights reserved.

Microsoft Corp. v. i4i Limited Partnership et al.: Supreme Court Observations

Posted today at the National Law Review  by Robert Greene Sterne  and Nirav N. Desai of Sterne, Kessler, Goldstein & Fox P.L.L.C  a great recap of today’s U.S. Supreme Court ruling in Microsoft Corp. v. i4i Limited Partnership et al.

In Microsoft v. i4i, the U.S. Supreme Court today unanimously (8-0) affirmed the clear and convincing evidence standard for invalidating issued U.S. patents under Section 282 of the Patent Act (1952).  In 2007, i4i sued Microsoft in U.S. District Court for infringement of i4i’s patent. As part of its defense, Microsoft asked for a jury instruction reciting a preponderance of the evidence standard for finding i4i’s patent invalid, rather than the long-standing clear and convincing evidence standard.  The District Court rejected Microsoft’s lower standard of proof, and a jury found that the patent was valid and that Microsoft infringed, awarding i4i a 9 figure damages sum.  Microsoft appealed to Federal Circuit, asserting in particular, that the District Court improperly instructed the jury on the standard of proof for invalidity.  The Federal Circuit affirmed the lower court’s holding and Microsoft petitioned the Supreme Court for certiorari, which was granted.

In its argument to the Supreme Court, Microsoft argued that either (1) a defendant in a patent infringement action need only convince the jury that an issued patent is invalid by a preponderance of the evidence standard, or (2) alternatively, that at the very least, the preponderance of the evidence standard should apply to evidence that was never considered by the PTO during examination.  The Supreme Court in its decision rejected both of Microsoft’s arguments.

In its decision, the Court first focused on the language of Section 282, which specifies that “[a] patent shall be presumed valid” and “[t]he burden of establishing invalidity of a patent … shall rest on the party asserting such invalidity.”  Microsoft had argued that Federal Circuit precedent establishing a clear and convincing evidence standard was not supported by the 1952 Act because Section 282 did not explicitly set forth that standard.  The Supreme Court noted that, while the statute includes no express articulation of the standard of proof, the statute does use the term “presumed valid,” which has a settled meaning in the common law.  Relying on its long-standing decision in Radio Corporation of America (RCA) v. Radio Eng’g Labs., Inc., 293 U.S. 1 (1934), the Court found that the common law jurisprudence dating back to the 19th century reflects that Microsoft’s proposed preponderance standard of proof “was too ‘dubious’ a basis to deem a patent invalid.”  According to the common law, the Court held, “a defendant raising an invalidity defense bore a ‘heavy burden of persuasion,’ requiring proof of the defense by clear and convincing evidence.”

The Court also noted that the Federal Circuit has interpreted Section 282 to require this clear and convincing evidence standard for nearly 30 years. And while Congress has amended the patent laws several times since the Patent Act was passed, “the evidentiary standard in § 282 has gone untouched.”  The Court concluded that Congress is well aware of the Federal Circuit’s treatment of the statute, but thus far has not amended the statute, and further that “[a]ny re-calibration of the standard of proof remains in [Congress’s] hands.”

The practical implications of the decisions are many.  First and foremost, the decision preserves the status quo, which in turn maintains the strength of U.S. patents and current patent enforcement mechanisms, particularly as they relate to innovation, business certainty, and job creation.  The Court has also sent a clear signal that, in view of well-established jurisprudence, if the standard is to change, it must be done by Congress, as any such change would have a profound ripple effect on the entire patent system.

© 2011 Sterne Kessler

Employers are Watching Your Facebook: Worker Privacy Significantly Diminished in the Digital Era

Congrats to Michael Carlin  of University of Minnesota Law School winner of the Spring 2011 National Law Review student legal writing contest winner!   Michael’s topic explores the legal basis for privacy in and out of the workplace, specifically off- duty employee monitoring in the private sector.    

  Introduction

As surveillance technology improves, employers increasingly monitor their employees, both in and out of work.  Public sector employees enjoy First and Fourth Amendment protections, but private sector employees lack these fundamental protections.  State and federal common law and statutory protections developed during the past twenty years provide a handful of remedies for private workers when employers unduly infringe upon their right to be let alone.  Nevertheless, these laws fail to provide adequate protection in light of technological advances that make employer monitoring simple, cheap, and surreptitious.   Employees, with limited exceptions, should be given greater protection of their privacy and freedom of expression both in and especially out of the workplace.

This paper explores the legal basis for privacy in and out of the workplace, specifically off- duty employee monitoring in the private sector.  Part I details this history, discusses disturbing trends in employee monitoring, and explores open legal and ethical questions stemming from the increase in employee monitoring.  Part II reviews the interests implicated by employee monitoring and suggests a balancing point to stem employer invasiveness but protect against employee malfeasance.  The current common law protections described in Part III as well as the statutory protections covered by Part IV demonstrate that, in practice most law misses the mark and leaves employees with insufficient rights against invasive monitoring.  Finally Part V proposes new federal legislation to close the gaps in employee privacy law.

I.  Social and Historical Context of Off Duty Monitoring

A.  History of Worker Monitoring

The separation between work and home life is a recent phenomenon, developed during industrialization and urbanization.[1] The typical family in preindustrial society received little privacy; “business was conducted in the house, and the house was a crowded bustling place with little opportunity for the family to retreat in isolation.”[2]  It was not until city dwellers started working predominantly in offices that the home life was thought of as separate from work life.[3]  As Justices Warren and Brandeis stated, “[t]he intensity and complexity of life, attendant upon advancing civilization, have rendered necessary some retreat from the world. . .”[4]

Today privacy is taken, albeit mistakenly, for granted.[5]  However, even in the early Twentieth Century, the concept of privacy was challenged by the desire to monitor employees in and out of the workplace.  For example, Henry Ford created a “Sociology Department . . . . responsible for ferreting out immoral and undesirable behaviour on the part of Ford employees.”[6]  Today news stories frequently describe how employees are disciplined for their off duty behavior.[7]  Underlying these stories is a private employer’s right to substantially monitor their employees.  Employers are given broad discretion, with some exceptions, to log and monitor an employee’s phone use, voicemail,[8] and much more.

B.  Recent Developments of Off Duty Monitoring

An American Management Association study found sixty six percent of employers monitor workers’ Web site connections; forty three percent review e-mail; forty percent of companies analyze the contents of outbound e-mail; forty five percent track content, keystrokes, and time spent at the keyboard; and thirty percent have fired for misuse of the internet.[9]  RFID is another tool many employers use to track the location of their employees in and out of work, although not much is known about the extent to which this is used for off-duty monitoring.[10]  Eight percent of employers now use GPS technology to track wherever their employees go.[11]

Aligo’s WorkTrack is a technology that allows employers to monitor the location of their employees over the internet using employer provided cell phones.[12]  Technologies like Aligo promise to increase productivity, efficiency, and overall cost savings.[13]  However there are serious invasion of privacy concerns. First, the product has an “on break” mode, which allows employers to know when an employee is not working.[14]  These monitoring features often do not shut off at the end of the workday, allowing the employer to monitor even off duty behavior.[15]  Aligo and similar technologies are used by large employers such as Sun Microsystems, Lucient Technologies, and Motorola.[16]

The trend in monitoring appears to be increasing.[17]  As technology becomes more accessible, monitoring becomes easier. The social networking revolution is one prime example of how, if given easy means, employers will pry into the lives of their employees.  Employers increasingly use social networks to screen job applicants,[18] “Forty-five percent of employers use social networking sites to research job candidates.”[19]  Employers now have the power “to gather enormous amounts of data about employees, often far beyond what is necessary to satisfy safety or productivity concerns.”[20]  It is very likely that without greater privacy protections, as GPS and RFID monitoring become less expensive that more employers will begin utilizing it.

C.  Unanswered Legal Questions

Underlying the employer’s power to collect data on employers is the long line of court decisions upholding an employer’s right to monitor.  The Supreme Court’s latest of decision was City of Ontario v. Quon. Although concerning public employees, and the First and Fourth Amendments, the Quon decision raised interesting policy concerns regarding the potential importance of electronic communications as essential means of for self expression.[21]  However, the court also mentioned that these devices are so easily and cheaply available that one could easily purchase a device for personal use, defeating any expectation of privacy.[22]  This decision failed to analyze the basis for which an employee has a reasonable expectation of privacy,[23] so the expectation of privacy regarding digital monitoring is still not clear.[24]

II.  Should There Be a Line Between Work and Private Life Online? If so Where Should We Draw the Line?

A.  Employer’s Perspective

First, from an employer’s perspective, monitoring of employees is within their discretion because of the nature of at-will employment.  Generally, with the exception of Montana, employment is considered at will in the U.S,[25]  meaning employees can be fired, or leave, at any time for whatever or even no reason.[26]  Employers argue that if employees do not want to be monitored they can leave.

Employers also need to protect the integrity of their business and prevent unlawful activity.  Never before has so much damage been accomplished by low level employees through mindless behavior and social media.  One example of this occurred in April 2009 when two Domino’s Pizza employees posted several videos of disgusting, and unsanitary activities in preparation of a customer’s pizza.[27]  The video went viral and was responsible for a steep decline in stock values.[28]

Employers also need to protect against the leaking of confidential data.  In February 2010 the personal information of Shell employees in dangerous parts of the work was leaked to a blogger and published.[29]  This leak posed a great threat to the lives of these individuals; Shell employees have been attacked, and kidnapped in places like Nigeria.[30]  Similarly, the risk of liability is high for leaking of trade secrets and for initial public offerings before they are public.[31]

Productivity concerns also cause many employers to monitor employees. Even minor personal internet use in the workplace can lead to millions in lost profits.[32]  Off-duty, employers can claim fewer interests in monitoring, but in a world where telecommuting is on the rise, the line between office and home is blurring and this means that an employer may need to monitor an employee while working remotely.  Additionally, employers may want to check against irresponsible drinking, and negligent driving as evidenced by traffic tickets, especially if the worker is in a driving profession.[33]

B.  Employee’s perspective

When employers monitor their workers morale can decrease substantially.[34]  Monitoring may also undermine intended purposes of increasing productivity by spurring stress related ailments such as increased illness and absenteeism.[35]  Information gleaned from social media may also be inaccurate, forgeries of facebook accounts are commonplace.  Moreover, monitoring is usually inequitable where employees are not represented by unions, “[b]ecause of the substantial interests individuals have in both employment and in privacy, invasive monitoring puts employees in a ‘catch-22’ situation, forcing them to sacrifice reasonable expectations of privacy because of their need to work.”[36]

Technological advances exacerbate the invasiveness of monitoring and allow employers to know intimate details about an employee’s life, as one commenter notes “what happens when an employer virtually observes the employee stopping during her lunch hour at Planned Parenthood and fires her based on assumptions about her position on family planning methods?”[37]  Further, technology like social networking has become such an integral part of self expression.  Although in the context of cell phones, the Supreme Court acknowledged that it may be that some forms of communication are “essential means or necessary instruments for self expression, even identification.”[38]  This is just as true of social media.[39]

Employer monitoring has already altered the online behavior of many bloggers and social networking users, “29% of employees have become more conservative online because they fear that ‘employers can use anything and everything as an excuse to fire” them in a down economy.”  Social networking and blogging merits protection because not only is it integral to self expression, it serves a socially useful purpose by keeping people connected, and sharing and breaking news in a more effective way than traditional means ever could.[40]  Although First Amendment protection does not extend to workers in the private sphere, employer monitoring can affect speech in ways that would be unconstitutional if done by a government employer.  Most Americans spend nearly a quarter of their lives at work;[41] do we want constitutional protections to extend to only three quarters of a person’s life?  Do we want to allow employers to treat their employees like sex offenders, under constant surveillance?

Most social networking users begin using in their teens; because of this many of these users have material from their youth that depicts less than mature behavior.  Young people’s past lawful, but unfortunate conduct should not harm their employment prospects later.[42]  Even those with private profiles, as discussed in Part IV may still be at risk for having their profiles hacked by employers. Without protections we allow employers to be voyeurs and produce a chilling effect to use of online communications.[43]  Finally, the right to adequate livelihood is an international human right; one should not have to waive expression rights to enjoy the right to a livelihood.[44]

C.  Other Policy Considerations Make Line Drawing Difficult.

On one hand the free flow of information should not be impeded to protect what is usually discriminated against: misconduct and unpopular speech.  We should not have to protect people from making public fools of themselves.  Nevertheless, as the lifestyle discrimination statutes and case law discussed in Part IV attest to, employers who monitor off duty scrutinize a great deal of legal and socially important behavior including political speech.

Another issue is that the internet is by definition public, and speech is not being infringed by any unconstitutional means by employers checking social media.  However, off-duty social networking use merits privacy protections because employees have a higher expectation of privacy off the clock.[45]  Although any manager could check out an employee’s Facebook, there is a difference when this action is done with the intention to dig up dirt.  This argument also fails to consider that employers may find ways to view even non public profiles.

Finally, we must also consider whether employers should be punished just because they are using information for actions socially disapproved of.  After all, there are many anti-discrimination and collective bargaining labor laws designed to prevent employers from the really harmful discrimination.  However, anti-discrimination lawsuits are not a simple means of protecting the worst forms of discrimination; they are among the most difficult cases to prove.[46]  Employers who reserve the right to monitor of social network use and GPS location off duty can relatively easily use any information they gather as pretext for more heinous action.  Finally, the low interest the employer has in off-duty behavior, and the high value of privacy in U.S. culture, tips the balance in favor of the employee.  Although when employers suspect serious misconduct that would expose the employer to liability or lost profits, they should be allowed to monitor the employee with proper notice.

III.  Common Law Protections Are Generally Not Available for Digital Off-Duty Monitoring

Private sector privacy actions are typically based in the common law tort of intrusion upon seclusion.[47]  The elements for an intrusion claim are “[1] [intentional] intru[sion], physically or otherwise, upon the solitude or seclusion of another or his private affairs or concerns . . . [and] [2] the intrusion would be highly offensive to a reasonable person.”[48] In other words, did an individual have a reasonable expectation of keeping a matter private which the employer intruded upon.  Voluntary disclosure of information is a problem for social networking users.[49]  Some jurisdictions allow for an employer to use “intrusive and even objectionable means to obtain employment-related information about an employee.[50]  Generally, invasion of privacy actions will not be available to bloggers and social network users given the public nature of these activities.[51]  However, invasion of privacy claims may be available for monitoring off-duty personal cell phones,[52] home computer use, and location via GPS.  Still, these claims will probably fail if the employer reserves the right to monitor in an employee handbook.[53]

One recent exception to waiver of a reasonable expectation of privacy via employer notice has been found if the communication is privileged.  In Stengart v. Loving Care Agency, Inc., a home care nursing professional used her employer provided laptop to communicate with her attorney via a web-based yahoo mail account.[54]  The employer collected these emails in preparation for a lawsuit the employee filed against it. Although the employer use policy stated that employees can expect to be monitored, the New Jersey Supreme Court held that the employee had a reasonable expectation of privacy in her attorney-client privileged emails even on a work computer.[55]

IV.  Current Statutory Causes of Action Provide Little Protection.

A.  ECPA Claims Against Off-Duty Monitoring Fail.

The Electronic Communications Privacy Act (ECPA) was enacted “to provide greater protection of an individual’s privacy from emerging communication technologies in the private sector.”[56]  The Act “prohibits the intentional or willful interception, accession, disclosure, or use of one’s electronic communication.”[57]  It extends the protections of the Wiretap Act to electronic communications; it allows for criminal prosecution as well as civil action.[58]  However, “[c]ase law interpreting ECPA is virtually uniform in finding that employers can monitor with or without consent, even without notice.”[59] Further, courts disagree as to whether the interception of emails stored on a centralized server are prohibited by ECPA.

All that is necessary for a party to waive their privacy is to give so called consent, which can easily be done by the employer providing a poster or notice in a policy handbook that communications will be monitored.[60]  Further, consent or notice is not required in many federal jurisdictions when equipment is used in the course of business.[61]  Because the EPCA effortlessly allows employers to skirt the statute’s requirements, off-duty monitoring suits do not succeed against employers.[62]

B.  SCA Claims Require Employers to Behave Extremely Irresponsibly.

The Stored Communications Act (SCA) prevents communications companies from turning over communications to the government, but also prohibits hacking and exceeding authorization to view information.[63]  In Konop, an employee of Hawaiian Airlines created a blog, requiring authorization and terms of use that prohibited the airline management from reading and any disclosure of the contents of the blog.[64]  Hawaiian Airlines used the usernames and passwords of other employees to access Konop’s blog.  The company then terminated Konop after reading his critical commentary of the airline’s president and labor practices. The court held that because only a website user or provider could authorize a third party’s access under SCA, summary judgment should not have been granted for this claim.[65]

Although the employee here was given a cause of action, the remedy was limited because the court decided that “for a website such as Konop’s to be ‘intercepted’ in violation of the Wiretap Act, it must be acquired during transmission, not while it is in electronic storage.”[66]  The First Circuit disagreed with this in United States v. Councilman, holding that communications in storage can be intercepted in violation of the ECPA.[67]

Another shortcoming of these statutes is that neither EPCA or SCA would not protect all instances of employer digital snooping.  The following alteration of Konops facts illustrates this.  If Hawaiian Airlines was given the Facebook login information of Konop’s Facebook friend, and used it to login and see Konop’s critical wall posts of the company; the employer would avoid liability under SCA because there is no Facebook policy prohibiting the use of another’s login information.[68]  ECPA and SCA weaknesses points to the need for stronger statutory protections in the area of employee privacy.

C. CFAA Generally Does not Apply to Employers.

The Computer Fraud and Abuse Act (CFAA) is a criminal statute that prohibits the unauthorized access of computers involved in interstate or foreign commerce.[69]   However, unless an employer hacked into an employee’s personal computer, an action would not be possible against a monitoring employer.

D. State Protections, Statutory Privacy and Lifestyle Discrimination Statutes Mostly Miss the Mark.

Though as many as ten state constitutions explicitly provide privacy protections, nine of these provisions are interpreted to require government invasion of privacy.[70]  California is exceptional in that the state constitution provides a remedy for invasion of privacy actionable against private individuals.[71]

Twenty five states protect against employee discrimination for the use of tobacco and other legal products off-duty.[72]  However, these laws would not protect against employer monitoring and adverse action based on political or other lawful expression gleaned from social network use.  Five states prohibit adverse action based on political behavior.[73] Only California, Colorado, New York, and North Dakota protect against discrimination from legal off-duty behavior in general,[74] but these statutes may be limited where an employer declares a policy that prohibits blogging about work.[75]  Limiting employee monitoring is not a popular option even when tailored narrowly; Michigan and Illinois are the only states that prevent an employer from monitoring political activity.[76]  Only eleven states have some form of RFID use restrictions, and none have GPS monitoring restrictions.

V.  “Privacy Protection in Employment Act” a Proposal to Close Privacy Gap

Congress made two attempts to pass employee privacy legislation, the broad Privacy for Consumers and Workers Act in the 1990s and the toothless Notice of Electronic Monitoring Act in 2000.[77]  Though these failed, federal legislation is necessary for several reasons. The courts are too slow and lack the technological expertise to adequately keep privacy up to date with technological changes.  Moreover, “providing protections for employees on a state-by-state basis can cause “a race to the bottom” with states purposefully providing low protections to encourage business.”[78]  To close the gaps in employee privacy law Congress should pass what some have call the “Privacy Protection in Employment Act”.[79]  This Act would generally prevent all off-duty monitoring of employees in the home, and in any secluded area. Employers would only be permitted to monitor off-duty behavior if the employer has “reasonable grounds to believe the employee is engaging in behavior that will cause a significant concrete harm to the employer.”[80]  However, the employer must carry the burden to prove reasonable grounds.  An employer also must put the employee on notice of the scope and duration of any monitoring, and provide them an opportunity to review all information collected. The Department of Labor would also monitor compliance with these provisions, and a violation of the Act would allow a civil action with an allowance for plaintiff’s attorney fees.[81]

VI.  Conclusion

Statutory and common law protections show that there should be a line between work and private life even in this age of diminishing privacy.  However, these protections are inadequate to keep up with monitoring techniques.  Although there are important interests in promoting the free flow of information and the profitability of businesses; the risk for discriminatory use of information is great.  Interests in privacy must be balanced against interests in security of employment and reflect well reasoned normative views of society.  This can be accomplished by enacting legislation like the Privacy Protection in Employment Act.


[1] Daniel J. Solove, Conceptualizing Privacy, 90 Cal. L. Rev. 1087, 1138 (2002) (documenting the history of the concept of privacy and exploring new ways to think of it).

[2]Id. (“homes were primarily devoted to work, a shop with a place in the back or above to eat and sleep.”)

[3]Edward Shils, Privacy: Its Constitution and Vicissitudes, 31 Law & Contemp. Probs. 281, 289 (1966). See also Tamara K. Hareven, The Home and the Family in Historical Perspective, 58 Soc. Res. 253, 259 (1991) (“Following the removal of the workplace from the home as a result of urbanization and industrialization, the household was recast as the family’s private retreat, and home emerged as a new concept and existence.”).

[4]Samuel D. Warren & Louis D. Brandeis, The Right to Privacy, 4 Harv. L. Rev. 193, 196 (1890).

[5]C.f. Solove, supra note 1.

[6]Donald V. Nightingale, Workplace Democracy: An Inquiry into Employee Participation in Canadian Work Organizations 9 (1982).

[7]See Stephanie Chen, CNN International, Can Facebook get you fired? Playing it safe in the social media world, http://edition.cnn.com/2010/LIVING/11/10/facebook.fired.social.media.eti… (reviewing story of woman fired for posting about her boss reprimanding her for union activity); Don Aucoin, MySpace vs. WorkPlace, Boston Globe, May 29, 2007, at D1 (describing an Olive Garden employee fired for posting MySpace pictures of herself); Hyoung Chang, Bud Man: Canned for Coors?, USA Today, May 18, 2005, http://www.usatoday.com/money/industries/food/2005-05-18-beer-man_x.htm (finding a Budwieser employee was fired for drinking a Coors in public).

[8]Jane Kirtley, Privacy Protection, Safety and Security, Intellectual Property Course Handbook Series PLI Order No. 23334 15, 119 (Practising Law Institute, 2010) (citing Fact Sheet 7: Workplace Privacy and Employee Monitoring, Privacy Rights Clearinghouse, June 30, 2010, http://www.privacyrights.org/fs/fs7-work.htm#2c) (finding exceptions in California, where in state callers must be informed of monitoring, and in the Eleventh Circuit where the employer realizes the call is personal).

[9] American Management Association, 2007 Electronic Monitoring & Surveillance Survey: Many Companies Monitoring, Recording, Videotaping and Firing Employees, Feb. 8, 2008, http:// www.amanet.org/press/amanews/ems05.htm.

[10]Although less is known, RFID presents the largest potential invasion of privacy issues; RFID can be placed in Id badges, clothing, cell phones, and just about anything without being detectible by employees. Jeremy Gruber, RFID and Workplace Policy, (last visited, Dec. 1, 2010)  http://www.workrights.org/issue_electronic/RFIDWorkplacePrivacy.html#_ft….

[11]Id.

[12]Aligo – The Mobile Enterprise Software Company, WorkTrack, http://aligo.c3design.jp/products/workTrack/ (last visited Dec. 1, 2010).

[13]Id.

[14]This feature is marketed to help reduce unnecessary billing time, but it has troublesome invasion of privacy implications.  Jill Yung, Big Brother Is Watching: How Employee Monitoring in 2004 Brought Orwell’s 1984 to Life and What the Law Should Do About It, 36 Seton Hall L. Rev. 163, 173 (2005).

[15]Id.

[16]Aligo Inc., Aligo Customers, (last visited December 1, 2010), http://aligo.c3design.jp/customers/.

[17] Friedman, Barry A. and Lisa J. Reed, Workplace Privacy: Employee Relations and Legal Implications of Monitoring Employee E-Mail Use, 19 J. Bus. Ethics 75 (2007) (describing the follies of employer use of social networks as a monitoring tool).

[18] Jenna Wortham, More Employers Use Social Networks to Check Out Applicants, New York Times, http://bits.blogs.nytimes.com/2009/08/20/more-employers-use-social-netwo… (finding an increasing trend in use of social networks to screen applicants).

[19]Career Builder, Press Release, Forty-five Percent of Employers Use Social Networking Sites to Research Job

Candidates, CareerBuilder Survey Finds, August 19, 2009, http://uncw.edu/stuaff/career/documents/employersusingsocialnetworkingsi…

[20]Frederick S. Lane III, The Naked Employee: How Technology Is Compromising Workplace Privacy 3-4 (2003).

[21] Id. (“Cell phone and text message communications are so pervasive that some persons may consider them to be essential means or necessary instruments for self-expression, even self-identification.”)

[22]Id. (“[E]mployees who need cell phones or similar devices for personal matters can purchase and pay for their own.”).

[23]City of Ontario v. Quon, 130 S.Ct. 2619, 2630 (2010).

[24]The court also did not address whether employers can monitor their employees while off duty. C.f. Gregory I. Rasin & Ariane R. Buglione, Social Networking and Blogging: Managing the Conversation, N.Y.L.J., July 27, 2009, available at http://www.law.com/jsp/nylj/PubArticleNY.jsp?id=1202432487473&slreturn=1….

[25]See, e.g., Ariana R. Levinson, Carpe Diem: Privacy Protection in Employment Act, 43 Akron L. Rev. 331, 338 (2010).

[26]See generally, James A. Sonne, Monitoring for Quality Assurance: Employer Regulation of Off-Duty Behavior,43 Ga. L. Rev. 133, 140 (2008).

[27]Paul E. Starkman, What You Need to Know about Monitoring Employees’ Off-Duty Social Networking Activity (last accessed Dec. 2, 2010), http://chiefexecutive.net/ME2/Audiences/dirmod.asp?sid=&nm=&type=Publish….

[28]Id. (receiving over a million views in two days).

[29]Id.

[30]James Herron, Shell Data Leak May Compromise Safety Of Staff –Emails, Feb. 4, 2010 http://royaldutchshellplc.com/2010/02/04/shell-data-leak-may-compromise-….

[31]See Starkman, supra note 27.

[32]See, Association of  Local  Government Auditors, Monitoring  Internet  Usage, Spring  2010, http://www.governmentauditors.org/index.php?option=com_content&view=arti… This potential loss may only get worse as the average gen-y’er spends upwards of thirty four percent of their time online doing personal tasks, as opposed to the twenty five percent found in the rest of the working population.  Burst Media, “Online At Work”, Nov. 11, 2007,http://www.burstmedia.com/pdfs/research/2007_11_01.pdf.

[33]Ronald J. Rakowski, Employee Off-Duty Conduct: Be Careful!, Sep 7, 2010, http://www.suite101.com/content/employee-off-duty-conduct-be-careful-a28….

[34]See Mia Shopis, Employee Monitoring: Is Big Brother a Bad Idea?, Dec. 9, 2003, http://searchsecurity.techtarget.com/news/interview/0,289202,sid14_gci94….

[35]Jay P. Kesan, Cyber-Working or Cyber-Shirking?: A First Principles Examination of Electronic Privacy in the Workplace, 54  Fla. L. Rev. 289, 319-20 (April 2002)

[36]S. Elizabeth Wilborn, Revisiting the Public/Private Distinction: Employee Monitoring in the Workplace, 32 Ga. L. Rev. 825, 835 (1998).

[37]Yung, supra note 14at 174.

[38] City of Ontario v. Quon, 130 S.Ct. 2619, 2630 (2010).

[39]See Peggy Orenstein, The Way We Live Now: I Tweet, Therefore I Am, August 1, 2010, available at http://www.nytimes.com/2010/08/01/magazine/01wwln-lede-t.html

[40]I use social media broadly: it includes blogs, YouTube, and any other internet based means of conveying information.

[41]See supra note 36.

[42] Leigh A. Clark & Sherry J. Roberts, Employer’s Use of Social Networking Sites: A Socially Irresponsible Practice, 95 J. Bus. Ethics 507 (2010) (exploring the ethical concerns of employer use of social networking to monitor employees and screen applicants in the private workplace).

[43] Friedman, Barry A. and Lisa J. Reed. 2007. Workplace Privacy: Employee Relations and Legal Implications of Monitoring Employee E-Mail Use, 19 J. Bus. Ethics 75.

[44]Nevertheless, the U.S. does not recognize the International Covenant on Economic, Social and Cultural Rights, or the optional protocol, which would give rise to a claim for damages for the right to work. G.A. Res. 2200A (XXI), U.N. Doc. A/6316 (Dec. 16, 1966), Dec. 16, 1966, 993 U.N.T.S. 3, entered into force Jan. 3, 1976.

[45] Compare withthe following “the use of computers in the employment context carries with it social norms that effectively diminish the employee’s reasonable expectation of privacy with regard to his use of his employer’s computers.” TBG Ins. Servs. Corp. v. Superior Court, 96 Cal. App. 4th 443, 452 (2002) (holding that an employee who used a computer designated for working at home did not have sufficient privacy interests to prevent an employer from monitoring his computer use).

[46]See generally Michael Selmi, Why are Employment Discrimination Cases So Hard to Win?, 61 La. L. Rev. 555, (2001), see also Jonah Gelbach et al.,Passive Discrimination: When Does It Make Sense To Pay Too Little?, 76 U. Chi. L. Rev. 797 (2009) (“federal antidiscrimination law inadequately addresses either intentional or unintentional passive discrimination”)

[47] Tanya E. Milligan, Virtual Performance: Employment Issues in the Electronic Age, 38 Colo. Law. 29, 34 (2009) (exploring defamation, invasion of privacy, wiretap, EPCA, and SCA causes of action as a result of employer monitoring).

[48]Restatement 2d. Torts § 652B.

[49] Robert Sprague, Fired for Blogging, 9 U. Pa. J. Lab. & Mp. L. 355, 384 (2007) (exploring legal protections bloggers may be able to assert as a result of monitoring off duty conduct).

[50] Kelly Schoening & Kelli Kleisinger, Off-Duty Privacy: How Far Can Employers Go, 37 N. Ky. L. Rev. 287, 290-292 (2010) (exploring the limits of employer peering into the private lives of employees using technology under several privacy statutes as well as common law tort claims) (citing Baggs v. Eagle-Picher Indus., Inc., 957 F.2d 268 (6th Cir. 1992)).

[51]Sprague supra note 49at 363.

[52] But see Karch v.  Baybank FSB, 794 A.2d  763  (N.H.  2002) (refusing to find a cause of action against an employer who uses information surreptitiously intercepted from a cell phone conversation by a third party to reprimand an employee).

[53]See e.g. Thygeson v. U.S. Bancorp, 2004 WL 2066746 (D. Or. 2004).

[54]990 A.2d 650 (N.J. 2010)

[55]Id. at  663-664 (“e-mails she exchanged with her attorney on her personal, password-protected, web-based e-mail account, accessed on a company laptop, would remain private.”).

[56] Michael Newman, Shane Crase, What in the World is the Electronic Communications Privacy Act? An Overview of the ECPA Hurdles in the Context of Employer Monitoring, 54 Fed. Law. 12 (2007).

[57]  18 U.S.C. §§ 2510-2520.

[58]18 U.S.C. §§2510 to 2712.  Although an employer cannot violate the wiretap act because of a deficiency in language of the statute, they could be liable under the ECPA).  Jill Yung, supra note 14at 182 n.90.

[59]Corey A. Ciocchetti, The Privacy Bailout: State Government Involvement in the Privacy Arena, 5 Entrepreneurial Bus. L.J. 597, 605 (2010).

[60]See United States v. Rittweger, 258 F. Supp. 2d 345, 354-55 (S.D.N.Y. 2003) (finding a handbook made monitoring policy clear).

[61]Arias v. Mutual Cent. Alarm Serv. Inc., 202 F.3d 553, 559 (2d Cir. 2000).

[62]Cf. Konop v. Hawaiian Airlines, Inc., 302 F.3d 868 (9th Cir. 2002) cert denied, 537 U.S. 119 (2003) (dismissing the 18 U.S.C.A. § 2511(1)(a) claim).

[63] 18 U.S.C. § 2701, et. seq.

[64]Konop 302 F.3d at 876.

[65]Id.

[66]302 F.3d 868, 878-879.

[67]See Newman supra note 56at 14 (quoting 418 F.3d 67, 79-81 (1st Cir. 2005)).

[68]See Facebook terms http://www.facebook.com/terms.php.

[69] 18 U.S.C. §1030.

[70]See, Corey A.Ciocchetti, The Privacy Bailout: State Government Involvement in the Privacy Arena, 5 Entrepreneurial Bus. L.J. 597, 620.

[71]Chico Feminist Women’s Health Ctr. v. Butte Glenn Med. Soc’y, 557 F. Supp. 1190, 1203

(E.D. Cal. 1983) (finding an action against defendants for an infringement of the state’s constitutional privacy right to prevent procreative choice interference).

[72]Corey A.Ciocchetti, The Eavesdropping Employer: A Twenty-First Century Framework For Employee Monitoring, 17 (2010)http://www.futureofprivacy.org/wp-content/uploads/2010/07/The_Eavesdropping_Employer_%20A_Twenty-First_Century_Framework.pdf

[73]Id.

[74]Id.See also e.g., Colo. Rev. Stat. § 24-34-402.5 (“[i]t shall be a discriminatory or unfair practice for an employer to terminate the employment of any employee due to that employee’s engaging in any lawful activity off the premises of the employer during nonworking hours. . .”); N.D. Cent. Code §§ 14-02.4-03 (“[i]t is a discriminatory practice for an employer to fail or refuse to hire a person; to discharge an employee; or to [otherwise discriminate with respect to] participation in lawful activity off the employer’s premises during nonworking hours . . . .”).

[75] Levinson,supra note 25at 372.

Jessica Jackson, Colorado’s Lifestyle Discrimination Statute: A Vast and Muddled Expansion of Traditional Employment Law, 67 U. Colo. L. Rev. 143 (1996).

[76]Ciocchetti, supra note 72.

[77]Levinson,supra note 25at 343.

[78]Id.

[79]Id. at 331.

[80]Id. at 402 (These would exclude activities that merely reduce office morale, and injury to reputation and would include, but are not limited to activity such as: competition with employer’s business, reduction in the employees work or that of co-workers, harassment, obscene behavior if the employee is a child’s role model, financial harm, and complaints).

[81]Id. at 411.

© Copyright 2011 Michael Carlin