Category: Uncategorized

China’s New Civil Law Adds Right of Publicity

The Third Session of the 13th National People’s Congress (NPC) voted and passed the “Civil Code of the People’s Republic of China” on May 28, 2020. This law will come into effect on January 1, 2021.  Part IV of the law is dedicated to Personality Rights, which include portrait rights, which is similar  California’s right of publicity and right of publicity for the deceased.  Portrait rights in China were previously protected under the General Principles of Civil Law and the new law provides significant clarification on these rights and also codifies existing case law.

Article 990 defines personality rights as “the rights of life, body, health, name, portrait, reputation, honor, privacy and other rights enjoyed by civil subjects.” However, these rights cannot be waived, transferred or inherited per Article 992.  Even though there is no inheritance, a spouse, children and parents can enforce the deceased rights per Article 994.  This codifies existing law from the Supreme People’s Court  case Zhou Haiying v. Shaoxing Yuewang Jewellery and Gold Co., Ltd., which held a close relative was entitled to sue for a violation of Lu Xun’s portrait right after his death.

Article 995 confirms that plaintiffs are entitled to compensation and injunctions for the violation of personality rights.  Article 996 adds that the compensation may include damages for mental anguish. Article 997 adds preliminary injunctions are available when when “a civil subject has evidence to prove that the perpetrator is or is about to commit an illegal act that infringes on his personality rights, and if he fails to stop it in time, his legal rights and interests will be irreparably damaged.”

Article 1018 defines the right of portrait as “…image that can be recognized by a specific natural person reflected on a certain medium through video, sculpture, painting, etc.” and gives natural persons “…the right to make, use, disclose or permit others to use their own portraits in accordance with the law.”

Article 1019 expands on Article 995 by stating “it is forbidden to make, use or publish portraits of portrait right holders without the consent of the portrait right holders, except as otherwise provided by law.” However, exceptions are provided in Article 1020 including personal use, art appreciation, education or scientific research, news, government use with the required scope of their duties, images of public environments where it is inevitable that people will be present, and public interest.

Articles 1021 and 1022 cover portrait right contracts and are favorable to the portrait right owner.  Per Article 1021, if there is a dispute in the meaning of a term, the explanation should favor the portrait right owner.  Article 1022 covers term of the contracts. If no term is specified, either party may cancel at any time but provide reasonable notice. If a term is specified, the portrait right owner can cancel the contract before the end of term as long as reasonable notice is provided.

Article 1023 states the right to name and voice are also covered similarly by this section IV of Personality Rights with respect to portraits.

The new Civil Law may have a favorable impact on famous foreigners looking to protect their rights in China.  For example, Bruce Lee’s heir has recently sued a fast food chain for portrait right infringement and Michael Jordan has several long running disputes with Qiaodan Sports Co., Ltd. (Qioadan is the Chinese pronunciation of Jordan) over use of his name and likeness and recently won a victory on the trademark side.

© 2020 Schwegman, Lundberg & Woessner, P.A. All Rights Reserved.

Hirst Spot Print Turned into Spots by MSCHF, Courtroom Artists Face New Challenge, Banksy Pays Homage to Hospital Workers

Still No LOVE in Robert Indiana’s Estate Battle

In the ongoing suit over the rights to Robert Indiana’s artworks, defendant Michael McKenzie, the founder of American Image Art, filed new counterclaims against the Morgan Art Foundation alleging that Morgan orchestrated “one of the most massive art frauds in history.” McKenzie argues that intellectual property rights were abandoned by Indiana decades ago and that the artist’s famous LOVE artwork is in the public domain. McKenzie further alleges that Morgan “fraudulently affixed” copyright to more than 1,000 sculptures worth more than $100 million and an additional million items valued at least $50 million in retail sales – Indiana did not affix a copyright symbol to his work when it was first published. McKenzie also seeks to invalidate two federal trademarks that Morgan registered for the design and reproduction of LOVE. Notably, several other counterclaims made by McKenzie and Indiana’s estate were dismissed in 2019. Morgan maintains that it has the rights to all images and sculptures that Indiana produced between 1960 and 2004, as well as the exclusive right to fabricate and sell certain sculptures, including LOVE, pursuant to agreements dating back to 1999. Morgan’s direct claim against McKenzie is over the sale of works it alleges were falsely attributed to Indiana.

As SCOTUS Moves Oral Arguments Online, Courtroom Artists Forced to Use Their Ears – and Imaginations – for Illustrations of Oral Arguments

The U.S. Supreme Court’s justices and their staffs are not the only people in the courtroom having to adapt. Court-appointed artists still capture the oral arguments, but must now rely on their ears and imaginations rather than their eyes to create the illustrations. The inability to be inside the courtroom during the arguments not only makes it difficult to paint a picture but also leaves lawyers in the dark as to the justices’ reactions to their arguments.

The Most Expensive Game of (Dis)Connect the Dots: A $30,000 Hirst Print Sold Off Spot by Spot

Damien Hirst created a spot print titled L-Isoleucine T-Butyl Ester. Now, MSCHF, a Brooklyn-based art collective, cut out each of the print’s 88 spots as part of the project called Severed Spots, created in protest against the practice of fractionizing the ownership of artworks. MSCHF sold off each of the spots for $480, generating a profit of about $12,000 over the $30,000 purchase price; in yet another example of an artwork’s value apparently growing as a result of its destruction (think Banksy’s Love Is in the Bin), they stand to gain even more as bidders line up to purchase leftover white paper. Our readers will remember MSCHF for auctioning off The Persistence of Chaos, a computer with the world’s most malicious viruses last year, among other news-making stunts/artworks. MSCHF also sold Jesus Shoes, custom Nike Air Max 97s with holy water from the River Jordan in the soles. Damien Hirst’s studio has not yet responded to this latest stunt by the collective.

Founder of Napster Involved in Suit Over Ownership of an Old Master Painting

Auction house Christie’s recent court filings to enforce an arbitration award reveal that art collector Sean Parker, founder of Napster and first president of Facebook, was embroiled in a dispute over a sale of Peter Paul Rubens’s A Satyr Holding a Basket of Grapes and Quinces with a Nymph (1620). In 2018, Parker acquired the artwork at a Christie’s auction for his foundation, after which the consignor of the artwork inexplicably sought to cancel the sale, despite making more than $1 million in profit. The consignor claimed that she tried to withdraw the painting before the auction took place. When the parties were unable to amicably resolve the dispute, it was submitted to arbitration. The arbitrator ruled that Christie’s complied with its contractual obligations and that Parker lawfully acquired the painting. The case highlights the legal and financial responsibilities of the parties involved in consigning an artwork to an auction house.

Former Paddle8 CEO Sued for Alleged Misappropriation of Funds

A group of creditors brought suit in the Southern District of New York, accusing former Paddle8 CEO Valentine Uhovski of engaging in acts of gross mismanagement and disloyalty, including alleged misappropriation of funds from the auctions to pay the company’s operating expenses. Uhovski has denied the allegations. Paddle8 filed for bankruptcy in March, following a separate suit by a nonprofit cinema group that alleged misappropriation of funds from a charity auction.

Mail Art Experiencing Revitalization

In recent months, Mail Art – a 1950s art movement centered around sending small-scale artworks via the postal service – has regained popularity. Artists have been reaching out via social media for submissions, and to date, hundreds of individuals have answered the call. The original idea was to create a form of artistic production that bypasses the traditional channels of art dissemination. The reborn interest in Mail Art is “creating a sense of connectivity” while allowing for people stuck in their homes to take a break from their screens.

EUROPE

INTERPOL Recovers 19,000+ Artifacts in a Massive Operation Spanning 103 Countries

More than 300 INTERPOL investigations coordinated between 103 countries resulted in recovery of more than 19,000 artifacts. Recalling the work of the Monuments Men – unlikely World War II heroes who saved many of Europe’s art treasures – the investigations were focused on criminal networks that deal in artworks looted from war-torn countries as well as artifacts stolen from archeological excavations and museums. The success of the mission highlights the need for global cooperation in fighting the trafficking of cultural goods.

MoMA Voices Concerns Over Norway’s Handling of Picasso Murals

The Norwegian government is in the process of demolishing a government building in Oslo that features Pablo Picasso’s murals sandblasted onto the concrete walls. While plans have been made to relocate the artworks, many are concerned that once moved, the murals will crack. The MoMA letter, published in the Norwegian press, expresses grave concerns over the preservation of the murals and emphasizes their significance to the art community. In addition, the petition to preserve the building holding the murals has garnered more than 47,000 signatures.

Van Eyck Exhibition Organizers Argue Coronavirus Triggers Cancellation Policy

Organizers of the largest exhibition ever dedicated to the Flemish Old Master Jan Van Eyck will distribute refunds to 144,000 ticket holders who were unable to attend due to early closure following the coronavirus outbreak. The organizers are seeking coverage from their cancellation insurer for the refunds of more than €3.5 million.

Counterfeit Artwork Seized at Heathrow Airport Part of a Larger Problem

The British Museum’s inspection revealed that hundreds of what looked to be Middle Eastern artifacts intercepted last July by an officer at Heathrow Airport were fakes. While the items were discovered to be counterfeit, they had the potential to be sold for thousands of dollars to unsuspecting buyers.

Croatia Rushes to Save Valuable Pieces of Art

While the world deals with the ongoing coronavirus pandemic, Croatia experienced a 5.4 magnitude earthquake in its capital, Zagreb. The earthquake damaged some 26,000 buildings, palaces, university buildings and hospitals. The Museum of Decorative Arts, which planned on celebrating its 140th anniversary, suffered a roof collapse during the earthquake. While the building has been classified as unsafe for use, the Museum has been expeditiously removing many fragile objects, even while the aftershocks continued. Many other pre–20th century buildings also sustained damage.

Banksy Pays Homage to Hospital Workers

As a tribute to the National Health Service and health care workers during this pandemic, renowned street artist Banksy created an artwork titled Game Changer (2020), which he donated to England’s Southampton General Hospital. The piece came with a note to the health care workers that read: “Thanks for all you’re doing. I hope this brightens the place up a bit, even if it’s only black and white.” Just days after the artwork was installed, an opportunistic thief wearing a hazmat suit and armed with a drill was caught attempting to steal it.

ASIA

Archaeologists Uncover Further Evidence of Vital Role of Women in Ancient Mongolian Society

Archaeologists discovered 1,500-year-old skeletons of women warriors in northern Mongolia, near China – recalling the story of Hua Mulan, originally described in the Ballad (Ode) of Mulan composed in the fifth or sixth century CE, and appearing as the main character in the 1998 animated Disney film. A study of the skeletons revealed the two women to be skilled in archery and horseback riding. The skeletons were found in a cemetery at the Airagiin Gozgor archeological site. Disney has been planning to release a live-action adaptation of Mulan, currently scheduled for July 24, social distancing guidelines permitting.

 

© 2020 Wilson Elser

Guide to Federal Reserve Main Street Loan Facilities and Primary Market Corporate Credit Facility

The Federal Reserve has created a number of programs to provide loans and other credit facilities to support the economy in response to COVID-19.  Several of these programs provide for new extensions of credit for small, medium and large businesses, including the Main Street Lending Program and the Primary Market Corporate Credit Facility.  The Main Street Lending Program creates three separate facilities (“MSLFs”):  (1) the Main Street New Loan Facility, (2) the Main Street Expanded Loan Facility and (3) the Main Street Priority Loan Facility.  Each of these facilities contemplates banks and other financial institutions making “new money” loans to eligible borrowers, and in turn selling participation interests in the loans to a Fed / Treasury special purpose vehicle.  The Primary Market Corporate Credit Facility (“PMCCF”) i contemplates a Fed / Treasury special purpose vehicle that will make new money extensions of credit to eligible borrowers by directly purchasing bonds issued by them, or by making loans to such eligible borrowers, whether as a direct lender or by purchasing loans to such borrowers under syndicated loan facilities.

The Federal Reserve released and then updated term sheets for the MSLFs and PMCCF in March and April 2020 and circulated an FAQ for the MSLFs in April 2020, and the Federal Reserve Bank of New York released and circulated FAQs for the PMCCF in April and May 2020.  The term sheets and FAQs provide a number of material terms and conditions for the facilities, but many questions and issues remain in terms of structuring and implementing these facilities generally and for agents, lenders, trustees, borrowers, issuers and other parties satisfying eligibility requirements for and participating in transactions under these facilities.

The MSLFs and PMCCF, which collectively represent hundreds of billions of dollars of new money financing for borrowers and issuers, are expected to launch by the end of May 2020.

A comprehensive summary of the MSLFs and PMCCF based on the term sheets and FAQs issued to date, market reconnaissance and strategic planning and considerations around these facilities can be accessed here.  We will periodically update and supplement the MSLF/PMCCF summary and separately provide additional alerts and guidance regarding these facilities generally and the parties qualifying for and participating in transactions under these facilities.

© 2020 Bracewell LLP

For more on Federal Reserve Main Street Loans, see the National Law Review Financial Institutions and Banking law section.

COVID-19: IRS Extends Production Tax Credit/Investment Tax Credit Safe Harbors

On May 27, 2020, the IRS issued Notice 2020-41, which responds to industry-wide supply chain disruptions due to the COVID-19 pandemic by giving renewable energy developers additional time to complete their projects. Most importantly, the Notice extends two safe harbors applicable to the renewable energy production tax credit (PTC) and investment tax credit (ITC).

First, the “Continuity Safe Harbor” is extended from four years to five years for projects that began construction in 2016 or 2017. Developers that put the project in service by the end of the fifth calendar year after the year construction began will be deemed to meet the continuous construction requirement.

Second, relief is provided for developers that intend to meet the beginning construction requirement by incurring 5% of project costs, i.e., by making payments for services or property they reasonably expected to receive within 3½ months (a/k/a the 3½ Month Rule). Developers that pay for services or property on or after September 16, 2019 and actually receive the services or property by October 15, 2020, will be deemed to satisfy the 3½ Month Rule.

This relief is available to developers of wind, solar, biomass, geothermal, landfill gas, trash, hydropower, fuel cells, microturbines, and combined heat and power systems.

©2020 Pierce Atwood LLP. All rights reserved.

For more on IRS Safe Harbors, see the National Law Review Tax Law section.

Temperature Checks: Three Things to Know Before Screening Employees and Customers

As businesses begin the calculated process of re-opening their doors to employees and customers, many are considering implementing temperature checks to monitor for at least one known COVID-19 symptom – the fever.

Beyond nailing down the logistics of temperature checks (e.g., who will perform them, has that person been trained, do employees need to be paid while waiting in line, how will social distancing be maintained, etc.) there are several significant legal considerations that should be evaluated before implementation.

The Illinois Biometric Privacy Act

Some temperature screening devices utilize facial-recognition technology to quickly identify those with fever so that they can be promptly tracked down and removed from the facility. While these systems provide logistical advantages, especially to large employers and retailers, they likely implicate provisions of the Illinois Biometric Privacy Act (BIPA) which can lead to costly litigation and result in stiff penalties for anyone who violates the statute, even unwittingly.

According to BIPA, businesses utilizing this type of facial-recognition technology must obtain advance, written consent from the individuals to be scanned, and must also maintain a publicly available policy that specifies information regarding the collection, use, storage, and destruction of individuals’ biometric information. And, again, these policies and consents must be executed and implemented before temperature screenings begin. It is, therefore, critical to determine whether your temperature screening devices perform facial recognition scans or capture other biometric information.

Confidentiality of Employee Information

Employers screening employee temperatures must also remember they are conducting a “medical examination,” as defined by the Equal Employment Opportunity Commission (EEOC) and would be wise to adhere to the EEOC’s guidance on the issue. This means information collected about employees’ temperature, such as the temperature readings themselves, or the fact that an employee had or has a fever, must be treated as confidential medication information and maintained in a confidential file separate from an employee’s personnel file. Employers should also take care to not divulge the identity of any employee sent home with fever, absent consent from the employee to share that information with other personnel, or a strict need-to-know among involved supervisor(s) or members of human resources.

The California Consumer Privacy Act

California’s sweeping new privacy law, the California Consumer Privacy Act (CCPA), contains broad protection of consumers’ “personal information,” and requires businesses subject to the statute to, among other things, notify consumers when their personal information is being collected. Though body temperature is not explicitly mentioned in the statute, the definition of “personal information” is broad, and includes information that “identifies, relates to, describes, is capable of being associated with, or could reasonably be linked, directly or indirectly, with a particular consumer …” It includes biometric information. Whether an individual’s temperature constitutes personal information is up for some debate, but debates often lead to costly litigation, and it is easy enough to amend CCPA notices to include temperature until that debate is resolved in an effort to avoid litigation altogether.

So, if a business is subject to the CCPA and intends to collect employee or customer temperatures (whether or not with the use of biometric technology), it should consider updating its CCPA notices to include “temperature” (and, if applicable, scans of face geometry) to the list of personal information collected.

© 2020 Much Shelist, P.C.

For more employer COVID-19 guidance, see the National Law Review Coronavirus News section.

PPP Loan – Will You Be Forgiven?

The United States Department of the Treasury (Treasury) and the Small Business Administration (SBA) began issuing information, guidance and rules with respect to the forgiveness piece of the Paycheck Protection Program (PPP) and the loans available under it by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act). These have been much anticipated, especially for those early borrowers in the PPP whose covered period is coming to an end. The SBA recently released the PPP Loan Forgiveness Application (this or the lender’s equivalent is the Application) which provides guidance and instruction on the calculation of the forgivable portion of a PPP loan. The Treasury and the SBA followed the Application up with interim rules “Loan Forgiveness” and “SBA Loan Review Procedures and Related Borrower and Lender Responsibilities” (collectively, First Forgiveness Interim Rules). The Application and the First Forgiveness Interim Rules shed light on a number of the issues surrounding the loan forgiveness process, calculations related to the same and the potential review of PPP loans by the SBA.

A. Loan Forgiveness Process

In order for a borrower to receive forgiveness on all or a portion of its loan amount, the borrower must complete the Application and submit it to its lender. After the lender has determined what portion, if any, of the borrower’s loan is entitled to forgiveness, the lender will advise the SBA of that determination. The SBA will remit the forgiveness amount to the lender (plus any accrued interest) no later than 90 days after receipt of the lender’s determination of the forgiveness amount; provided, however, that such 90 days is subject to extension if the SBA is reviewing the loan, the loan application or forgiveness calculation. The more material aspects of the submission and determination process include:

  • The lender has 60 days after its receipt of the Application to issue its determination to the SBA. That determination can be in the form of: (a) approval in whole or part; (b) denial; or (c) if directed by the SBA, a denial without prejudice due to a pending SBA review of the underlying PPP loan.
  • The SBA may review any PPP loan that it deems appropriate, and the review may include evaluation of: (i) the borrower’s eligibility (i.e., size of employees, accuracy of certifications, etc.); (ii) calculation of the loan amount and use of the proceeds; and (iii) the loan forgiveness determination.
  • The SBA may undertake a review of a PPP loan at any time, including within a 6 year period after the later of: (1) forgiveness of the loan; and (2) the date of repayment in full.  A borrower will be permitted to respond to questions raised by the SBA in its review of such borrower’s PPP loan. If the borrower fails to respond to an inquiry by the SBA, it risks being deemed ineligible for the loan in general or ineligible for forgiveness. A borrower will be able to appeal determinations of the SBA, and further rules will be issued on this process.
  • A borrower that is not eligible for a PPP loan will not receive forgiveness on any portion of the loan, and the SBA may pursue repayment of the loan and other remedies available to it.

Prior to the issuance of the First Forgiveness Interim Rules, it was unclear what role the lender would have in the forgiveness process. The lender is charged with confirming that: (A) borrower has completed the Application; (B) borrower has submitted all other required documentation (see Section C. below for more details); (C) the calculations for loan forgiveness match the supporting documentation; and (D) borrower correctly calculated what percentage of the requested loan forgiveness was used for payroll costs. The lender’s confirmations and review are to be done in good faith, and the lender may rely on the borrower’s representations and documents in conducting such review.

Key Takeaway – The SBA’s ability to review a borrower’s PPP loan will extend well past the forgiveness period process, and a borrower’s lender will be active in the review and submission of the Application. We expect many lenders to include certifications or attestations made by the borrower for the benefit of the lender with respect to the accuracy and completeness of the information and supporting documents provided with the Application.

B. Certifications

The Application requires a borrower to make additional certifications at the time of the loan forgiveness request.

Key Takeaway – The borrower is not recertifying that the economic uncertainty made the loan request necessary to support the ongoing operations of the borrower. The certifications, however, do include:

  • The dollar amount for which forgiveness is requested (a) was used to pay costs that are eligible for forgiveness; (b) includes all applicable reductions due to decreases in the number of FTE employees and salary/hourly wage reductions; (c) does not include non-payroll costs in excess of 25% of the amount requested; and (d) does not exceed 8 weeks’ worth of 2019 compensation for any owner-employee or self-employed individual/general partner, capped at $15,385 per individual. Key Takeaway – Although “owner-employee” is not defined in the Application, this limitation comes in previously issued rules, and more specifically as set forth in 85 CFR 21747, 21749 (April 20, 2020), and we believe it is limited to those employees that are self-employed for federal income tax purposes and file Form 1040, Schedule C, and not to employees who are also shareholders of corporations taxed as C-corporations or S-corporations for federal income tax purposes.
  • If the loan proceeds were knowingly used for unauthorized purposes, the government may pursue recovery of loan amounts and/or civil or criminal fraud charges.
  • Borrower accurately verified the payments for the eligible payroll and non-payroll costs for which forgiveness is requested.
  • The documentation required to verify payrolls costs, the existence of obligations and service (as applicable) prior to February 15, 2020, and eligible business mortgage interest payments, business rent or lease payments and business utility payments were submitted to the lender.
  • The information provided in the Application and information provided in all supporting documents and forms is true and correct in all material respects. The certifying party also certifies that it understands that knowingly making a false statement to obtain forgiveness is punishable under law, including by imprisonment and/or fine.
  • The tax documents submitted to the lender are consistent with those borrower submitted or will submit to the IRS and/or state tax or workforce agency.

C. Documentation

Borrowers are required to submit certain documents and information to its lender along with the Application. This includes the loan forgiveness calculation form and the PPP Schedule A that are part of the Application. In addition, borrowers must provide the following:

  • Documentation necessary to verify the cash compensation and non-cash benefit payments for the payroll costs paid or incurred, including:
    • Bank statements or third party payroll service provider reports documenting the compensation paid to employees.
    • Tax forms (or equivalent reports from third party payroll service providers) for the periods in question, such as (a) payroll tax filings (e.g., Form 941), and (b) state quarterly business or individual employee wage reporting and unemployment insurance tax filings.
    • Payment receipts, cancelled checks or account statements documenting borrower’s contributions to employee health insurance and retirement plans that are included in the forgiveness amount.
  • Documents showing the average number of FTE employees on the payroll per month employed by borrower between either (i) February 15, 2019 and June 30, 2019, or (ii) January 1, 2020 and February 29, 2020, as selected by borrower. A borrower that is a seasonal employer will use the time period it selected, which can be different than the two options above.
  • Documents verifying that existence of the obligations or services prior to February 15, 2020, and the eligible payments of those non-payroll costs included in the forgiveness amount, including where applicable:
    • Business mortgage interest payments, such as lender amortization schedules and receipts or cancelled checks verifying payments, or lender account statements for the relevant periods of time.
    • Business rent or lease payments, such as current lease agreement and receipts or cancelled checks verifying payments.
    • Business utility payments, such as copies of invoices and receipts or cancelled checks, or account statements verifying the payments for the relevant periods of time.

Each borrower should also have available, but it is not required to submit to the lender, such borrower’s PPP Schedule A Worksheet or equivalent, along with (1) documents supporting the listing of each employee in that worksheet, whether the listing is done for salary/hourly wage reduction or exclusion of individuals receiving an annualize rate of compensation of more than $100,000, (2) documents regarding any job offers and refusal, firings for cause, voluntary resignations and written requests by employee for reduction, if applicable, (3) documents supporting the FTE Reduction Safe Harbor calculation on such worksheet. Further, all records related to the borrower’s PPP Loan, such as its application, support for its certifications, its eligibility and support for forgiveness must be retained for 6 years after the later of the date of its loan forgiveness, and its repayment of the loan.

Key Takeaway – The documentation to be submitted to the lender for forgiveness is relatively light. However, the amount of supporting documents and backup that the borrower should have at the ready for a six year plus period is quite extensive.

D. Forgivable Expenses

The Application and the First Forgiveness Interim Rules set forth in greater detail than the CARES Act itself the expenses that a borrower pays or incurs that are eligible for forgiveness. Those expenses are grouped into two categories: (1) payroll costs, and (2) non-payroll costs. In general, to be forgiven, the enumerated expenses must be paid or incurred during the applicable 8-week period.

  1. Covered Period and Paid/Incurred. In general, payroll costs and non-payroll costs are eligible for forgiveness only if they are paid or incurred in the applicable covered period. The Application and new rules provide very meaningful guidance in this area.
    1. Covered Period. First, borrowers have the option of selecting which 8-week period will be used to measure the paid or incurred payroll costs. Borrowers can seek forgiveness for payroll costs for the 8-week period beginning on either: (i) the date of disbursement of the loan proceeds (Original Covered Period); or (ii) the first day of the first payroll cycle in the 8-week period in the Original Covered Period (Alternative Payroll Period). The Alternative Payroll Period provides flexibility to a borrower and helps it align the covered period better to its payroll cycle. The Alternative Payroll Period is not available for non-payroll costs.
    2. Paid/Incurred. The CARES Act indicated that the forgivable expenses of the borrower had to be paid and incurred in the covered period. This created questions surrounding how to measure the same, and whether or not the use of “and” was intended to be conjunctive or disjunctive in nature. The Application and rules greatly simplify the analysis on this front. In short, a borrower can seek forgiveness for appropriate payroll and non-payroll expenses that are paid during the applicable covered period, and for those 5 expenses incurred during the applicable covered period that are paid on the next regular payroll date, or for non-payroll costs on the next regular billing cycle. Payroll costs are considered paid on the day that paychecks are distributed or the day borrower originates an ACH credit transaction. Payroll costs are incurred on the day the employee’s pay is earned (i.e., the day the employee worked).

Key Takeaway – A borrower can submit expenses either paid or incurred in the applicable period so long as they are not double counted. And, unless changed by supplemental rules, a borrower gets the benefit of more than 8 weeks of payroll paid or incurred during the Original Covered Period or the Alternative Payroll Period, as applicable.

  1. Payroll Costs. The new guidance reiterates that forgivable payroll costs is the compensation to employees whose principal place of residence is in the United States during the applicable 8-week period. Compensation includes (a) salary, wages, commissions or similar compensation; (b) cash tips or equivalent (based on borrower’s records of tips or, if no such records, a reasonable good-faith estimate); (c) payment for vacation, parental, family, medical or sick leave; (d) allowance of separation or dismissal; (e) payment for the provision of employee benefits consisting of group health coverage, including insurance premiums, and retirement; (f) payment of state and local taxes assessed on compensation of employees; and (g) for an independent contractor or sole proprietor, wages, commissions, income or net earnings from self-employment or similar compensation. Key Takeaway – The First Forgiveness Interim Rules clarify that compensation payments to furloughed employees in the applicable 8-week period are eligible for forgiveness (subject to the $100,000 annualized cash compensation limitation). In addition, if an employee’s total cash compensation does not exceed $100,000 on annualized basis, the employee’s hazard pay and bonuses are eligible for forgiveness. Finally, the amount of forgiveness requested for owneremployees and self-employed individuals’ payroll compensation can be no more than the lesser of 8/52 of 2019 compensation or $15,385 per individual in total across the business (see commentary in Section B. on the definition of “owneremployee”).
  2. Non-Payroll Costs. While the Application and latest rules do not define payroll costs and non-payroll costs specifically, they do shed light on a few questions surrounding the items includable in those categories. Generally, the Application and the rules reiterate that non-payroll costs that are potentially forgivable are (a) interest payments on business mortgage obligations on real or personal property that were incurred before February 25, 2020 (but not any prepayment or payment of principal); (b) payments on business rent obligations on real or personal property under a lease agreement in force before February 15, 2020; and (c) business utility payments for the distribution of electricity, gas, water, transportation, telephone or internet access for which service began before February 15, 2020.

Key Takeaway – Payments under rental or lease agreements for personal property are eligible for forgiveness. And, the SBA confirmed prepayment of interest is not a forgivable use of PPP loan proceeds.

E. Reduction in Forgiveness Mechanics

The SBA also addressed and answered several outstanding questions related to the reductions for forgiveness required under the CARES Act and the rules promulgated thereunder, including those for reduction in work force (including furloughs and reduction in hours) or employees’ wages. Additionally, the SBA created several borrower-friendly exemptions in the process, relying on “administrative convenience” and the statutory authority to grant de minimis exemptions. Several of the First Forgiveness Interim Rule’s questions and answers are worthy of note, but with guidance still ever-changing and regulations still to follow, we advise seeking counsel and reviewing the most up-to-date guidance before calculating whether a PPP loan is subject to a reduction in forgiveness.

  1. Order of Application. There are specific instances where the amount of forgiveness can be reduced. Those instances are when there is a reduction in employee pay level, a reduction in the number of FTEEs, and more than 25% of the amount sought to be forgiven is related to non-payroll costs. Before issuance of the Application, it was not clear in what order these potential reductions were to apply, and how they would interact. Key Takeaway – The reductions are to be applied by first addressing the reduction in employee pay level, then the reduction for any decrease in FTEEs, and finally calculation of any reduction needed because more than 25% of the amount applied for forgiveness is attributable to non-payroll costs.
  2. Employees Who Refuse to Come Back to Work. Prior guidance indicated that if a borrower offered to restore an employee to its prior wage/hours/employment status and the employee refused, that employee would not be counted against the borrower in calculating forgiveness. This was codified in the First Forgiveness Interim Rules, which also applied this exemption to situations where the borrower had previously reduced the hours of the employee and offered to restore the employee to the same salary or wages. Key Takeaway – The First Forgiveness Interim Rules provided a five-part test for borrowers to qualify for the exemption. The test includes that the borrower must make a good faith offer to rehire or restore the reduced hours to the same salary or wages and same number of hours as earned by the employee in the last pay period prior to the separation or reduction in hours. The offer must be rejected by the employee, and the offer and rejection must be documented. The borrower must inform the state unemployment office of the rejected offer within 30 days of the employee’s rejection of the offer.
  3. Effect of a Reduction in Full-Time Equivalent Employees (FTEEs). When calculating a reduction in forgiveness based on a reduction in FTEEs, the borrower is to divide the average number of FTEEs during the Original Covered Period or the Alternative Payroll Period by the average number of FTEEs during the “reference period,” with the total eligible expenses available for forgiveness reduced proportionally by the percentage of reduction in FTEEs. In prior publications, the SBA had suggested that the borrower may not be able to choose the reference period (as had initially been suggested by the language of the CARES Act) and that borrowers that were in business prior to February 15, 2019 had to use February 15 to June 30, 2019 as the reference period.  Key Takeaway –The SBA made clear that the borrower will have a choice in selecting the reference period, which should allow most borrowers to choose the reference period that minimizes any reduction to forgiveness based on a reduction in workforce. Most borrows have two choices in determining the reference period to calculate any reduction of forgiveness due to a reduction in FTEEs: (a) February 15-June 30, 2019, or (b) January 1-February 29, 2020. Seasonal employers, however, could also choose any consecutive 12-week period between May 1 and September 15, 2019.
  4. Calculating FTEEs. FTEE calculations are determined on a 40 hour work week. Any employee who works 40 hours or more is considered one FTEE. However, the SBA creates two options for calculating FTEEs when it comes to employees who work less than 40 hours per week. The borrower must apply the option it selects consistently for calculating both the reference period and the Original Covered Period (or the Alternative Payroll Period), and for all employees. The first option is to calculate the actual numbers a part-time employee was paid per week and divide that number by 40. The second, alternative option—created for administrative convenience—is to use a full-time equivalency of 0.5 for each part-time employee, without concern to the actual hours the employee worked. Key Takeaway – The second option for calculating FTEEs will be significant for certain borrowers, like those in retail and restaurant industries, who are slowly re-opening at reduced capacity, and often have a significant portion of the staff working less than 40 hours a week. While we advise seeking counsel prior to making a choice between the two options provided, the creation of the second option may allow some borrowers to mask small reductions in hours for individual employees that are likely to occur as the borrower is reopening at reduced capacity. Of note, this option does not exempt these part-time employees from calculating a reduction in forgiveness due to a reduction in salary, nor does it change the requirement that at least 75% of the forgivable amount be actually spent on payroll costs.
  5. Effect of a Reduction in Employees’ Wages on Forgiveness. The SBA made clear that the reference period for calculation in wage-reduction was January 1 through March 31, 2020 and that the reduction is based on a per employee basis (not in the aggregate). Key Takeaway – Borrowers will not be doubly penalized for a reduction in FTEEs when calculating reductions in forgiveness. If a borrower merely reduces hours but does not change the salary/wage of the employee, the SBA indicates that the borrower will not also suffer a reduction in forgiveness for a reduction in wages. Likewise, terminating an employee should not also count as a reduction in wages to that employee. 
  6. Safe Harbor for Rehiring. The CARES Act provides for a safe harbor period for any borrower who saw a reduction in FTEEs or employee wages from February 15 through April 26 (30 days after the Act was enacted), but cures those reductions by June 30, 2020. Key Takeaway – The rules provide that a borrower who saw reductions to FTEEs or wages during the safe harbor period, but cures such reduction by June 30 will suffer no reduction in forgiveness for that employee. However, even with this 8 effort for clarity, borrowers should seek counsel before calculating safe harbor exemptions to reductions in forgiveness, as, for example, an employee who was laid off on February 14 is treated differently than one laid off on February 15, and an employee who had wages reduced on April 26 is treated differently than one whose wages were reduced on April 27.
  7. Employees fired for cause or voluntarily causes reduction in hours. The First Forgiveness Interim Rules give a borrower a better understanding of what employees or former employees count in the FTEE calculations, and certain terminations of employment will not be counted against the borrower. Key Takeaway – The SBA created an exemption not contemplated by the CARES Act. Specifically, when an employee is fired for cause, voluntarily resigns, or voluntarily requests a reduction of hours during the covered period, the borrower may count such employee as the same FTEE level as before the event when calculating the FTEE penalty. This would likely include employees who abandoned positions after being offered to return to work, even if the employee did not formally reject the offer as otherwise required in Section E.2 above. However, the SBA cautioned borrowers that the borrower must maintain records (for up to six years) demonstrating the employee was fired for cause, voluntarily resigned or requested a reduced schedule, and must provide the records upon request of the SBA.

F. Questions that Remain Unanswered.

While the Application and the First Forgiveness Rules addressed several issues surrounding the forgiveness aspects of the PPP, borrowers will be waiting and watching for further issuances by the Treasury and the SBA on questions not yet addressed. Some of those items are:

  • Will lenders be able to extend the 6 month deferment on the repayment of the PPP loan so as to allow the forgiveness process to be completed, or will a borrower need to start making payments based on the lender’s determination of forgiveness?
  • If a borrower has multiple payroll cycles (e.g., bi-weekly and monthly), does it only get to use the Alternative Payroll Period once, or can it elect to change the Original Covered Period for each payroll cycle?
  • Are retirement plan contributions, which are not monthly payroll cycle matches, but instead discretionary in nature, a forgivable expense if paid during the applicable covered period?
  • Is there a deadline for a borrower to make the request for forgiveness?
  • Can PPP loan proceeds be used for permissible purposes after June 30, 2020, or if not spent by then do they need to be returned to the lender? We expect even more guidance and interim rules on the loan forgiveness aspects of the PPP to be forthcoming.

© 2007-2020 Hill Ward Henderson, All Rights Reserved

For more on SBA’s PPP loan see the National Law Review Coronavirus News section.

CDC’s Detailed Guidance to Reopen Businesses

The Center for Disease Control (“CDC”) has issued 60 pages of detailed guidance to reopen businesses, health care facilities and providers, schools, transit, and other industries. This guidance also provides information regarding testing and data to assist with exposure and risk concerns for those industries. The following is an overview of the topics addressed in the newly released guidance.

  • High Risk Employees: Employers with workers at high risk are recommended that they self-identify and employers should avoid making unnecessary medical inquiries. Employers are encouraged to offer options to telework if possible, or duties that minimize their contact with customers and other employees.
  • Restaurants and Bars: Restaurants and bars may reopen utilizing social distancing and reduced capacity. The CDC also recommends formal policies in place to enforce proper hygiene, including the use of cloth facemasks and encourage employees to stay at home if ill. Employers are advised to follow applicable OSHA guidance as well.
  • Surveillance Systems: The CDC sets forth sample surveillance systems to assist with capturing all parameters of the pandemic, including testing, contract tracing and other guidance regarding limiting exposure. This guidance offers details for local and state health departments related to testing efforts and best practices to assist with controlling the spread of the disease and gating criteria.
  • Schools: The CDC recommends that schools remain closed and continue virtual learning. Schools may slowly reopen pursuant to the reopening guidelines, including recommendations for spacing students six feet apart and staggering lunch periods, along with increased social distancing for students and staff. If an individual is diagnosed with COVID-19 schools may consider closing for a short time (1-2 days) for cleaning and disinfection.
  • Summer Camps: At this time, the CDC recommends that summer camps provide services only to children of essential workers and those who live in local geographical area.
  • Child Care: Child care programs should be gearing up to reopen and the guidance sets forth interim guidance to assist with the gradual scale up for operations. Step one restricts daycares to children of essential workers; step two expands daycare services to all children with enhanced social distancing measures; Step three remaining open for all children with social distancing measures.
  • Mass Transit: Mass transit is recommended to consider revising its routes based on local virus spread and advised to coordinate with local health officials.

The list above is not exhaustive, and the latest guidance provides roadmaps for businesses in various industries as they navigate this new normal. Specific to businesses, the CDC’s May 21, 2020 changes include:

  • Updated cleaning and disinfection guidance
  • Updated best practices for conducting social distancing
  • Updated strategies and recommendations that can be implemented now to respond to COVID-19

Related CDC links for businesses include:

For guidance on reopening within Wisconsin, review the Wisconsin Economic Development Corporation’s (WEDC) Reopen Guidelines linked here. WEDC offered general guidelines as well as customized guidance for each industry.

© 2020 Davis|Kuelthau, s.c. All Rights Reserved

For more on business reopening, see the National Law Review Coronavirus News section.

“Caveat Emptor”: New York Bankruptcy Court Disallows Bankruptcy Claims Purchased from Recipients of Avoidable Transfers; Is Enron Going, Going, . . . ?

A recent Bankruptcy Court decision, In re Firestar Diamond, Inc., out of the Southern District of New York (“SDNY”) by Bankruptcy Judge Sean H. Lane, disallowed creditors’ bankruptcy claims purchased from sellers who allegedly received (and had not repaid) avoidable preferences and fraudulent transfers from the debtors.1 Judge Lane provides a cogent warning to claims purchasers that they bear the risk of Bankruptcy Code section 502(d) disallowance.

Judge Lane based the Firestar Diamond decision on Bankruptcy Code section 502(d), which mandates disallowance of claims of an entity that has received property that the estate may recover (e.g., avoidable transfers) unless that entity or its transferee has repaid the avoidable or recoverable amount.2  Further, in so ruling, Judge Lane aligned his Court with the view of the Third Circuit Court of Appeals in In re KB Toys Inc.3  There, when faced with the same issue, the Third Circuit held that the taint of section 502(d) disallowance risk travels with the claim itself and the taint cannot be cleansed through a subsequent transfer of the claim to a third-party transferee.

Notably, in reaching its holding in Firestar Diamond, Judge Lane rejected a holding by a District Court in its own district.  Thirteen years ago, in the aftermath of the Enron bankruptcy, District Court Judge Shira Scheindlin held that Bankruptcy Code section 502(d) is a “personal disability and does not travel with the ‘claim,’ but with the ‘claimant.’”  In a decision that was regarded as a boon to the secondary bankruptcy claims trading market, Judge Scheindlin ruled that purchasers of claims (not mere assignees) would take free from the risk of section 502(d) disallowance.4 The District Court vacated the Bankruptcy Court’s order disallowing claims and remanded to determine the nature of the transfer.  If the transfer were a sale, rather than an assignment, it would not be disallowed under section 502(d).5  But the Enron decision found few adherents.  Firestar Diamond joins a lengthening line of decisions criticizing or declining to follow it.

Some risk mitigation suggestions are set forth in the “Implications” section below.

Background:

In Firestar Diamond, the Debtors were three wholesalers of jewelry – Firestar Diamond, Inc., Fantasy, Inc., and A. Jaffee, Inc. (collectively, “Firestar” or the “Debtors”) – who sold mainly to department stores and specialty chain stores in the United States.  Firestar filed for Chapter 11 protection in February of 2018 in the SDNY in the “shadows of an alleged massive fraud” conducted by Firestar’s owner, Nirav Modi, who allegedly used a number of shadow entities (“Non-debtor Entities”) to pose as independent third parties in sham transactions in order to obtain billions of dollars in bank financing.

The SDNY Bankruptcy Court appointed an examiner to look into these allegations.  The examiner found “substantial evidence” of the Debtors’ “knowledge and involvement” in the alleged criminal conduct.  As a result, the court appointed a Chapter 11 trustee to administer the Debtors’ estates.6

A number of banks filed proofs of claims in the Chapter 11 case.  The banks’ claims were not based on their dealings with the Debtors.  Instead, the banks’ claims were based on amounts that the Debtors owed to the Non-debtor Entities, which had pledged their receivables or sold their invoices to the banks at a discounted price for amounts the Debtors owed.7 

The Chapter 11 trustee objected to the banks’ claims under section 502(d) because the claims had been acquired from claim sellers who had received fraudulent transfers and preferences from the Debtors.  The banks opposed the trustee’s argument based on Enron, arguing instead that “disallowance under Section 502(d) is a personal disability and does not travel with the ‘claim,’ but with the ‘claimant’” and that the banks had “acquired rights to payment from the Debtors through a ‘sale’ rather than an ‘assignment’.” Therefore, the claims had been washed clean.8

In contrast, the trustee argued that “sale” or “assignment” was of no import and urged the Court to reject Enron and follow rulings by other courts, including the Third Circuit’s decision in KB Toys.  In the trustee’s view, the banks’ claims should be treated the same as if they had been filed by the Non-debtor Entities and disallowed.

Ultimately, Judge Lane agreed with the trustee and held that the banks’ claims should be disallowed because section 502(d) focuses on the claims themselves rather than who holds them. The original claims were disallowable and, therefore, remained disallowable even after their sale to the banks.

Enron and KB Toys:

Enron and KB Toys represent opposing views interpreting section 502(d).  Generally, Enron attributed disallowance under section 502(d) to the claimant rather than a feature that transfers with a claim. On the other hand, KB Toys viewed section 502(d) disallowance as an attribute of the claim and therefore a feature that travels with the claim upon transfer.

In Enron, the court also held that when a claim is transferred, the “nature of that transfer” will dictate whether there may be a disallowance under section 502(d).  Indeed, a transfer of a claim by assignment would allow the personal disability to transfer with the claim because an assignee “stands in the shoes of the assignor” and would, therefore, take on the transferred property with “whatever limitations it had in the hands of the assignor[.]”  Meanwhile, a transfer by a sale would allow the purchaser only to receive the claim, washing the claim of the disability.  Judge Scheindlin reasoned that recovery of property under the threat of section 502(d) disallowance would not be achieved if the claim was held by a creditor who had not received the preference.9

KB Toys rejected the distinction between “assignment” and “sale,” noting that there is no support for this distinction in the Bankruptcy Code.  The Third Circuit concluded that “claims that are disallowable under [section] 502(d) must be disallowed no matter who holds them.”10  The Third Circuit reasoned that allowing a claim originally held by the recipient of a fraudulent or preferential transfer to be washed clean of section 502(d) disabilities would “contravene” the purpose of section 502(d), “which is to ensure equality of distribution of estate assets.”11  If the original claimant could rid the claim of its disabilities by selling the claim to a transferee, trustees would be “deprive[d] . . . of one of the tools the Bankruptcy Code gives trustees to collect assets—asking the bankruptcy court to disallow problematic claims.”12

A number of other courts and scholars alike have agreed with the Third Circuit, thereby concluding that section 502 follows the claim rather than the claimant.13

In re Firestar Diamond:

Judge Lane’s recent decision in Firestar Diamond continues that trend.  Indeed, Firestar Diamond adopted KB Toys’ reasoning and rejected the banks’ position and reliance on Enron.14  Judge Lane, focusing on the claims rather than the claimants, granted the trustee’s section 502(d) claim objections.  The banks’ claims were tainted by fraudulent and preferential transfers received by participants in Firestar’s bank fraud scheme.  Those Non-debtor Entities could not cleanse their other claims against the debtor by selling them to third parties, unless they repaid the avoidable transfers.

In addition, Judge Lane rebuffed the banks’ argument that disallowance of their claims would “wreak havoc in the claims trading market or unfairly punish good faith transferees.”  Rather, the Court explained that it would be “inequitable” to favor the banks over other creditors.15

Following KB Toys, Judge Lane thus concluded that claims purchasers should bear that risk because (i) they voluntarily chose to participate in the bankruptcy and were aware of the risks of doing so, and (ii) they are able to mitigate that risk through due diligence and including an indemnity clause in the transfer agreement.  On the other hand, other creditors in a bankruptcy “have no way to protect themselves against the risk that claims with otherwise avoidable transfers will be washed clean by a sale or assignment.”16

Implications

Firestar Diamond continues the trend of disallowing creditor claims acquired from sellers who received avoidable or preferential transfers from the debtor. In light of yet another decision coming out this way, claims purchasers need to transact with eyes wide open and be mindful of potential consequences pursuant to section 502(d) of the Bankruptcy Code.

Duly informed claims purchasers may mitigate some risk by, among other things, considering the following measures:

  • Conduct due diligence with the goal of aiming to minimize disallowance risk under section 502(d) by investigating and inquiring into the seller’s relationship and transactions with the debtor.
  • Consider including protections in claim transfer agreements, such as indemnification language in the event of a claim objection based on section 502(d).
  • Consider documenting transfers as “sales” rather than assignments to take advantage of whatever protection or benefit the Enron rationale may still bestow and provide.

1   In re Firestar Diamond, Inc., et al., No. 18-10509 (SHL), 2020 WL 1934896 (Bankr. S.D.N.Y. Apr. 22, 2020) (“Firestar Diamond”).

2   Section 502(d) provides, in part, “[T]he court shall disallow any claim of an entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 or this title.”

3   736 F.3d 247 (3d Cir. 2013) (“KB Toys”).

4 Judge Scheindlin limited protection from section 502(d) disallowance to claims held by creditors who acquired their claims by “sale” rather than “assignment.”  The District Court reasoned that a transfer by assignment will not grant the assignee more rights than possessed by the assignor – an assignee “stands in the shoes of the assignor” and takes with the assignor’s limitations.  379 B.R. at 435.  But a claim that is “sold” is not subject to the personal disabilities of the transferor.  Id. at 436.

5   In re Enron Corp., 379 B.R. 425, 445-46 (S.D.N.Y. 2007) (“Enron”) (“the nature of the transfer will determine whether [the] claims can be subject to . . . disallowance based on [Debtor]’s conduct”).  The Third Circuit, other courts, and bankruptcy commentators have questioned the distinction between “sale and “assignment,” finding it “problematic” and unsupported by state law.  See KB Toys, 736 F.3d at 254; Firestar Diamond, 2020 WL 1934896 at *9-12.

6   Firestar Diamond, 2020 WL 1934896 at *2-3.

7   Id. at *4 n.3.

8   Id. at *4-6.

9   Enron, 379 B.R. at 443 (The purpose of section 502(d) is to “coerce the return of assets obtained by preferential transfer. That purpose would not be served if a claim in the hands of a claimant could be disallowed even where that claimant had never received the preference to begin with, and as a result, could not be coerced to return it. It seems implausible that Congress would have intended such a result.”).

10 KB Toys, 736 F.3d at 252.

11 Id. at 252.

12 Id.

13 See Firestar Diamond, 2020 WL 1934896 at *10-11 (collecting cases and scholarly articles); In re Motors Liquidation Co., 529 B.R. 520 (Bankr. S.D.N.Y. 2015); In re Wash. Mut., Inc., 461 B.R. 200 (Bankr. D. Del. 2011), vacated in part on other grounds, 2012 WL 1563880 (Bankr. D. Del. Feb. 24, 2012); Adam J. Levitin, Bankruptcy Markets: Making Sense of Claims Trading, 4 Brook. J. Corp. Fin. & Com. L. 67, 92 (2009); Jennifer W. Crastz, Can a Claims Purchaser Receive Better Rights (Or Worse Rights) Than Its Transferor in a Bankruptcy?, 29 Cal. Bankr. J. 365, 637 (2007); Roger G. Jones & William L. Norton, III, Norton Creditor’s Rights Handbook § 8:8 (2008).

14 Firestar Diamond, 2020 WL 1934896 at *9.

15 Id.

16 Id. at *13-14.

© Copyright 2020 Cadwalader, Wickersham & Taft LLP

Legislation Enabling Policyholders to Obtain Insurance Coverage for Coronavirus Claims is Constitutional Part 1

On top of its human toll, the coronavirus pandemic has had massive economic effects.  Stay-at-home orders, which remain in place in much of the United States, have resulted in massive layoffs, spiraling claims for unemployment compensation, and unprecedented federal aid.

Many businesses affected by the pandemic have turned to their insurers seeking “business interruption” coverage.  As its name suggests, this coverage typically reimburses the policyholder for costs incurred when the business is unable to open.  Insurers have denied policyholders’ pandemic-related claims, contending that they only have to cover business interruption that results from a “physical injury” and that the damage that results from infestation with the coronavirus or a governmental shutdown order does not constitute “physical injury.”  Insurers have also cited the exclusions in many of their policies that purport to bar coverage for virus-related injuries.

Legislative Responses to the Crisis

One response to the insurance industry’s position has been introduction of legislation voiding virus exclusions and/or defining physical injury to include coronavirus.  New Jersey, Massachusetts, Ohio, New York, Pennsylvania, and South Carolina are all considering such legislation.  The proposed bills generally provide that, notwithstanding any other law or policy language to the contrary, every insurance policy that insures against loss or damage to property which includes the loss of use and occupancy and business interruption shall be construed to include coverage for business interruption resulting from COVID-19.  The bills typically provide mechanisms for insurers to seek reimbursement from a state established and managed fund for losses paid related to COVID-19.

Insurance Industry Responses to the Proposed Legislation

Predictably, the insurance industry has objected to this legislation.  For example, in a recent interview, Evan Greenberg, CEO of Chubb, said in an interview on CNBC state governments can’t force insurance companies to cover incidents not included in the policy.  “You can’t just retroactively change a contract. That is plainly unconstitutional,” Greenberg told “Mad Money” host Jim Cramer.  See https://www.cnbc.com/2020/04/16/chubb-ceo-making-insurers-cover-pandemic-losses-is-unconstitutional.html.

Law firms that defend insurers have similarly argued that “This proposed legislation …., is unfair and is likely unconstitutional, as it appears to run afoul of the Contracts Clause of the Constitution.”   That Clause prohibits States from “pass[ing] any . . .  Law impairing the Obligation of Contracts . . . .”  U. S. Const., Art. I, Sec. 10.  The insurer lawyers contend that “the proposed legislation would substantially impair insurance policies, as [it] would operate to rewrite policies to cause them to cover a risk they do not currently cover.…”   While acknowledging that the Supreme Court has upheld state laws that impair contracts, so long as they are reasonably tailored to fulfill a legitimate interest, insurer counsel contend that such laws are still unconstitutional.  Counsel claim that the proposed laws do not fulfill a legitimate interest because they “arguably benefit[] only a narrow class of businesses; the public at-large is only an indirect beneficiary.”  Id.  And counsel assert that the proposed laws are not “appropriate and reasonable” because they “attempt[] to shift the responsibility of providing financial assistance to small businesses from the government to certain insurance companies. . . .” Id.

Why the Insurance Industry Is Wrong about the Contracts Clause

This analysis is simply mistaken.  The case law interpreting the Contracts Clause demonstrates that legislation designed to provide relief to policyholders is constitutional.

As discussed below, under the cases, courts have established a balancing test that weighs the extent to which the challenged legislation contravenes contractual expectations against the purpose of the legislation and the means used to achieve that purpose.  Under that test, the proposed legislation is constitutional.

Basic Principles

The range of state legislative actions that can affect contractual relationships is broad. For instance, a state statute may render a contract wholly illegal.  See Stone v. Mississippi, 101 U.S. 814, 819 (1879) (upholding state statute outlawing lottery against claim that it violated contract rights of lottery company).  Or a statute may directly change the term of a contract.  E.g., United States Trust Co. v. New Jersey, 431 U.S. 1, 3 (1977) (state law abrogated covenant in contract with holders of state bonds); Home Bldg. & Loan Ass’n v. Blaisdell, 290 U.S. 398, 416 (1934) (state law modified foreclosure provisions in mortgages).  Even a law that has nothing to do with either the express terms of the contract or its subject matter can affect the parties’ allocation of risk, such as a law that changes the statute of limitations for contract actions.  See J. Ely, Jr., Whatever Happened to the Contract Clause?, 4 Charleston L. Rev. 371, 377 & n.48 (2010) (discussing Contracts Clause cases involving statutes of limitations).

Yet, as the Supreme Court has made clear, “it is not every modification of a contractual promise that impairs the obligation of contract under federal law.”  City of El Paso v. Simmons, 379 U.S. 497, 506–07 (1965).  Even though the language of the Contracts Clause is  “facially absolute,” Energy Reserves Group v. Kansas Power & Light Co., 459 U.S. 400, 410 (1983), “the prohibition against impairing the obligation of contracts is not to be read literally,” Keystone Bituminous Coal Ass’n v. DeBenedictis, 480 U.S. at 502.  Rather, “[t]he States must possess broad power to adopt general regulatory measures without being concerned the private contracts will be impaired, or even destroyed, as a result.”  United States Trust Co. v. New Jersey, 431 U.S. at 22.  In other words, the ban on impairment of contracts “must be accommodated to the inherent police power of the State ‘to safeguard the vital interests of its people.’’’  Energy Reserves Group, 459 U.S. at 410, quoting Home Bldg. & Loan Ass’n v. Blaisdell, 290 U.S. at 434.

Though not specifically referenced in the Constitution, the “police power” gives state legislatures broad leeway to pass laws to protect the public health, safety, and welfare.  The classic case is Stone v. Mississippi, 101 U.S. 814 (1879).  There, a state statute outlawing lotteries was challenged by a company that had previously obtained a charter from the state to run a lottery.  Rejecting the challenge, the Court held that the state’s power to shield the public from the evils of gambling trumped the contract rights of the lottery company.  Id. at 819.  Over time, the definition of the police power expanded to include a wide variety of laws designed to protect the public.  See, e.g., Home Building & Loan Association v. Blaisdell, 290 U.S. 398, 444 (1934) (Great Depression “furnished a proper occasion for the exercise of the reserved power of the State to protect the vital interests of the community” by providing for mortgage relief for financially strapped homeowners); Manigault v. Springs, 199 U.S. 473, 480 (1905) (even if contract for sale of alcohol was permissible when made, state could later prohibit such sales without violating Contracts Clause).

As we’ll discuss in the next part of this post, since the New Deal, the Supreme Court has generally applied these principles to uphold state legislation against challenges brought under the Contracts Clause.  We’ll also discuss how these basic principles have been applied by lower courts in insurance coverage cases and why we think the proposed legislation passes muster under the Constitution.

© 2020 Gilbert LLP

ARTICLE BY Mark A. Packman of Gilbert LLP.
For more business policies & the coronavirus, see the National Law Review Insurance, Reinsurance, and Surety law section.

Veterans Affairs Case Offers Clarification on WPA Burden of Proof

In Sistek v. Dep’t of Veterans Affairs, 955 F.3d 948, 954 (Fed. Cir. 2020), the Federal Circuit clarified a federal whistleblower’s burden of proving retaliation when the discrimination he alleges is not specifically identified as a prohibited personnel action in the Whistleblower Protection Act of 1989 (“WPA”), 5 U.S.C. § 2302(b)(8). The WPA protects federal employees who disclose evidence of illegal or improper government activities. Under the WPA, an agency may not take or threaten to take certain personnel actions because of a protected disclosure by an employee.

This blog reviews the elements of a WPA claim, then discusses how Sistek affects these proof requirements when the retaliation consists, in part, of subjecting the employee to an internal investigation.

Background on the Whistleblower Protection Act

To state a claim under WPA, an employee must allege that (1) there was a disclosure or activity protected under the WPA; (2) there was a personnel action authorized for relief under the WPA; and (3) the protected disclosure or activity was a contributing factor to the personnel action. See 5 U.S.C. § 1221(e)(1). If the appellant makes out a prima facie case, the agency is given an opportunity to prove, by clear and convincing evidence, that it would have taken the same personnel action in the absence of the protected disclosure. 5 U.S.C. § 1221(e)(2); see Fellhoelter v. Department of Agriculture, 568 F.3d 965, 970–71 (Fed. Cir. 2009). The WPA is a “remedial statute,” and its terms are to be construed “broadly.” Weed v. Soc. Sec. Admin., 113 M.S.P.R. 221, 227 (2010). See also Fishbein v. Dep’t of Health & Human Servs., 102 M.S.P.R. 4, 8 (2006) (“Because the WPA is remedial legislation, the Board will construe its provisions liberally to embrace all cases fairly within its scope, so as to effectuate the purpose of the Act.”).

A. Protected Disclosures

An employee engages in a protected disclosure when he or she makes a formal or informal communication of information that he or she reasonably believes evidences “any violation of any law, rule, or regulation” or “gross mismanagement, a gross waste of funds, an abuse of authority, or a substantial and specific danger to public health and safety.” 5 U.S.C. § 2302(b)(8)(A). The WPA also protects disclosures that an employee reasonably believes are evidence of censorship related to research, analysis, or technical information that the employee believes is, or will cause, either a “violation of law, rule or regulation” or “gross mismanagement, a gross waste of funds, an abuse of authority, or a substantial and specific danger to public health or safety.” Pub. L. No. 112-199, sec. 110, 126 Stat. 1465 (Nov. 27, 2012). Protected disclosures include those made to a supervisor or to a person who participated in the activity that was the subject of the disclosure, as well as those made “during the normal course of duties of an employee.” Id.; Day v. Dep’t of Homeland Sec., 119 M.S.P.R. 589, 599 (2013).

The WPA defines a “disclosure” very broadly. See 5 U.S.C. § 2302(a)(2)(D) (“‘disclosure’ means a formal or informal communication or transmission”). The relevant inquiry is whether an employee “reasonably believed” that the disclosure evinces a violation of any law, rule, or regulation; gross mismanagement; gross waste of funds; abuse of authority, or; a substantial and specific danger to public health or safety. See, e.g., Miller v. Dep’t of Homeland Sec., 2009 WL 1445346 (M.S.P.B. May 4, 2009) (employee’s criticisms of new policies were protected disclosures under WPA because he reasonably believed that these policy changes would pose a substantial and specific danger to public safety).

B. Personnel Action

Under the Whistleblower Protection Act, a “personnel action” may refer to:

  1. an appointment;

  2. a promotion;
  3. an action under chapter 75 of this title or other disciplinary or corrective action;
  4. a detail, transfer, or reassignment;
  5. a reinstatement;
  6. a restoration;
  7. a reemployment;
  8. a performance evaluation under chapter 43 of this title or under title 38;
  9. a decision concerning pay, benefits, or awards, or concerning education or training if the education or training may reasonably be expected to lead to an appointment, promotion, performance evaluation, or other action described in this subparagraph;
  10. a decision to order psychiatric testing or examination;
  11. the implementation or enforcement of any nondisclosure policy, form, or agreement; and
  12. any other significant change in duties, responsibilities, or working conditions;
  13. 5 USCA § 2302(a)(2)(A). The list is comprehensive, and covers a wide swath of adverse personnel actions.

C. Contributing Factor

Under the “knowledge/timing test,” an individual may demonstrate that a protected disclosure was a contributing factor to a personnel action through circumstantial evidence, such as evidence that the official taking the personnel action knew of the whistleblowing disclosure and took the personnel action within a period of time such that a reasonable person could conclude that the disclosure was a contributing factor in the personnel action. See Atkinson v. Dep’t of State, 107 M.S.P.R. 136, 141 (2007) (citing 5 U.S.C. § 1221(e)(1)).

However, whistleblowing activities may still be a contributing factor in the taking or failure to take a personnel action, even absent evidence that the deciding official had knowledge of the whistleblowing activities. See Dorney v. Dep’t of Army, 117 M.S.P.R. 480, 485–86 (2012). If the deciding official was influenced by one with knowledge of the whistleblowing activities, then such activities may be a contributing factor to personnel actions under the WPA. Id.

Sistek v. Dep’t of Veterans Affairs

A. Facts and Procedural History

Between 2012 and 2014, Leonard Sistek, Jr., then-director at the Department of Veterans Affairs (“VA”), disclosed information to agency staff, one of his supervisors, and the VA’s Office of the Inspector General (“OIG”) about inappropriate financial practice within the VA. Shortly thereafter, his supervisor appointed an Administrative Investigation Board (“AIB”) to investigate unrelated misconduct within the organization. His supervisor formally added Mr. Sistek as a subject of the investigation.

The AIB investigation found that the management team, which included Mr. Sistek, failed to report allegations about an inappropriate sexual relationship between two other staff members, and it recommended that Mr. Sistek receive “an admonishment or reprimand.” Consistent with the recommendation, Mr. Sistek’s supervisor issued a letter of reprimand in August 2014. In January 2015, without explanation, Mr. Sistek’s second-level supervisor rescinded the letter of reprimand and expunged it from Mr. Sistek’s record. In March 2015, the OIG confirmed that the concerns previously raised by Mr. Sistek were justified, and that the VA had violated appropriations law and used funds in unauthorized ways.

Mr. Sistek filed a complaint with the U.S. Office of Special Counsel (“OSC”), alleging whistleblower reprisal. After OSC issued a closure letter, Mr. Sistek filed an individual right of action appeal.

The Administrative Judge (“AJ”), considered whether the investigation and resulting letter of reprimand constituted prohibited personnel actions. The AJ determined that a retaliatory investigation is not a personnel action under the WPA and declined to order corrective action in favor of Mr. Sistek. See Sistek v. Dep’t of Veterans Affairs, 2018 MSPB LEXIS 3010 (M.S.P.B. Aug. 8, 2018). The AJ’s initial decision became the final decision of the MSPB, and Mr. Sistek petitioned the Federal Circuit for review.

B. The Federal Circuit’s Finding of Harmless Error

The Federal Circuit affirmed the Board’s decision. First, it reasoned that the WPA’s list of eleven specific personnel actions does not mention a “retaliatory investigation,” or indeed, “any investigation at all.” Sistek v. Dep’t of Veterans Affairs, 955 F.3d 948, 954 (Fed. Cir. 2020). Second, the court found that the investigation against Mr. Sistek did not significantly alter his job or working conditions, and thus did not fall within the last catchall provision of the WPA’s list of personnel actions. “[I]nvestigations may qualify as personnel actions ‘if they result in a significant change in job duties, responsibilities, or working conditions.’” Sistek, 955 F.3d at 955 (quoting S. Rep. No. 112-155, at 20 (2012)). The court elaborated that in certain circumstances, “an investigation alone could constitute a significant change in working condition,” or “a retaliatory investigation could contribute toward the creation of a hostile work environment that is actionable as a significant change in working conditions.” Id. In such circumstances, a retaliatory investigation would be a qualifying personnel action under the WPA. The Sistek Court held, however, that the investigation did not establish a significant change in working conditions because Mr. Sistek was interviewed once, did not offer evidence of a hostile work environment, and the resulting letter of reprimand was later rescinded and expunged. See id. at 956.

Third, the court considered Mr. Sistek’s effort to bring his claim within the rationale of controlling precedent on retaliatory investigations. See Russell v. Dep’t of Justice, 76 M.S.P.R. 317 (1997). In Russell, a whistleblower disclosed misconduct by two of his superiors, after which, one of the superiors initiated an investigation of the whistleblower’s conduct, resulting in disciplinary charges against the whistleblower and the whistleblower’s demotion. Id. at 321. The Board held that the agency investigation was evidence of prohibited retaliation because the investigation was “so closely related to the personnel action that it could have been a pretext for gathering evidence to retaliate, and the agency [did] not show by clear and convincing evidence that the evidence would have been gathered absent the protected disclosure.” Id. at 324. “That the investigation itself is conducted in a fair and impartial manner, or that certain acts of misconduct are discovered during the investigation, does not relieve an agency of its obligation to demonstrate by clear and convincing evidence that it would have taken the same personnel action in the absence of the protected disclosure.” Id. (citing 5 U.S.C. § 1221(e)(2)). In other words, if an agency investigation leads to an adverse personnel action, that investigation—coupled with the ensuing personnel action—is prohibited retaliation, unless the agency can demonstrate that it would have commenced the same investigation and taken the same personnel action absent the protected disclosure. “To here hold otherwise would sanction the use of a purely retaliatory tool, selective investigations.” Id. at 325.

The Sistek court acknowledged that Russell is “the Board’s foundational decision in this area,” and that the drafters of the Whistleblower Protection Enhancement Act (“WPEA”), Pub. L. No. 112-199, 126 Stat. 1465 (2012), intended that Russell would remain “governing law.” Sistek, 955 F.3d at 955. Applying Russell, the Sistek court found that the Board erred by failing to consider Mr. Sistek’s allegedly retaliatory investigation as part of its evaluation of the letter of reprimand. See id. at 957. Applying Russell, the VA’s investigation into Mr. Sistek was “so closely related” to the letter of reprimand “that it could have been a pretext for gathering evidence to retaliate.” Russell, 76 M.S.P.R. at 324. By “fail[ing] to apply Russell in evaluating the letter of reprimand,” the Board committed error. Sistek, 955 F.3d at 957.

Regardless, the Sistek Court held that the Board’s error was harmless. Id. The Court distinguished the present facts from the facts of Russell “because here there is no evidence that the official who initiated the allegedly retaliatory investigation had knowledge of any protected disclosures.” Id. The Court held that the supervisor who initiated the investigation lacked both actual and constructive knowledge of Mr. Sistek’s protected disclosures, and further, Mr. Sistek did not allege such knowledge. By failing to allege knowledge, Mr. Sistek could not demonstrate that his protected disclosure was a contributing factor to the alleged personnel action. In other words, even if the investigation and letter of reprimand were an adverse action, the WPA claim would have nonetheless failed because Mr. Sistek did not present sufficient evidence that his whistleblowing was a contributing factor in his adverse action.

Significance of Sistek

Sistek reaffirmed the holding of Russell, that a retaliatory investigation may be a prohibited personnel action if it leads to a significant change in job duties, responsibilities or working conditions; if it creates a hostile working environment, or; if it is “closely related” to a personnel action under the WPA. If Mr. Sistek had demonstrated facts to meet the knowledge/timing causation test, then the Court would have remanded the case to the Board to consider whether the investigation and letter together were qualifying personnel actions. And Russell would mandate that the answer is yes.

Further, if an employee can demonstrate that an investigation was undertaken in retaliation for a protected disclosure, the WPA provides that the Board may order corrective action that includes “fees, costs, or damages reasonably incurred due to an agency investigation” that is “commenced, expanded, or extended in retaliation” for a protected disclosure or activity—i.e., a retaliatory investigation. 5 U.S.C. §§ 1214(h), 1221(g)(4).

“So long as a protected disclosure is a contributing factor to the contested personnel action, and the agency cannot prove its affirmative defense, no harm can come to the whistleblower.” Marano v. Dep’t of Justice, 2 F.3d 1137, 1142 (Fed. Cir. 1993). The WPA thus continues to protect federal whistleblowers from retaliatory investigations, and Sistek merely provides a cautionary note about establishing the causation element of such a claim.

© Katz, Marshall & Banks, LLP
For more on whistleblower protections, see the National Law Review Criminal Law & Business Crimes section.