Tag: SDNY

Relying on Noncompete Clauses May Not Be the Best Defense of Proprietary Data When Employees Depart

Much of the value of many companies often is wrapped up with and measured by their intellectual property (IP) portfolios. Some forms of IP, such as patents, are known by the public. Others derive their value from being hidden from the public. Many companies, for example, have gigabytes of data or “know-how” that may be worth millions, but only to the extent that they remain secret. This article discusses some ways to keep business information confidential when an employee who has had access to that information leaves the company.

Many companies traditionally turned to employment agreements, specifically noncompete clauses, to protect proprietary competitive information. The legality of noncompetes is in question following the Federal Trade Commission’s (FTC’s) ban on them, which is being challenged in court by the U.S. Chamber of Commerce, causing confusion and concerns about protecting information via noncompete agreements. As covered in Wilson Elser’s prior articles* on this subject, the timeline of the FTC rule in question was as follows:

  • The FTC promulgated new rules to take effect in September 2024 banning all noncompete agreements.
  • The U.S. Supreme Court overturned the 40-year-old method of reviewing agency rules (Chevron Deference), throwing all agency rules, including the FTC’s rule on noncompetes, into question.
  • The District Court for the Northern District of Texas preliminarily enjoined the FTC from enforcing its new rule banning noncompetes.

After this flurry of activity, noncompetes are, for now, not banned. But do they offer an effective solution for businesses seeking to protect their proprietary information?

Noncompete Clauses Are Not Always Effective
Vortexa, Inc. v. Cacioppo, a June 2024 case from the District Court for the Southern District of New York, illustrates the limitations of noncompete clauses in employment agreements. That case presents the familiar fact pattern of an employee leaving and going to work for a competitor. With some evidence of the employee’s access to proprietary competitive information in hand (but no evidence of actual misappropriation), the former employer sought a preliminary injunction to prevent the employee from working for the competitor for one year, the term stated in the noncompete clause in the employee’s contract with the former employer. The contract also included common non-disclosure and confidentiality clauses.

Absent evidence of actual misappropriation, the plaintiff employer relied on the “Inevitable Disclosure” doctrine, which assumes that a departing employee will inevitably disclose confidential information when they go work for a competitor. The court refused to apply this doctrine, explaining that inevitable disclosure may substitute for actual evidence of misappropriation only when the information is a trade secret. Here, none of the information about which the former employer was concerned was a trade secret.

The proprietary information that the former employee had was pricing data, marketing strategies and “intricacies of the business.” These types of information do not, in and of themselves, constitute trade secrets. In addition, the information was not afforded trade secret treatment because (1) some of it was ascertainable by the competitor without reference to the first employer’s information; (2) the companies sell different products; (3) some of the information was developed without the expenditure of a good deal of money and effort; (4) some of the information was provided to clients without a non-disclosure agreement; (5) some of the information was shared on company-wide collaboration channels; and (6) “google drive log records show that [the former employee] opened and viewed these documents, which underlines the lack of security protecting this purportedly confidential information.”

Most of these reasons for the information not being accorded trade secret status cannot be changed by any action of the employer. For example, if information can be generated by means independent of the first employer, that information cannot be protected by trade secret law and nothing the first employer can do will change that after the fact. However, any business seeking to protect its valuable competitive information can change the way that it secures, protects and manages access to its competitive information, and this may be enough to ensure that its information is protected by trade secret law.

What Businesses Should Do to Protect Their Proprietary Competitive Information
Generally, proprietary competitive information can be protected as a trade secret by operation of law or via contract. In many cases, the “boots and suspenders” approach is best – the information should be protected both by contract and by meeting the requirements for protection under trade secret law. As described, a contract alone is sometimes ineffective, so information that derives its value from not being generally known to the public should also be treated in such a manner that the courts would see it as being a trade secret.

Specifically, for something to qualify for trade secret protection under federal and state statues and common law, it must be securely kept and carefully protected from disclosure. Some easy ways to protect information are to (1) restrict access to folders on a company’s internal computer systems, (2) physically lock rooms that contain hard copies and (3) have computers lock automatically when not accessed for set time periods. Protecting information via noncompete, confidentiality and non-disclosure contractual obligations is another way to ensure that information remains secret, such that it is protected under trade secret law. Internal policies on how information may be shared with third parties, such as clients, also are helpful evidence of trade secret treatment. In addition, the business may consider maintaining records on the time, effort and monetary expenditures required to develop proprietary information, which should allow the business to demonstrate that making such information freely available to a competitor is fundamentally unfair.

In some cases, information protected as a trade secret may be the most valuable IP that a company owns. But the value can easily be lost if the company does not properly secure the information. Different scenarios call for different methods of security, and a good rule of thumb to protect information from disclosure by a departing employee is to protect this information both by contract and as a trade secret.

The first step for any business is to think through their overall data protection strategy and consult with experienced intellectual property counsel to put appropriate protections in place.

© 2024 Wilson Elser
For more news on Proprietary Business Data, visit the NLR Intellectual Property section.

Federal Agencies Have Placed a Heightened Priority on Whistleblowers and Speedy Cooperation

As new areas of the law emerge, driven in part by technology and the free flow of information, federal agencies are becoming more aggressive with a tried and true carrot-and-stick approach to law and regulatory enforcement.

In a recent PLI panel on government enforcement priorities in May 2024, Brent Wible, Chief Counselor, Office of the Assistant Attorney General, Department of Justice (DOJ or Department); Daniel Gitner, Chief of the Criminal Division, US Attorney’s Office for the Southern District of New York (SDNY or the Office); and Antonia Apps, Director of the New York Regional Office of the Securities and Exchange Commission (SEC or Commission) shared their thoughts, priorities and practices in 2024 enforcement and beyond.

All of the government lawyers stressed that the DOJ and enforcement agencies are open and are actively encouraging whistleblowers with new incentives and programs. To that end, Mr. Gitner from the SDNY stated very directly that corporations need to understand that there is a “need for speed” in corporate self-disclosures. Otherwise, whistleblowers will be closing the door to the benefits of corporate self-disclosures. Put differently, enforcement agencies do not want a corporation to complete lengthy internal investigations before reporting.

A uniform theme and stance taken by all is that whistleblowers are valuable, and bounties will be paid in cash or in deferred prosecution agreements or possibly both. Whistleblowers must be protected. Internal and external whistleblowers should be encouraged.
This article focuses on three whistleblower initiatives—(i) the SEC’s Whistleblower Program, (ii) the SDNY Whistleblower Pilot Program and (iii) DOJ’s Pilot Whistleblower Program for voluntary self-disclosure—and how those programs may impact a corporation’s response to whistleblowers, internal investigations, and disclosures.

SEC 21F WHISTLEBLOWER PROGRAM

Since its inception more than a decade ago, the SEC’s Whistleblower Program is widely viewed as successfully incentivizing whistleblower reports of violations of the securities laws. In its 2023 fiscal year, the SEC received more than 18,000 tips from whistleblowers and issued the most awards to whistleblowers ever in one year, totaling nearly US$600 million. That year, the Commission also issued its largest ever award of US$279 million to a single whistleblower.1

What is the SEC’s Whistleblower Program?

Section 21F of the Securities Exchange Act of 1934, codified as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, requires the SEC to pay awards to whistleblowers who provide information to the SEC about violations of federal securities laws.2 Accordingly, the SEC has issued a series of rulemakings implementing Section 21F to create its whistleblower program. To qualify as a whistleblower, an individual must voluntarily provide the SEC with original information in writing about a possible violation of federal securities law that has occurred, is ongoing, or is about to occur.3 To qualify for an award, this information must lead to a successful enforcement action with monetary sanctions totaling more than US$1 million.4

“Original” information means that it cannot be found in publicly available sources and is not already known by the Commission, but is instead the product of the whistleblower’s independent knowledge or analysis.5 A submission is “voluntary” if the whistleblower provides it to the SEC before receiving a regulatory request or demand for information relating to the same subject matter. Therefore, a submission of information that is made in response to a request, inquiry, or demand by the SEC, the Public Company Accounting Oversight Board, a self-regulatory organization (such as the Financial Industry Regulatory Authority), or a separate federal or state governmental body does not qualify as a voluntary submission.6 Additionally, a submission that is required under a legal or contractual duty to the Commission is not considered voluntary and is thus ineligible for an award.7

The SEC’s whistleblower rules also include anti-retaliation protections intended to ensure that the incentives provided to whistleblowers for reporting are not outweighed by a fear of reprisal from their employer. Under Rule 21F-17, companies are prohibited from interfering with or impeding a whistleblower’s communications to the SEC about a possible violation of the securities laws, including through enforcement or threatened enforcement of a confidentiality agreement that may be read to prevent whistleblower communications with the SEC.8

The SEC is taking violations of Rule 21F-17 seriously and has increased enforcement activity in this area over the last two years. The Commission brought a number of actions, with significant civil penalties, focused on corporate agreements containing confidentiality language that, according to the SEC, does not provide an express exception for whistleblower communications. The enforcement actions extend to different types of companies, including publicly traded companies, privately held companies, broker-dealers and investment advisers, and to a variety of forms of agreements with employees and customers alike.9

For example, a gaming company paid US$35 million to settle claims that it had violated the whistleblower protection rule by requiring former employees to execute separation agreements that obligated them to notify the company of any request for information received from the Commission, in addition to compliance failures regarding workplace complaints.10 In January 2024, the SEC settled the largest ever standalone Rule 21F-17 case, imposing US$18 million in civil penalties against a dually registered investment adviser and broker dealer for allegedly requiring clients to sign a confidential release agreement—without expressly allowing for direct communications to regulators regarding potential securities law violations—in order to receive certain credit or settlement payments.11 In another case involving US$10 million in civil penalties, the Commission charged a registered investment adviser with a standalone violation of Rule 21F-17 based on employment agreements that contained a confidentiality clause prohibiting external disclosure of confidential company information, without a carve-out for voluntary communications with the SEC concerning possible violations of the securities laws.12 As recently stated by the co-chief of the SEC Enforcement Division’s Asset Management Unit, “Investors, whether retail or otherwise, must be free to report complaints to the SEC without any interference. Those drafting or using confidentiality agreements need to ensure that they do not include provisions that impede potential whistleblowers.”13

SDNY WHISTLEBLOWER PILOT PROGRAM

In February 2024, the SDNY launched a whistleblower pilot program. The purpose of the program is to encourage early and voluntary self-disclosure of criminal conduct by individual participants.14 The program is applicable to disclosures of conduct committed by public or private companies, exchanges, financial institutions, investment advisers, or investment funds involving fraud or corporate control failure or affecting market integrity, or criminal conduct involving state or local bribery or fraud relating to federal, state, or local funds.15 In exchange for a qualifying self-disclosure, the Office will enter into a non-prosecution agreement with the whistleblower.16

Given that a non-prosecution agreement is promised, the SDNY has identified factors to determine whether a whistleblower qualifies for a discretionary non prosecution agreement. The most salient include: whether and to what extent the misconduct is unknown to either SDNY or the DOJ; whether the information is disclosed voluntarily to SDNY and not in response to an inquiry or obligation to report misconduct; whether the whistleblower provides substantial assistance in the investigation and prosecution of culpable individuals, and in the investigation and prosecution of the disclosed conduct; whether the whistleblower truthfully and completely discloses all criminal conduct they participated in and are aware of; whether the whistleblower is a chief executive officer or chief financial officer of a public or private company, who is not eligible for the pilot program; and the adequacy of noncriminal sanctions, such as remedies imposed by civil regulators.

Mr. Gitner said the defense bar is coming around to a non-prosecution carrot for individuals involved in wrongdoing within the corporation. Mr. Gitner said that SDNY seeks early discussions, and the pilot program seems to be driving toward that goal.

DOJ PILOT PROGRAM ON VOLUNTARY SELF-DISCLOSURES FOR INDIVIDUALS

In March 2024, the DOJ announced an upcoming program to reward whistleblowers who report corporate crimes. The new program seeks to bolster existing whistleblower programs established by the SEC (discussed above), the Commodities Future Trading Commission (CFTC), the Internal Revenue Service, and the Financial Crimes Enforcement Network.17 Accordingly, the program will offer rewards to whistleblowers who provide information on misconduct that is not under the jurisdiction of those agencies. In particular, the Department is interested in criminal abuses of the US financial system, foreign corruption cases outside of the SEC’s jurisdiction, and domestic corruption cases. In order to qualify, an individual must provide original, nonpublic, and truthful information that assists the Department in uncovering “significant corporate or financial misconduct” and is previously unknown to the agency.18 Like the SEC and CFTC, the Department does not plan to provide awards for information that is submitted under a preexisting duty or in response to an inquiry.19 Access to the program is only available where existing programs or qui tam actions do not exist. Additionally, the whistleblower in this program cannot be involved in the criminal activity itself. After compensation to victims, the whistleblower will receive a portion of the resulting forfeiture as a reward.20

Interestingly, however, it appears the Department may be moving away from offering monetary awards to whistleblowers. In April 2024, the Department introduced a pilot program that tracks with the SDNY and offers mandatory non prosecution agreements to individuals who provide information on corporate misconduct.21 Under the program, an individual must voluntarily self-disclose original information to the Criminal Division about criminal misconduct that is not previously known to the Department. The information must be “truthful and complete,” meaning it must include all known information relating to the misconduct, including the individual’s own culpability. In particular, the Department seeks information on violations by financial institutions; violations related to market integrity committed by financial institutions, investment advisers, investment funds, or public or private companies; foreign corruption and bribery violations by public or private companies; violations relating to health care fraud or illegal health care kickbacks; fraud or deception against the United States in connection with federally funded contracting; and bribery or kickbacks to domestic public officials by public or private companies. The whistleblower also cannot be a chief executive officer, chief financial officer, or those equivalents of a public or private company; or an elected or appointed foreign government or domestic government official; nor can the whistleblower have a previous felony conviction or a conviction of any kind involving fraud or dishonesty. Irrespective of this program, the Department still has the discretion of offering a non-prosecutorial agreement to individuals who may not meet the above criteria in full, subject to Justice Manual and Criminal Division procedures.22

TAKEAWAYS

The takeaways here for corporate in-house legal departments are:

  • Federal agencies are incentivizing whistleblowers with cash and non-prosecution agreements. It is clear that wrongdoers and witnesses now more than ever have several whistleblower programs from which to choose. As a result, corporations must become more vigilant at detecting wrongdoing and effectively utilizing internal reporting systems. Careful consideration of an early self-disclosure to the appropriate agency may also be warranted. Internal investigations will take a heightened priority to aid the c-suite and board on disclosure decisions.
  • Not only is protecting whistleblowers a priority but encouraging whistleblowers through heightened compliance programs, updated hotlines or other internal reporting programs should be considered. You may also wish to consider offering financial incentives for timely reporting to the corporation’s internal reporting program. All of which will benefit the company in any government disclosure.
  • The enforcement risk for companies under the SEC’s whistleblower rules is real and potentially significant, including with respect to day-to-day business activities (such as entering into client or employee confidentiality agreements) that may not otherwise be recognized as creating regulatory exposure. Companies may wish to revisit their standard contracts and compliance materials to ensure that any confidentiality provisions align with Rule 21F-17.

We acknowledge the contributions to this publication from our summer associate Minu Nagashunmugam.

1 https://www.sec.gov/newsroom/enforcement-results-fy23.

2 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 2.

3 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 2.

4 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 3.

5https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

6 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

7 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 5.

8 https://www.sec.gov/about/offices/owb/reg-21f.pdf, p. 28.

9 The SEC’s Office of the Whistleblower has stated that violations of Rule 21F-17 may be triggered by “internal policies, procedures, and guidance, such as codes of conduct, compliance manuals, training materials, and other such documents.” SEC, Whistleblower Protections (last updated July 1, 2024) https://www.sec.gov/enforcement-litigation/whistleblower-program/whistleblower-protections#anti-retaliation.

10 https://news.bloomberglaw.com/securities-law/sec-biggest-whistleblower-penalty-signals-broad-protection-focus?context=search&index=11

11 In re JP Morgan Sec. LLC, File No. 3-21829 (Jan. 16, 2024), https://www.sec.gov/files/litigation/admin/2024/34-99344.pdf.

12 In re D.E. Shaw & Co., L.P., File No. 3-21775 (Sept. 29, 2023), https://www.sec.gov/files/litigation/admin/2013/34-70396.pdf.

13 SEC Press Release (Jan. 16, 2024), https://www.sec.gov/newsroom/press-releases/2024-7.

14 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

15 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

16 https://www.justice.gov/d9/2024-05/sdny_wb_policy_effective_2-13-24.pdf

17 https://www.justice.gov/opa/speech/acting-assistant-attorney-general-nicole-m-argentieri-delivers-keynote-speech-american

18 https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-keynote-remarks-american-bar-associations

19 https://www.justice.gov/criminal/media/1347991/dl?inline

20https://www.justice.gov/opa/speech/deputy-attorney-general-lisa-monaco-delivers-keynote-remarks-american-bar-associations

21https://www.justice.gov/criminal/media/1347991/dl?inline

22 https://www.justice.gov/criminal/media/1347991/dl?inline

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Copyright 2024 K & L Gates
For more on Whistleblowers, visit the NLR Criminal Law Business Crimes 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

The Migratory Bird Treaty Act: Flight of Fancy or Enduring Change?

The Trump Administration has issued a proposed rule, 85 Fed. Reg. 5915 (February 3, 2020), that would codify its interpretation of the Migratory Bird Treaty Act (MBTA), 16 U.S.C. 703 et seq., as applying only to the direct take of birds subject to the Act.  For decades, the federal government interpreted the MBTA as criminalizing both the direct (intentional) and incidental (unintentional and incident to an otherwise lawful activity) take of birds, their nests, and eggs covered by the Act.  Permission could be obtained for direct take, for example for hunting or for control of nuisance birds, but no such MBTA-specific framework existed to evaluate and permit incidental take under the Act.  As a result, project proponents, such as builders of wind farms, were left negotiating informal arrangements with the federal government in some circumstances or found themselves at the mercy of “prosecutorial discretion,” in others.  The leading causes of incidental bird deaths — cats, collisions with buildings, and collisions with cars — were left largely unaddressed by the federal government in implementation of the MBTA.  Judicial decisions addressing the scope of the Act have held both that the Act does criminalize incidental take and that it does not.

Into this flighty situation stepped the Trump Administration.  On December 22, 2017, the Principal Deputy Solicitor of the Department of the Interior issued a legal opinion that reversed years of practice and a prior legal opinion, concluding that the MBTA does not prohibit incidental take.  Consistent with that opinion, on February 3, 2020, the Administration issued a proposed rule that would codify the revised interpretation.  The proposed rule relies on the plain language of the statute, its history, and on constitutional concerns surrounding the extension of criminal liability under a statute that is ambiguous at best.

The MBTA makes it unlawful: “at any time, by any means or in any manner, to pursue, hunt, take, capture, kill, attempt to take, capture, or kill, possess . . . any migratory bird, any part, next, or egg of any such bird . . . .”  16 U.S.C. 703(a).  Proponents of the prior interpretation urge that the language “at any time, by any means or any manner” evidences an intent to broadly criminalize any acts that result in bird deaths, even if they are not deliberate and not targeted at birds.  The proposed rule rests on a contrary view – that the words “hunt, take, capture, kill” are all affirmative acts directed at birds that have the purpose of reducing them to human control.   In the proposed rule, the Administration considers the legislative history of the Act and concludes that it confirms the view that the MBTA was enacted to address the direct take of birds — in response to over-hunting of birds and to Canadian concerns regarding the impact of U.S. actions on bird populations in Canada – and not to broadly criminalize any and all behavior that may kill birds.

The Trump Administration’s interpretation is already under review in the United States District Court for the Southern District of New York.  In that case, the plaintiffs brought a direct challenge to the Department of the Interior’s 2017 legal opinion.   The court denied the government’s Motion to Dismiss the matter; summary judgment briefing is ongoing.

Comments on the proposed rule can be submitted through March 19, 2020, in Docket No. FWS-HQ-MB-2018-0090 at www.regulations.gov.

© 2020 Bracewell LLP

ARTICLE BY Ann D. Navaro of Bracewell LLP.