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On January 23, 2017, the SEC announced that it awarded more than $7 million to three whistleblowers who came forward with information that led to a successful SEC enforcement action.  One whistleblower provided information that the SEC considered to be the primary impetus for the start of the Commission’s investigation.  Consequently, the SEC awarded more than $4 million to that whistleblower.  The other two whistleblowers split more than $3 million for jointly providing new information during the SEC’s investigation that significantly contributed to the success of the enforcement action. The whistleblowers are the 39 th , 40 th and 41 st relators to receive an award under the SEC whistleblower program. Since 2011, the SEC has paid approximately $149 million to whistleblowers who provided information resulting in the collection of monetary sanctions against violators of the securities laws. To date, the SEC has recovered more than $935 million from enforcement actions resulting from whistleblower tips. The SEC declined to identify the whistleblowers or the wrongdoers. By law, the SEC protects the confidentiality of whistleblowers and does not release information that might directly or indirectly reveal the whistleblower’s identity. Commenting on the award, Jane Norberg, Chief of the SEC’s Office of the Whistleblower, stated: “Whistleblowers played an important role in the success of this case as they helped our agency detect and prosecute a scheme preying on vulnerable investors. Whistleblowers not only helped us open the investigation but provided critical information after the investigation was already underway.” Under the program, whistleblowers are eligible for an award if they voluntarily provide the SEC with original information that leads to a successful enforcement action that exceeds $1 million. The award can range from 10 percent to 30 percent of the money collected. All payments come from an investor protection fund established by Congress that is financed through monetary sanctions paid to the SEC by securities law violators.  No money is taken or withheld from harmed investors to pay whistleblower awards. Takaway: As noted by this Blog earlier in the month, the SEC rang in the New Year with a whistleblower award of more than $5.5 million to a relator who helped stop an ongoing fraud. With this award, the SEC is reiterating its commitment to encourage whistleblowers to come forward with information about violations of the securities laws.

In December 2016, UBS lost an $18.5 million arbitration brought by two former clients, a husband and wife, in connection with the sale of close-end funds that were collateralized by Puerto Rican bonds. The controversy arose in the wake of the collapse of the island nation's bond market in 2013 during which time UBS allegedly increased the local demand for the bonds artificially and misled the clients about the potential risks associated with the investments. In 2014, the couple filed a complaint in arbitration, claiming breach of fiduciary duty, unsuitability, and other misconduct. During the arbitration proceeding, UBS claimed the clients maintained investments in the bonds with rival firms and rejected the recommendations of UBS financial advisors to diversify. While the arbitration transcript showed that this recommendation was in fact rejected, the couple argued that UBS profited from the sale of artificially  inflated bonds. After numerous hearing sessions, the couple was awarded damages, plus attorney's fees. Finra Arbitrator Disclosure Requirements Now, UBS is seeking to overturn the award in federal court, claiming that two of the three arbitrators were not impartial judges of the merits of the case because they failed to disclose key material facts before the proceeding began. One arbitrator did not disclose her involvement as a plaintiff in a securities fraud class action seeking to recover personal investment losses. The second arbitrator failed to disclose that she had committed fraud, and denied she had previously filed for bankruptcy. In sum, UBS claims that those who have committed fraud or who have made material misrepresentations, are barred from acting as arbitrators by FINRA rules. In addition, UBS argues that the claims should have been dismissed because one of the clients is a Harvard educated attorney and a savvy investor who made his own investment decisions and rejected UBS financial advisors’ recommendation to sell his bond positions. Some observers believe that UBS will prevail in overturning the award since potential arbitrators are required to disclose certain information about their professional and personal histories. Nonetheless, there are reportedly hundreds of other claims against UBS related to its sale of the Puerto Rican bonds. The Takeaway While it is unclear what the outcome of this case will be, it does illustrate the importance of financial advisors fulfilling their fiduciary obligations to their clients. The case also shows the importance of selecting the right arbitrators for a case and the arbitrators' obligation to comply with the rules and regulations that govern them. These issues, among others, are important for investors who have a dispute with their broker or financial advisor to understand. Accordingly, if they find themselves in such a dispute, they should engage the services of an experienced arbitration attorney.

Being a whistleblower is not easy. It involves personal sacrifice and professional risk. Many violations of the law go unreported, especially in the workplace, because people who know about them are afraid of being disciplined, losing their job, being demoted, or being passed over for promotion. Recognizing the financial, reputational and professional risks associated with whistleblowing, Congress included in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) strong anti-retaliation provisions to protect whistleblowers who provide information to the SEC or the CFTC about violations of the securities and commodities laws, or violations of any protected activity under the Sarbanes-Oxley Act of 2002 (“SOX”). The Dodd-Frank Act created a private right of action for employees who have suffered retaliation ( e.g. , threats, harassment or discrimination) “because of any lawful act done by the whistleblower – ‘(i) in providing information to the Commission in accordance with ; (ii) in initiating, testifying in, or assisting in any investigation or judicial or administrative action of the Commission based upon or related to such information; or (iii) in making disclosures that are required or protected under the Sarbanes-Oxley Act of 2002,’” the Securities Exchange Act of 1934, and “‘any other law, rule, or regulation subject to the jurisdiction of the .’” A whistleblower may file a retaliation claim in federal court and seek, among other remedies, reinstatement, double back pay (as opposed to just back pay, as under SOX) with interest, litigation costs, expert witness fees and reasonable attorneys’ fees. Under SOX, employees of publicly traded companies are protected from retaliation by their employers for reporting certain types of fraud and other securities violations. An employee seeking relief from retaliation under SOX must file the claim with the Occupational Safety and Health Administration (“OSHA”) of the Department of Labor, which investigates the claim and issues a determination. A claim brought under SOX is adjudicated by administrative law judges or by judges in federal district court. If successful, the employee is entitled to recover back pay, front pay, compensatory damages for emotional distress, and attorneys’ fees. In order to state a retaliation claim, both SOX and the Dodd-Frank Act require plaintiffs to demonstrate, among other things, that they engaged in protected whistleblowing activity, that their employer knew they engaged in protected activity, and that there was a causal connection between the protected activity and an adverse employment action. With the foregoing in mind, consider Feldman-Boland vs. Morgan Stanley , No. 15-CV-6698 (S.D.N.Y. July 13, 2016), where whistleblowers notified their supervisor of their concerns about unlawful activities and were terminated from their employment for blowing the whistle. Feldman-Boland vs. Morgan Stanley and the Importance of Complying With All Pleading Requirements: Facts : The plaintiffs, Jamie Feldman-Boland (“Feldman”) and James Boland (“Boland”), worked at Morgan Stanley & Co. (“Morgan Stanley”). Feldman joined Morgan Stanley as a financial advisor in 2008. At that time, she executed an agreement requiring her to split commissions from high-net-worth clients with a more senior Morgan Stanley advisor, Michael Silverstein (“Silverstein”). In 2010, Boland joined Morgan Stanley as a trainee. In March 2011, Feldman and Boland witnessed Morgan Stanley employees violating the federal securities laws and mail and wire fraud statutes. Among other things, they observed: (1) unlicensed employees executing trades; (2) cold calling clients using deceitful practices (such as promising unrealistic annual returns to entice individuals to transfer 401(k) retirement plans into risky mutual funds); (3) retroactive alterations of clients’ risk profiles to permit riskier investments; and (4) employees working without branch office supervision. In April 2011, Feldman met with her supervisor David Turetzky (“Turetzky”) to complain about a variety of problems with Silverstein, her senior advisor. She also raised concerns regarding the fraudulent activity she had observed. Turetzky dismissed Feldman’s concerns and instructed her to leave his office. Later, he requested a list of Feldman’s clients and prospects. Feldman claims that Turetzky sought permission to fire her on the pretext of substandard performance. In May 2011, Feldman had an altercation with Silverstein that she reported to Turetzky. She also reiterated her complaint that Silverstein failed to supervise brokers. Rather than investigate her complaints, Morgan Stanley rejected a profitable commodities deal that she had proposed without any explanation. In June 2011, Boland wrote to Morgan Stanley’s CEO, alerting him to “discriminatory, unethical and perhaps illegal practices” that could “escalate a very negative, public perception of the Firm.” Boland reiterated those concerns in follow-up communications with the human resources department. In July 2011, Feldman and Boland submitted identical complaints to the SEC regarding fraudulent conduct. In response, FINRA investigators met with the plaintiffs for six hours in early August. Later that month, FINRA audited the Morgan Stanley branch where the plaintiffs worked. FINRA’s investigation focused on allegations of unsupervised employees and deceptive cold calling. Feldman and Boland overheard Morgan Stanley risk officers discussing their concerns about the specificity of FINRA’s investigation. Morgan Stanley’s Regional Risk Officer concluded that the Plaintiffs’ complaints were “unsubstantiated,” even though she never interviewed them. In late August, Turetzky fired Feldman for substandard performance, despite the fact that she had just signed a $1.8 million account. Boland claims that, thereafter, Morgan Stanley undermined his ability to develop business. In September 2011, Boland informed Morgan Stanley risk officers that he had filed complaints with the SEC and FINRA. In early November 2011, Boland was permitted to take medical leave to care for Feldman, who was scheduled to undergo surgery. Less than 48 hours after he returned to work, Morgan Stanley fired Boland under the pretext of substandard performance. In February 2012, Feldman filed a complaint with OSHA against Morgan Stanley, alleging that she was fired in retaliation for her complaints to regulators. Three months later, Boland filed a complaint with OSHA mirroring his wife’s allegations. Those complaints were assigned to an investigator, but no findings had been made at the time the plaintiffs filed their complaint in federal court. The Allegations in the Complaint and The Motion to Dismiss : Feldman and Boland sued Morgan Stanley and their former supervisor Turetzky for $20 million on the grounds that they were fired for reporting improper and unlawful broker practices to the SEC and FINRA, in violation of the whistleblower protection provisions of SOX and the Dodd-Frank Act. These practices included, among others, cold calling employees at large companies, such as Pfizer Inc. and Verizon Communications Inc., who were near retirement and had 401(k) plans at Fidelity Investments to solicit them to roll over their account to Morgan Stanley with the enticement of a 15% annual return; and changing the client’s risk profile to allow for investments in riskier closed-end funds. This was the second time that this Morgan Stanley branch had been sued under the anti-retaliation provisions of the Dodd-Frank Act. In 2012, Clifford Jagodzinski, a risk officer mentioned in the plaintiffs’ complaint, sued Morgan Stanley for $1 million, claiming he was told by Turetzky not to report alleged violations, including improper Treasury trades, drug use by an adviser and advisers working from home without registering their home office as an alternative work location. The defendants moved to dismiss all claims on the grounds that: (1) the claims were barred by collateral estoppel; (2) the complaint failed to state a claim under SOX or the Dodd-FrankAct; and (3) the plaintiffs failed to exhaust their administrative remedies under SOX. The defendants also moved to strike the claim for emotional distress damages under SOX and claims for special damages under the Dodd-Frank Act. The Court’s Decision: Collateral Estoppel : The defendants argued that the plaintiffs were collaterally estopped from bringing their claims because the New York City Commission on Human Rights (“NYCCHR”) had determined that they were “terminated for legitimate non-discriminatory reasons and not because of discrimination.” Prior to filing the action in federal court, Feldman filed a gender-discrimination complaint with the NYCCHR, and Boland filed a Family Medical Leave Act complaint with the same agency. The Court rejected this argument, holding that the plaintiffs were not precluded by collateral estoppel, because there was no identity of issues – the two cases involved different sets of claims and standards of proof. To establish a prima facie case under SOX, Plaintiffs need only establish that whistleblower retaliation was a contributing factor to their termination. Likewise, under Dodd-Frank, Plaintiffs need only establish that their termination was causally connected to protected whistleblower activity. Defendants would then need to demonstrate by clear and convincing evidence that Plaintiffs’ employment would have been terminated in the absence of any protected activity. The issue of whether it was more likely than not that Plaintiffs were fired for reasons other than gender discrimination, or retaliation for taking family leave, is plainly not identical to the issue of whether Defendants can demonstrate by clear and convincing evidence that Plaintiffs would have been fired without engaging in activities under the whistleblower protections of SOX and Dodd-Frank. In dicta , the Court found that “ ven if there were an identity of issues, Plaintiffs did not have a full and fair opportunity to litigate the issue before the NYCCHR.” The Court explained that the plaintiffs “were not afforded an evidentiary hearing where they could confront witnesses against them, nor did they have the benefit of discovery. Moreover, … had no opportunity, and certainly no apparent reason, to introduce issues of retaliation under SOX or Dodd-Frank before the NYCCHR.” Accordingly, the Court concluded that the plaintiffs were not collaterally estopped from asserting their claims. Failure to State a Claim : As noted above, to state a claim for retaliation under both SOX and the Dodd-Frank Act, a plaintiff must demonstrate, among other things, that s/he engaged in protected whistleblowing activity, that his/her employer knew s/he engaged in protected activity, and that there was a causal connection between the protected activity and the adverse employment action. The defendants sought dismissal on the grounds that Morgan Stanley and Turetzsky were not aware that Feldman and Boland had engaged in whistleblowing activities – that is, they filed complaints with the SEC about violations of the securities laws. The Court rejected this argument. According to the Court, the facts alleged by the plaintiffs were sufficient to infer “that Morgan Stanley knew, or had sufficient reason to know, that Plaintiffs had filed a complaint with regulators precipitating the audit.” These facts included, among others: (a) Feldman and Boland each raised concerns about violations of the securities laws with Turetzky in April 2011 and June 2011, respectively; (b) the August 2011 FINRA audit addressed some of the same issues raised by the plaintiffs in their complaints to the SEC; (c) Morgan Stanley co-workers observed the FINRA audit team documenting regulatory violations; and (d) Boland alleged that he informed Morgan Stanley risk officers, prior to his termination, that he filed complaints with the SEC and FINRA. Exhaustion of Administrative Remedies Under SOX : As noted, SOX requires an employee to file a complaint with OSHA when complaining about violations of the anti-retaliation provision of the act. The failure to comply with this requirement deprives the court of subject matter jurisdiction. The defendants sought dismissal, arguing that the plaintiffs failed to exhaust their administrative remedies as to both Morgan Stanley and Turetzky. The Court rejected the argument as to Morgan Stanley, but not Turetzky. As to Morgan Stanley, the Court held that the plaintiffs exhausted their administrative remedies by filing their complaints with OSHA, “given that the OHSA complaints pled allegations concerning Defendants’ “improper and unlawful broker practices.” (Internal quotation and citations omitted.) This finding was reinforced by the fact that the law does not require a “particular form of complaint” “to trigger a claim before OSHA.” (Internal quotation and citations omitted.) As to Tureztky, the Court found that the plaintiffs had not exhausted their administrative remedies. In that regard, the Court noted that although their OSHA complaints mentioned Turetzky, simply mentioning someone is insufficient to put that person on notice that they are the subject of a complaint: t is not sufficient to merely mention an individual in the body of an administrative complaint without specifically listing as a defendant . . . the particular named person. Plaintiffs therefore failed to exhaust . . . administrative remedies as against Turetzky, by failing to include Turetzky as a named person in the administrative complaint. Accordingly, the SOX claim against Turetzky is dismissed. The Motion to Strike : The Court denied the defendants’ motion to strike the emotional distress damages and special damages, finding that such damages are recoverable under SOX and the Dodd-Frank Act.   The court’s decision can be found here .

On January 13, 2017, the United States Supreme Court agreed to consider whether, under American Pipe & Construction Co. v. Utah , 414 U.S. 538 (1974) (“ American Pipe ”), the filing of a securities class action lawsuit tolls the statute of repose found in Section 13 of the Securities Act of 1933 (the “Act”).  In American Pipe , the Court held that “the commencement of a class action suspends the applicable statute of limitations as to all asserted members of the class who would have been parties had the suit been permitted to continue as a class action.” 414 U.S. at 554.  This was the second time, the Court granted certiorari to consider the issue. In Public Employees’ Retirement System of Mississippi v. IndyMac MBS, Inc. , 134 S. Ct. 1515 (2014), cert . dismissed as improvidently granted , 135 S. Ct. 42 (2014), the Court granted certiorari to decide whether the tolling doctrine established under American Pipe applies to securities claims subject to the three-year repose period set forth in Section 13 of the Act. The issue was never decided by the Court because the case was settled. The Supreme Court’s January 13, 2017 order granting the petition for a writ of certiorari in California Public Employees’ Retirement System v. ANZ Securitites Inc . can be found here . Background: ANZ Securities arose out of the collapse of Lehman Brothers. Prior to its bankruptcy in 2008, Lehman Brothers operated as a global investment bank whose stock traded on the New York Stock Exchange. Between July 2007 and January 2008, Lehman Brothers raised over $31 billion through debt offerings. The California Public Employees’ Retirement System (“CalPERS”), the largest pension fund in the United States, purchased millions of dollars of those securities. On June 18, 2008, a putative class action complaint was filed in the Southern District of New York (the “Class Action”), alleging that the defendants, who were involved in underwriting the debt offerings, were liable under Section 11 of Act for making false and misleading statements in the registration statements. Among other things, the Class Action alleged that the registration statements contained untrue statements and omitted material facts concerning Lehman’s accounting practices (including improperly removing tens of billions of dollars from its balance sheet), risk-management activities (including its accumulation of illiquid assets), and exposure to risky mortgage and real estate-related assets. In February 2011, more than three years after the securities were offered to the public, but before the district court had decided whether to certify the class, CalPERS decided to file its own complaint against the defendants in the Northern District of California. Cal. Pub. Emps.’ Ret. Sys. v. Fuld , No. 3:11-cv-00562-EDL (N.D. Cal. Feb. 7, 2011). CalPERS also alleged violations of the Act. The case was subsequently transferred to the Southern District of New York and consolidated with the Class Action for pretrial purposes. Later that year, the parties to the Class Action reached a settlement and the district court preliminarily certified a class for settlement purposes. Upon receiving the court-ordered notice of the settlement, CalPERS opted out to pursue its own claims individually.  The district court, however, dismissed CalPERS’ individual suit as untimely. In so doing, it rejected CalPERS’ tolling argument that the pendency of the Class Action rendered CalPERS’ individual lawsuit timely. CalPERS appealed. On July 8, 2016, the Second Circuit affirmed.  In a summary order ( here ), the Second Circuit held that the timely filing of the Class Action had not tolled the statute of repose for CalPERS. CalPERS had argued that because the Class Action “was commenced by a named plaintiff with proper standing,” its claims were timely filed.  The Second Circuit rejected this argument as “inconsistent with the reasoning of IndyMac .” IndyMac made no reference to the standing of named plaintiffs when it concluded that American Pipe tolling did not apply to section 13’s statute of repose; its conclusion was instead derived from two longstanding principles. First, if American Pipe is grounded in equity, its tolling rule cannot affect a legislatively enacted statute of repose. Second, if American Pipe establishes a “legal” tolling principle grounded in Rule 23, to apply it to a statute of repose would violate the Rules Enabling Act by permitting a procedural rule to abridge the substantive rights created by statutes of repose. Accordingly, under IndyMac ’s reasoning, the inapplicability of American Pipe tolling to a statute of repose turns on the nature of the tolling rule and its ineffectiveness against statutes of repose, not whether the named plaintiffs have proper standing to assert claims on behalf of a class. Notably, the Second Circuit acknowledged that there is a split among the circuits on the issue, stating that the tolling question “may be ripe for resolution by the Supreme Court.”  Presently, the Tenth, Seventh and Federal Circuits hold that the filing of a putative class action tolls the statute of repose, while the Second, Sixth and Eleventh Circuits hold that such a filing does not toll the Act’s statute of repose. The Second Circuit emphasized that “unless and until the Supreme Court informs us that our decision was erroneous, IndyMac continues to be the law of the Circuit and its reasoning controls the outcome of the case.” The Cert. Petition: On September 22, 2016, CalPERS filed a petition to the Supreme Court for a writ of certiorari ( here ), seeking to have the Court reverse the Second Circuit’s decision.  CalPERS presented two questions for the Court’s review, the first of which was presented in the dismissed IndyMac petition: 1) “Does the filing of a putative class action serve, under the American Pipe rule, to satisfy the three-year time limitation in Section 13 of the Securities Act with respect to the claims of putative class members? (Question granted in IndyMac )”; and 2) “May a member of a timely filed putative class action file an individual suit on the same causes of action before class certification is decided, notwithstanding the expiration of the relevant time limitations?” To invite review, CalPERS cited the split of authority among the circuits. On January 13, 2017 the Supreme Court granted CalPERS’ petition, but only as to the first of the two questions presented, e.g. , whether American Pipe tolls the Act’s statute of repose. The Court denied the writ on the second question presented.

What is a forum selection clause?  Corporations and other business entities are all too familiar with them. In its simplest form, a forum selection clause is a provision in a contract that designates a specific location (or a particular court within a specific location) for litigation in the event of a dispute. Forum selection clauses are common in commercial contracts because they “provide certainty and predictability in the resolution of disputes.” Boss v. American Express Fin. Advisors, Inc. , 6 N.Y.3d 242, 247 (2006), quoting Brooke Group Ltd. v. JCH Syndicate , 87 N.Y.2d 530, 534 (1996). They come in two forms: mandatory and permissive. In the former, the parties are “required to bring any dispute to the designated forum,” while the latter “only confers jurisdiction in the designated forum, but does not deny plaintiff his choice of forum, if jurisdiction there is otherwise appropriate.” Phillips v. Audio Active Ltd. , 494 F.3d 378, 383, 386 (2d Cir. 2007). Under New York law, “parties to a contract may freely select a forum which will resolve any disputes over the interpretation or performance of the contract.” Brooke Group , 87 N.Y.2d at 534. Such clauses “are prima facie valid” and “are not to be set aside unless a party demonstrates that the enforcement of such would be unreasonable and unjust or that the clause is invalid because of fraud or overreaching, such that a trial in the contractual forum would be so gravely difficult and inconvenient that the challenging party would, for all practical purposes, be deprived of his or her day in court.” Sterling Nat. Bank as Assignee of Norvergence, Inc. v. Eastern Shipping Worldwide, Inc. , 35 A.D.3d 222 (1st Dep’t 2006) (citations and quotations omitted). In Atlantic Marine Construction Co. v. United States District Court for the Western District of Texas , 134 S.Ct. 568, 583 (2013), the United States Supreme Court provided the contractual basis for the enforcement of forum selection clauses: When parties have contracted in advance to litigate disputes in a particular forum, courts should not unnecessarily disrupt the parties’ settled expectations. A forum-selection clause, after all, may have figured centrally in the parties’ negotiations and may have affected how they set monetary and other contractual terms; it may, in fact, have been a critical factor in their agreement to do business together in the first place. In all but the most unusual cases, therefore, ‘the interest of justice’ is served by holding parties to their bargain. Prospect Funding Holdings L.L.C v. Maslowski: Last week, the Appellate Division, First Department, issued a decision concerning the enforceability of a forum selection clause. In Prospect Funding Holdings L.L.C v. Maslowski , 2017 NY Slip Op. 00253 (1st Dep’t Jan. 12, 2017), the Court held that a forum selection clause should not have been enforced because it was unreasonable and unjust to do so. Facts and Proceedings in The Motion Court : The defendant, Pamela Maslowski (“Maslowski”), was involved in an automobile accident that left her with brain trauma and facial lacerations. The accident occurred in Minnesota, where Maslowski was a long-time resident. Maslowski brought a personal injury lawsuit in Minnesota against the tortfeasors responsible for the accident. In need of money, and unable to await the completion of her lawsuit, Maslowski entered into a sale and repurchase agreement with the plaintiff, Prospect Funding Holdings L.L.C. (“Holdings”). Holdings is a limited liability company established under the laws of New York, but maintains its principal place of business in Minnesota. Pursuant to the agreement, Holdings advanced a small amount of money to Maslowski. Notably, the agreement had a mandatory forum selection clause that provided: The parties irrevocably agree that all actions or proceedings in any way, manner or respect, arising out of or related to this agreement shall be litigated only in courts having situs in New York County, New York, each party consents and submits to personal jurisdiction in the state of New York and waives any right such party may have to transfer venue of any such action or proceeding. Maslowski eventually filed an action in Minnesota challenging the validity of the agreement. The courts in Minnesota determined that the agreement (which charged her a fee of 19%, and required that she pay an interest rate at 60% per annum) was void as against public policy. Shortly thereafter, Holdings filed the action in New York alleging, among other things, that Maslowski breached the agreement. Maslowski moved to dismiss the complaint on forum non-conveniens grounds. The motion court denied Maslowski’s motion.  Maslowski appealed. The First Department’s Ruling : The Court reversed, holding that enforcement of the forum selection clause was unreasonable and not in the interests of justice because Maslowski had no contacts with New York: The New York action should have been dismissed pursuant to CPLR 327(a). “ n the interest of substantial justice,” the parties’ dispute should be heard in Minnesota (CPLR 327 ;  Islamic Republic of Iran v Pahlavi , 62 NY2d 474, 478-479 <1984> ,  cert denied  469 US 1108 <1985> ). Ms. Maslowski demonstrated that the choice of forum provision in the parties’ agreement is unreasonable and should not be enforced ( see Brooke Group v JCH Syndicate 488  , 87 NY2d 530, 534 <1996> ). Every aspect of the transaction at issue occurred in Minnesota, the parties, documents, and witnesses are located in Minnesota, and defending this action in New York would be a substantial hardship to Ms. Maslowski. Takeaway: Prospect Funding teaches that forum-selection clauses are not automatically enforceable. They can be found to be unenforceable when: it is unreasonable or unjust to do so; it is against public policy; or it is the result of fraud or overreaching. In addition, a forum selection clause can be set aside when a party can demonstrate “that a trial in the selected forum would be so gravely difficult that the challenging party would, for all practical purposes, be deprived of its day in court.” Chiarizia v. Xtreme Rydz Custom Cycles , 43 A.D.3d 1353, 1354 (4th Dep’t 2007). Finally, and perhaps more significant in today’s world of e-commerce, a forum selection clause can be invalidated when its existence was not reasonably communicated to the plaintiff – that is, it was unreasonably masked from the view of the prospective purchaser. Jerez v. JD Closeouts, LLC , 36 Misc. 3d 161, 170 (Nassau Dist. Ct. 2012). The lesson of Prospect Funding therefore is that forum selection clauses, while prima facie valid, are not iron-clad, and can be found unenforceable if a litigant is not careful.

A breach of contract comes in two primary varieties: a material breach and a minor breach.  The former is substantial, goes to the very heart of the agreement and prevents the contract from being performed. When a material breach occurs, the non-breaching party can cease performing under the agreement and sue to collect the damages caused by the breach.  The latter, also known as a partial breach, occurs when a party fails to complete a less important part of a contract. Importantly, the contract can still be completed. Thus, the non-breaching party remains obligated to complete his/her performance under the agreement, but has the right to sue for damages. In deciding whether a breach is material, courts often look to the Restatement (Second) of Contracts, as well as to other court decisions that arose from contract disputes. In New York, “courts generally consider the extent to which the non-breaching party will be prejudiced or damaged by lack of full performance.” Awards.com v. Kinko's, Inc. , No. 603105/03, 2006 WL 6544391, at *5 (Sup. Ct. N.Y. Cnty. 2006) (quoting Callanan v. Powers , 199 N.Y. 268, 284 <1910> , aff’d as modified , 42 A.D.3d 178 (3d Dept. 2007)).  This determination is not as easy as it seems. The Restatement (Second) of Contracts provides a list of circumstances that help determine whether a breach is material – that is, whether the non-breaching party is prejudiced by the breach.  These circumstances include: “(a) the extent to which the injured party will be deprived of the benefit which he reasonably expected; (b) the extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived; (c) the extent to which the party failing to perform or to offer to perform will suffer forfeiture; (d) the likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances; (e) the extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing.” Restatement (Second) of Contracts § 241 (1981).  These factors are discussed below. The extent to which the injured party will be deprived of the benefit which he reasonably expected: An example of this factor can be seen from the Volkswagen emissions scandal. Volkswagen marketed and sold its turbocharged direct injection (“TDI”) diesel engines as “clean diesel” vehicles. Purchasers of these vehicles believed that they were buying vehicles that met or exceeded emissions requirements in the United States. However, Volkswagen intentionally programmed its TDI diesel engines to activate emissions controls only during laboratory emissions testing. Thus, the vehicles were not environmentally clean as represented. For millions of environmentally conscious consumers, the purpose of buying the TDI diesel engine vehicles was denied – that is, they were deprived of the clean diesel vehicles they agreed to buy. The extent to which the injured party can be adequately compensated for the part of that benefit of which he will be deprived : If the breach can be corrected with reasonable effort or expense, while keeping the contract in effect, it is less likely to be a material breach. Consider the Volkswagen TDI diesel engine example. Volkswagen did not have the technology to make the TDI diesel engine clean. Because the manufacturer could not fix the problem, a court would consider Volkswagen to have breached the contract in a material way. The extent to which the party failing to perform or to offer to perform will suffer forfeiture : This factor looks at the amount or degree of performance by the breaching party to fulfill his/her end of the bargain? In the Volkswagen example, the company failed to deliver at inception. It did not expend the time and resources needed to deliver a clean diesel engine vehicle. Under that circumstance, the breach is material. There are other more common, everyday examples of this factor.  For instance, consider the homeowner who hires a contractor to replace his roof with modern tiling. About sixty percent of the way into the job, the homeowner discovers that the contractor is not using the modern tile as agreed upon, though the material used is considered to be comparable. If the homeowner declares a breach of contract, the contractor will have lost a significant amount of time and money than if the breach was declared before the job commenced. If most of the contractual obligations have been completed, the homeowner would be less likely to claim a material breach of contract. The likelihood that the party failing to perform or to offer to perform will cure his failure, taking account of all the circumstances including any reasonable assurances: This factor considers whether breaching party can and will correct the problem. The more likely the breaching party can and will fix the problem, the less likely the breach will be deemed to be material. In the Volkswagen case, the technology for “clean diesel” engines did not exist.  Thus, there was no likelihood that Volkswagen could fix the emissions problem. The extent to which the behavior of the party failing to perform or to offer to perform comports with standards of good faith and fair dealing : If the breach was intentional or resulted from bad faith or unfair dealing, a court is more likely to presume a material breach of contract. In the Volkswagen case, the facts showed that in order to deceive the buying public and government regulators about compliance with emissions standards, Volkswagen intentionally programmed its TDI diesel engines to activate emissions controls only during laboratory emissions testing. These controls were automatically turned off once the emissions testing concluded. The extent to which the Contract Defines A Material Breach : Often, the parties to a contract will include provisions in their agreement stating that certain events will constitute a material breach of the agreement. For example, a clause may state that certain activities, such as a failure to make payments, a failure to maintain insurance, or a failure to achieve certain sales goals, will constitute a material breach under the contract. Notably, because a delay in performance and/or payment may not be material, parties often include a “time is of the essence” clause, to signify that a delay will be considered a material breach of the agreement. Matter of Buffalo Schools Renovation Program: On December 8, 2016, the Supreme Court, Commercial Division, in Erie County issued a decision in the  Matter of Buffalo Schools Renovation Program , 2016 NY Slip Op. 51846(U), in which it dismissed a breach of contract and rescission claim because the breach alleged was not material. Facts : Buffalo Schools arose out the renovation of 48 schools for the City of Buffalo City School District (“District”), formerly known as the Buffalo Schools Renovation Program (the “Program”). The general framework of the Program was governed by a Comprehensive Program Packaging and Development Services Provider Agreement, signed by the City of Buffalo Joint Schools Construction Board (“JSCB”) and LPCiminelli, Inc. (“LPC”) in 2002 (“PPDSA”). JSCB acted as the District’s agent in implementing and overseeing the Program. LPC served as the “Program Provider”. Pursuant to the PPDSA, the Program was implemented over five (5) phases; each phase was governed by separate phase agreements (the “Phase Agreements”). The Phase Agreements set out the delivery model for the phase and the specific schools to be renovated pursuant to that delivery model. While substantially all of the Program was financed with state funds (not the District’s or the City of Buffalo’s), the District, the JSCB, and the bond insurers and underwriters insisted that LPC agree to commit to fixed-priced construction agreements for each phase of the renovations, pursuant to which LPC assumed virtually all of the risk of cost overruns and time delays. The Phase Agreements required that amounts due LPC were to be determined by the Program’s architects, based upon the percentage of completion of the stipulated sum, not the actual cost of construction and administration. For more than a decade (and five phases of the Program) the JSCB approved and paid 265 of LPC’s Program payment requisitions, without reservation — until late 2014. At that time (and at the behest of certain members of the District’s Board of Education), the JSCB failed to process certain of LPC’s payment requisitions for completed portions of the Program, totaling in excess of $3.1 million (the “Disputed Payment Requisitions”), and the District insisted that it — not the JSCB, was solely responsible for considering them. For the first time, the JSCB and the District demanded that LPC produce documentation of, inter alia , LPC’s Program-related overhead and administration costs, construction expenses and profit (the “Disputed Information”). The Motion Court’s Rulings : The District filed a complaint against LPC on January 29, 2016, alleging, among other things, breach of contract. On February 17, 2016, LPC filed a verified petition and complaint against the District and the JSCB, alleging, among other things, the failure to act on the Disputed Payment Requisitions. Each side moved to dismiss the complaints pursuant to CPLR § 3211; the District and the JSCB also moved to dismiss pursuant to Section 3813 of the New York Education Law, and by way of cross-motion to direct LPC to preserve any documentation related to the construction program at issue. The Court (by decision rendered on the record on August 15, 2016) disposed of some, but not all aspects of the motions. Instead, it invited further submissions on the remaining issues that were the subject of the Court’s decision. The Court found that LPC did not breach any provision of the PPDSA. Nevertheless, the Court addressed the allegation that the breach ( i.e. , the failure to provide certain documentation required under the PPDSA) was material and, therefore, permitted the District and the JSCB to cease performing under the contract.  The Court found that, “even if accepted as true,” LPC’s failure “to provide required information” was not material “as a matter of law and, in any event, justify the District’s refusal to pay LPC for the work approved and accepted.” The Court explained that: Only a material breach of contract gives rise to a cause of action or a right to rescind. A material breach is generally regarded as a breach which substantially defeats the purpose of an agreement in such a fundamental way as to defeat the object of the parties in making the contract, and otherwise occurs where a party fails to perform a substantial part of the agreement performance of which was the initial inducement for entering the agreement. For a breach to be material, it must go to the root of the agreement between the parties. A party to a contract will not be excused from paying for the other party’s services absent such material breach. In determining whether a breach is material, courts generally consider the extent to which the non-breaching party will be prejudiced or damaged by lack of full performance. Whether a breach is material is a question of law to be decided by the Court. * * * Here, any alleged breach by LPC’s purported failure to provide certain information was not material. The purpose of the Program and its contracts was to renovate forty-eight (48) District schools for a stipulated sum. That purpose was fully accomplished. The District does not dispute this. It accepted the work, occupied the buildings, and received the certifications of the Architects of Record, who signed off on the outstanding payment applications. For twelve (12) years, the District never claimed that LPC failed to provide it with regular reports or required information. The District’s claim, raised at Program completion, does not go to the “root” of the contracts; it was not so substantial that it defeated the object of the parties in making the contracts; and, equally important, the provision of information was never an inducement for the District to enter into the contracts at issue. The District wanted schools renovated, at a fixed priced, and that is what it received. Under a fixed-price contract, the actual cost to the design-builder is irrelevant and immaterial. The provision that the District relies most heavily on – PPDSA § 11.05 – predates the entry of the Phase Agreements, meaning it had even less materiality once the fixed-price model was agreed on. (Internal quotations and citations omitted). Takeaway: Buffalo Schools stands as a reminder that parties to an agreement that want to cease performing because of an alleged breach better be sure that the breach goes to the root of the agreement such that performance cannot be made. Otherwise, that party is exposing itself to a claim of breach of contract that may in fact be material.

On January 6, 2017, the SEC announced that it awarded $5.5 million to a whistleblower who came forward with information that led to a successful SEC enforcement action.  The whistleblower is the 38 th relator to receive an award under the SEC whistleblower program. In total, since 2011, the SEC has paid approximately $142 million to whistleblowers who provided information resulting in the collection of monetary sanctions against violators of the securities laws. To date, the SEC has recovered $904 million from enforcement actions resulting from whistleblower tips. According to the Order Determining Whistleblower Claim , the relator came forward “while still employed with the company … and … provided critical information that helped end an on-going fraud that preyed predominantly on a more vulnerable investor community.” The Commission agreed to make the award notwithstanding the fact that the relator failed to comply with Rule 21F-9(d), which requires tips to be in writing “if the information was first submitted to the Commission during the interim period between the enactment of the whistleblower program— i.e. , July 21, 2010, when the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was signed into law—and the effective date of the Commission’s whistleblower rules.”  The Commission found that, among other things, the relator “was already actively working with before the enactment of the Dodd-Frank Act, and … it would have been counter-productive and unreasonable to require … the revert to providing information to the Commission staff in writing.” The SEC declined to identify the whistleblower or the wrongdoers. By law, the SEC protects the confidentiality of whistleblowers and does not release information that might directly or indirectly reveal the whistleblower’s identity. Commenting on the award, Jane Norberg, Chief of the SEC’s Office of the Whistleblower, stated: “Whistleblowers play a key role in bringing wrongdoing to the SEC’s attention, and this whistleblower helped prevent further harm to a vulnerable investor community by boldly stepping forward while still employed at the company.” Under the program, whistleblowers are eligible for an award if they voluntarily provide the SEC with original information that leads to a successful enforcement action that exceeds $1 million. The award can range from 10 percent to 30 percent of the money collected. All payments come from an investor protection fund established by Congress that is financed through monetary sanctions paid to the SEC by securities law violators.  No money is taken or withheld from harmed investors to pay whistleblower awards. Takaway: This Blog has repeatedly noted that the SEC’s whistleblower program is, by all accounts, a success.  In Fiscal Year 2016 (ended September 30, 2016), the SEC awarded more than $57 million to whistleblowers under the program. As the SEC rings in the new year with this award, the SEC is clearly signaling that it wants whistleblowers to continue to come forward with original information regarding alleged violations of securities laws.

What is the fate of the fiduciary rule under the Trump Administration? In May of last year, this Blog wrote about the Department of Labor's fiduciary rule, which requires financial advisors to put their clients' interests first when making investment recommendations for retirement accounts, such as 401(k)s and IRAs. The rule, designed to prevent conflicts of interest, has strong support from the Obama administration and investor advocates who argue that inappropriate recommendations cost retirement investors $17 billion a year. While legal challenges have been brought based on claims that the Labor Department failed to adhere to regulatory procedures when promulgating the rule (discussed here and here ), two federal courts have already disagreed, while a consolidated case in Texas is still pending. In any event, as of now, the rule is effective and advisory firms must be in compliance by April 2017. However, the provision requiring financial advisors to acknowledge their role as a fiduciary in a contract with investors does not become effective until 2018. At the same time, some observers believe the incoming Trump Administration could roll back the fiduciary rule. To do so, however, there are a number of regulatory hurdles to clear. The rule is actually under the purview of the DOL's Employee Benefits Security Administration, which is headed by an assistant secretary.  As of now, this slot has not been filled, so immediate action on the rule is not likely. Though, it is important to note that Trump's nominee for secretary of labor, Andrew Puzder, is a vocal opponent of the regulation. Also, changing or replacing the rule means undoing what was a 6-year effort by the Labor Department. This would essentially require new rule making - a process that could take years not months, according to some observers. In light of the fact that the compliance deadline is fast approaching, however, it is possible that this date will be delayed until incoming officials have the opportunity to evaluate the measure. Nonetheless, many financial firms have already started preparing for the new rule by devising new policies and procedures. Moreover, the Trump administration could seek to repeal the rule through congressional action. However, that option, while having the support of the Republican controlled Congress, would have to overcome likely opposition from Democrats, especially in the Senate. Finally, the Trump administration could stop defending the regulation in the pending lawsuits. By doing so, the new administration would be conceding the cases to the rule's opponents. Readers may recall, the Obama administration took this approach with the Defense of Marriage Act in 2011. The Takeaway Given the time and money already spent to meet the deadline, it may be in the best interest for these firms to proceed as the fate of the fiduciary rule is uncertain at best. In the meantime, investment advisors should seek the advice and counsel an experienced  securities attorney for developments regarding any changes to the DOL fiduciary rule.

Business owners hate litigation. In fact, there are few things they hate more. Litigation damages relationships, tarnishes reputations, and interferes with business operations. Even small claims divert time, money and talent. So, how can corporations and small businesses avoid these costs and expenses? The answer: alternative dispute resolution, such as arbitration and mediation. Over the past few decades, it has become commonplace for corporations and small businesses to incorporate arbitration provisions into their agreements with customers and employees. While these clauses often seem to be merely procedural, they are not.  They prevent consumers and employees from having their day in court before a judge or a jury. Over the past few decades, the courts have endorsed the use of arbitration as an alternative to litigation, reduced the ability of individuals to avoid arbitrating their disputes, and narrowed the possibility of obtaining judicial review. They have adopted pro-arbitration doctrines such that arbitration agreements are almost always upheld when challenged, even when individuals can show that an arbitration clause was buried in fine print or incorporated by reference to an obscure and inaccessible source.  This Blog previously wrote about this issue here . But, as a New Jersey appellate court ruled last year, to be enforceable, an arbitration provision must not only be clear and unambiguous, but it must clearly state that the customer is waiving his/her right to bring a claim in a court of law before a judge or a jury. Defina v. Go Ahead and Jump 1, LLC d/b/a Sky Zone Indoor Trampoline Park , Docket No. A-1371-15T3 (N.J. Super. App. Div. July 12, 2016). The Facts and Motion Court Proceedings: The defendant, Go Ahead & Jump 1, LLC, owned and operated an indoor trampoline facility in Pine Brook, N.J., known as the Sky Zone Indoor Trampoline Park (“SZITP”).  Before using the facility, the defendant required all customers to sign an agreement entitled, “Participation Agreement, Release and Assumption of Risk” (the “Agreement”). Slip op. at 2. The Agreement contained a number of substantive provisions, including a release of liability for any injury to person or property caused by participation in the park, a choice of law and venue provision, a severability clause and an arbitration provision. The arbitration provision provided, in pertinent part, that “any disputes regarding th agreement,” would be resolved “by binding arbitration before one arbitrator” rather than through trial. Importantly, the Agreement stated that by signing the document, the participant was “waiv any right … to a trial.” Id . at 2-4. On February 8, 2014, Michael Defina signed the Agreement electronically on the defendant’s website. He certified that he was the legal guardian of two participants: Alexander Defina, his nine-year-old son, and another child. Defina’s son was injured while participating in various activities in the facility, including “Ultimate Dodgeball.” Id . at 4. More than a year later, on June 18, 2015, the plaintiffs (Alexander and his parents as guardians ad litem) filed a complaint against SZITP, alleging various violations of the law related to Alexander’s injuries, including the failure to provide adequate warnings and instructions regarding the dodgeball activity; negligence in creating, advertising and promoting an ultra-hazardous and dangerous dodgeball game; and the failure to properly supervise, attend to, control or regulate the conduct of other invitees over whom the defendant had supervisory responsibility, thereby rendering the dodgeball game unsafe and ultra-hazardous for persons participating in that game. Id . at 5. Among other relief, the plaintiffs sought compensatory and punitive damages, interest, attorney’s fees, and costs of suit. Id . On September 2, 2015, the defendant filed a motion to compel arbitration and stay proceedings. Id . The plaintiffs opposed the defendant’s motion and filed a cross-motion to rescind the Agreement. Id . On October 23, 2015, the motion court granted the motion to compel arbitration and stayed the action. Id . at 5-6. The court found that the arbitration clause was enforceable. Id . at 6. The motion court denied the cross motion. The plaintiffs thereafter filed a motion for reconsideration. After hearing oral argument, the motion court denied the motion. Id . The court rejected, among other things, the “plaintiffs’ contention that the arbitration clause clearly and unambiguously placed the person signing it on notice that he was waiving the right to a trial and agreeing that any disputes would be determined by binding arbitration.” Id . at 7. The plaintiffs appealed. The Appellate Division’s Ruling: On appeal, the plaintiffs argued, among other things, that the motion court erred by finding that the arbitration clause in the Agreement was enforceable.  The Court agreed. In doing so, the Court found that the arbitration clause did not clearly and unambiguously “inform Michael Defina that he was giving up his right to bring claims in court and have a jury resolve the dispute”: We are convinced that the arbitration clause at issue in this matter did not clearly and unambiguously inform plaintiff that he was giving up his right to bring claims arising out of the participation in activities at SZITP in a court of law and have a jury decide the case. The arbitration clause states that the person signing the agreement waives any right to a “trial” and agrees that any dispute shall be determined “by binding arbitration before one arbitrator to be administered by JAMS pursuant to its Comprehensive Arbitration Rules and Procedures.” Although the clause refers to a “trial’, there is no “clear and unambiguous statement that the person signing the Agreement is waiving right to sue or go to court to secure relief.” Indeed, there is no reference in the clause to a court or a jury. The Agreement also does not explain how arbitration differs from a proceeding in a court of law. We conclude that the Agreement did not clearly and unambiguously inform Michael Defina that he was giving up his right to bring claims in court and have a jury resolve the dispute. Accordingly, we conclude that the trial court erred by finding that arbitration clause in the Agreement is enforceable. We therefore reverse the order compelling arbitration and staying further trial court proceedings. Id . at 12 (internal quotations and citations omitted). Conclusion As the Defina court noted, there is a strong public policy “both at the state and federal levels favoring arbitration agreements.” Id . at 8. Notwithstanding, mandatory arbitration agreements have come under fire as of late. Consumer advocates, legislators, and judges have argued that such agreements unfairly deny people access to the courts, as well as exclude them from exercising their constitutional right to a jury.  While not declaring arbitration agreements unenforceable or against public policy, the Defina court nevertheless took a stand to ensure that the party with no bargaining power ( i.e. , the customer or employee) understood the consequences of an otherwise and clear and unambiguous arbitration agreement.

Your client comes to you with a complaint that was recently served on him. Among other claims, the plaintiff contends that your client breached his agreement to sell widgets. After discussing the claims with your client, you decide to file an answer. Your analysis of the contract claim leads you to conclude that the contract is void because performance would require your client to violate certain labor laws. In addition to general denials, you assert several affirmative defenses, including the defense of illegality. New York’s Civil Practice Law & Rules (“CPLR”) § 3018(b) provides that a party must plead as an affirmative defense “all matters which if not pleaded would be likely to take the adverse party by surprise or would raise issues of fact not appearing on the face of a prior pleading.” CPLR 3018(b) lists the defenses commonly asserted, including “facts showing illegality either by statute or common law,” but makes it clear that the list is not exhaustive. What happens, however, when the defendant fails to plead an affirmative defense? As a general rule, the defense would be deemed waived. However, where the defendant raises the defense in motions (many affirmative defenses can be asserted as a basis for a motion under CPLR 3211), for example, the courts have ruled that the defense may be entertained because there is no surprise or prejudice by its assertion. That was the holding of the Appellate Division, First Department in American Stevedoring, Inc. v. Red Hook Container Terminal, LLC , 2016 NY Slip Op 08470 (1st Dep’t. Dec. 15, 2016). Facts: Red Hook Container Terminal, LLC (“RHCT”) provided stevedoring services at a marine container terminal located in Brooklyn, New York (the “Brooklyn Terminal”). Prior to RHCT, American Stevedoring, Inc. (“ASI”) provided those services at the Brooklyn Terminal. During RHCT’s tenure, RHCT entered an equipment lease agreement with ASI (the “Lease”) for certain inland marine equipment, then valued by ASI at approximately $10 million (the “Equipment”). Most of the Equipment was located at the Brooklyn Terminal. Slip op. at 2. The Lease included provisions that were designed to protect ASI’s Equipment and to assure an orderly transfer of the Equipment from RHCT at the end of the lease period. The Lease was to terminate on March 31, 2012. After the expiration of the Lease, RHCT retained possession of the Equipment. Id . On March 27, 2012, a few days before the expiration of the Lease, ASI advised RHCT of the location to deliver the Equipment. RHCT objected to the location because delivery would block city streets for a full day and was not within the 20 mile limit provided in the Lease. On April 13, 2012, ASI provided RHCT with another location for delivery of the Equipment. Five days later, RHCT informed ASl that the second location was not acceptable, primarily because the owner of the site did not give RHCT permission to store the Equipment at that location. In response, ASI commenced the action. The Proceedings Before the Motion Court: ASI asserted many claims against RHCT, including one for breach of contract. ASI sought the return of the Equipment and recovery of compensatory and punitive damages. RHCT counterclaimed for, among other things, its post-Lease storage fees for the Equipment. Thereafter, the parties moved for partial summary judgment. ASI based its motion on RHCT’s failure to return the Equipment as provided for in the Lease. RHCT sought dismissal of the breach of contract claim, among others, on the grounds that it was not obligated to deliver the Equipment because the delivery sites selected by ASI were unsuitable and/or did not satisfy the requirements of the Lease. RHCT claimed that by delivering the Equipment to the locations identified by ASI, it would have required RHCT to trespass or otherwise violate the law. The Motion Court granted ASI’s motion with regard to the breach of contract claim. In granting partial summary judgment, the court rejected RHCT’s illegality argument because it was not pleaded as an affirmative defense. ASI argues that an illegality defense is an affirmative defense which must be pleaded in a responsive pleading or addressed in a motion to dismiss lest it be waived. The defense was not pleaded. . . . While RHCT has referred to the issue of having the permission of the site owner during the pendency of this case, for example, by demanding that ASI provide evidence of permission to use the site when the Third Location was  specified, the issue appears to have been touched on only in the context of questioning whether  RHCT would be able to access the site and complete delivery. RHCT has not shown that it previously raised a concern about trespassing or illegality. Rather, it expressed a concern that it would be denied access. Accordingly, … RHCT has waived the illegality defense. Slip op. at 8 (citation omitted). The First Department’s Ruling: In a unanimous ruling, the First Department reversed the motion court’s holding that Red Hook waived its affirmative defense of illegality. In so doing, the Court noted that “ n prior motions defendant had raised the argument that it should not be forced to commit trespass,” which, the Court observed, the “plaintiff had responded to.” Consequently, “ ecause plaintiff … was not surprised or prejudiced by its assertion, the defense may be entertained.” Takeaway: CPLR 3018 is clear: an “affirmative defense” must be pleaded to be preserved. If it is not so pleaded, it is waived. Therefore, the failure to plead an affirmative defense could have significant consequences. But, as American Stevedoring teaches, such consequences may not always follow when the defendant demonstrates that the plaintiff had a full and fair opportunity to respond to, and oppose, the defense being asserted – that is, the plaintiff suffers no prejudice or surprise by the assertion of the defense.

From time to time, this Blog has written about lawsuits involving corporations, including those brought as shareholder derivative actions ( here ). As this Blog explained, a derivative action is a lawsuit brought by a shareholder of a company, on behalf, and for the benefit, of the company to enforce or defend a legal right or claim. Derivative actions seek the recovery of damages and/or equitable relief arising from unlawful or improper conduct engaged in by officers, directors, or other persons in control of the company. The power of the derivative action is immeasurable. It allows a shareholder to compel changes in a company that otherwise might not happen, such as corporate governance reforms that strengthen and protect shareholder value, removal of officers or directors whose misconduct harmed the corporation, and monetary payments in the form of damages and/or disgorgement (repayment) of ill-gotten gains. Although a shareholder has the derivative action in his/her arsenal, he/she cannot immediately run to court to redress an alleged wrongdoing. The shareholder must first formally demand the company’s board of directors act in the manner that the shareholder requires, such as suing the wrongdoers. The “demand” requirement, however, can be waived if the suing shareholder can show that such a demand would have been futile. If the shareholder makes a demand on the board, then the board must be allowed time to determine the proper course of action to pursue. To assist it, the board will often seek outside counsel and/or create a committee of disinterested directors who were not involved in the transaction about which the shareholder is complaining. If the board and/or committee recommend legal action, then the board will likely file an action against the wrongdoers who have pursued, or are pursuing, the illegal or improper course of conduct. If, however, the board and/or the committee determine that legal action is not appropriate, then the demanding shareholder may commence an action for the benefit of the company. A derivative action typically involves claims against an officer or director of the corporation, but can also include claims against others, such as outside accountants or advisors. Misconduct that can be addressed by a derivative action can include, among others, breach of the duties of loyalty, due care, and/or candor; fraud or other unlawful activity; self-dealing by insiders; conflict of interest; waste of corporate assets; improprieties related to executive compensation (including share ownership); and decisions that expose the company to harm or risk ( e.g. , violations of the law). KNET, Inc. v. Ruocco : Consideration for The Issuance of Company Stock and The Board’s Business Judgment On December 28, 2016, in KNET, Inc. v. Ruocco , 2016 NY Slip Op. 08853, the Appellate Division, Second Department, had the opportunity to consider a derivative action involving, among other things, the breach of fiduciary duty in connection with the issuance of stock to corporate insiders. KNET arose from conduct that, according to the plaintiffs, caused losses, near ruin and harm to the corporate plaintiff, Interceptor Ignition Interlocks, Inc. (“Interceptor”). By their complaint, the plaintiffs, shareholders of Interceptor, sought the recovery of damages caused by one or more of the defendants’ breach of fiduciary duties, corporate waste, mismanagement, self-dealing, and engagement in conduct that contravenes the by-laws of Interceptor and the rights of its shareholders to participate in the management of its corporate business. The Facts: Interceptor was originally formed as Safe Start, Inc. in 2000 by the defendant, John Ruocco (“Ruocco”).  Ruocco had developed and patented a proprietary ignition interlock system for use in automobiles of drivers who had been convicted of driving under the influence of alcohol. Ruocco incorporated Safe Start to market and sell the device. In February 2007, Ruocco changed the name of the company to Interceptor, and amended the certificate of incorporation to provide that Ruocco was the owner of 500,000 of Interceptor’s 10,000,000 shares. At the time, the par value of Interceptor’s shares was $.001 per share. In May 2007, Interceptor issued 1,500,000 shares of company stock to Rosemarie Sylvester (“Sylvester”), Ruocco’s sister and a defendant in the action, as well as to himself. Three years later, in May 2010, Ruocco and Sylvester were each issued 2,500,000 shares of Interceptor stock, for a total of 4,000,000 shares each. Interceptor also issued shares to outside investors, pursuant to subscription agreements, at $2 per share. In June 2010, Interceptor entered into a business development agreement and a consulting agreement with the plaintiff, KNET, Inc. (“KNET”), a company owned by the plaintiff Gary Melius (“Melius”). These agreements allowed KNET to earn shares of Interceptor at par value if KNET performed certain services for Interceptor. Pursuant to the agreements, KNET would earn 2,803,214 shares of Interceptor stock upon the enactment of a state or federal law requiring the use of Interceptor’s device, 934,405 shares for introducing Interceptor to one or more public officials and one or more automobile insurers, 934,405 shares upon Interceptor being certified in at least one state where it was not yet certified, and 3,176,976 shares upon securing financing for Interceptor “in the minimum amount” set by Interceptor. In November 2010, the financing provision of the consulting agreement was amended, in pertinent part, to provide that if Interceptor received a loan of $1,500,000 from Flushing Savings Bank, KNET would receive 5% of the outstanding shares of Interceptor. The Motion Court Proceedings: In 2013, Melius, as principal of KNET, and Thomas Grogan, the owner of 57,500 shares of Interceptor stock, filed a derivative complaint against Ruocco and Sylvester, alleging, among other things, that Interceptor issued shares to Ruocco and his family members without adequate consideration, resulting in at least $10,000,000 in damages. Following proceedings involving a request for injunctive relief, the plaintiffs moved for summary judgment on their claim to invalidate the shares of Interceptor stock that Ruocco and Sylvester had issued years before for allegedly little or no consideration, to enjoin them from voting those shares, and to determine the number of shares of Interceptor held by KNET. By order dated December 24, 2013, the Supreme Court, granted the plaintiffs’ motion. In doing so, among other things, the court invalidated all but 500,000 shares of Interceptor stock issued to Ruocco and all of the shares of Interceptor stock issued to Sylvester “based upon defendants’ undisputed failure to provide sufficient consideration for their shares.” Slip op. at 2. Under New York law, “directors of a corporation cannot issue or dispose of the corporate stock to themselves for an inadequate consideration.” Id . (citation omitted). The reason being, directors “owe a fiduciary responsibility to the shareholders in general and to individual shareholders in particular to treat all shareholders fairly and evenly.” Id . (internal quotation and citation omitted). Therefore, a director breaches that duty when he/she issues new stock for no or inadequate consideration. Id .  (citations omitted). In pertinent part, the court found: The record demonstrates that defendants’ shares were improperly issued and issued without sufficient consideration. Once Ruocco … accepted $50,000 for 25,000 shares …  he could no longer treat Interceptor as his own personal property and thereafter issue to himself or his sister shares for either no or minimal consideration. * ** Here, 5 million shares were issued in 2010 for no consideration and reliance cannot be made to the claimed October 31, 2006 transfer of funds to which no nexus is shown of an intended purchase of stock. In any event, the inadequate price is demonstrated by the sale of stock for two dollars a share, when defendants claim that on the very next day, they acquired shares for a pittance. * ** No legitimate business purpose was offered supporting the issuance of stock to the defendants at the price claimed, nor was the claim made that the price they paid a fair one. Id. at 13, 14 (internal quotations and citations omitted). The Second Department Ruling: Citing to New York’s Business Corporations Law and the business judgment rule, the Second Department reversed the Supreme Court’s grant of summary judgment, finding issues of fact for the trier of fact to resolve. With respect to the contention that Ruocco and Sylvester were improperly issued shares in Interceptor, consideration for shares may consist of “money or other property, tangible or intangible; labor or services actually received by or performed for the corporation for its benefit or in its formation . . . In the absence of fraud in the transaction, the judgment of the board or shareholders, as the case may be, as to the value of the consideration received for shares shall be conclusive ” (Business Corporations Law § 504 ). Here, issues of fact exist as to whether Ruocco and Sylvester were improperly issued shares in Interceptor since the parties’ submissions indicate that Ruocco was the founder of the corporation and performed services in the formation of Interceptor ( see Matter of Heisler v Gingras , 90 NY2d 682, 687), that Ruocco and Sylvester invested in the company, and that Sylvester’s  shares may have been a gift from Ruocco. Slip op. at 3. Takeway: KNET teaches two important lessons.  First, as set forth in New York statutory law, consideration for the issuance of shares comes in all forms. Business Corporations Law § 504 . Money is not the only form of consideration. Second, the business judgment of the board of directors cannot be easily disturbed absent fraud, waste, a breach of fiduciary duty or bad faith. The “business judgment rule” presumes that the directors of a corporation will act in the corporation’s best interests. Thus, if a plaintiff sues a company’s officers or directors for breaching a fiduciary duty, he/she will have to show that the officers or directors were not acting in the best interests of the company and that they failed to meet their duties of loyalty, care, or good faith. As the plaintiffs in KNET learned, if they are to succeed, they will have to prove that Ruocco caused Interceptor to issue company stock for little or no value in violation of Business Corporations Law § 504 – that is, he breached his fiduciary duties to the company and its shareholders.

On December 22, 2016, the Department of Justice (“DOJ”) announced that Teva Pharmaceutical Industries Ltd. (“Teva”), the world’s largest manufacturer of generic pharmaceutical products, and its wholly-owned Russian subsidiary, Teva LLC (“Teva Russia”), agreed to resolve criminal charges and to pay a criminal penalty of more than $283 million for violating the Foreign Corrupt Practices Act (“FCPA”). The charges relate to various schemes involving the bribery of government officials in Russia, Ukraine and Mexico. The Securities and Exchange Commission (“SEC” or “Commission”) also announced on that date, the filing of a cease and desist order against Teva, whereby the company agreed to pay approximately $236 million in disgorgement to the SEC, including prejudgment interest.  In total, Teva agreed to pay nearly $520 million in criminal and regulatory penalties. The announcements came one day after the DOJ and SEC, together with Brazilian and Swiss authorities, reached a settlement of $3.6 billion with Odebrecht SA, the engineering conglomerate, and its affiliate Braskem SA, in connection with violations of the FCPA related to the Petrobras corruption scandal. The Russian Connection: According to the DOJ, Teva and Teva Russia admitted that its executives and employees paid bribes to a high-ranking Russian government official for the purpose of increasing sales of Teva’s multiple sclerosis drug, Copaxone, in annual drug purchase auctions held by the Russian Ministry of Health. Between 2010 and at least 2012, pursuant to an agreement with a repackaging and distribution company owned by the Russian government official, Teva earned more than $200 million in profits on Copaxone sales to the Russian government.  Moreover, the Russian official earned approximately $65 million in corrupt profits through inflated profit margins granted to the official’s company. The relationship ultimately ended in 2013, several months after the official resigned his position. The Ukrainian Connection: Teva admitted to paying bribes to a senior government official within the Ukrainian Ministry of Health to influence the Ukrainian government’s approval of Teva drug registrations, which were necessary for the company to market and sell its products in the country.  Between 2001 and 2011, Teva engaged the official as the company’s “registration consultant,” paid him a monthly fee and provided him with travel and other things of value totaling approximately $200,000.  In exchange, the official used his official position and influence within the Ukrainian government to influence the registration in Ukraine of Teva pharmaceutical products, including Copaxone and insulins. The Mexican Connection: Teva admitted that it failed to implement an adequate system of internal accounting controls and failed to enforce the controls it had in place at its Mexican subsidiary, which allowed bribes to be paid by the subsidiary to doctors employed by the Mexican government.  Teva admitted that its Mexican subsidiary had been bribing these doctors to prescribe Copaxone since at least 2005.  In total, Teva Mexico illegally paid approximately $16.8 million to doctors employed at government hospitals. Teva executives in Israel responsible for the development of the company’s anti-corruption compliance program in 2009 had been aware of the bribes paid to government doctors in Mexico.  In November 2011, a Teva employee with responsibility for financial controls over Teva Mexico even identified deficiencies in internal accounting controls in Teva’s Latin American operations, writing a memorandum that said the company could not guarantee that it was not “executing payments that would violate FCPA anti-bribery provisions” or “properly accounting for any such payments under the books and records provision of the FCPA.” Despite their knowledge of inadequate controls, Teva executives approved policies and procedures that they knew were not sufficient to meet the risks posed by Teva’s business and were not adequate to prevent or detect payments to foreign officials.  Teva also admitted that its executives put in place managers to oversee the compliance function who were unable or unwilling to enforce the anti-corruption policies that had been put in place. The DOJ and SEC Settlements: Teva entered into a deferred prosecution agreement (“DPA”) in connection with a criminal information , charging the company with one count of conspiracy to violate the anti-bribery provisions of the FCPA and one count of failing to implement adequate internal controls.  Pursuant to the DPA, Teva will pay a criminal penalty of $283,177,348.  Teva also agreed to continue to cooperate with the DOJ’s investigation, enhance its compliance program, implement rigorous internal controls and retain an independent corporate compliance monitor for a term of three years. Teva Russia agreed to plead guilty to a one-count criminal information, charging the company with conspiring to violate the anti-bribery provisions of the FCPA.  The plea agreement is subject to court approval. The DOJ said that Teva had not self-reported the violations and so was not eligible for a more significant discount or a declination of prosecution, but that the company had received a 20 percent discount off the sentencing guidelines for cooperating with the government’s investigation and engaging in remediation. Although Teva cooperated with the investigation, it nevertheless did not receive full credit for that cooperation because of “vastly overbroad assertions of attorney-client privilege and not producing documents on a timely basis.” In the SEC action, Teva agreed to pay more than $236 million in disgorgement and interest to the Commission. The criminal cases are United States v. Teva Pharmaceutical Industries Ltd. , case number 1:16-cr-20968, and United States v. Teva LLC (Russia) , case number 1:16-cr-20967, and the civil case is Securities and Exchange Commission v. Teva Pharmaceutical Industries Ltd. , case number 1:16-cv-25298, all in the U.S. District Court for the Southern District of Florida. Takeaway: Andrew Ceresney, the former Director of the SEC’s Enforcement Division, once suggested that FCPA violations would become an “increasingly fertile ground” for whistleblowers under the SEC Whistleblower Program. Although it appears that the Teva settlements did not result from the SEC Whistleblower Program or the False Claims Act, publicly available documents show the presence of internal whistleblowing. As noted in the SEC complaint, “On or about February 23, 2007, an anonymous letter was delivered to a Teva internal auditor stating, among other things, that Teva Mexico was authorizing illicit payments to government officials as an incentive to increase sales.” Teva even initiated an internal investigation in response to the charges made in the letter, and terminated 11 Teva Mexico employees for their role in the alleged wrongdoing. Unfortunately, Teva’s internal accounting controls were still not sufficient to meet the risks posed by Teva’s business in Mexico. The internal whistleblowing that occurred in Teva is consistent with recent statistics showing that employees who discover misconduct first report it internally. For example, according to the SEC in its latest annual report to Congress, to date almost 65% of award recipients were company insiders, approximately 80% of whom raised concerns internally to supervisors or compliance personnel, or understood these personnel were aware of the violations, before reporting their concerns to the SEC. In 2015, only 50% of award recipients were company insiders. These statistics indicate that the majority of employees who learn of violations of the law first report the misconduct internally – action that is encouraged by the SEC. In fact, the SEC has implemented several rules under the Whistleblower Program that are intended to encourage internal reporting of misconduct through company ethics and compliance programs and procedures. For example, a person who reports misconduct internally can receive whistleblower status under the law, so long as the person reports the same information to the SEC within 120 days. This means that the whistleblower will not lose his/her place vis-à-vis a whistleblower award if someone else reports the same information to the SEC before he/she does so. a person who reports misconduct internally can receive credit for the findings made by the company in response to the whistleblower’s report. Thus, where a company conducts an investigation and discloses the results of the investigation to the SEC, the whistleblower receives credit for triggering the investigation and reporting to the Commission. a person who reports (or fails to report) misconduct internally is a factor considered by the SEC in determining how much to award the whistleblower. Under the SEC Whistleblower Program, a whistleblower, whose information led to a successful enforcement action, can receive between 10% and 30% of the amount recovered by the SEC. Notably, the courts are split on whether employees who first report misconduct internally are entitled to the law’s protections against retaliation. Not surprisingly, the SEC has advocated that those protections should extend to internal whistleblowers. Whether the courts will ultimately rule in favor of the whistleblower remains to be seen.  However, one thing is certain, the SEC Whistleblower Program is designed to encourage whistleblowers to first report misconduct internally. To learn more about the SEC Whistleblower Program, visit the SEC Whistleblower pages of this website.