Court Grants Motion to Dismiss in Qui Tam Action Alleging False Claims in the Form of Federal Grant Applications

In United States of America, ex rel. v. CASA de Maryland , No. CV PX-16-0475, 2018 WL 1183659 (D. Md. Mar 6, 2018), the United States District Court for the District of Maryland was asked to decide whether the complaint alleged claims under the False Claims Act (“FCA”) in connection with federal grant applications and whether the complaint also alleged claims of retaliation under the FCA and the tort theory of termination in violation of public policy (i.e., wrongful termination). The court granted the motion to dismiss filed by CASA de Maryland (and other related entities and individuals) (“CASA”), but granted the plaintiff leave to amend the FCA claims. In granting leave to amend, however, the court noted it was “skeptical that [the plaintiff]’s pleading deficiency can be cured.” The court also granted CASA’s motion to dismiss with prejudice with respect to the wrongful termination claim. Hyatt & Weber attorney, Stephen Stern, was one of CASA’s defense counsel.

CASA receives federal grants through the United States Department of Education’s (“DOE”) Fund for the Improvement of Education and Investment in Innovation Fund, as well as the United States Department of Labor’s (“DOL”) Occupational Safety and Health Susan Harwood Training Grants. As a condition of receiving these grants, CASA had to complete Program Participation Assurances (“PPAs”) on Office of Management and Budget (“OMB”) Form SF424B, and provide annual financial status reports (“FSPs”) using OMB Form SF270. Because CASA expended more than $500,000 in federal funds in 2014, it was required to undergo an audit for that fiscal year pursuant to OMB Circular A-133 (the “A-133 audit”). In the PPAs, FSPs, and the A-133 audit, CASA had to certify that it complied with “applicable requirements” under federal law and regulations.

Plaintiff-Relator, Amalia Potter (“Potter”), was CASA’s Human Resources Manager, from May 20, 2013 through August 20, 2014. Potter alleged that during the A-133 audit she discovered a number of CASA’s I-9 forms (forms that confirm an individual is authorized to work in the United States) dating back to the 1980s appeared deficient. Potter claimed that she alerted Virginia Kase (“Kase”), CASA’s Chief Operating Officer (“COO”), of the alleged problem and that Kase instructed Potter to fix the issue going forward for all new employees, but do nothing about the past deficiencies. When Potter learned in June 2014 that CASA would be subject to an A-133 audit for the preceding fiscal year, she allegedly conducted a “self-audit” that revealed other deficiencies with CASA’s I-9 forms. Potter claims she discussed these concerns with Kase, who allegedly instructed Potter to fill out the defective I-9 forms herself. Potter claims to have refused Kase’s instruction, but agreed to work with CASA’s management on updating the I-9s for current employees. Potter contends the updates were never made and, when she attempted to address the I-9 issues with Kase one more time, Kase “became irate” and accused Potter of “complicating matters.” Potter contends that Kase later “chastised” her for sending an email to all CASA managers that instructed them to have employees bring their I-9 documentation to an all staff meeting one day and that she was subsequently terminated from employment. Potter further claims that CASA failed to “disclose its widespread noncompliance with federal employee eligibility regulations” and, as a result, its certification was false.

To state a claim under the FCA for making false statements to the government to secure government funding (Count I in this case), a plaintiff must allege: (1) that there was a false statement or fraudulent course of conduct; (2) that was made or carried out with the requisite knowledge; (3) that was material; and (4) that caused the government to pay money or forfeit money that was due. When government funding is conditioned on compliance with certain requirements and that compliance is falsified, an FCA claim may be brought. Liability does not exist, however, “merely for non-compliance with a statute or regulation[;]” rather, the falsified compliance must be “a prerequisite” “to securing the government funding.” The court described Potter’s claim as one where she alleged CASA’s certification of “general compliance, without disclosing CASA’s more specific I-9 noncompliance[] renders the information provided to the government a misrepresentation.” The court found that Potter’s claim “sweeps too broadly” in that Potter’s allegations “fail[] to demonstrate how CASA’s certifications to the government plausibly relate to CASA’s employees’ I-9s.” The court further found that Potter “d[id] not show, for example, how CASA’s certifications relate, refer, or are at all connected to properly executed I-9s or even compliance with federal immigration laws.”

The court also examined the certification forms CASA signed. When examining the Data Collection Form for the A-133 audit, the court found that “[n]othing on this form allows the [c]ourt to infer that certification of compliance means that failure to disclose I-9 noncompliance is a ‘misleading half-truth.’” The SF424B form required CASA to certify that it was in compliance with a number of requirements, including “other Federal laws . . . governing this program .” (emphasis added by court). The court found that “[n]owhere in this exhaustive list is I-9 or immigration compliance mentioned, directly or indirectly.” As for the SF270 form, it required CASA to attest to the accuracy of certain financial data it submitted and that “all outlays were made in accordance with the grant conditions or other agreement and that payment is due and has not been previously requested.” Again, the court found that “nothing in the form requests any information, directly or indirectly, about I-9 or immigration compliance.” For these alone, Potter’s FCA claimed failed to state a claim.

The court nevertheless proceeded to examine the materiality requirement, finding that even if Potter established a false statement was made she did “not plausibly aver that the omissions were material.” The court explained that an omission of “violations of statutory, regulatory, or contractual requirements” is a basis for liability under the FCA “only if the omissions ‘render the defendant’s representations misleading with respect to the goods or services provided .’” (emphasis added by court). To this end, the court found that the complaint did “not include any facts showing that the sufficiency of CASA’s employees’ I-9s related at all to the decision to grant CASA government funding.” Instead, the court found that the complaint “merely assert[ed] . . . that CASA would not have received federal funds if the government knew about the I-9 deficiencies” and further lacked any factual allegations that showed “funding [wa]s tied to the sufficiency of I-9s or to compliance with immigration regulations generally.” For these reasons, Potter’s claim for a substantive violation of the FCA failed as well. The court, however, granted Potter leave to amend, even though it was “skeptical that Potter’s pleading deficiency can be cured.”

As for Count II, which alleged conspiracy to violate the FCA, it failed to state a claim for the same reasons that Count I failed to state claim, as the two counts were based on the same factual allegations. In addition, conspiracy claims are “premised on . . . claims of underlying FCA violations” and, thus, such claims “rise[] and fall[] with the individual claims.” The court granted Potter leave to amend Count II for the same reasons it granted leave to amend Count I.

When it addressed Count III, retaliation under the FCA, the court once again found Potter’s allegations insufficient. To assert a claim for retaliation under the FCA, a plaintiff must allege that: (1) the employee engaged in protected conduct; (2) the employer had notice of the employee’s protected conduct; and (3) the employer retaliated against the employee. There are two types of protected activity. The first kind is activity to further an FCA claim, which includes initiating, testifying for, or assisting with the filing of an FCA claim. Such conduct is considered in furtherance of an FCA claim if it involves a “distinct possibility” of FCA litigation. The second kind of protected activity involves activity undertaken to stop one or more substantive FCA violations. It requires an objectively reasonable belief that the employee’s employer is violating or will soon violate the FCA. This element will be satisfied if the employee’s words or actions are “sufficiently suggestive of fraud or falsity” such that the employer knew or should have known that FCA litigation “was a reasonable possibility.”

As for the first type of conduct, the court found that Potter did not satisfy the requirements because she “voluntarily disclosed” the alleged insufficiency of CASA’s I-9 practices to the United States Department of Justice (“DOJ”) after her employment terminated. In addition, Potter claims that CASA made “negative, unsavory and defamatory remarks” about her to prospective employers, but Potter did not identify when those comments allegedly were made and, as a result, they are insufficient to support a claim for retaliation. Moreover, the court found it significant that Potter’s DOJ disclosure did not indicate whether it was made to stop CASA’s alleged ongoing FCA violation or a broader complaint about noncompliance with immigration regulations. The court, however, granted Potter leave to amend her claim with respect to the “post-termination retaliation [allegedly] motivated by the DOJ disclosure.”

The court likewise found Potter’s allegations regarding her purported attempt to prevent an FCA violation were insufficient to state a claim. To this end, the court found that Potter’s alleged discovery of CASA’s I-9 verification violations, which was made on one occasion during a “self-audit,” does not permit an inference that she reasonably believed an FCA violation would occur. “Missing are any facts to suggest that any of the certifications in the A-133 audit process explicitly or implicitly included an attestation of I-9 compliance.” Furthermore, the court found that Potter’s alleged self-audit of I-9s from decades ago suggested the opposite – that an FCA violation was not about to occur.

Even if Potter alleged facts to indicate she engaged in protected activity, the court found that she did not allege any facts to indicate CASA was on notice of her protected conduct. To this end, there were no allegations in the complaint to suggest that CASA could interpret Potter’s supposed complaints to indicate there was a reasonable possibility of FCA litigation. Instead, Potter’s alleged complaints to CASA focused solely on I-9 compliance, not any potentially fraudulent activity. Thus, Potter’s FCA claim for retaliation failed to state a claim for these reasons too, but Potter was granted leave to amend her complaint “ only if she can allege facts to cure the[ ] deficiencies.” (emphasis added by court).

Lastly, with respect to Count IV, Potter failed to state a claim upon which relief could be granted because a statutory remedy was available to her (i.e., the FCA anti-retaliation provision) and the availability of such a remedy is a bar to filing a wrongful termination claim under Maryland law. Even if that did not bar Potter’s claim, her claim still failed because, to state a claim for wrongful termination in Maryland, the employee must report alleged misconduct to outside authorities before the employee’s employment is terminated. Here, Potter did not allege that she reported the alleged improper conduct to a government official; she claimed that she reported it only internally to executives. For these reasons, the court dismissed Potter’s wrongful termination claim, with prejudice.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Amendments to Data Breach Notification Statute in Maryland Take Effect January 1, 2018

Amendments to the Maryland Personal Information Protection Act took effect January 1, 2018. The amendments primarily expand the definition of what constitutes “personal information” and include specifications regarding notification procedures in the event of a breach.

Prior to the amendments taking effect, the definition of “personal information” was limited to an individual’s first name or first initial and last name in combination with the following information when not encrypted or otherwise protected to make it unreadable or unusable: a social security number; a driver’s license number; a financial account number, including a credit card number or debit card number, in combination with any security or access code or password that would permit access to the individual’s financial account; or an individual taxpayer identification number. Under the amendments, the definition of “personal information” has been expanded to include: a taxpayer identification number, passport number, or other identification number issued by the federal government; a state identification card number; health information, including information about an individual’s mental health; a health insurance policy or certificate number or health insurance subscriber identification number that, in combination with “a unique identifier used by an insurer or an employer that is self-insured,” permits access to the individual’s health information; biometric data generated by automatic measurements of an individual’s biological characteristics, such as fingerprint, voice print, genetic print, retina or iris image, or other unique biological characteristic that can be used to authenticate the individual’s identity; and a user name or email address in combination with a password or security question and answer that permits access to an individual’s email account. The amendments define “health information” as any information protected by the Health Insurance Portability and Accountability Act (“HIPAA”).

Previously, the statute imposed requirements on businesses when destroying a customer’s “personal information.” Now the amendments apply those procedures to the destruction of “personal information” for current and former employees too.

Another significant requirement of the amendments is the time within which notification must be provided when there is a data breach. Previously, a business had to provide notification “as soon as reasonably practicable” after it determined a misuse of personal information has occurred or is likely to occur as a result of a data breach. Now the amendments require a business to provide notice to affected individuals if it determines that a data breach “creates a likelihood that personal information has been or will be misused” and the notification must be given “as soon as reasonably practicable, but not later than 45 days after the business concludes” its investigation into a suspected data breach. Similarly, when a business “maintains computerized data that includes personal information of an individual residing in [Maryland] that the business does not own or license,” the business also shall notify the owner or licensee of the personal information of the breach as soon as practicable, but no later than 45 days after discovering the breach. There are certain limited exceptions where the notification can be delayed.

Lastly, the amendments also include an alternative notification procedure when a data breach involves only information that permits access to an individual’s email account. In that case, the company may provide notice that directs the individual whose personal information has been breached to promptly: (1) change the account password and security question or answer; or (2) take other steps “appropriate to protect the email account” and “all other online accounts for which the individual uses the user name or email and password or security question or answer.” If the notice given to the affected individuals is to be given electronically, there are certain limitations on when/how that notice can be provided, namely that the notice be “clear and conspicuous” and “delivered to the individual online while the individual is connected to the affected email account from an Internet protocol address or online location from which the business knows the individual customarily accesses the account.”

With data breaches becoming more common, it is important that businesses understand their obligations in the event of a breach. With requirements varying by state, as well as at the federal and international level, it is important to conduct a comprehensive review of potentially applicable laws so that businesses understand how to respond, not only substantively but procedurally and timely, in the event of a data breach. With respect to companies affected by the Maryland Personal Information Protection Act, it is important to keep in mind that this post focuses on the amendments that took effect earlier this year and there are additional obligations for companies to follow in terms of data protection that were in effect prior to the amendments.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Court Grants Summary Judgment to Association That Did Not Sue Its Former Law Firm Pursuant to a Prior Settlement Agreement

In Hanrahan v. Wyndham Condominium Association, Inc. , Case No. 13-C-16-109204, a case defended by Hyatt & Weber attorneys Stephen Stern and Amitis Darabnia, the Circuit Court of Maryland for Howard County granted summary judgment to Wyndham Condominium Association, Inc. (“Wyndham”), and dismissed an eight count complaint (that, as a practical matter, asserted ten different causes of action). This lawsuit was premised on multiple prior lawsuits between the parties (the Plaintiffs being Brian and Judith Hanrahan) dating back as much as ten years. The case involved claims for breach of contract, intentional misrepresentation, abuse of process, violations of the Maryland Consumer Debt Collection Act (“MCDCA”), and defamation.

The primary dispute between the parties involved a claim for breach of a settlement agreement, which raised a number of complicated issues involving contract interpretation, legal ethics/public policy, and the interpretation/enforceability of releases. The settlement agreement included a provision that stated Wyndham will “promptly . . . commence litigation against . . . [its] Prior Counsel [with] the goal of recovering legal fees paid by Wyndham to [P]rior [C]ounsel and to obtain any other relief that may be available against . . . Prior Counsel.” The settlement agreement also stated that Wyndham “will pursue the New Lawsuit to trial so long as it obtains legal representation . . . on a 100% contingency basis.” The settlement agreement further provided that Wyndham “will not voluntarily enter into any settlement . . . unless such settlement obtains a gross value of $800,000.” In the event that Wyndham breached the settlement provision, there was a liquidated damages provision that included a formula that would result in a payment to the Plaintiffs of approximately $207,000. The settlement agreement called for the attorney who represented the Plaintiffs in the settled lawsuit to become Wyndham’s counsel in the New Lawsuit against Wyndham’s prior counsel. The settlement agreement additionally provided that “in the event that [the attorney who will be representing Wyndham] is . . . not willing or able to proceed, Wyndham agrees to make diligent efforts to obtain other counsel to proceed.” The settlement agreement included mutual releases of “any liability . . . losses, damages or causes of action of whatsoever kind and nature.”

After nearly three years of Wyndham not filing a lawsuit against its former attorneys, the Plaintiffs filed the instant lawsuit against Wyndham, claiming breach of contract. The Plaintiffs further claimed that the alleged breach equitably tolled their release of claims and permitted them to file a number of other claims that were available to them at the time the settlement agreement was entered into – namely abuse of process and two MCDCA claims. The original complaint included three causes of action for defamation, but the court dismissed those claims in response to Wyndham’s motion to dismiss based on the applicable statute of limitations having expired. The Plaintiffs subsequently amended their complaint to add three (as a practical matter, five) new claims for defamation.

On the day that trial was to begin, the court held a hearing to address Wyndham’s motion for summary judgment, which sought dismissal of the entire case. In a lengthy oral opinion that was stated on the record after the court conducted a hearing for several hours, the court granted Wyndham’s motion for summary judgment in its entirety.

The court spent most of its time addressing the complex issues raised by the breach of contract claim. The court started its analysis by noting that there are essentially two arguments regarding the alleged breach: (1) that Wyndham did not file a lawsuit “promptly” and (2) that Wyndham did not exercise “diligent efforts” after its attorney withdrew as counsel. The court found that neither of those arguments had merit.

With respect to the “promptness” argument, the court noted that “prompt” could take on various meanings, but it must account for an attorney to exercise his/her duty of competence to investigate and evaluate a claim to avoid the filing of a frivolous lawsuit. In this case, the attorney who initially represented Wyndham represented Wyndham for nearly two years and, at the time he withdrew as counsel, he had determined that there was not enough of a basis upon which he could proceed. The court also noted that the statute of limitations should be accounted for when evaluating what is “prompt” and part of acting “promptly” in this case was out of Wyndham’s control in that the speed with which Wyndham would act, if at all, was largely in the attorney’s control.

As for the “diligent efforts” argument, the court noted that it could not find any standard under Maryland law that articulated what constituted “diligent efforts.” The court, however, located a journal article that compared “diligent efforts” to “best efforts” and the article contended that summary judgment should rarely be granted in “best efforts” cases, as what constituted “best efforts” typically is a fact issue for the jury. Despite the article’s position on summary judgment with respect to “best efforts” or “diligent efforts” cases, the court found that the standard requires good faith and diligence and those standards were satisfied in this case. The court specifically noted that Wyndham’s new outside General Counsel, Andrew Robinson, was tasked with finding a replacement for the attorney who withdrew from representation. Robinson contacted multiple attorneys in this endeavor and they all said they would not represent Wyndham in the lawsuit it was supposed to file against its former law firm. This alone was sufficient for the court to conclude that Wyndham engaged in “diligent efforts” to replace its counsel. The court, however, also noted that some of the contract’s unique provisions should be accounted for when determining what was “diligent” in this case. For example, although the court stated it would not rule on Wyndham’s public policy arguments regarding the enforcement of certain provisions of the settlement agreement, the court noted there were a number of provisions in the settlement agreement that raised “red flags” (i.e., ethical issues) for an attorney representing Wyndham in a lawsuit against its former law firm and it was understandable that Wyndham might have had difficulty finding another attorney to represent it in a lawsuit against its former law firm.

Even if the Plaintiffs could establish that Wyndham breached the settlement agreement, the court found that they could not establish damages. The claim for damages against Wyndham’s former law firm appeared to be premised on excessive attorneys’ fees allegedly being charged to Wyndham. To establish that Wyndham’s former law firm charged Wyndham excessive or unreasonable attorneys’ fees, the court concluded that the Plaintiffs would need an expert witness to testify what constitutes reasonable attorneys’ fees under the circumstances. The Plaintiffs’ designated expert, however, was not designated for that purpose. Thus, the Plaintiffs could not establish damages (or that Wyndham would have won the case against its former law firm) even if they were able to establish a breach. Thus, the court dismissed the breach of contract claim for this reason as well and, by dismissing the breach of contract claim, the court necessarily dismissed the intentional misrepresentation claim (which concerned the same contract).

As for the abuse of process and MCDCA claims, the court held that the statute of limitations and the release in the settlement agreement barred each of these claims, as the alleged facts underlying each of these claims occurred more than three years before the original complaint was filed and those claims were based on events that occurred before the settlement was entered into (on or about November 1, 2013). The court rejected the Plaintiffs’ equitable tolling argument, finding that equitable tolling would apply only if there is a breach of the settlement agreement. The court also noted that it could not find any case law where a release was tolled and, even if equitable tolling could apply to a release, there are public policy concerns for such an application that might incentivize frivolous lawsuits. The court further found that even if the release could be equitably tolled, there would be no equitable tolling in this case. In this regard, there was a severability provision in the settlement agreement and the court found that the liquidated damages clause in the litigation section of the settlement agreement was a standalone provision, meaning that the remedy in the event of a breach of the settlement agreement would not be to void the release, but that the Plaintiffs could sue to recover the amount of the liquidated damages provision. The court also found that the abuse of process claim and MCDCA claims failed for other reasons that are beyond the scope of this post.

Lastly, the court granted summary judgment to Wyndham with respect to all five allegedly defamatory statements. The court found that the statements were not defamatory in the context in which they were made and, even if they were, a qualified privilege applied to at least some of the statements. In addition, the court found that there was no evidence that four of the five alleged defamatory statements were made by anyone who was acting within their scope as a Wyndham Board member or at the direction of Wyndham’s Board.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Sixth Circuit Holds Title VII Prohibits Transgender or Transitional Status Discrimination

In E.E.O.C. v. R.G. & G.R. Harris Funeral Homes, Inc. , — F.3d –, No. 16-2424, 2018 WL 1177669 (6th Cir. Mar. 7, 2018), the United States Court of Appeals for the Sixth Circuit held that discrimination on the basis of transgender or transitional status constitutes discrimination on the basis of sex in violation of Title VII of the Civil Rights Act of 1964, as amended (“Title VII”).

The plaintiff, Aimee Stephens, was formerly known as Anthony Stephens. She worked for R.G. & G.R. Harris Funeral Homes, Inc., which was a closely held for profit corporation. Stephens was terminated from employment shortly after she advised the owner of the funeral home that she intended to transition from male to female and would represent herself as a woman at work, including dressing as a woman. The federal district court recognized a claim for discrimination based on failing to conform to sex stereotypes, but the district court ruled that Stephens could not advance an alternative theory of sex discrimination based on her transgender or transitional status. The Sixth Circuit affirmed the district court’s decision with respect to sex stereotyping claim, but devoted much of its lengthy opinion to the issue of transgender/transitional status discrimination.

The EEOC and Stephens argued that transgender discrimination is based on non-conformance of an individual’s gender identity and appearance based on sex-based norms and expectations, which constitutes a form of sex discrimination. The funeral home argued that transgender status refers to one’s self-assigned gender identity, not that person’s sex, and therefore does not constitute sex discrimination. The Sixth Circuit found that the EEOC and Stephens had the better argument for two reasons.

First, the Sixth Circuit found that it is “analytically impossible to fire an employee based on that employee’s status as a transgender person without being motivated, at least in part, by the employee’s sex.” While the funeral home argued that its decision to terminate Stephens’ employment was based on her refusal to comply with the company’s dress code for men, the court framed the question as “whether Stephens would have been fired if Stephens had been a woman who sought to comply with the women’s dress code.” The court concluded that the answer “obviously is no” and, thus, “confirm[ed] that Stephens’[] sex impermissibly affected [the company’s] decision to fire Stephens.” The court buttressed its conclusion by comparing the case before it to a case where an employee was fired after the employee converted from one religion to another and the court found the termination constituted discrimination “because of religion” in that discrimination because of religion “easily encompasses discrimination because of a change in religion.” (emphasis added by court).

Second, the Sixth Circuit concluded that “discrimination against transgender persons necessarily implicates Title VII’s proscriptions against sex stereotyping.” In this regard, the court noted that a transgender person is someone who “fails to act and/or identify with his or her gender” – “i.e., someone who is inherently ‘gender non-conforming.’” As a result, the Sixth Circuit concluded that “an employer cannot discriminate on the basis of transgender status without imposing its stereotypical notions of how sexual organs and gender identity ought to align.” “There is no way to disaggregate discrimination on the basis of transgender status from discrimination on the basis of gender non-conformity, and we see no reason to try.”

The funeral home also asserted other defenses beyond the viability of a claim premised on transgender status. One of those defenses was the ministerial exception under Title VII. In order for the ministerial exception to bar a claim, the employer must be a religious institution and the employee must have been a ministerial employee. Although the ministerial exception is not limited to a church, diocese, synagogue, or any entity operated by a traditional religious organization, to qualify for the exception, the institution must be “marked by clear or obvious religious characteristics.” The court found that the funeral home, however, had no religious characteristics. In this regard, the funeral home did not purport to “establish and advance” Christian values, it was not affiliated with any church, its articles of incorporation did not avow any religious purpose, its employees are not required to hold any particular religious views, and it served people of all religions. The fact that the funeral home’s mission statement stated that “its highest priority is to honor G-d in all that we do as a company and as individuals” was not sufficient to overcome the absence of the many other indicia of being a religious institution. Even if the funeral home could establish that it was a religious institution, Stephens was not a “ministerial employee,” which further precluded the exception from applying.

Another defense the funeral home asserted was based on the Religious Freedom Restoration Act (“RFRA”). The RFRA precludes the government from “substantially burden[ing] a person’s exercise of religion even if the burden results from a rule of general applicability” unless the government “demonstrates that the application of the burden to the person – (1) is in furtherance of a compelling government interest; and (2) is the least restrictive means of furthering that compelling governmental interest.” In responding to this defense, the court noted that Congress intended the RFRA to apply “only to suits in which the government is a party.” While the lawsuit was filed by the EEOC, Stephens became an intervenor at the appellate level. The funeral home contended that the question of the RFRA’s application to Title VII suits between private parties “is a new and complicated issue that has never been part of this case and has never been briefed by the parties.” The court agreed with the funeral home that it would be prejudicial to allow Stephens to intervene on appeal and use that as a basis to remand the case without applying the RFRA. The court spent several pages addressing the various steps to apply the RFRA defense and ultimately concluded that it did not apply.

The Sixth Circuit’s decision in Harris Funeral Homes is significant because it represents another federal appellate court that has expanded the reach of Title VII sex discrimination claims. Most of the attention regarding sex discrimination claims under Title VII recently has focused on sexual orientation cases, but transgender cases are very similar in that both theories rely heavily on sex role stereotyping and/or gender role conformity to support a claim. While federal appellate courts recognizing sexual orientation discrimination and transgender discrimination as forms of sex discrimination in violation of Title VII remain the minority, the number of circuits recognizing such claims continues to expand.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Second Circuit Reverses Precedent and Holds Title VII Prohibits Discrimination on the Basis of Sexual Orientation

In a precedent setting case, the United States Court of Appeals for the Second Circuit reversed course in an en banc decision and held in Zarda v. Altitude Express, Inc. , 883 F.3d 100 (2d Cir. 2018), that sexual orientation discrimination is a form of sex discrimination that is prohibited by Title VII of the Civil Rights Act of 1964, as amended (“Title VII”). The decision by the Second Circuit continues the divide among federal courts on this issue. The decision also is noteworthy because it reverses a decision by the Second Circuit last year that held Title VII does not prohibit sexual orientation discrimination (written about here ).

Donald Zarda was a skydiving instructor with Altitude Express, Inc. With him being in close physical proximity to so many clients when doing tandem dives, many of Zarda’s co-workers routinely referenced his sexual orientation and made sexual jokes around clients. On one instance, a female client complained that Zarda touched her inappropriately during or preparing for a dive and he used his alleged sexual orientation as a basis to excuse his behavior. When the company received the complaint, it terminated his employment. Zarda filed suit alleging that he was terminated from employment because his sexual orientation failed to conform to male sex stereotypes.

The Second Circuit acknowledged that it is “well-settled” that “gender stereotyping” violates Title VII as a form of sex discrimination, but Second Circuit precedent established that sexual orientation discrimination, including in the form of failing to conform to a gender stereotype, was not prohibited by Title VII. The court then noted that in 2015 the Equal Employment Opportunity Commission (“EEOC”) held for the first time that “sexual orientation is inherently a ‘sex-based’ consideration;’ accordingly an allegation of discrimination based on sexual orientation is necessarily an allegation of sex discrimination under Title VII.” The court further noted that since the EEOC’s decision in 2015, two federal appellate courts had addressed the issue and reached different conclusions. In Evans v. Georgia Reg’l Hosp. , 850 F.3d 1248 (11th Cir. 2017), cert. denied , 138 S. Ct. 557 (2017), the United States Court of Appeals for the Eleventh Circuit relied on past precedent to hold sexual orientation was not protected by Title VII. On the other hand, the United States Court of Appeals for the Seventh Circuit in Hively v. Ivy Tech Cmty. Coll. of Ind. , 853 F.3d 339 (7th Cir. 2017) (written about here ), held that “discrimination on the basis of sexual orientation is a form of sex discrimination.” The court also noted its decision in 2017 where a concurring opinion invited an en banc review of the issue.

The court started its analysis of Title VII by looking at the plain text. The operative phrase is that an employer may not discriminate “because of . . . sex.” This phrase has been interpreted to mean that discrimination is prohibited “based on traits that are a function of sex, such as life expectancy . . . and non-conformity with gender norms.” The Second Circuit framed the question it had to answer as “whether an employee’s sex is necessarily a motivating factor in discrimination based on sexual orientation” and, if it is, sexual orientation discrimination is “a subset of actions taken on the basis of sex.” In framing the issue in this way, the Second Circuit specifically rejected the notion that “Title VII protection does not hinge on whether sexual orientation is ‘synonymous with sex discrimination.’”

The court started by finding “the most natural reading” of the phrase “because of . . . sex” “is that it extends to sexual orientation discrimination because sex is necessarily a factor in sexual orientation.” The court found that this conclusion is supported by the notion that sexual orientation can involve sex role stereotyping, which is predicated on assumptions about how persons of a certain sex are supposed to act. The court further found that its conclusion was supported from the perspective of associational discrimination in that when sexual orientation is implicated an employer is opposing an individual’s romantic association with an individual of a particular sex. Furthermore, the court found that examining any person’s sexual orientation necessarily requires an examination of that person’s sex (and that of individuals to whom the person is sexually attracted). For these reasons, the court concluded that “because sexual orientation is a function of sex and sex is a protected characteristic under Title VII, it follows that sexual orientation is also protected.”

After rejecting several arguments offered by the defense and amici, the Second Circuit then examined whether sexual orientation discrimination satisfied the requirement that the employee was treated differently “but for that person’s sex.” The court relied on the fact scenario in Hively (written about here) to illustrate the point. In Hively , the plaintiff was a woman who was attracted to women. She was denied a promotion. According to her theory, if she were a male who was attracted to woman, she would not have been denied the promotion. Under this theory, according to the Second Circuit, Hively would not have been denied her promotion “but for” her sex. The court then examined several other examples and rejected arguments by the defense, and moved on to issues concerning gender stereotyping.

When addressing gender stereotyping, the court concluded that “sexual orientation discrimination is almost invariably rooted in stereotypes about men and women.” To illustrate, the court referenced the United States Supreme Court decision in Price Waterhouse v. Hopkins , 490 U.S. 228 (1989), which concluded that impermissible sex discrimination occurred when adverse employment actions were taken “based on the belief that a female accountant should walk, talk, and dress femininely.” The court then applied the rationale used in Price Waterhouse to conclude when, for example, “an employer . . . acts on the basis of a belief that [men] cannot be [attracted to men], or that [they] must not be,” “but takes no such action against women who are attracted to men, the employer ‘has acted on the basis of gender.’” The court further concluded that failing to recognize sexual orientation discrimination involves sex role stereotyping leads to an unworkable outcome, which has been illustrated by a number of federal district court decisions. To illustrate, the court found it inconsistent to recognize a claim for sex discrimination if a woman is terminated from employment because she was “too macho,” but she fails to state a claim if she alleges she was terminated from employment for being perceived as a lesbian. The court again addressed several other arguments and then moved on to associational discrimination concepts.

The court noted that it was well established that associational discrimination is prohibited under Title VII. It relied on a number of race discrimination cases to illustrate and that the same rationale applies to sexual orientation. The court further noted that the notion of associational discrimination applying to sex should not be controversial. As an example, it noted that no one should question the notion that a woman could state a claim for sex discrimination if she is terminated from employment for having close friendships with male friends. To this end, the court concluded it makes no sense to “carve out” an exception to this concept for sexual orientation and not recognize a claim when an employee “associates” romantically with individuals of the same sex.

For these reasons, and many others described in the lengthy opinion, the Second Circuit held that Title VII does prohibit discrimination on the basis of sexual orientation.

The Second Circuit’s decision in Zarda is significant because the Second Circuit becomes just the second federal appellate court to recognize sexual orientation discrimination constitutes sex discrimination in violation of Title VII. Although many state and local statutes prohibit discrimination on the basis of sexual orientation, it is not universal, and companies should continue to monitor developments in this regard, as courts remain split at the federal level.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Maryland Enacts Paid Sick Leave Law

The Maryland Healthy Working Families Act took effect February 11, 2018. Pursuant to the Act, Maryland employers with 15 or more employees must provide employees with paid leave called “earned sick and safe leave.” The statute has many detailed requirements, as well as exceptions and carve-outs.

Under the statute, employees shall accrue earned sick and safe leave of at least one hour for every 30 hours worked, but an employer is not required to allow an employee to accrue more than 40 hours of earned sick and safe leave in a year. An employer also may not be required to allow an employee to use more than 64 hours of earned sick and safe leave in a year or accrue more than 64 hours of earned sick and safe leave at any time. At the end of a year, employees may carry forward the balance of earned sick and safe leave to the following year, but the employer may prohibit employees from carrying forward more than 40 hours. There are a number of other provisions related to the accrual of leave. For example, after an employee terminates employment, there are circumstances where leave may be reinstated. In addition, hours may not be accrued if an employee works less than a certain number of hours during a pay period. Also by way of example, the total amount of leave may be granted in a lump sum at the beginning of the year.

“Earned sick and safe leave” takes on a broader meaning than several other leave statutes. For example, leave may be used to obtain services related to addressing domestic violence, sexual assault, or stalking, not only for the employee, but the employee’s family member. It also covers mental and physical illnesses, injuries, or conditions, both for the employee and the employee’s family member.

For employers with less than 15 employees, they must provide the “earned sick and safe leave,” but the leave can be unpaid. In addition, employees who are under the age of 18 before the beginning of the year are not considered “employees” under the statute. There are a number of job title and industry exceptions as well.

Employees are required to provide employers with “reasonable advance notice” of the need for leave, but employers cannot require more than seven days advance notice before the leave is to begin. If the need for leave is not foreseeable, employees are required to provide notice “as soon as practicable” and generally comply with the employer’s notice or procedural requirements for requesting other forms of leave. The employer may deny the request for leave if the employee fails to comply with the notice requirements or the employee’s absence will “cause a disruption to the employer.” There are other exceptions where employers may deny the request for leave if they provide services to developmentally disabled or mentally ill individuals.

The statute permits employers not to modify existing leave policies if they allow employees to accrue and use leave under terms and conditions that are “at least equivalent to the earned sick and safe leave provided for under” the statute or if the employer’s paid leave policy does not reduce employee compensation for an absence due to sick or safe leave. Employers are required to provide notice to employees that they are eligible for earned sick and safe leave. A sample notice is available on the Maryland Department of Labor, Licensing, and Regulation (“DLLR”) website. Other guidance also has been provided by DLLR on its website.

If an employee believes a violation has occurred, the employee can file a complaint with DLLR. DLLR has the authority to issue orders of compliance and order monetary relief, as well as assess a civil penalty of up to $1,000 for each employee for whom the employer is not in compliance. In civil actions filed in court, employees may be awarded three times the value of the employee’s unpaid earned sick and safe leave, punitive damages, reasonable attorneys’ fees and costs, and injunctive relief, among other relief the court deems appropriate. The statute also includes an anti-retaliation provision.

This new statute is important for employers who have employees in Maryland. There are a number of detailed provisions that extend beyond the scope of what is described in this post. And, although guidance has been provided by DLLR, a number of questions remain regarding the interpretation and application of the statute. Businesses with employees in Maryland should be coordinating with their counsel regarding implementation of the statute.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Supreme Court Gives Clarity as to Who is a Whistleblower Under The Anti-Retaliation Provision of the Dodd-Frank Act

In Digital Realty Trust, Inc. v. Somers , 138 S. Ct. 767 (2018), the United States Supreme Court was asked to decide whether the anti-retaliation provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank” or “Dodd-Frank Act”) extends to an individual who has not reported a violation of the securities laws to the Securities and Exchange Commission (“SEC” or “Commission”). The Supreme Court held Dodd-Frank does not protect such a person; to be protected a person must “provid[e] . . . information relating to a violation of the securities laws to the Commission.”

In the wake of the financial crisis of 2008, Congress enacted the Dodd-Frank Act, in part to assist the SEC “in identifying securities law violations.” To assist with this process, the Dodd-Frank Act included a whistleblower protection provision. The statute defines a whistleblower as “any individual who provides . . . information relating to a violation of the securities laws to the Commission , in a manner established, by rule or regulation, by the Commission.” (emphasis added by the Court). The statute also created an award program for “whistleblowers who voluntarily provid[e] original information to the Commission that le[ads] to the successful enforcement of [a] covered judicial or administrative action.” The award ranges from 10% to 30% of the monetary sanctions the SEC collects in the enforcement action. The statute further provides that an employer may not take adverse employment action against a “whistleblower” “because of any lawful act done by the whistleblower” (1) “in providing information to the Commission in accordance with [15 U.S.C. § 78u-6];” (2) “in initiating, testifying in, or assisting in any investigation or . . . action of the Commission based upon” information provided to the SEC in accordance with § 78u-6; or (3) “in making disclosures that are required or protected under” either the Sarbanes-Oxley Act (“SOX”), the Securities Exchange Act of 1934, the criminal anti-retaliation provision of 18 U.S.C. § 1513(e), or “any other law, rule, or regulation subject to the jurisdiction of the Commission.”

When implementing the Dodd-Frank Act, the SEC promulgated certain regulations. Rule 21F-2 included two discrete definitions of a “whistleblower.” To obtain the monetary award available under the statute, a “whistleblower” is a person who must “ provide the Commission with information . . . relat[ing] to a possible violation of the Federal securities laws.” (emphasis added by the Court). For purposes of the anti-retaliation provision, however, the SEC defined a “whistleblower” as a person who “possess[es] a reasonable belief that the information you are providing relates to a possible securities law violation” and who “provide[s] that information in a manner described in” clauses (i) through (iii) of § 78u-6(h)(1)(A). The SEC’s regulations further provide that the “anti-retaliation protections apply whether or not you [the whistleblower] satisfy the requirements, procedures and conditions to qualify for an award.” In other words, under Rule 21F-2, an individual may obtain “whistleblower” protection without providing information to the SEC, provided that “he or she provides information in a manner shielded by one of the anti-retaliation provision’s three clauses.”

Paul Somers was a Vice President of Digital Realty Trust, Inc., from 2010 to 2014. He alleged that the company terminated his employment shortly after he reported to senior management what he believed were securities laws violations by the company. He did not report his concerns to the SEC, however, and he did not file an administrative complaint for protection under the Sarbanes-Oxley Act (“SOX”). The federal district court denied Digital Realty’s motion to dismiss and, on interlocutory appeal, the United States Court of Appeals for the Ninth Circuit affirmed. The Supreme Court, however, reversed those decisions.

The Supreme Court started its analysis by explaining that the definition of “whistleblower” operates in conjunction with the three clauses of § 78u-6(h)(1)(A) to establish the scope of protection afforded to a “whistleblower.” To this end, the Court explained that the definition of “whistleblower” describes who is eligible for protection – a person who provides pertinent information “to the Commission.” The Court then explained that the three clauses of § 78u-6(h)(1)(A) describe what conduct is protected from retaliation. The Court concluded that only an individual who satisfies both requirements may seek protection under Dodd-Frank’s anti-retaliation provision.

To further support this conclusion, the Court noted that another whistleblower provision of the Dodd-Frank Act (that concerning the Consumer Financial Protection Bureau) did not impose any requirement that information must be conveyed to a government agency. By noting this provision, the Supreme Court relied on the rule of statutory construction that provides “[w]hen Congress includes particular language in one section of a statute but omits it in another[,] . . . th[e] Court presumes that Congress intended a difference in meaning.” By placing the government reporting requirement in § 78u-6(h), but not elsewhere in the statute, the Court determined it was “not at liberty to dispense with the condition – tell the SEC – Congress imposed.” By holding that the Dodd-Frank whistleblower protections require reporting information to the SEC, the Court determined that Somers necessarily failed to state a claim.

The Supreme Court’s decision in Digital Realty is significant because it narrows the scope of who is a “whistleblower” under the Dodd-Frank Act. While this narrower definition creates a more limited universe of potential whistleblowers, the Court determined that this narrower definition is consistent with the statute’s text and purpose. With that said, part of the Court’s analysis (not included in this post) included a comparison to the whistleblower protection provisions of SOX, which the Court noted are broader. Thus, whistleblowers of potential securities violations are not without protections, including under the Dodd-Frank Act.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Supreme Court Rules on Timeliness of State Law Claims When Dismissed From Federal Court and Refiled in State Court

In Artis v. District of Columbia , 138 S. Ct. 594 (2018), the United States Supreme Court held in a five to four decision that the statute of limitations for a state law claim is tolled while it is pending in federal court if the claim was filed in federal court based on supplemental jurisdiction and subsequently dismissed for lack of jurisdiction after the federal claim was dismissed.

In Artis , the Supreme Court examined the supplemental jurisdiction statute, 28 U.S.C. § 1367, which enables federal district courts to exercise jurisdiction over state law claims when those claims “are so related to claims . . . [subject to original jurisdiction of the federal court] that they form part of the same case or controversy.” When district courts dismiss all claims in an action that independently qualify for federal jurisdiction, they typically dismiss the related state law claims as well. Section 1367 provides that “[t]he period of limitations for any [state] claim [joined with a claim within federal-court competence] shall be tolled while the claim is pending [in federal court] and for a period of 30 days after it is dismissed unless State law provides for a longer tolling period.” The issue presented to the Court in this case was what the word “tolled” mean in the context of § 1367. The Supreme Court posed two possible interpretations of what the word “tolled” meant in the § 1367: (1) the statute of limitations is suspended during the pendency of the federal suit; or (2) although the state limitations period continues to run, a plaintiff is given a grace period of 30 days to refile in state court after the federal case is dismissed. The Court held that the former meaning applies, meaning the statute of limitations is held in abeyance (i.e., the clock is stopped) while the state law claims are pending in federal court.

The controversy arose because the plaintiff in this case, Stephanie C. Artis, refiled her state law claims (which arose under the District of Columbia Code and common law) in state court 59 days after her federal lawsuit was dismissed. When Artis first filed her claim in federal court, nearly two years remained on the applicable three year statute of limitations for her state law claims, but the federal court took nearly two and one-half years before it dismissed her claims (the state law claims being dismissed for lack of federal jurisdiction). The District of Columbia Superior Court held that the supplemental jurisdiction statute did not apply a “stop the clock” meaning to the term “tolled” and, thus, it dismissed Artis’ state law claims as untimely. The District of Columbia Court of Appeals affirmed.

The Supreme Court commenced its analysis by identifying a number of examples where the statute of limitations is “tolled” while the claim is pending elsewhere. The Court commented that the term “tolled” in this context typically means that “the limitations period is suspended (stops running) while the claim is . . . elsewhere [and] then starts running again when the tolling period ends, picking up where it left off.” The Court cited to Black’s Law Dictionary to support this interpretation, and some cases where this interpretation was applied. The Court, however, acknowledged that some legislative acts instead apply a simple “grace period” to the term “toll.” And, when a “grace period” is applied, the statute of limitations continues to run while the claim is pending in another forum. While the majority identified one federal statute as an example of a “grace period” (28 U.S.C. § 2415), the majority noted that neither the District of Columbia nor the dissent identified an example of this kind of statute in their analyses. The majority further noted that it could identify only one prior case where it had applied a “grace period” to the term tolled. The Court commented, however, that this lone decision was “atypical” and that it constituted “a feather on the scale against the weight of decisions in which ‘tolling’ a statute of limitations signal[ed] stopping the clock.”

The Court then applied the rule of construction that requires courts to give words their ordinary meaning. According to the text of § 1367(d), the statute of limitations is tolled at “two adjacent time periods” – once while the claim is pending in federal court and the other for 30 days after the claim was dismissed from federal court. In both instances, the Court found that the plain meaning requires the clock to be stopped. Furthermore, the Court concluded the approach that it adopted would promote judicial economy, which would not be the case if the dissent’s approach were adopted. In this regard, the Court concluded that if the “grace period” interpretation were applied, claimants would be incentivized to file lawsuits simultaneously in federal and state court and ask the state court to hold its action until there is a resolution by the federal court. The majority explained that its approach averts the need for such dual filings. The Court proceeded to explain why it rejected various other arguments advanced by the District of Columbia and the dissent.

The Supreme Court’s decision in Artis is significant because it “expands” the period of time a claimant has to refile claims in state court if those claims were dismissed in a federal court action for lack of jurisdiction. While this may appear to be a burden on defendants, the definition of “tolled” that the Court applied is not very controversial (although it did result in a 5-4 decision), in that the definition it applied is how the term has typically been applied in other contexts (which the Court noted in its decision). And this ruling does not benefit only individuals, as businesses may benefit from this ruling as well if they need to pursue state law claims against individuals or other businesses that were once pending in federal court but were dismissed for lack of jurisdiction.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Court Finds Board of Directors Not Entitled to Benefit of Business Judgment Rule

In Brining v. Donavan , Civil Action No. 16-3422-BLS1, 2017 WL 4542947 (Sup. Ct. Mass. Sept. 14, 2017), a court denied a motion to dismiss filed by a corporation and, thus, denied its board of directors the benefit of the business judgment rule because the board’s decision not to pursue litigation or a derivative action against a former director who also was managing the company “raise[d] serious questions . . . concerning the independence of the [b]oard and the good faith of its decision to seek no redress for the serious financial improprieties” reported by an independent accounting firm.

Jennifer Brining was a shareholder in Sendletter, Inc. (“Sendletter”), an internet-based company. Although Brining was a minority shareholder owning approximately 11% of the company, her investment made her the largest shareholder in the company. Brining alleged that nearly all the money invested in Sendletter was taken by John Donovan, who was a director and effectively the manager of Sendletter, for personal use, not for the benefit of the company. Brining at one point sent a letter to Sendletter’s Board of Directors (“Board”), seeking redress of Donovan’s alleged misconduct. The Board removed Donavan as a Board member and assured Brining that Donovan no longer had control over Sendletter funds. The Board also retained AlixPartners, LLP, a forensic accounting firm, to investigate the transactions involving Donovan. At the time that AlixPartners issued its report on April 18, 2017, the Board composition had changed, as the Board members at that time were John Rose, Nadir-Yohan Zohar (who became President of Sendletter as of February 1, 2017), and Bhaskar Panigrahi.

The AlixPartners report found that Sendletter had essentially no internal controls as of December 2016. Donovan and his wife did not invest any cash in Sendletter, but they loaned “Sendletter Entities” $202,074, which was documented in a note signed by Zohar on March 30, 2017. The report did not explain why Zohar signed loan documents on loans made before he became President or what Zohar did to confirm the amounts, sources, and use of the funds received. The report found there were lease obligations to Donovan related entities for $363,970, but the estimated value of the lease obligations was only $192,206. There were a number of other odd findings and conclusions in the report, including the fact that of $2,846,276 disbursed by Donovan on behalf of Sendletter, $1,274,506 “appear[ed] . . . related to the business activities of Sendletter[,]” “$800,018 [was] not related to Sendletter business activity[,]” and $771,552 of disbursements “cannot be determined based on the scope of work performed.” The report also concluded that “[d]ocuments regularly included handwritten modifications of dates, interest rates, and loan amounts; [m]etadata indicated that documents were created or modified days, months and years after the date on the face of the document; . . . [m]ultiple versions of documents contained materially different terms and varying dates; . . . and [d]ating and amounts on the documents are inconsistent within the document.”

The Board, however, chose not to pursue action against Donovan because any judgment against Donovan “would not be of substantial value.” The Board also determined that litigation would be expensive, distract employees and management, negatively affect partnership and investment opportunities, and adversely affect the company’s public image and share price (to which the court noted that there does not appear to be a market for the company’s shares). The Board further concluded Brining had “demonstrated that her values and motivation are not aligned with this Board and are not compatible with the success of the company.” As a result of the Board’s decisions, Brining pursued legal action on her own.

After addressing choice of law issues, the court examined the independence of the Board. The court noted that, under Delaware law, a director generally is deemed independent “only when the director’s decision is based entirely on the corporate merits of the transaction and is not influenced by personal or extraneous considerations.” The court further noted that there is no bright line rule for determining when a director breaches the duty of independence through self-interest to rebut the presumption of the business judgment rule. Despite this high burden, the court found there were “certain confounding factors presented in this case.” First, the court noted that the Board composition had changed from when the issue was first presented to the Board and when the report was issued for the Board to decide whether to pursue action against Donovan. In this regard, the court questioned the appropriateness of Donovan selecting individuals with whom he had a prior relationship to serve on the Board when those individuals were being asked to make a determination about pursuing claims against him. Second, the court noted when Board independence is questioned, a special litigation committee often is formed to consider the potential claim, but no such committee was formed here. Third, the court questioned the independence of the Board as a result of Zohan signing loan documents for loans that pre-dated his appointment as President, particularly while AlixPartners was investigating the proprietary of those transactions.

The court then proceeded to analyze the business judgment rule, stating that, if one assumes the Board is functionally independent of Donovan as it relates to the decision not to pursue litigation against him, the Board’s decision should receive the benefit of the business judgment rule. Under the business judgment rule, the decision not to pursue a claim or permit a derivative action against Donovan would be binding unless sufficient facts raise a reasonable doubt that the Board adequately investigated the claims or acted in good faith, consistent with its duty of loyalty. Stated differently, the business judgment rule would apply and protect the decision of the Board unless the decision “is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.” The court found that a reasonable investigation was conducted, as evidenced by the Board retaining AlixPartners, but there was reasonable doubt as to whether the Board acted in good faith based on the Board’s conclusions.

The court questioned the Board’s decision in a number of respects. For example, the court found that there was no evidence in the Board minutes to support its conclusion that any judgment against Donovan would not be of substantial value. In fact, the court found that the AlixPartners report indicated there was a “strong likelihood of obtaining a substantial judgment against Donovan” (and the court proceeded to dissect many aspects of the report to support this conclusion). While the court acknowledged that a judgment may not be of substantial value if the judgment debtor did not have sufficient assets to satisfy a judgment, the court noted that the Board minutes do not suggest the Board gave any consideration to this issue. The court also examined the potential harm the lawsuit against Donovan would cause to Sendletter achieving its business objectives, but the court once again noted that Board minutes did not specify any transactions that would be jeopardized, whether they be partnering arrangements, investments, or other transactions. Additionally, in light of new management, the court could not find any reason based on the information presented why a potential individual or entity would not want to do business with Sendletter as a result of such a lawsuit against Donovan. Moreover, the court questioned the Board’s decision not even to attempt to negotiate a settlement with Donovan and recoup some of the funds without the cost of litigation. Based on these and other factors the court discussed, the court found that there were “serious questions . . . concerning the independence of the Board and the good faith of its decision to seek no redress for the serious financial improprieties” the Board discovered.

The court’s decision in Brining is significant for companies and their boards of directors. While the business judgment rule is applied broadly and often protects many decisions of boards, even questionable decisions, the protections afforded by the rule are not unlimited. As illustrated in Brining , although a board may reach certain conclusions, the basis for those conclusions should be sufficiently investigated and significant factual developments cannot simply be ignored. When a board fails to exercise reasonable care in evaluating courses of action and analyzing data presented to it, the board faces potential legal action and it will not necessarily be protected by the business judgment rule. Each board decision should be evaluated on its own merits, but, when it comes to decisions about taking legal action against a current or former officer or director, boards at a minimum should evaluate such decisions with the assistance of counsel.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

DISCLAIMER: This Blog/Website is for educational purposes and to provide readers with general information about developments in the law. This Blog/Website is not intended and should not be relied on for legal advice. This Blog/Website does not constitute an advertisement for legal services and it does not endorse, promote, or recommend the products, services, or websites of any third party. Reading, reviewing, or any other use of this Blog/Website does not create an attorney-client relationship between the reader and the firm or any attorney at the firm.

Court Holds Insurance Policy Applies to Merged Company

In BCB Bancorp, Inc. v. Progressive Casualty Insurance Co. , Civil Action No. 13-1261, 2017 WL 4155235 (D.N.J. Sept. 18, 2017), a federal district court analyzed the interplay of a directors and officers liability insurance policy with a New Jersey statute to determine that insurance coverage for a shareholder class action lawsuit was available to the merged entity under the insurance policy issued to the company that no longer existed after the merger.

Two banks, BCB Bancorp, Inc. (“BCB”), and Pamrapo Bancorp, Inc. (“Pamrapo”), entered into a merger agreement and became named defendants in a shareholder class action related to the merger transaction. Prior to the merger, Progressive Casualty Insurance Company (“Progressive”) issued a claims-made directors and officers liability insurance policy to Pamrapo for the policy period June 15, 2009 through June 1, 2010. The insured “Company” under the policy constituted four Pamrapo entities and each of the individual officers and directors were insured persons under the policy. Under the “Other Insurance or Indemnification” provision of the policy, the coverage provided by Progressive was to be excess coverage if there was any other non-excess insurance available or if an insured was entitled to indemnification from “any entity other than the Company[,]” “unless such other insurance is written only as specific excess insurance over the Limits of Liability providing by this Policy.” The policy did not expressly exclude coverage for the surviving entity of a merger that occurred outside the policy period.

On June 30, 2009, BCB and Pamrapo announced they had entered into a merger agreement, pursuant to which Pamrapo would merge into BCB, meaning BCB was the surviving entity. The merger was consummated on July 6, 2010. According to the merger agreement, the merger was conducted “in accordance with the New Jersey Business Corporation Act (“NJBCA”).” The merger agreement also provided that BCB “shall indemnify and hold harmless” and defend Pamrapo’s employees, including its officers and directors, to the extent that Pamrapo’s employees would be entitled such benefits under Pamrapo’s Certificate of Incorporation, bylaws, or certain disclosed agreements. The Certificate of Incorporation provided that Pamrapo would indemnify its officers and directors to the extent authorized by the NJBCA.

Shortly after the merger was announced, Pamrapo shareholders filed derivative class action lawsuits against Pamrapo, its directors and officers, and BCB, alleging claims for breach of fiduciary duty, among other claims. Those lawsuits were later consolidated into a single action. The lawsuit eventually was settled.

Pamrapo tendered the claim for coverage to Progressive on August 21, 2009. Progressive acknowledged coverage and reserved its rights under the policy. Progressive agreed to advance defense costs incurred by Pamparo and its officers and directors, subject to its reservation of rights, including the requirement that the $125,000 retention be exhausted. Among the reservations noted by Progressive was the fact that the directors and officers may be subject to indemnification from another source which would trigger the “Other Insurance or Indemnification” provision.

Pamrapo indemnified its officers and directors, paying their legal fees in the shareholder litigation until July 6, 2010 when the merger closed. Indemnifying the directors and officers for their legal fees satisfied the $125,000 retention. On July 30, 2009, less than one month after the merger closed, Progressive advised BCB that it was disclaiming coverage pursuant to the “Other Insurance or Indemnification” provision because it believed its policy was now excess of BCB’s indemnification obligation based on the merger agreement. This coverage dispute ensued.

The court relied heavily on the NJBCA in finding there was coverage under the Progressive policy. In this regard, the court noted that the NJBCA provides the surviving company in a merger “possess[es] all the rights, privileges, powers [and] immunities . . . of each of the merging or consolidating companies.” The court further noted that the NJBCA also provides that the surviving corporation “shall be liable for all the obligations and liabilities of each of the corporations so merged.” In other words, all of Pamrapo’s rights became BCB’s rights and liabilities after the merger closed, including Pamrapo’s rights under the Progressive insurance policy. Indeed, the court specifically noted that the NJBCA does not exclude insurance policies of the entity that merged with the surviving entity. Based on these statutory provisions, the court rejected Progressive’s argument that it no longer had an obligation to provide coverage under its policy after the merger closed because the surviving company (BCB) was not the “Company” identified in the policy. Thus, the court held that Progressive had to insure BCB after the merger closed just as Progressive had to insure Pamrapo before the merger closed – BCB stepped into the shoes of Pamrapo. The court further held that, to disclaim coverage after a merger, “an insurance contract must contain specific exclusionary language to prevent a transfer of rights to the surviving entity under the NJBCA.” No such exclusionary language was included in Progressive’s policy. As for Progressive’s argument that the court’s interpretation would deprive it of the benefit of the bargain and require it to incur unforeseen risks, the court rejected that argument as well, explaining that the transfer or assignment occurred after the insured event in this case, meaning Pamrapo made a valid claim for the shareholder litigation during the policy period and the merger occurred after the policy period expired, which precluded any prejudice to the insurer regarding coverage for an unforeseen risk.

With shareholder class action lawsuits often filed after a merger is announced, the court’s decision in BCB Bancorp provides important guidance for insurers and insureds when evaluating potential coverage obligations in the merger and acquisition context, particularly when an “other insurance” clause is at issue. While the decision in BCB Bancorp is driven largely by a New Jersey statute, insurers and insureds should determine whether similar provisions exist in other jurisdictions when the law of other jurisdictions is at issue.

If you have any questions regarding this post, please contact Stephen B. Stern at sstern@hwlaw.com or (410) 260-6585 or Amitis Darabnia at adarabnia@hwlaw.com or (410) 260-6592.

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