Federal Judge Orders California Waste Hauling Firm to Reinstate Two Drivers and Cease Anti-Union Activity

At the request of the National Labor Relations Board, a U.S. District Judge this week ordered a San Jose area waste hauling company to offer reinstatement to two drivers and restore full assignments to other drivers who had expressed support for a union during an organizing campaign.

In issuing the temporary injunction May 17, Judge Jeremy Fogel of the U.S. District Court in San Jose said the NLRB’s Office of General Counsel was likely to win its case against the company, OS Transport LLC, and that the employees would experience irreparable harm if an order did not issue immediately.

The decision stated that the agency “has made a substantial showing that (the company) engaged in serious unfair labor practices, including the termination of a lead organizer and another Union supporter, retaliation against Union efforts in the form of unfavorable assignments, threats to Union supporters, and promises of improved treatment of employees who disavow the Union. These actions appear calculated to chill the employees’ rights to the point that the organizing campaign could be defeated before the Board issues its final determination.”

The dispute began in January 2010, when drivers were told they must incorporate as individual corporate entities in order to continue working. The drivers, who spoke primarily Spanish, were later told to sign incorporation applications filled out in English, or risk being fired. During this period, some drivers contacted the Teamsters Union, Local 350, and signed a joint letter of protest to the company. The union supporters were reassigned to less lucrative routes, and two were later fired.

The union filed charges with the NLRB Regional Office in Oakland and, following investigations, complaints were issued in December 2010 and February 2011 alleging multiple violations of federal labor law. The case was heard by an administrative law judge early this year, but a decision has not yet issued.

Under the injunction, the company owner must read the full order to employees in English and Spanish, or be present when the full order is read by an agent of the NLRB. In addition, the company must provide full names and addresses of employees to union representatives.

Prevailing Antitrust Defendants Recover $367,000 in e-Discovery Costs

Recently, prevailing antitrust defendants were awarded $367,000 in e-discovery costs incurred by their vendor. See Race Tires America v. Hoosier Racing Tire Corp., 2011 WL 1748620 (W.D. Pa. May 6, 2011). While the Court labeled the facts as “unique” and that its holding was limited, the Court’s opinion is very thorough and the facts may be familiar to many antitrust defendants.

In today’s age where the costs of e-discovery can run several hundred thousand dollars or more and outside vendors are routinely hired to help, this holding can be used as a shield and a sword. During discovery, a party can alert the other side that aggressive discovery requests and a demand for many electronic search terms is a major factor in awarding costs of e-discovery – if the responding party prevails. And, if a party should prevail, the potential for an award of the costs of e-discovery can be an additional bonus and/or leverage for any post-verdict resolution without appeal.

The facts are simple. Plaintiff Specialty Tires America (STA) brought antitrust claims against Hoosier Racing, its tire supplier competitor, and Dirt Motor Sports, Inc. d/b/a World Racing Group, a motorsports racing sanctioning body. STA claimed that a so-called “single tire rule” by various sanctioning bodies like Dirt Motor Sports, as well as the related exclusive supply contracts between some of these sanctioning bodies and Hoosier violated Section 1 and 2 of the Sherman Act and caused STA in excess of $80 million in damages. See Race Tires America v. Hoosier Racing Tire Corp., 614 F. 3d 57, 62-73 (3d Cir. 2010). The District Court granted summary judgment in favor of defendants finding that STA had failed to demonstrate antitrust injury, and the Third Circuit Court of Appeals affirmed. Id. at 83-84.

The normal rule that “costs — other than attorney’s fees — should be allowed to the prevailing party” (Fed. R. Civ. P. 54(d)(1)) creates a “strong presumption” that all costs authorized for payment will be awarded to the prevailing party, so long as the costs are enumerated in 28 U.S.C. § 1920, the general taxation-of-costs statute. As prevailing parties, the defendants each filed a Bill of Costs in which the majority of amounts requested were e-discovery costs. Plaintiff objected arguing that e-discovery costs were not taxable under 28 U.S.C. § 1920(4).
Section 1920(4) allows recovery of “[f]ees for exemplification and the costs of making copies … necessarily obtained for use in the case.” 28 U.S.C. § 1920(4). There are two statutory interpretation questions that have divided Courts. First, costs of electronic scanning of documents can be recoverable as “necessary” or unrecoverable as a mere “convenience.”

The other issue takes a few different forms, but focuses on whether the terms “exemplification” and “copying”, which originated in the world of paper, should be limited to physical preparation or rather updated to take into account changing technology and e-discovery. The Court discussed a litany of these cases. Some courts that have applied § 1920(4) to today’s e-discovery demands, have limited exemplification and copying to just the costs for scanning of documents, which is considered merely reproducing paper documents in electronic form, and refused to extend the statute to cover processing records, extracting data, and converting files. Courts are also divided on whether extracting, searching, and storing work by outside vendors are unrecoverable paralegal-like tasks, or whether such costs are recoverable because outside vendors provide highly technical and necessary services in the electronic age and which are not the type of services that paralegals are trained for or are capable of providing.

In this case, because the Court and the parties anticipated that discovery would be in the form of electronically stored information and because plaintiff aggressively pursued e-discovery (e.g., directing 273 discovery requests to one defendant and imposing over 442 search terms), defendants’ use of e-discovery vendors to retrieve and prepare e-discovery documents for production was recoverable as an indispensable part of the discovery process. The Court also found that the vendor’s fees were reasonable, especially because the costs were incurred by defendants when they did not know if they would prevail at trial.

The Court also denied the plaintiff’s request for a Special Master to assess the reasonableness of e-discovery costs incurred by the prevailing defendants as an unnecessary cost and delay.

Court Throws Out Antitrust Claims Against Netflix

In an April 29, 2011 opinion, the District Court for the Northern District of California granted defendant Netflix’s summary judgment motion against a putative class of plaintiffs comprising of individuals who subscribed to Blockbuster, Inc.’s online DVD rental services. See Order Granting Motion for Summary Judgment, No. M-09-2029 PJH, Dkt. No. 376 (“Order”).

Plaintiffs made no conspiracy allegations against Blockbuster, which was their subscription provider. Instead, the multidistrict litigation stemmed from a May 19, 2005 marketing/promotion agreement between Netflix and Walmart, pursuant to which Walmart allegedly exited the market allowing Netflix to enhance its dominant position in the market for DVD rentals, and to eventually raise its subscription prices. Plaintiffs claimed that the reduced competition in the online DVD rental market allowed Blockbuster, which now operated in a two-firm market, to also raise its subscription prices for DVD rentals to plaintiffs. Order at 2.

Plaintiffs’ key allegations were that (1) Blockbuster entered the market in late 2004; (2) Netflix dropped the price of its 3-out subscription plan from $21.99 to $17.99 in October 2004, in response to Blockbuster’s entry and never raised that price; (3) in May 2005, defendants entered into their allegedly illegal “promotional agreement” pursuant to which Walmart subsequently exited the market; (4) Blockbuster was charging $14.99 for its subscription plan prior to the challenged “promotional agreement”; (5) according to a Blockbuster executive, the $14.99 price was “not sustainable”; (6) Blockbuster had begun testing the $17.99 price in connection with certain of its subscription programs in advance of defendants’ announcement of their allegedly unlawful agreement; and (7) in August 2005, three months after the promotional agreement was announced, Blockbuster raised its subscription price from $14.99 to $17.99, the price being charged by Netflix.

The court initially had granted a motion to dismiss with prejudice based on the indirectness of the alleged injury, speculative nature of the harm and complexity of apportioning damages. Id. at 3 (relying on Assoc. Gen. Contractors of Cal. v. Cal. State Council of Carpenters, 459 U.S. 519 (1983)). Later, however, the court reconsidered its prior order and granted plaintiffs leave to amend to allege a direct and proximate causal injury.

In denying a second motion to dismiss, the court noted that plaintiffs’ revised theory of causation differed from their original theory in that “it now focused on Netflix’s ability to convert a competitive price into a supracompetitive price by refusing to compete in an unrestrained market, as well as Blockbuster’s ‘reliance’ on Netflix pricing in setting its own pricing.” Id. at 5 (emphasis in original). Combined with a number of new allegations, the court held that this new theory of causation was sufficient to get plaintiffs past the pleading stage. Nonetheless, the court continued to express concern about plaintiffs’ ability to satisfy the direct injury requirement and encouraged the parties to bring early summary judgment motions directed specifically to antitrust standing. Id. at 5-6.

At the summary judgment stage, and after discovery on the antitrust standing issue had been completed, plaintiffs no longer alleged that Blockbuster’s August 2005 price increase was a direct response to Walmart’s exit from the market. Instead, they argued that, in the but-for world, Netflix would have lowered its price to a true competitive level, and that because Blockbuster’s price derived from Netflix’s, Blockbuster would have followed suit by lowering its price, resulting in lower prices as of August 2005. The court determined that the only issue before it was, assuming Netflix would have lowered its price to the level alleged by plaintiffs, would Blockbuster “track” or “match” Netflix’s pricing.

Among other facts, evidence showed that Blockbuster believed that Netflix “defined” the maximum market price as early as 2003; that Blockbuster used Netflix’s then prevailing price as a baseline in setting its prices; that Blockbuster would not, and indeed did not, exceed Netflix’s pricing; and that each time Netflix cut prices, Blockbuster responded by cutting its price to undercut Netflix. Based on these facts, plaintiffs argued that had Netflix lowered its price below $17.99, Blockbuster would have followed and at least matched Netflix’s price. Id. at 9-10.

However, evidence also showed that Blockbuster considered a variety of factors in setting its prices, besides the price charged by Netflix, including its own financial condition, costs, price testing, product usage and research. Evidence also showed that, although Blockbuster had lowered its prices to compete with Netflix, its price of $14.99 was “temporary” and deemed “not sustainable”; that it believed it had “inferior services” compared to its rival; and that it had already begun a program of raising its prices to $17.99 for some subscriptions before defendants’ promotional agreement was announced. Id. at 10-11.

Concluding that there was no genuine issue of material fact present and that the only dispute was as to the legal effect to be given the undisputed facts, the court granted Netflix’s motion. Id. at 15. The court held that, even viewing all facts in the light most favorable to plaintiffs, they had failed to demonstrate that Netflix pricing truly set Blockbuster’s pricing “as a function of any interdependent market interaction, as opposed to simply a likely function of competitive dynamics of the market.” Id. at 14. At best, the court explained, “plaintiffs demonstrate only that Blockbuster pricing was set with reference to Netflix pricing. But, there is nothing to indicate that Blockbuster pricing – or its price increase in August 2005 – was in any way directly influenced or impacted by Netflix’s alleged anticompetitive conduct . . . .” Id. at 14-15 (emphasis in original).

Reinstatement of Debt: A Bankruptcy Court’s Strict Interpretation and Application of Change-in-Control Provisions to Protect Senior Secured Lenders

In In re Young Broadcasting, Inc., et al., 430 B.R. 99 (Bankr. S.D.N.Y. 2010), a bankruptcy court strictly construed the change-in-control provisions of a pre-petition credit agreement and refused to confirm an unsecured creditors’ committee’s plan of reorganization, which had been premised on the reinstatement of the debtors’ accelerated secured debt under Section 1124(2) of the Bankruptcy Code.

“Reinstatement” refers to a chapter 11 plan proponent’s ability to reinstate the pre-default terms of an accelerated debt by curing all defaults. This cure is typically accomplished by paying off all late payments and other arrearages and bringing the loan current. The bankruptcy court in Young Broadcasting rejected the committee’s attempt to reinstate the debtors’ senior secured debt because the committee’s plan resulted in a default under the change-in-control provisions of the pre-petition credit agreement. In so holding, the bankruptcy court rejected the committee’s arguments that certain provisions of the plan which “formalistically” complied with the change-in-control provisions were sufficient to avoid a default, finding the plan provisions to violate the plain terms and clearly expressed purpose of the change-in-control provisions.

Factual Background

Young Broadcasting, Inc. (“YBI“) and certain affiliates (collectively, the “Debtors“) owned and operated various television stations across the country and a national television sales representation firm. Prior to the bankruptcy filing, YBI had obtained senior secured financing of $350 million (the “Senior Secured Debt“). In addition, YBI had issued senior subordinated notes in the amount of $640 million.

After filing for chapter 11, competing plans of reorganization were filed in the Debtors’ jointly-administered cases by the Debtors and the Official Committee of Unsecured Creditors (the “Committee“). Under the Debtors’ proposed plan, holders of the Senior Secured Debt would receive equity in a new company formed to hold all of the common stock of the reorganized Debtors and the senior subordinated noteholders would receive equity warrants in the new company. As a result, the Debtors would be completely deleveraged.

By contrast, the Committee’s proposed plan would reinstate $338 million of the Senior Secured Debt. The Committee’s plan would also provide the senior subordinated noteholders with a pro rata share of 10% of the reorganized Debtors’ common stock and options to purchase preferred stock and additional common stock. In connection with the proposed reinstatement, and in an attempt to remain in compliance with the change-in-control provisions of the credit agreement (described below), the Committee’s plan provided that Vincent Young, one of the Debtors’ founders (“Mr. Young“), would receive all of the Class B shares of common stock of the reorganized Debtors and certain accompanying voting rights described further below. Upon full repayment of the Senior Secured Debt in November 2012 (the original maturity date), such stock would convert to 10% of the Class A common stock.

Holders of the Senior Secured Debt objected to confirmation of the Committee’s plan on the grounds that the proposed reinstatement was impermissible as it would violate certain change-in-control provisions in the credit agreement and that the plan was not feasible and violated the absolute priority rule.

Analysis

Section 1124 of the Bankruptcy Code defines when a creditor’s claim is deemed “impaired”, thereby entitling the creditor to vote on a plan of reorganization. A creditor whose claim is “unimpaired” is not entitled to vote. Pursuant to Section 1124(2), a plan of reorganization may render a claim unimpaired by providing for the reinstatement of the original terms of the prepetition obligation as it existed before default. This Section requires (i) that the plan provides for the cure of any payment or performance defaults (other than an ipso facto default), (ii) that the plan provides for compensation for any damages caused by the creditor’s reasonable reliance on the right of acceleration, (iii) that the plan provides for compensation for any actual pecuniary losses incurred as a result of a failure to perform a nonmonetary obligation, (iv) that the plan provides for the affirmation of the original terms, including maturity, and (v) that the plan not otherwise alter the legal, equitable or contractual rights of the creditor. Because an obligation that is so reinstated is deemed to be unimpaired, the reinstated creditor is deemed to have accepted the plan of reorganization and will have no right to vote. In effect, by meeting the requirements set forth under Section 1124(2), the plan proponent will have the ability to reverse a lender’s exercise of its contractual or legal right of acceleration and reinstate the original terms of the obligation. This can be a powerful tool for debtors and creditors when formulating plans under chapter 11 of the Bankruptcy Code. It is typically used with respect to obligations that had been accelerated pre-petition. Fully matured obligations must be paid in full in order to be reinstated.

In Young Broadcasting, the holders of the Senior Secured Debt argued that reinstatement was improper because the terms of the plan violated the change-in-control provisions in the credit agreement, resulting in uncured defaults. Both sides cited to In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009), where the bankruptcy court found no default under a change-in-control provision when a plan of reorganization provided the relevant principal with the necessary voting rights and voting power, but divorced those rights from the underlying economic interest in the company (i.e., the principal’s voting power was out of proportion to his underlying equity interest in the reorganized debtor).

The pertinent provisions of the Senior Secured Debt holder’s credit agreement provided that a change-in-control default would occur if Mr. Young, his immediate family members, certain persons controlled by Mr. Young and members of management ceased to hold over 40% of the Voting Stock (which stock granted the holder general voting power to elect the board of directors). The credit agreement also required that if any person or group were to own more than 30% of the total outstanding Voting Stock, then the Young group must own more than 30% or, alternatively, have the right or ability to elect a majority of the Debtors’ board of directors.

The Committee’s plan provided for two classes of directors and two classes of stock with different voting rights. There would be six Class A directors and one Class B director. The stock was likewise split between Classes A and B, with Mr. Young receiving all of the Class B shares of common stock of the reorganized Debtor. Each Class A share of common stock (5,000,000 of which were to be issued) would have 20 votes for Class A directors and 1 vote for the Class B director. Each Class B share of common stock (500,000 of which were to be issued) would have 1 vote for Class A directors and 1,000 votes for the Class B director. Under this structure, the Committee argued that the terms of its plan complied with the change-in-control provisions of the credit agreement because Mr. Young, who would be given all of the Class B stock, would have over 82% of the vote – far in excess of the 40% requirement. The Committee arrived at this figure by comparing the total number of votes Mr. Young would be entitled to vote (i.e. 500,500,000) to the total number of votes all Class A shareholders would be entitled to vote (i.e. 105,000,000). Thus, the Committee relied on the idea that Mr. Young’s retention of 82% of the absolute number of votes would suffice to avoid a default under the change-in-control provisions, even though, as a result of the two tiers of directors and stock, Mr. Young retained much less than the required 40% of the actual voting power.

Disagreeing with the Committee’s contentions, the bankruptcy court, applying New York law to interpret the credit agreement, found that the plain meaning of the change-in-control provisions required that the Young group retain the power to elect over 40% of the entire board of directors and not just over 40% of the votes. Under the Committee’s proposed terms, Mr. Young would have the ability to control less than 15% of the entire board. The bankruptcy court found that the clear intent of the change-in-control provisions was to preclude third parties from obtaining more control than the Young group and management. Accordingly, the bankruptcy court held that reinstatement of the Senior Secured Debt pursuant to the Committee’s plan was impermissible since the plan resulted in defaults under the change-in-control provisions of the pre-petition credit agreement that were not cured.

The bankruptcy court also denied confirmation of the Committee’s Plan for failure to meet the requirement under Bankruptcy Code Section 1129(a)(11) that the plan be feasible. Applying the “reasonable likelihood of success” standard for feasibility and looking at expert valuations and projections, the bankruptcy court found that the Committee’s plan was not feasible because the Committee failed to establish that the reorganized Debtors could satisfy the Senior Secured Debt upon maturity in November 2012 through either a sale or a refinancing.

Lastly, the bankruptcy court found that the Committee’s Plan violated the absolute priority rule because the Committee failed to produce sufficient evidence showing that the distribution of equity to Mr. Young, while general unsecured creditors were not paid in full, was outweighed by the value of the benefits conferred by reinstatement of the Senior Secured Debt. Thus, ultimately, the Committee in Young Broadcasting was unable to establish that reinstatement was a beneficial bargain for the estate.

Lessons Learned

Young Broadcasting has lessons for both lenders and debtors. For lenders, it highlights the importance of clearly drafted change-in-control provisions which can be used as a weapon to guard against an unfavorable reinstatement in a chapter 11 bankruptcy case. For debtors and other plan proponents, Young Broadcasting establishes some clear limits on the gamesmanship that can be played with change-in-control provisions in a reinstatement under Bankruptcy Code Section 1124(2). Though the Charter Communications case indicates that it may be possible to separate the economic interest from the voting interest, Young Broadcasting shows that it may not be possible to separate the actual number of votes from the underlying voting power and avoid a change-in-control default. The equitable considerations at play in Young Broadcasting also highlight the importance of clearly establishing the economic benefits to be obtained by the estate from the reinstatement.

Department of Labor Releases Timesheet Smartphone “App” for Employees

On May 9, the Wage and Hour Division (WHD) of the U.S. Department of Labor (DOL) launched its first application (or “app”) for smartphone platforms. The app (dubbed “DOL-Timesheet App”) is an electronic timesheet that allows employees to independently track the hours they work and determine the wages they believe they are owed.

The development and launch of the DOL-Timesheet App signals a continued and aggressive commitment by the WHD to enforce wage and hour laws across the country—but it also reflects a not-so-subtle shift in the WHD’s tactics. Aware that it has limited capacity for investigation and enforcement (especially in these times of budget cuts), the WHD is pushing measures, such as the DOL-Timesheet App, that essentially “deputize” employees, giving them the power and the know-how to determine whether their employers are complying with applicable wage and hour laws. In light of these measures, it is critical that employers take steps to ensure compliance with federal and state wage and hour laws and ensure the accuracy of their timekeeping systems.

The DOL-Timesheet app appears to be in line with the so-called “Right to Know” regulatory initiative the DOL unveiled in December 2010. Moreover, according to the DOL’s regulatory agenda, the DOL is considering a proposed rule that would require covered employers to notify workers of their rights under the Fair Labor Standards Act (FLSA), and to provide information regarding hours worked and wage computation.

The DOL-Timesheet App undoubtedly will add fuel to the wage and hour litigation fire sweeping across the country. Employers should not expect that this fire will die down in the near future.

About the Application

The application is a fairly simple time-tracking tool—with potentially dangerous consequences for employers that do not have reliable and accurate time-recording systems in place.

A user first enters his or her employment information, including the employer’s name, the employee’s hourly rate, and the day of the week on which the employee’s workweek begins. That information is saved, and moving forward the employee need only tap on that employer’s name to get to two prompts: “Start Work” or “Manual Time Entry.”

The “Start Work” function works like a stopwatch, and records the exact time that the icon is selected. Users will see the name of the employer and time information (e.g., “XYZ Corp., Started work on 5/12/11 9:36 am”). Tapping the employer’s name again allows the user to either “Stop Work,” presumably to signal the end of the workday, or “Start Break,” to record any break periods during the workday.

If “Start Break” is chosen, the user can select either “Meal” or “Other” as the type of break, and can add comments regarding that break. The timesheet will then show that information (e.g., “Break started at 9:44 am”). Users who are unfamiliar with rules relating to the compensability of break time under federal law can view a summary of the federal regulations on this topic.

Once “Stop Work” is selected, the DOL-Timesheet App gives the user a summary of his or her workday, which the user can email to anyone he or she chooses. The summary calculates gross pay for the week, based on the employee’s regular rate, and the app can calculate the number of overtime hours and wages due as a result.

The “Manual Time Entry” feature is similar in content, but simply allows the user to input historical data on start and stop times and breaks for any given date.

The DOL-Timesheet App also contains a very limited “Glossary” that defines common wage and hour terms. Only a few basic terms are included, such as “breaks,” “gross pay,” and “workweek.” The app also features a “Contact Us” section that gives telephone numbers and email and office addresses for the WHD.

Following is a screenshot of the DOL-Timesheet App:

The DOL-Timesheet App is not currently enabled to track more advanced pay mechanisms—such as tips, commissions, bonuses, deductions, holiday pay, pay for weekends, shift differentials, and pay for regular days of rest. According to the DOL, future releases or updates of the application may contain these features.

The free application is currently available only on the iPhone and iPod Touch, although the WHD is considering releasing it on other smartphone platforms, such as Android and BlackBerry. According to the DOL, workers without a smartphone can use the DOL’s printable work hours calendar in English or Spanish to track rate of pay, work start and stop times, and arrival and departure times.

Both the app and the calendar can be downloaded from the Wage and Hour Division’s homepage at http://www.dol.gov/whd/, or through traditional application servers, like iTunes.

Conclusion

The DOL’s new app makes it especially important for employers to ensure the consistency and the accuracy of their time-reporting mechanisms. In particular, employers should make sure that their employees understand that the company’s timekeeping mechanisms are the basis for their pay and the company’s compliance with applicable laws, and those records must be filled out completely and accurately regardless of whether the employees are using any other means for tracking their time. In addition, employers should not in any way discourage their employees from using the application lest they be charged with retaliation against their employees’ exercise of rights under the FLSA.

Employers defending wage and hour litigation also should consider this application as a potential source of relevant information. If the employee actually has maintained accurate, contemporaneous time records on the application, the information could be helpful to the employer’s defense as compared with an employee’s after-the-fact estimation of hours worked developed during litigation.

District Court Decision Reversed as Genuine Issue of Material Fact Remained: Zobmondo Entertainment LLC v Falls Media LLC

In an appeal from a decision of the Central District of California, Zobmondo Entertainment LLC v Falls Media LLC (Case 08-56831, April 26 2010), the US Court of Appeals for the Ninth Circuit has reversed a grant of summary judgment in favour of an accused trademark infringer, holding that questions of fact existed as to whether the trademark WOULD YOU RATHER…? as applied to board games was suggestive or merely descriptive.

Falls Media LLC and Zobmondo Entertainment LLC both incorporate the mark WOULD YOU RATHER…? on books and board games based around the idea of posing humorous, bizarre or undesirable choices. For example, one question from Zobmondo asks: “would you rather have your grandmother’s first name or her haircut?”.

Falls Media filed an ‘intent to use’ application for the WOULD YOU RATHER…? mark in July 1997 for books and board games. It released books incorporating the mark in 1997 and 1999, and a board game in 2004. The ‘intent to use’ application was allowed in 2002 and, following the submission of a statement of use in commerce, the US Patent and Trademark Office (USPTO) issued a registration for WOULD YOU RATHER…? in July 2005.

Zobmondo’s founder filed an ‘intent to use’ application for the mark WOULD YOU RATHER in September 1997. Falls Media’s mark was cited against Zobmondo and the application was subsequently abandoned. Regardless, beginning in 1998, Zobmondo went on to produce multiple games based around humorous ‘would you rather’-style questions, and in 2002 released its first game featuring the WOULD YOU RATHER…? mark.

In 2006, following the registration of Falls Media’s mark, Zobmondo filed suit against Falls Media in the Central District of California alleging among other things, trade dress infringement, copyright infringement and unfair competition. Falls Media responded by filing its own suit in the Southern District of New York claiming, among other things, trademark infringement and unfair competition. Zobmondo counterclaimed for cancellation of the WOULD YOU RATHER…? mark. The New York action was transferred to California and the two cases were consolidated.

Both parties filed motions for summary judgment. The court granted Zobmondo’s motion on several claims, including Zobmondo’s counterclaim for cancellation of Falls Media’s mark. In short, the court found, as a matter of law, that:

  • l the WOULD YOU RATHER…? mark was merely descriptive; and
  • l no rational juror could find that the mark had acquired secondary meaning by 2002, when Zobmondo first released a game prominently featuring the mark.

Falls Media appealed to the Ninth Circuit.

The district court had turned to several tests to determine that the WOULD YOU RATHER…? mark was merely descriptive. First, it applied the ‘imagination’ test, asking whether imagination or a mental leap was required in order to reach a conclusion as to the nature of the product referenced. Second, it applied the ‘competitors’ needs’ test to determine the extent to which the mark is needed by competitors for their goods and services. Finally, it utilized the ‘extent of use’ test, which evaluates the extent to which others have used the mark on similar merchandise. The court determined that both the ‘imagination’ and ‘extent of use’ tests indicated that the mark was descriptive, while the ‘competitors’ need’ test was difficult to apply. It buttressed its opinion with evidence in the form of statements by persons related to Falls Media suggesting that they believed that the mark was merely descriptive.

The Ninth Circuit found several flaws with the district court’s ruling. First, a proper application of the ‘imagination’ test would have found that, without comprehensive consumer surveys, there was no way to conclude that consumers necessarily viewed the mark as merely descriptive of a game involving bizarre or humorous choices. Second, the court found that the ‘competitors’ needs’ test indicated that the mark was suggestive, given that Zobmondo debated 135 possible names for its games during development, and successfully sold its games for several years without use of the WOULD YOU RATHER…? mark. The circuit court declined to apply the ‘extent of use’ test, which is not a controlling measure of trademark validity in the Ninth Circuit.

As to the additional evidence cited by the district court, the Ninth Circuit ruled that, while probative, the statements suggested only that Falls Media believed that the mark was descriptive, and did not indicate that consumers would reach the same conclusion. The Ninth Circuit also believed that the district court had improperly discounted expert testimony that the mark had never been used as the title of a board game before Zobmondo entered the market, as that suggested that competitors did not find the mark useful in describing their products. Finally, the Ninth Circuit noted that Zobmondo’s attempt to register a similar mark supports the inference that, at one time, it believed that the mark was inherently distinctive.

The core of the Ninth Circuit’s determinations was that the district court had misapplied the summary judgment standard as it relates to trademarks. A registered trademark enjoys a strong presumption of validity and where, as here, the USPTO does not require evidence of secondary meaning, the mark is entitled to a presumption that it is inherently distinctive as well. Trademark validity is also an intensely factual issue, and summary judgment is disfavoured in trademark claims generally. Given this, and the normal summary judgment standard requirement that all reasonable inference be drawn in favour of the nonmoving party, the Ninth Circuit simply could not conclude, based on incomplete and conflicting evidence, that there was no issue of fact as to whether WOULD YOU RATHER…? was suggestive or merely descriptive.

Supreme Court Affirms No “First Sale” Defense for Foreign-Made Copies

On December 13, 2010, the Supreme Court affirmed the Ninth Circuit’s decision in Omega S.A. v. Costco Wholesale Corp., upholding the Ninth Circuit’s interpretation of the first sale doctrine as inapplicable to foreign-made goods covered by U.S. copyrights.

Omega, a Swiss luxury watch manufacturer, sold its products internationally through various authorized dealers in the U.S. and abroad. One such product, a watch that included a design protected by a U.S. copyright, was made overseas and sold by Omega to one of its authorized foreign distributors. Following this sale, these copyrighted watches were imported into the U.S. without Omega’s approval by an unidentified third party. The watches were then purchased by ENE Limited, a NY company, which in turn sold the watches to Costco, which then began selling them in California.

Upon learning of Costco’s sales, Omega filed a copyright infringement action in the Central District of California. In its defense, Costco argued that the first sale doctrine under 17 U.S.C. § 109(a) barred Omega’s ability to bring the action, because the watches were the subject of an authorized sale to one of Omega’s foreign distributors. This, Costco argued, shielded it from liability despite the fact that its subsequent U.S. sale was unauthorized. The district court agreed, ruling in favor of Costco on summary judgment. Omega promptly appealed.

On appeal, Omega argued that § 109(a) applies only to the sale of goods “lawfully made under [U.S. copyright law]” and, therefore, the first sale doctrine did not apply because the goods were made outside the U.S. In response, Costco asserted that Omega’s reliance on earlier Ninth Circuit case law, specifically BMG Music v. Perez1, Parfums Givenchy, Inc. v. Drug Emporium, Inc.,2 and Denbicare U.S.A. Inc. v. Toys “R” Us, Inc.,3was misplaced because these cases had been overruled by the Supreme Court in Quality King Distribs., Inc. v. L’anza Res. Int’l, Inc.4

In its opinion, the Ninth Circuit first restated that an owner of a copy “lawfully made under [Title 17]” who imports and sells that copy does not infringe under the first sale doctrine. After reviewing BMG Music, Drug Emporium, and Denbicare, the court turned to the Supreme Court’s Quality King decision. In Quality King, the copyrighted goods had been “round trip” imported: they were first manufactured in the U.S., exported through an authorized distributor, sold to an unidentified third party abroad, and then shipped back to the U.S. where they were sold without the copyright holder’s permission. The Court in Quality King ruled that the first sale doctrine provided a defense against copyright infringement under these facts. However, the Court declined to address whether the same result would be warranted if the copyrighted products were first manufactured outside the U.S.5

Picking up where Quality King left off, the Ninth Circuit concluded that the first sale doctrine provides a defense against copyright infringement “only insofar as the claims involve domestically made copies of U.S.-copyrighted works” (emphasis added).6 Thus, under this decision, the first sale doctrine is available as a defense only if the copies were legally made in the U.S. Accordingly, the Ninth Circuit rejected Costco’s position and reversed the district court, finding no inconsistency between Quality King and the rule of law established by BMG, Drug Emporium, and Denbicare. Costco then sought certiorari to the Supreme Court.

In a per curium opinion released December 13, 2010, an equally-divided Supreme Court affirmed the Ninth Circuit’s decision.7 Justice Kagan recused herself and took no part in the decision, most likely due to her role as Solicitor General in preparing an amicus brief on behalf of the U.S. In this brief, the U.S. supported Omega’s assertion that “lawfully made under this title” as used in § 109(a) means made in accordance with U.S. copyright law, which does not apply extraterritorially.

On its face, the case appears to strike a blow to one of the remaining openings in the gray market, and may provide a powerful tool for international manufacturers who maintain separate marketing and pricing structures in separate international markets. A foreign DVD, camera, or electronics manufacturer, for example, would be able to charge less for its goods in the Asian market than it does in the U.S., and could enforce that marketing decision so long as the goods themselves are manufactured outside the territory of the United States. The Ninth Circuit’s holding that foreign-made goods are excluded from the first sale doctrine, combined with the increasing trend of manufacturing luxury goods abroad, may result in higher prices due to a reduced gray market.8

But this decision may be less a “victory” for international venders than it appears at first glance. After all, the 4-4 split merely earns Omega a win by default, not an express affirmation of its legal position. Indeed, the decision may also be viewed as a near miss on a Ninth Circuit reversal, rather than as an approval of that court’s interpretation of § 109(a). While one might assume that Justice Kagan—in light of the position taken by her, as Solicitor General, on behalf of the government—would have given Omega the final, precedent-setting vote it needed had she taken part, there is no guarantee of that. Nor can one assume that, had it come to a reasoned decision, the Court would not have created its own, different interpretation of the disputed provision.

The outcome of last week’s decision leaves the Ninth Circuit at least9 in support of a narrow interpretation of the “first sale” doctrine and market division programs based on control of copyrights in products.

Software Compilation Not A Trade Secret Under State Law

The U.S. Court of Appeals for the Fourth Circuit vacated and remanded a grant of summary judgment to Defendants on Plaintiff’s claims for misappropriation of trade secrets and breach of contract against defendant Sentia Group and several former employees of the plaintiff.  Decision Insights, Inc. v. Sentia Group, Inc et al., Case No. 09-2300, (4th Cir., March 15, 2011) (per curiam).

Decision Insights offers software used as an analytical tool in preparing negotiation strategies.   In 2006, Decision Insights filed suit against a group of former employees alleging that they improperly used the plaintiff’s propriety source code and breached non-disclosure agreements in forming Sentia Group, a competing software company.   Decision Insights also alleged that the defendants used materials containing the plaintiff’s trade secrets, such as marketing and research reports, client information and information contained in its software user manual.

To qualify as a trade secret under Virginia law, information must possess independent economic value, not be generally known or readily ascertainable by proper means and   be subject to reasonable efforts to maintain secrecy.

The district court granted summary judgment for the defendants, holding that Decision Insights failed to establish that its software qualified as a trade secret, because the plaintiffs did not show that the software was not generally known or ascertainable.   The district court also dismissed the plaintiff’s trade secret claims towards the additional, non-software materials, finding that because the plaintiff’s claims failed towards its source code, the plaintiff’s other claims also failed.

On appeal, the 4th Circuit determined that the deposition testimony and testimony of Plaintiffs’ expert witnesses created sufficient issues of fact to merit consideration by a jury and on that basis vacated and remanded the summary judgment determination.   One of the plaintiff’s expert witnesses, a co-author of the original source code at issue, opined that certain elements of the source code had never been published, supporting a finding that the plaintiff’s source code qualified as a trade secret.   A second expert witness, also a co-author of the source code, testified that portions of the source code and its sequence had been purposefully kept confidential.

Further, the 4th Circuit determined that the district court improperly granted summary judgment without considering the other two elements required for trade secret protection – whether the plaintiff’s source code possessed independent economic value and whether Decision Insights engaged in reasonable efforts to maintain secrecy.   Further, the 4th Circuit directed the district court to consider the plaintiff’s trade secret claims towards non-source code materials independently from the trade secret claim concerning the plaintiff’s source code.

The House Enters the Patent Reform Fray

The U.S. House of Representatives March 30 began discussion on a patent reform bill, H.R. 1249, introduced earlier that day. The House bill (known as the America Invents Act) aligned with a Senate bill (S. 23) in a number of ways but also had some differences, as expected.

Throughout the month, a number of changes to the House bill were proposed.  Most of those changes were designed to bring the House bill closer to the closer to the Senate’s bill.  For example, on April 12, 2011 Lamar Smith (R-TX) floated a draft of a manager’s amendment, scheduled to be discussed in an April 14 markup session.  The draft expands an inventor’s options during the one-year grace period before patent application filing, curtails options to use the prior user rights defense and adopts the heightened threshold for inter partes review of the Senate bill.

Another run was made to remove the transition to a first-to-file system.   That effort failed.   However, Rep. Jim Sensenbrenner (R-WI) vowed to try again to remove the first-to-file provision.

One interesting addition to the House bill is the commissioning of a federal study of patent suits by non-practicing entities.

After the intense mark-up session on April 14, the House Judiciary Committee voted 32-3 to report out an amended H.R. 1249, sending the revised legislation to the House floor for further debate and a vote on the long-awaited bill’s final passage.

As passed to the floor, the House bill transitions the United States to a first-to-file system, establishes a new post-grant review process, subjects business method patents to a special ex partereexamination procedure, allows third parties to submit prior art for review, allows the U.S Patent and Trademark Office (USPTO) to set its fee amounts and hang onto the fees it collects and retains a best mode requirement for patent application filings.

Although the House bill largely tracks the Senate version (see IP Update, Vol. 13, No. 2) and both move the United States from a first-to-invent to a first-to-file system (thus harmonizing the U.S. system with the systems in place in most industrialized countries), there are a few differences in terms the post grant opposition systems provided by each.

Post-Grant Oppositions

The post-grant opposition period in H.R. 1249 is longer than that provided in S.23 (12 months as opposed to nine months) and includes, in additional to a showing of a likelihood that at last one claim will be found unpatentable as the threshold basis for acceptance, the existence of important unsettled legal question.

The House bill also provides for an automatic stay of declaratory judgment actions if the declaratory judgment plaintiff is the party in interest petitioning for post-grant review and a discretionary stay in the event of litigation involving a patent involved in post-grant review.

Claim Construction: Too Much Structure Will Spoil the Brew

In affirming-in-part grants of summary judgment on non-infringement by two separate district courts, the U.S. Court of Appeals for the Federal Circuit reiterated the role of a district court in claim construction is to give meaning to the limitations actually contained in the claims, “not to redefine claim recitations or to read limitations into the claims.”  American Piledriving Equip., Inc. v. Geoquip, Inc., Case Nos. 10-1283, -1314 (Fed. Cir., Mar. 21, 2011) (Linn, J.).

American Piledriving filed suit against Geoquip in the Eastern District of Virginia and separately against Bay Machinery in the Northern District of California alleging that each infringed its patent by selling piledrivers manufactured by Hydraulic Power Systems.   The patent in issue relates to counterweights for “vibratory” piledrivers, which rely on vibrations to drive piles into the ground.   The representative claim recites, inter alia, a limitation requiring “counterweights having a cylindrical gear portion and an eccentric weight portion integral with said cylindrical gear portion, said eccentric weight portion having at least one insert-receiving area formed therein.”

A Markman hearing was held in each case and each of district courts consistently construed the term “integral” to mean “formed or cast of one piece.”

The district courts diverged, however, on their construction of “eccentric weight portion” and “insert-receiving area.”   The California district court construed “eccentric weight portion” to mean “the bottom portion of the counterweight, which extends forward from the front face of the gear portion, containing more weight than the top portion due to its larger mass, including at least one insert receiving area formed therein to receive at least one solid tungsten rod.”   The Virginia district court construed the same term to mean “that portion of the counterweight that extends either forward or rearward from the front or back face of the gear portion such that it shifts the center of gravity radially outward from the gear’s rotational axis.”

With regard to the term “insert-receiving area,” the Virginia district court construed that term to mean “a bore located, at least in part, within the eccentric weight portion that is shaped to hold securely a solid insert member,” whereas the California district court construed the same claim language to mean “a bore formed in the eccentric weight portion of the counterweight, which extends fully through the gear portion and fully through the eccentric weight portion of the counterweight capable of receiving a solid tungsten rod.”

In both the California and Virginia actions, the defendants moved for, and the district courts granted, summary judgment of non-infringement.   The summary judgment grants were based on each court’s constructions of the disputed phrases “integral,” “insert-receiving area” and “eccentric weight portion.”   American Piledriving appealed.

On appeal, American Piledriving argued that the district courts misconstrued these three terms.   The Federal Circuit affirmed the Virginia court’s construction of each of these claim terms, as well as the California court’s construction of “integral” (which was identical to that of the Virginia court).

In upholding the Virginia constructions, the Federal Circuit found that the California constructions imported unnecessary limitations into the construction of “eccentric weight portion” and “insert-receiving area.”   In its analysis, the Court reviewed the claims, the specification and the file history as it related to each of these terms.   With regard to both “eccentric weight portion” and “insert-receiving area,” the Court found that there was no support in the intrinsic evidence for the additional structural limitations imported by the California district court.

The Federal Circuit affirmed both of the district court’s grants of summary judgment of non-infringement with regard to the accused products.

Discover Bank Is Dead: The U.S. Supreme Court Rules That Federal Law Preempts State Laws That Obstruct The Enforcement Of Class Action Waivers In Arbitration Agreements

On April 27, 2011, the Supreme Court held that the Federal Arbitration Act “preempts California’s rule classifying most collective arbitration waivers in consumer contracts as unconscionable.” AT&T v. Concepcion, 563 U.S. ____, majority at 5, 18 (2011). The Court referred to this rule as the “Discover Bank rule,” after the California Supreme Court’s decision in Discover Bank v. Superior Court, 36 Cal.4th 148 (2005), though variations of this public policy-based rule have been articulated by many other court decisions in California and elsewhere. Writing for the majority in a 5 to 4 opinion, Justice Scalia concluded that state laws that undermine the enforceability of class action waivers in consumer arbitration agreements improperly obstruct the FAA.

The plaintiff in Concepcion brought a class action against AT&T for false advertising in violation of California law for charging $30.22 in sales tax for a cell phone advertised as free. AT&T moved to compel arbitration and enforce a class action waiver. The federal trial court in San Diego denied the motion based on the three prongs of Discover Bank, finding that the class action waiver was unconscionable because 1) the contract was a non-negotiable contract of adhesion, 2) the damages at issue were small, and 3) the plaintiff alleged a scheme to cheat consumers of small sums of money. The Ninth Circuit affirmed, holding that the FAA did not preemptDiscover Bank. The Supreme Court reversed.

The Court was unpersuaded by the rationale of Discover Bank: that enforcing class action waivers in cases involving small sums of money will essentially kill any such claim. As the dissent argued: “The realisticalternative to a class action is not 17 million individual suits, but zero individual suits, as only a lunatic or a fanatic sues for $30.” Id., dissent at 9. The majority was untroubled: “The dissent claims that class proceedings are necessary to prosecute small-dollar claims that might otherwise slip through the legal system. But States cannot require a procedure that is inconsistent with the FAA, even if it is desirable for unrelated reasons.” Id., majority at 17.

Given its broad reasoning, Concepcion should apply beyond Discover Bank to other judicially-constructed obstacles to the enforcement of consumer arbitration clauses in California. For example, some courts have held that there is an unwaiveable right to a class action under California’s Consumers Legal Remedies Act (the “CLRA”). Some courts have held that there is an unwaiveable right to a class action in the context of employment disputes. Some courts have held that claims for public injunctions under the CLRA and California’s Unfair Competition Law cannot be arbitrated.

Under Concepcion, the FAA now preempts all these judicial attacks on arbitration. According to the Court, “When state law prohibits outright the arbitration of a particular type of claim, the analysis is straightforward: The conflicting rule is displaced by the FAA.” Id., majority at 7. In his concurring opinion, Justice Thomas writes: if the FAA, “means anything, it is that courts cannot refuse to enforce arbitration agreements because of a state public policy against arbitration, even if the policy nominally applies to ‘any contract.'” Id., concurring at 1. “Contract defenses unrelated to the making of an agreement—such as public policy—could not be the basis for declining to enforce an arbitration clause.” Id., concurring at 4.

The majority recognizes that the FAA does not preempt “generally applicable contract defenses.” Id., majority at 9. Discover Bank, which purports to apply the generally applicable defense of unconscionability, went too far by refusing to enforce class action waivers in cases involving small sums of money. As an example of what the FAA does not preempt, in a footnote, the majority writes that, “Of course States remain free to take steps addressing the concerns that attend contracts of adhesion—for example, requiring class action-waiver provisions in adhesive arbitration agreements to be highlighted. Such steps cannot, however, conflict with the FAA or frustrate its purpose to ensure that private arbitration agreements are enforced according to their terms.” Id., majority at 12, n. 6. State legislatures, presumably, will have to craft such rules without singling out arbitration in a way that imposes obstacles not imposed on the enforcement other contract terms.

Two Respondents Receive Show Cause Order In Inv. No. 337-TA-763 – International Trade Commission

Chief ALJ Luckern issued an order to show cause why two respondents, Koko Technology Ltd. and Cyclone Toy & Hobby, should not be found in default in Inv. No. 337-TA-763, Certain Radio Control Hobby Transmitters and Receivers and Products Containing Same.  The respondents failed to respond to the complaint by April 4, 2011 and the Chief ALJ has required both respondents to respond to the show cause order by May 12, 2011.

New Directions in the Federal Circuit: Motivation to Combine

Through two recent panels, both including Judge Lourie, the Federal Circuit expanded upon the Supreme Court’s leading obviousness case, KSR International Co. v. Teleflex, Inc., 550 U.S. 398 (2007), finding motivation to combine references to render the patents-in-suit invalid as obvious. Both panel decisions indicate the Federal Circuit’s increasing readiness to find motivation to combine, even when explicit motivation is not present in the references.

Moreover, in both cases the Court ruled on motivation to combine without the benefit of expert testimony, perhaps illustrating a growing willingness to decide obviousness on summary judgment. Both cases involved simple mechanical inventions, however, so it remains to be seen whether the Federal Circuit will apply its apparent openness to determining obviousness on summary judgment to more complicated technologies that may require the assistance of experts.

Wyers v. Master Lock Co.1

In Wyers v. Master Lock Co., 616 F.3d 1231 (Fed. Cir. 2010), cert. denied the Federal Circuit, reversing a jury decision that three trailer hitch lock patents were valid and infringed, found that even in the absence of expert testimony, judges can make a common sense determination to combine the prior art to find patent claims obvious and thus invalid. Prior to Wyers, the Federal Circuit rarely relied on common sense as the basis for finding a motivation to combine prior art. Wyers confirms that successful obviousness challenges are possible without expert testimony. On February 22, 2011, the Supreme Court declined to grant Wyers’ petition for a writ of certiorari.

Tokai Corp. v. Easton Enterprises, Inc.

InTokai Corp. v. Easton Enterprises, Inc.,—F.3d—, 2011 WL 308370 (Fed. Cir. 2011), the Federal Circuit in a split decision affirmed a grant of summary judgment which found the patents-in-suit to be invalid as obvious. Tokai’s March 3, 2011 petition for panel rehearing and rehearing en banc is pending.

Tokai’s patents relate to automatic child-safety mechanisms for safety utility lighters. Judge Lourie wrote for the majority:

It would have been obvious to one of ordinary skill and creativity to adapt the safety mechanisms of the prior art cigarette lighters… to fit a utility lighter as disclosed by [the prior art], even if it required some variation in the selection or arrangement of particular components.

The Court concluded that “the undisputed facts in this case – including the state of the prior art, the simplicity and availability of the components making up the claimed invention, and an explicit need in the prior art for safer utility lighters – compel a conclusion of obviousness.” The Court also affirmed the exclusion of expert declarations because Tokai failed to submit expert reports.

Impact of Wyers and Tokai

These decisions support a summary judgment strategy for invalidity claims in three ways: (1) by making it easier to find a motivation to combine, (2) by not requiring expert testimony to establish a motivation to combine and, (3) in cases where a strong prima facie case of obviousness is established, by making it difficult for secondary considerations to save the patents. “[T]he ultimate inference as to the existence of a motivation to combine references may boil down to a question of ‘common sense,’ appropriate for resolution on summary judgment,” Wyers, 616 F.3d at 1240, and “expert testimony concerning motivation to combine is unnecessary and, even if present, will not necessarily create a genuine issue of material fact.” Id. at 1239, citing KSR, 550 U.S. at 427.

Tokai also makes it challenging for a simple mechanical patent to withstand an obviousness challenge particularly when there is a known need.

For a more in-depth look at this issue, please click here.

Texas Supreme Court: A Liability Insurer’s Duty to Indemnify May Exist Even Though the Duty to Defend May Not Initially Attach

The Texas Supreme Court recently ruled that a liability insurer’s duty to indemnify its insured for settlements or judgments is determined by the evidence, not merely the pleadings, and may be invoked even when the duty to defend did not initially appear to attach. In short, the court recognized that there are instances when an insurer may have an obligation to indemnify an insured against a third-party claim even if the insurer were not initially ruled to have an obligation to defend. The Burlington Northern and Santa Fe Railway Company f/k/a The Atchinson, Topeka and Santa Fe Railway Company v. National Union Fire Insurance Company of Pittsburgh, Pa., No. 10-0064 (Tex. Feb. 25, 2011). This decision clarifies a previously ambiguous point of law in Texas, where insurers frequently argued-and some courts agreed-that “no duty to defend equals no duty to indemnify,” regardless of extrinsic evidence.

Background

Standard-form liability insurance policies typically require an insurer both to defend the insured against a third-party claim and to indemnify the insured in the event of a settlement or judgment. These two fundamental duties are subject to different legal standards as to when and how they are triggered. There are also varying standards for these duties among jurisdictions. Under most jurisdictions’ laws, the duty to defend is typically determined by comparing the allegations in the third-party claim (typically a complaint or petition) to the basic coverage provided by the insurance policy; if this comparison reveals at least a potential or possibility of coverage, then the insurer has an obligation to defend its insured, at least until the possibility of coverage has been conclusively negated. The duty to indemnify, however, is determined based on the actual facts and evidence. If the facts and evidence establish that there actually is coverage under the insurance policy, then the insurer must provide coverage.

In Burlington Northern, the allegations in the third-party claim revealed no apparent potential for coverage under the applicable policy. However, the actual facts developed in the course of the underlying litigation indicated that a potential for coverage did exist. The court then had to address the quixotic question: If the insurer initially appeared to have no duty to defend based on pleading allegations, did the insurer also, per se, have no duty to indemnify? In a well-reasoned decision, the Texas Supreme Court held that an insurer is not automatically relieved of its duty to indemnify.

The Texas Supreme Court Decision

Burlington Northern operated trains, and hired SSI Mobley (Mobley) to control vegetation along certain areas of Burlington Northern’s rights-of-way under a contract with a term of “1994 through 1996.” In August 1995, a Burlington Northern train collided with a car, killing the car’s driver and one passenger. Survivors of the deceased filed suit, alleging in part that Mobley failed to use reasonable care to control weeds, and because of its improper timing and application of chemical weed control, there was excessive vegetation that caused the collision.

Burlington Northern tendered the claims to National Union, which had issued a policy to Mobley that also insured Burlington Northern. National Union denied coverage. Burlington Northern filed a declaratory judgment action, and after some procedural maneuvering, the trial court granted summary judgment in National Union’s favor, holding that National Union had no duty to defend and therefore no duty to indemnify.

The trial court relied on an exclusion in the National Union policy for injury taking place away from Mobley’s premises and arising out of Mobley’s product or work. The exclusion contained a carve-out, however, for work that “has not yet been completed or abandoned.” This meant that the policy did provide coverage for claims arising out of work that was not completed or was abandoned. The policy provided that Mobley’s work would be “deemed completed” when, among other things, all of the work called for in the contract was completed, all of the work done at a site was completed, or part of the work at a site had been put to its intended use. The policy also stated that work that may need service, maintenance, or certain upkeep, but otherwise was complete, would be considered “completed.” The third-party complaint alleged that Mobley’s work took place in the past, thus apparently implicating the exclusion for work that had already been completed and negating National Union’s duty to defend.

The issue addressed by the Texas Supreme Court arose from the fact that both the trial and appellate courts found that National Union did not have a duty to indemnify without considering any of the actual facts developed in the underlying third-party suits. In its ruling, the Texas Supreme Court noted that the duty to defend and the duty to indemnify “enjoy a degree of independence from each other.” The duty to defend arises before litigation is completed; the duty to indemnify is determined “based on the facts actually established in the underlying suit.” Because the contract between Burlington Northern and Mobley had a term that extended through 1996, it was possible that the facts in the underlying suit established that Mobley’s vegetation control operations in fact were not “completed,” but extended to 1996. It thus was error for the trial and appellate courts not to consider all evidence presented by the parties in determining National Union’s coverage obligations.

Implications

The Texas Supreme Court’s holding finding that an insurer is not automatically relieved of its duty to indemnify is a reminder to policyholders that claims for coverage can be pursued even if the insurer appears to have no duty to defend. As shown in Burlington Northern, there are instances when a complaint may negate a duty to defend, but the facts that develop during the underlying suit establish that coverage actually does exist under the relevant insurance policy. These facts should be tendered to the insurer for review and reconsideration of any denial of a defense and/or indemnification obligation. In the event of a disputed claim that arises in similar circumstances, it may be necessary to involve experienced coverage counsel to parse through these nuanced factors.

Breach of Fiduciary Duty in the Context of Insolvency: Can Individual Creditors Seek Recovery?

In the context of today’s distressed financial markets, we have witnessed desperate people doing desperate things. Financial fraud (i.e., fraud committed against financial institutions) has risen dramatically. Owners and officers of companies are getting more than just a little creative with accounting functions, inventory controls and receivable reporting, to name just a few hot spots. As a result, they are more and more frequently becoming the target of suits by lenders and other creditors. These suits seek to hold the officers of the insolvent company responsible for fraud, and in some cases breach of fiduciary duties to creditors (primarily, in an effort to reach D&O policies).

Are these actions against officers and directors a source of potential recovery by an individual creditor? Though the Supreme Court of Illinois has yet to rule on this issue, a recent bankruptcy case holds that individual creditors lack standing to bring this type of action.

The Question of Insolvency

In the day-to-day operations of a going concern, officers and directors owe a fiduciary duty to their shareholders. But what happens when the company enters the “zone of insolvency”? The officers and directors then also owe a fiduciary duty to the company’s creditors. Companies often ask, “How do we know when are we in the zone of insolvency?” The answer is simple: if you are asking the question, you are likely in the zone. Of course, there are established legal assessments—such as the “balance sheet test,” the “cash flow test” and the “unreasonably small capital test.” But, in practice, if the board of directors is pondering the question of its own insolvency, then it’s a safe bet that the company is already there.

If an officer or director breaches his fiduciary duties in any number of ways, who may bring the action against that individual? May a creditor, on its own, successfully sue an officer or director for breaching his fiduciary duties? Judge Carol A. Doyle, former Chief Judge of the Northern District of Illinois Bankruptcy Court, predicted how the Illinois Supreme Court would handle this question in the context of insolvency.

In this recently published case (In Re John H. Netzel, et al., January 20, 2011), the court discussed the important distinction raised by the 7th Circuit Court of Appeals between claims based on liability owed to the general creditor body (which only a trustee in bankruptcy can assert) and claims that are more specific to an individual creditor (which only the creditor can assert). As a general rule, fiduciary duty is owed to shareholders, not creditors. That means a creditor may not sue an officer or director for a breach of fiduciary duty. The advent of insolvency, however, creates the exception to the general rule. Upon finding that the exception exists, the fiduciary owes a duty not only to the shareholders, but also to the general creditor body.

The state of the law in Illinois is that the winding up of an insolvent company’s affairs requires the officers and directors to marshal the assets and hold them in trust for the entire creditor body, pro rata. In this context, Judge Doyle made a small step of well-reasoned logic by holding that the Illinois Supreme Court would likely not permit an individual creditor to sue on its own behalf in order to obtain more than its pro ratashare of the insolvent company’s remaining assets. Therefore, according to this recent case, individual creditors lack standing to bring an individual action for breach of fiduciary duty by an officer or director of an insolvent company.

It appears that the exception to this standard would be a harm that was personal to the creditor—not injurious to the creditor body as a whole. However, it is difficult to imagine a scenario where a breach of fiduciary duty or a fraud committed by an officer or director would not also be injurious on some level to the entire creditor body.

A Primer on the Validity and Effect of Waiver of Subrogation Clauses

Waiver of Subrogation Clauses: An Overview

Pursuant to typical “waiver of subrogation” clauses, the parties to a contract will agree to waive any rights of recovery against each other if the damage is covered by insurance. Thus, the risk of loss gets shifted to the insurer.

Courts almost always hold that waiver of subrogation clauses are valid because they advance several important social goals, such as encouraging parties to anticipate risks and procure insurance covering those risks, thereby avoiding future litigation. Waiver of subrogation clauses have been validated even in the face of anti-indemnity, anti-exculpatory and anti-subrogation statutes. See Best Friends Pet Care, Inc. v. Design Learned, Inc., 77 Conn. App. 167, 823 A.2d 329 (2003); May Dept. Store v. Center Developers, Inc., 266 Ga. 806, 471 S.E.2d 194 (1996); 747 Third Ave. Corp. v. Killarney, 225 A.D.2d 375, 639 N.Y.S.2d 32 (1st Dep’t 1996). These courts held that waiver of subrogation clauses are not intended to relieve a party of liability for its own negligence, but are instead risk allocation clauses. Thus, the clauses did not violate the relevant statutes.

Illinois Law on Waiver of Subrogation Clauses

There is relatively little case law in Illinois regarding waivers of subrogation clauses. Although the case is over twelve years old, Intergovernmental Risk Management v. O’Donnell, Wicklund, Pigozzi & Peterson Architects, 295 Ill.App. 3d, 692 N.E.2d 739 (1st Dist. 1998) (“IRM”) remains the premier case in Illinois with regard to waiver of subrogation issues. In that case, the Village of Bartlett (“the Village”) was in the process of expanding its village hall (“the project”). Part of the project entailed constructing a new police station adjacent to the updated village hall. The Village contracted with Defendant O’Donnell, Wicklund, Pigozzi & Peterson Architects (“O’Donnell”) to provide architectural drawings and specification for the project. Pursuant to the contract, the Village purchased insurance from Travelers Insurance Co. through the IRM program. On January 28, 1994, a fire occurred at the newly constructed police station, which caused over $114,000 worth of damage. IRM and Travelers paid the Village that amount pursuant to their policies. IRM and Travelers then filed a subrogation action against O’Donnell, claiming that O’Donnell’s negligence caused the fire and sought reimbursement of the monies paid to the Village pursuant to the insurance policies.

In its motion to dismiss, O’Donnell argued that the plaintiffs’ claims were barred because the Village had waived its subrogation rights in the contracts for the project. The Owner-Architect Agreement between the Village and O’Donnell contained the following waiver of subrogation clause:

“The Owner and Architect waive all rights against each other and against the contractors, consultants, agents and employees of the other for damages, but only to the extent covered by property insurance during construction.”

The plaintiffs argued, inter alia, that the waiver of subrogation provisions could not apply to damage caused by the negligent and wrongful acts of the defendant. The plaintiffs contended that the waiver of subrogation clauses violated public policy by encouraging negligence. However, the court disagreed. It stated that “the purpose of waiver of subrogation provisions is to allow the parties to a construction contract to exculpate each other from personal liability in the event of property loss or damage to the work to the extent each party is covered by insurance.” IRM. at 792. The court noted that waiver of subrogation clause “shifts the risk of loss to the insurance company regardless of which party is at fault.” Thus, it did not matter whether the fire loss was caused by O’Donnell’s negligence so long as the loss was a covered loss that occurred during construction. Id. at 793.

The plaintiffs also argued that the waiver provisions violated of public policy in that they act as indemnity agreements holding the defendant harmless from its own negligence. The court rejected that argument as well. It noted that the waiver provisions do not involve injury suffered by a construction worker or a member of the general public but instead, damage suffered by one of the contracting parties due to the alleged negligence of another. Id. Thus, waiver of subrogation clauses do not violate the public policy considerations which outlaw indemnity agreements. Instead, they merely limit the parties’ recovery to loss sustained to the parties to the agreement and only to the extent that it was covered by insurance. Id. at 794.

The IRM court held that the waiver of subrogation clause was perfectly valid and that it applied to the insurers’ claims. Thus, the plaintiffs’ claims were barred and they could not recover the amounts that they paid to the Village. As mentioned above, IRM is still the preeminent case in Illinois with regard to the validity and effect of waivers of subrogation clauses. Insurers need to be mindful of the effect that such clauses may have on their rights.

Conclusion

Although courts nationwide consider waiver of subrogation clauses to be valid, there are circumstances under which these clauses will not be enforced. For example, in order to establish a waiver of subrogation, it is necessary to show by clear evidence an intentional relinquishment of the right. Thus, if the waiver of subrogation clause is ambiguous or confusing, if the clause conflicts with other contract provisions, or if the intention of the parties is not clear, then courts will not enforce it. See Sutton Hill Associates v. Landes, 775 F. Supp. 682 (S.D. N.Y. 1991); U.S. Fidelity and Guar. Co. v. Friedman, 540 So. 2d 160 (Fla. Dist. Ct. App. 4th Dist. 1989); Charter Oak Fire Ins. Co. v. National Wholesale Liquidators of Lodi, Inc., 2002 WL 519738 (S.D. N.Y. 2002) (applying New Jersey law).

Additionally, courts will not enforce waiver of subrogation clauses where the underlying insurance did not cover the loss at issue. See Gap, Inc. v. Red Apple Companies, Inc., 282 A.D.2d 119, 725 N.Y.S.2d 312 (1st Dep’t 2001);Chelm Management Co. v. Wieland-Davco Corp., 23 Fed. Appx. 430 (6th Cir. 2001) (applying Ohio law). This is of particular importance, as an insurer can craft a condition to coverage that protects its own subrogation rights. As indicated, it is common for insureds to include waiver of subrogation clauses in their contracts with other companies during the course of their business. Waivers under those circumstances will generally take place pre-loss. While these pre-loss waivers may be acceptable, it is important for insurers to make sure the insured does not do anything after a loss which would prejudice the insurer’s right to subrogation. A common condition to coverage that protects an insurer’s subrogation rights will read as follows:

“If the insured has rights to recover all or part of any payment we have made under this policy, those rights are transferred to us. The insured must do everything necessary to secure our rights and must do nothing after the loss to impair them.”

A condition like the one above added into the insurance contract will protect an insurer’s right to subrogation in the event that the insured, after a loss occurs, attempts to enter into an exculpatory agreement that includes a waiver of subrogation clause. While there is little an insurer can do about a pre-loss waiver of subrogation clause (aside from the defenses to enforcement discussed above), a provision similar to the one above will at least protect the insurer from post-loss waivers.

Seventh Circuit Expands on Illinois Law Regarding Insurer’s Duty to Provide Independent Counsel Due to Conflict of Interest

When insurers defend their insureds in liability actions, they have long had to be careful to protect the interests of the insured while still protecting their own interests.  Illinois courts have addressed two scenarios where the conflicting interests of the insured and the insurer are particularly difficult to reconcile:

(1) where the insurer’s coverage defenses create an incentive for the insurer to defend the case in a way that would maximize the insurer’s potential to prevail on its coverage defenses, even though that might create more exposure to the insured; and

(2) where the verdict potential of the case substantially exceeds the insurer’s policy limit, so that the insurer might be inclined to try the case rather than settle it within its limit in the hope that it will obtain a defense verdict and therefore pay nothing rather than paying all or most of its limit to settle the claim.

Illinois courts have adopted two different approaches to reconciling these potential conflicts.  For the first situation, Illinois courts have ruled that when the insurer’s coverage defenses create a conflict of interest with the insured, the insurer must give the insured the right to retain counsel of its own choosing, to be paid for by the insurer.  E.g.Maryland Cas. Co. v.  Peppers, 64 Ill.2d 187, 193, 355 N.E.2d 24, 28 (1976);Illinois Masonic Medical Center v. Turegum Ins. Co., 168 Ill.App.3d 158, 163, 522 N.E.2d 611, 613 (1st Dist. 1988). In the case where the verdict potential exceeds the policy limits, insurers generally maintain control over the defense of the case, but if the insurer acts in bad faith by unreasonably failing to settle the claim within its limit, the insurer will be liable for the full amount of the verdict or judgment entered against the insured, even though it exceeds the policy limits.  E.g.Haddick v. Valor Insurance, 198 Ill.2d 409, 763 N.E.2d 299 (2001); O’Neill v. Gallant Ins. Co., 329 Ill. App. 3d 1166, 769 N.E.2d 100 (5th Dist. 2002).

Despite the clear demarcation between these two lines of cases, the Seventh Circuit Court of Appeals recently ruled that under Illinois law, an insured is entitled to independent counsel whenever there is a substantial likelihood that the verdict in the case will exceed the insurer’s policy limit.  R.G. Wegman Constr. Co. v. Admiral Ins. Co., 2011 U.S. App. LEXIS 679 (7th Cir. Jan. 14, 2011).  In Wegman, Admiral issued a policy to Wegman with limits of $1 million.  A worker at one of Wegman’s construction sites was injured on the job, and sued Wegman.  Admiral defended the case through trial and a judgment was entered against Wegman for $2 million, $1 million in excess of Admiral’s limits.   The court acknowledged that when the case was first assigned to defense counsel, neither Admiral nor Wegman had any reason to believe the case would exceed the policy limit. However, according to the court, when the plaintiff was deposed and revealed the extent of his injuries, Admiral learned that a judgment or settlement could well exceed its $1 million limit.  The court stated that this “likelihood created a conflict of interest by throwing the interests of Admiral and Wegman out of alignment.”  The court went on to state that when such a conflict of interest exists, the insurer’s duty of good faith requires that it notify the insured. The court acknowledged that this usually occurs when the insurer denies coverage, but considered the principle to be the same when the conflict arises from the relationship between the policy limit and the insured’s potential liability.

The court carried this further by concluding that once notified of the conflict, the insured has the option to hire a new lawyer, whose loyalty will be exclusively to the insured, to be paid for by the insurer.  According to the court, the new lawyer “would have tried to negotiate a settlement with [the plaintiff] that would not exceed the policy limit; and if the settlement was reasonable given the risk of an excess judgment, Admiral would be obligated to pay.”

Much of the court’s opinion seems to have been supported by the fact that the insurer not only failed to notify the insured of a conflict of interest, it failed to notify the insured that the judgment was likely to exceed the policy limits.  As a result, the insured did not notify its excess carrier, so the excess verdict was not covered by excess coverage.  Nevertheless, the import of the court’s decision cannot be overemphasized. If followed by Illinois state courts, it creates a right of independent counsel whenever there is a substantial likelihood of an excess verdict.  Moreover, the court’s ruling that the independent counsel can negotiate a settlement, apparently without the insurer’s consent, which the insurer will have to pay if reasonable, takes control of the insurer’s funds and right to settle away from the insurer and gives it to the insured, in violation of the terms of the policy which give the power to settle to the insurer.

The decision in Wegman raises the question of why the court considered it necessary to mix up the concept of conflict of interest created by coverage defenses with the problems created by the potential for an excess verdict.  Illinois insureds have long had a remedy for an insurer which gambles with the insured’s money in the face of a potential excess verdict: an action against the insurer for bad faith failure to settle.  This protection has adequately protected the insured’s rights by ensuring that the insurer will consider the insured’s interests in avoiding an excess verdict at least equal with its own rights.  However, the conflict of interest standard does not fit this situation.  In a case presenting excess exposure, both the insured and the insurer have an interest in a strong defense that will result in a verdict of non-liability or a low settlement.  There is no need for independent counsel. Nor is there any need to take away the insurer’s control of settlement, when the insurer’s obligations to the insured mandate that it consider the insured’s interests at least equally with its own when faced with a potential excess verdict.

No previous Illinois state court case has gone as far as the court did in Wegman.  However, as long as Wegman stands without being challenged by an Illinois appellate court, insurers must be aware of the risk they face if they fail to appoint independent counsel when there is a substantial risk of an excess judgment.  At the same time, insureds concerned about excess judgments should seek to have the insurer appoint an independent counsel to represent them and potentially settle the claim.  Insureds must be cautious though, since a decision to settle without the agreement of the insurer could backfire if future courts do not follow Wegman.