Wisconsin Appellate Court Interprets Construction Defect Exclusion and Fungi Exclusion
Cincinnati Insurance Company v. James Ropicky, et al., No. 2023AP588, 2024 WL 5220615 (Wis. Ct. App. Dec. 26, 2024)
On December 26, 2024, the Court of Appeals of Wisconsin issued is decision in Cincinnati Insurance Company v. James Ropicky, et al., No. 2023AP588, 2024 WL 5220615 (Wis. Ct. App. Dec. 26, 2024), addressing whether an ensuing cause of loss exception to a Construction Defect Exclusion, Fungi Exclusion, and Fungi Additional Coverage endorsement contained in a homeowner’s insurance policy issued by Cincinnati to its insureds precluded coverage for damage sustained by the insureds’ home following a May 2018 rainstorm. A final publication decision is currently pending for this case.
Background Information
James Ropicky and Rebecca Leichtfuss (collectively “the insureds”) submitted a claim to their homeowner’s insurer, Cincinnati Insurance Company (“Cincinnati”), for alleged water and fungal damage that their home sustained as a result of a rainstorm that occurred on May 11, 2018. Based on Cincinnati’s investigation and the opinions rendered by its expert following his inspections of the insureds’ home, Cincinnati provided limited coverage for the insureds’ claim based on the contention that a majority of the damage was the result of “design or installation deficiencies” that had allowed storm water to enter the interior wall structure. Therefore, Cincinnati concluded the subject damage was either excluded under the policy’s Construction Defect Exclusion and Fungi Exclusion, or subject to the policy’s Fungi Additional Coverage endorsement. As a result, Cincinnati paid $10,000 under the policy’s fungi-related coverage (Fungi Additional Coverage endorsement) and $2,138.53 for other damages falling within the ensuing cause of loss exception to the Construction Defect Exclusion. Cincinnati denied coverage for costs associated with remedying and repairing the purported construction defects.
Eventually, Cincinnati filed a lawsuit against its insureds seeking declaratory judgement as to its coverage position. In response, Cincinnati’s insureds disputed Cincinnati’s coverage position and filed counterclaims against Cincinnati for breach of contract, declaratory judgment, and bad faith related to Cincinnati’s handling of their claim. The circuit court ultimately granted Cincinnati’s summary judgment motion as to coverage, agreeing that the Construction Defect and Fungi Exclusions contained in the applicable homeowner’s policy barred any additional coverage under the policy’s terms beyond that which Cincinnati had already paid with respect to the alleged May 2018 rainstorm damage. Further, because the circuit court ruled in Cincinnati’s favor and held that Cincinnati had not breached its contract with the insureds, the court dismissed, sua sponte, the insured’s bad faith claim as a matter of law. The insureds appealed the circuit court’s decision.
Decision and Analysis
On appeal, the Court of Appeals of Wisconsin concluded the ensuing cause of loss exception to the policy’s Construction Defect Exclusion reinstates coverage, and the policy’s Fungi Additional Coverage endorsement renders the Fungi Exclusion inapplicable. Thus, the appellate court reversed the circuit court’s decision, finding the circuit court erred in granting summary judgment in Cincinnati’s favor, and remanded the case for further proceedings.
First, the appellate court held that even assuming the Construction Defect Exclusion applies, the damage to the insureds’ home nevertheless constitutes an ensuing cause of loss under the policy’s ensuing cause of loss exception and the authority of Arnold v. Cincinnati Insurance Co., 2004 WI App 195, 276 Wis. 2d 762, 688 N.W.2d 707. Relying on Arnold as binding authority, the appellate court explained that an “ensuing loss” “is a loss that follows the excluded loss ‘as a chance, likely, or necessary consequence’ of that excluded loss[,]” and “in addition to being a loss that follows as a chance, likely, or necessary consequence of the excluded loss, an ensuing loss must result from a cause in addition to the excluded cause.” Id. at ¶¶27, 29 (emphasis added). The appellate court then proceeded to apply the following three-step framework adopted in Arnold to determine whether the ensuing cause of loss exception applies: (1) first identify the loss caused by the faulty workmanship that is excluded; (2) identify each ensuing loss, if any – that is, each loss that follows as a chance, likely, or necessary consequence from that excluded loss; and (3) for each ensuing loss determine whether it is an excepted or excluded loss under the policy. See id. at ¶34. Based on the appellate court’s application of this three-step framework, it concluded the rainwater at issue, i.e., the May 2018 rainstorm, was an ensuing cause of loss within the meaning of the applicable policy’s ensuing cause of loss exception to a Construction Defect Exclusion.
Second, the appellate court held that the policy’s Fungi Exclusion and its anti-concurrent cause of loss clause did not exclude coverage for the damage to the insureds’ home. Most significantly, in reaching this conclusion, the appellate court determined that the phrase “[t]his exclusion does not apply” in the Fungi Exclusion does not introduce an exception to the exclusion, but rather introduces two scenarios in which the Fungi Exclusion is never triggered in the first instance because its conditions for application are never satisfied. According to the appellate court, one of the circumstances enumerated in the Fungi Exclusion, wherein it states the exclusion “does not apply” “[t]o the extent coverage is provided for in Section I, A.5. Section I – Additional Coverage m. Fungi, Wet or Dry Rot, or Bacteria with respect to ‘physical loss’ caused by a Covered Cause of Loss other than fire or lightning,” rendered the exclusion inoperative with respect to the subject loss. Notably, the concurring opinion explains how the majority’s interpretation of the Fungi Exclusion’s “this exclusion does not apply” language appears to depart from prior case law, wherein Wisconsin courts have repeatedly concluded that this language creates an exception to an exclusion that reinstates coverage. See Neubauer, J. (concurring).
Third, the appellate court held the policy’s $10,000 limit of Fungi Additional Coverage applies to the portion of subject home’s damages that was at least partially caused by “fungi, wet or dry, or bacteria.” However, the $10,000 limit does not decrease or limit the coverage that was otherwise available for the home’s damages caused solely by rainwater.
Based on its interpretation of the policy provisions set forth above, the appellate court additionally held: (1) genuine questions of material fact exist at least as to whether “fungi, wet or dry rot, or bacteria” caused any of the damage to the insureds’ home, and if so, what portion of the damage is attributable to “fungi, wet or dry rot, or bacteria”; (2) only after properly apportioning any damage caused by “fungi, wet or dry rot, or bacteria” can Cincinnati determine the extent of coverage it is obligated to provide under the terms of the homeowner’s insurance policy; and (3) because issues of material fact remain as to the cost to repair the construction defects (not the ensuing loss), this issue remains to be addressed on remand. The appellate court also reinstated the insureds’ bad faith claim asserted against Cincinnati in the underlying action, which had been dismissed by the circuit court when granting summary judgment in Cincinnati’s favor.
7 Practical Tips for Preparing for the 2025 Annual Report and Proxy Season
As the 2025 proxy season approaches, public companies must gear up for an environment shaped by evolving regulations, investor expectations, and governance trends. To ensure your company is well-prepared, here are some practical tips to keep in mind:
1) Dust Off the Proxy Season Calendar and Confirm Filer Status
Start your preparations by revisiting your proxy season timeline. Ensure you know your key deadlines for Securities and Exchange Commission (SEC) filings, including the Form 10-K/20-F, proxy statement, and annual meeting. Check your filer status (e.g., large accelerated, accelerated, non-accelerated) to confirm applicable deadlines and determine whether any recent status changes affect your compliance requirements.
2) Be Aware of New SEC Disclosure Obligations
The SEC has introduced several new disclosure obligations for 2025. Among others, there are two key changes to note:
Insider Trading Policies and Procedures.
Narrative Disclosure – Item 408(b) of Regulation S-K requires a company to disclose whether it has adopted policies or procedures governing purchases, sales, or other dispositions of its securities by directors, officers, and employees or by the issuer itself and, if not, why it has not done so.
Exhibit Filing – Any insider trading policy must be filed as Exhibit 19 to the 2024 Form 10-K. If the company’s code of ethics includes such a policy, a separate exhibit filing is not required. (A similar disclosure requirement applies under Item 16J of Form 20-F.)
Option Award Granting Policies and Procedures (402(x) of Regulation S-K):
Narrative Disclosure – Under new Item 402(x), a company must provide narrative disclosure discussing its policies and practices regarding the timing of awards of stock options, stock appreciation rights (SARs) and similar option-like instruments in relation to the disclosure of material nonpublic information (MNPI), including how the board determines when to grant these awards. In addition, a company must disclose whether the board or compensation committee takes MNPI into account when determining the timing and terms of applicable awards, and, if so, how and whether the company has timed the disclosure of MNPI for the purpose of affecting the value of executive compensation.
Potential New Tabular Disclosure – New Item 402(x) also requires detailed tabular disclosure if, during the last completed fiscal year, stock options, SARs or similar option-like instruments were awarded to a named executive officer (NEO) within a period starting four business days before and ending one business day after the filing of a Form 10-K or 10-Q, or the filing or furnishing of a Current Report on Form 8-K that discloses MNPI (including earnings information).
3) Revisit Cybersecurity Disclosure in Light of SEC Comment Letters and Trends
On July 26, 2023, the SEC adopted final rules requiring (i) the disclosure of material cybersecurity incidents in Form 8-K, and (ii) new cybersecurity risk management, strategy, and governance disclosures in Form 10-K and 20-F. All public companies were required to comply with these disclosure requirements for the first time beginning with their annual reports on Form 10-K or 20-F for the fiscal year ending on or after Dec. 15, 2023. As a result, calendar fiscal year companies included these disclosures for the first time in their respective annual report filings last annual reporting cycle.
With the passage of time, we are beginning to see SEC comment letters issued on filings related to the new cybersecurity disclosure rules. We believe it is prudent to be familiar with these comment letter trends to assess whether any improvements might apply to a company’s first-year disclosures.
Here is an SEC comment exchange related to a company’s Item 1C cybersecurity disclosures (with the SEC comment in bold and the response following):
“We note your senior leadership team consisting of your CEO and his direct reports (SLT) is responsible for setting the tone for strategic growth, effective operations and risk mitigation at the management level, as well as, the overall managerial responsibility for confirming that the information security program functions in a manner that meets the needs of Equifax. We also note that you described the relevant expertise of your CISO but not of the other members of the SLT. Please revise future filings to discuss the relevant expertise of such members of senior management as required by Item 106(c)(2)(i) of Regulation S-K.
We respectfully acknowledge the Staff’s comment above. While our senior leadership team (“SLT”) has responsibility for risk management at the managerial level and overall managerial responsibility for the various programs of the Company, including information security, our Chief Information Security Officer (“CISO”) is the management position responsible for assessing and managing material risks from cybersecurity threats under Item 106(c)(2)(i) of Regulation S-K. In future filings, we will clarify that the CISO is the management position responsible for assessing and managing material risks from cybersecurity threats.”
It appears the SEC staff accepted the reporting person’s explanation in the above-referenced exchange, as there were no follow-up letters made public. A link to the actual letter is here.
4) Be Aware of Proxy Advisory and Institutional Shareholder Policy Updates
Both Glass Lewis and ISS have updated their guidelines for 2025, which take effect for meetings held after Jan. 1, 2025 for Glass Lewis and on or after Feb. 1, 2025 for ISS. Below are a few key takeaways from their updates:
Board Oversight of AI
Given the rise in the use of artificial intelligence (AI), Glass Lewis has noted the importance of boards’ awareness of and policies surrounding the use of such technologies and the potential associated risks. If the company has not suffered any material incidents related to its use or management of AI, Glass Lewis will generally not make voting recommendations on the basis of its oversight of AI-related issues, but if there has been a material incident, Glass Lewis will review the company’s AI-related policies to ensure sufficient oversight and adequate response to such incidents and may recommend against certain directors in light thereof.
Defensive Profile and Reincorporation.
Glass Lewis revised its stance on reincorporating the company in different states to clarify that it will take these on a case-by-case basis, depending on the shareholder rights, financial benefits, and other corporate governance provisions of the laws of the state or country of reincorporation.
ISS votes case by case when it comes to poison pills with a term of one year or less, but this year it added several factors to its list of items it takes into consideration, including the context in which the pill was adopted and the company’s overall track record regarding corporate governance. This allows for a more holistic approach in ISS’s evaluation.
Executive Compensation.
In the aftermath of the first full year of pay versus performance disclosures, Glass Lewis has clarified it will continue to evaluate executive compensation programs holistically and not in accordance with a predetermined scorecard. While there are some factors that may lead to a recommendation against or for a say-on-pay vote, Glass Lewis said it will evaluate each program in the context of its whole, rather than its parts.
Board Responsiveness to Shareholders.
Both advisors included discussion about the board’s willingness and ability to respond to shareholders in its updates for this year. Glass Lewis has added to its discussion on board responsiveness a recommendation that shareholder proposals that received significant support but did not pass (generally more than 30 percent but less than a majority) should illicit board engagement with shareholders to address the issue and then provide disclosure of those efforts. Additionally, in its evaluation of whether to recommend a vote for or against a short-term poison pill, ISS states it will include the board’s responsiveness to shareholders in its review of the company’s corporate governance practices.
Expansion of Environmental Focus.
ISS revised its guidance on what used to be its section on general environmental and community impact proposals to include all natural capital-related matters. This includes topics like biodiversity, deforestation and related ecosystem loss, and other areas that group under the theme “natural capital.”
SPACs
ISS revised its stance on proposals for special purpose acquisition companies (SPAC) extensions from a case-by-case model with a variety of factors at play, including length of the request, prior requests for extension, and acquisition transactions pending in the pipeline, to a general support of extensions of up to one year from the original termination date.
In addition to ISS and Glass Lewis, in December 2024 BlackRock released its updated U.S. proxy voting guidelines for benchmark policies.
5) Consider Hypothetical Risk Factors
On Nov. 6, 2024, the U.S. Supreme Court heard oral arguments for Facebook, Inc. v. Amalgamated Bank, a securities law case involving the 2016 Facebook (now Meta)/Cambridge Analytica’s user data scandal. Facebook investors alleged that the company, among other things, had included in its risk factor disclosures references to risks of unauthorized user data disclosures, but such risks were presented as hypothetical when in fact they had already materialized.
In its Oct. 18, 2023 opinion, the U.S. Court of Appeals for the Ninth Circuit ruled, “Because Facebook presented the prospect of a breach as purely hypothetical when it had already occurred, such a statement could be misleading even if the magnitude of the ensuing harm was still unknown.” Facebook subsequently filed a petition to the Supreme Court for a writ of certiorari. On Nov. 22, 2024, the Supreme Court dismissed the case on the grounds that the writ of certiorari was improvidently granted, affirming the Ninth Circuit’s ruling.
In light of this case and the continued hindsight focus on “hypothetical risk factors” by shareholder litigants, companies should consider reviewing their risk factors and assess whether any of them that may be deemed “hypothetical” have actually occurred, and therefore require further disclosures.
6) Familiarize Yourself With SEC Changes to EDGAR System
On Sept.27, 2024, the SEC adopted a series of rule and form amendments concerning access to and management of accounts on their Electronic Data Gathering, Analysis, and Retrieval system (EDGAR). These amendments – designed to enhance the security of EDGAR, improve the ability of filers to manage their EDGAR accounts, and modernize connections to EDGAR – are collectively referred to as EDGAR Next.
At the heart of the amendments is a shift in how filers (and appropriately permissioned third parties) access EDGAR. Presently, the SEC assigns EDGAR filers access codes; any individual in possession of a filer’s access codes may access the filer’s account, view and make changes to the information maintained therein, and transmit submissions on the filer’s behalf. EDGAR Next will retire the majority of these codes and require that EDGAR filers authorize specific individuals to perform the above-mentioned functions. Each authorized individual will verify their identity using login.gov credentials.
Enrollment in EDGAR Next opens on March 24, 2025, and all existing filers must enroll by Dec. 19, 2025.
To get a jump on preparing for enrollment, filers should take the earliest opportunity to (i) ensure that all of their existing EDGAR access codes are current and (ii) identify the individuals (e.g., employees, legal advisors, third-party filing agents) who will need access to their EDGAR accounts. Individuals who anticipate interfacing with the EDGAR Next system should obtain login.gov credentials.
7) Changes to Nasdaq Diversity Disclosure Requirement
In December 2024, the U.S. Court of Appeals for the Fifth Circuit vacated the SEC’s approval of Nasdaq’s board diversity rules. Nasdaq has stated that it will not appeal the decision. As a result, Nasdaq-listed companies will no longer need to include the previously required board diversity matrix in their proxy statement or on their website, or provide other narrative disclosure explaining why they did not have at least the minimum number of directors in specified diversity categories. There was no comparable disclosure requirement for New York Stock Exchange (NYSE) listed companies.
Notwithstanding this change, board diversity remains a continued focus for many public company boards and other considerations are still in place. For example, ISS, Glass Lewis and certain large institutional investors have their own diversity standards that may influence a company’s disclosure, and Item 407(c) of Regulation S-K may elicit diversity-related disclosures regarding a nominating committee’s consideration of director candidates. As a result, many companies are continuing to solicit such information in their directors and officers (D&O) questionnaires for the 2025 proxy season. Ultimately, each public company will need to consider relevant factors in determining whether, or to what extent, diversity factors into their SEC disclosures.
Beating Bump-Up Exclusions: Policyholder Prevails In Coverage for Settlement of M&A Shareholder Lawsuit
A Delaware court recently refused to enforce a directors and officers liability policy’s “bump-up” exclusion to a $28 million class action settlement, finding that the company’s insurers unjustifiably denied coverage. The decision, which is one of several recent bump-up D&O coverage disputes, provides valuable insights for corporate policyholders seeking coverage for M&A-related claims and settlements with shareholders.
Background
In connection with the sale of Harman International in 2017, a class of Harman stockholders filed a securities class action lawsuit alleging that disclosures made in connection with the sale were misleading and violated Section 14(a) and Section 20(a) of the Securities Exchange Act of 1934 (the “Baum action”). The Baum action was settled for $28 million. When Harman’s D&O liability insurers denied coverage under the policies’ so-called “bump-up” exclusion, the company sued for breach of contract and sought a declaratory judgment that the settlement was covered in full by the policies.
Bump-up exclusions are frequently found in D&O insurance policies. While the wording varies among policies, bump-up provisions bar coverage for settlements or judgments in deal-related litigation where the “loss” constitutes an increase (i.e., a bump-up) in the purchase price of the company. While insurers may agree to defend insureds against alleged wrongful acts in negotiating or approving the deal, they will not effectively fund the purchase price of the acquired company.
In the Harman transaction, the insurers rejected the claim by invoking the bump-up exclusion, which barred coverage for all claims alleging that the price “paid for the acquisition . . . of all or substantially all of the ownership interest in or assets of an entity is inadequate” and where the loss “represent[s] the amount by which such price or consideration is effectively increased.” Because the Baum action demanded the difference in price the shareholders received and the true value at the time of the acquisition, the insurers argued the settlement was excluded from coverage.
The Court’s Analysis
In a January 3 opinion, the Delaware Superior Court agreed with Harman and held that the insurers had wrongfully denied coverage for the settlement. In deciding that the bump-up exclusion did not apply, the court focused on three elements of the exclusion: (1) whether the settlement related to an underlying “acquisition”; (2) whether “inadequate deal price” was a viable remedy sought in the underlying litigation; and (3) whether the settlement represented an effective increase in transaction consideration. The insurers carried the burden to show that all elements were satisfied.
The Nature of the Transaction. The parties disagreed on whether the transaction, which was structured as a reverse triangle merger, was an “acquisition” potentially within the bump-up provision.
The court determined that the Harman transaction was an “acquisition” because, among other reasons, the transaction resulted in the buyer owning 100% of Harman, which was in effect an acquisition. Other factors, like Harman’s post-transaction legal status and cancellation of Harman’s shares, also supported Harmon being acquired. Finally, the court pointed to Harman’s own Form 8-K filed with the Securities and Exchange Commission, which described the transaction as an “acquisition.” The court found that these factors, taken together, made the transaction an “acquisition” as such term was used in the bump-up exclusion.
The Viability of Alleged Damages. Harman contended that the settlement could not constitute an increase in inadequate deal consideration because a Section 14(a) claim can’t be used to obtain damages for inadequate consideration. The insurers disagreed, contending that the settlement had to represent an increase in deal price because the Baum complaint expressly sought damages equal to the difference between Harman’s true value and the price paid to the shareholders when the transaction closed.
The court acknowledged that the Baum action alleged inadequate consideration, but the court emphasized that damages for an undervalued deal were not a viable remedy under Sections 14(a) and 20(a) of the Securities Exchange Act of 1934. Rather, the court said those claims focus on the accuracy of the proxy statement’s disclosures and did not raise any claims authorizing the court to remedy an inadequate deal price.
The Purpose of the Settlement. Lastly, the court examined the settlement and concluded it did not represent an increase in the deal price. The insurers contended that the settlement resulted in an increase in consideration because the settlement amount was based in part on the alleged fair value of Harman stock compared to what Harman shareholders actually received.
Harman argued that the settlement represented only the value of legal expenses that it avoided by not litigating. The court looked no further than the agreement itself, which denied liability and stated the sole purpose of the settlement was to avoid litigation. The $28 million settlement price closely resembled the estimated legal fees and was not in line with the potential increased deal consideration, which the court estimated would be over $279 million. Therefore, the court concluded that the Baum settlement did not constitute an adjustment of the consideration offered to Harman’s stockholders to complete the acquisition.
Discussion
The Harman decision has several takeaways for policyholders.
Deals Driving D&O Disputes. As insurers continue to test the limits of these exclusions, bump-up disputes continue to make headlines and drive high-value, contentious coverage litigation for deal-related D&O claims. The Harman decision is the latest example of judges grappling with enforcement of bump-up language in different scenarios, including other cases in Delaware, which have had varying outcomes for policyholders.
The recent win is significant, especially for policyholders incorporated in Delaware that may be more inclined to pursue coverage litigation in the First State where the Delaware Supreme Court has stated that Delaware law should apply to disputes over D&O policies sold to Delaware companies.
Insurers Have High Burdens. The decision reinforces the difficult burden that insurers should face in proving that a loss fits within a bump-up exclusion, especially in the context of a settlement rather than judicial decision on the merits. The court resolved the dispute through the “norm” that a bump-up exclusion is “construed narrowly” and that any ambiguity must be interpreted in favor of coverage. And a bump-up provision should apply only “if the settlement clearly declares that its purpose is to remedy inadequate consideration given in an acquisition.” While the Harman court felt that this standard was “beyond debate,” not all courts interpreting similar exclusionary provisions have been so clear in holding insurers to this burden, so it will surely be a welcome reminder for policyholders assessing deal-related D&O claims.
Allegations, Even of Inadequate Consideration, Are Not Dispositive. The insurers cited allegations of an “undervalued” acquisition resulting in damages calculated as “the difference between the price Harman shareholders received and Harman’s true value at the time of the Acquisition.” But the court more closely followed the language of the bump-up exclusion. The provision required not just that plaintiffs alleged inadequate consideration in the deal but that the loss “represent” an effective increase in consideration. The court only looked to the complaint to assess whether inadequate consideration was a viable remedy under the theories of liability alleged. Because cured inadequate deal price wasn’t available for Section 14(a) and Section 20(a) securities claims, the plaintiff’s “bare request” for relief for inadequate price was not enough. This will be welcome to policyholders because stockholder-plaintiffs routinely assert a variety of theories and purported damages in M&A litigation which should not necessarily dictate the nature of the settlement.
Consider Insurance Early and Often. The decision provides a roadmap of key issues for policyholders to consider when thinking about potential coverage in deal-related litigation. It starts with the structure of the deal itself, which here was a reverse triangular merger that Harman argued did not fit within the exclusion’s applicability to “acquisitions.” While the court did not accept that position, it pointed to a statement in Harman’s Form 8-K calling the deal an “acquisition” to suggest that the company in some sense understood it to be an acquisition.
More importantly, the court emphasized two aspects of the settlement agreement itself in determining the nature of the settlement: an express denial by the policyholder of any wrongdoing or liability; and statements that the reason for the settlement was “solely” to avoid protracted and expensive litigation and that it would be “beneficial to avoid costs, uncertainty, and risks” inherent in such litigation. This was not necessarily dispositive to the case. Given the lack of evidence from the insurers that might show the settlement was an effective increase in merger consideration, it may not have mattered if the settlement agreement read differently. But when faced with evidence that the settlement represented the estimated litigation costs, the court declined to speculate and rejected the insurers’ bump-up defense.
Conclusion
The Harman decision shows the continued importance of bump-up exclusions and how they can lead to coverage disputes in deal-related litigation. Policyholders need to understand whether their D&O policy has problematic exclusionary language and, if so, whether to address it before pursuing an M&A transaction. The decision also provides guidance for settlement strategies that may maximize coverage.
Second Circuit Adopts “At Least One Purpose” Rule for False Claims Act Cases Premised on Anti-Kickback Statute Violations
On December 27, 2024, the U.S. Court of Appeals for the Second Circuit held in U.S. ex rel. Camburn v. Novartis Pharmaceuticals Corporation that a relator adequately pleads a False Claims Act (“FCA”) cause of action premised on violation of the Anti-Kickback Statute (“AKS”) by alleging, with sufficient particularity under Federal Rule of Civil Procedure 9(b) (“Rule 9(b)”), that at least one purpose (rather than the sole or primary purpose) of the alleged kickback scheme was to induce the purchase of federally reimbursable health care products or services.[1]
In doing so, the Second Circuit joins seven other Circuit Courts—the First, Third, Fourth, Fifth, Seventh, Ninth, and Tenth Circuits—in adopting the “at least one purpose” rule. This ruling lowers the bar in the Second Circuit for relators pleading AKS-based FCA claims.
Interplay Between FCA and AKS Violations
Under the AKS, “a claim that includes items or services resulting from a violation [of the AKS] … constitutes a false or fraudulent claim” under the FCA.[2]
The AKS prohibits persons from, among other things, “knowingly and willfully” soliciting or receiving “any remuneration (including any kickback, bribe, or rebate) directly or indirectly, overtly or covertly, in cash or in kind—
in return for referring an individual to a person for the furnishing or arranging for the furnishing of any item or service for which payment may be made in whole or in part under a federal health care program, or
in return for purchasing, leasing, ordering, or arranging for or recommending purchasing, leasing, or ordering any good, facility, service, or item for which payment may be made in whole or in part under a Federal health care program[.]”[3]
Alleged “Sham” Speaker Events & Excessive Compensation
In U.S. ex rel. Camburn, the relator, a former Novartis sales representative, filed a qui tam action in the U.S. District Court for the Southern District of New York alleging violations of the FCA premised on violations of the AKS. The relator alleged that Novartis operated a kickback scheme with the intent of bribing providers to prescribe Gilenya, a multiple sclerosis drug. Specifically, the relator alleged that Novartis operated a sham peer-to-peer speaker program that served as a mechanism for the company to offer remuneration to physicians in exchange for prescribing Gilenya. The relator alleged that the payments made to providers under the guise of this speaker program “caused pharmacies and physicians to submit false claims to the government and to the states for healthcare reimbursement under programs including Medicare Part D, Medicaid, and TRICARE.”[4]
U.S. District Court’s Dismissal with Prejudice
The federal government, as well as 29 states and the District of Columbia, among other parties, declined to intervene in the lawsuit. After granting the relator multiple opportunities to amend his complaint to plead factual allegations with sufficient particularity required by Rule 9(b), the district court held that the relator still failed to adequately plead the existence of a kickback scheme. Because the relator’s FCA claim was based on violations of the AKS, the district court dismissed the relator’s Third Amended Complaint with prejudice and did not address whether the relator sufficiently pled the remaining elements of his FCA claim.
Second Circuit’s Adoption of “At Least One Purpose” Rule
On appeal, the Second Circuit adopted the “at least one purpose” rule and found that, to survive dismissal, the relator “needed only to allege that at least one purpose of the remuneration was to induce prescriptions, without alleging a cause-and-effect relationship (a quid pro quo) between the payments and the physicians’ prescribing habits.”[5] Applying this standard, the Second Circuit concluded that the relator adequately pleaded an AKS violation with respect to the following three categories of allegations: (1) holding “sham” speaker events with no legitimate attendees, (2) excessively compensating physician speakers for canceled events, and (3) deliberately selecting and retaining certain speakers to induce a higher volume of prescriptions of Gilenya.
Specifically, the Second Circuit found that the relator’s “illustrative examples” of physician-speakers presenting solely to other Novartis speakers or to members of their own practice over lavish restaurant meals supported a strong inference that at least one purpose of the speaker program was to provide kickbacks to prescribers. The panel also found that the relator’s allegations that the compensation paid to physician speakers for canceled events ($20,000 to $22,500 to each speaker) over a two-year period in comparison to the dollar value of the allegedly fraudulent claims submitted to the government for reimbursement (between to $1 to $1.7 million) during that same period gave rise “to a strong inference that the payments constituted, at least in part, unlawful remuneration.”[6] Likewise, the relator’s inclusion of testimony from two Novartis sales representatives regarding the company’s alleged practice of offering speaking engagements to physicians to incentivize them to prescribe Gilenya suggested that these engagements were organized to induce providers to prescribe the drug.
The Second Circuit held that these allegations, accepted as true for purposes of the motion to dismiss, “plausibly and ‘strongly’ suggest Novartis operated its speaker program at least in part to remunerate certain physicians to prescribe Gilenya.”[7] Accordingly, the Second Circuit remanded the case to the district court to determine whether the relator sufficiently pleaded the remaining elements of his FCA claim and to weigh the adequacy of the claims under state and municipal law.
The Second Circuit affirmed, however, the district court’s conclusion that the relator “failed to link Novartis’s DVD initiative, ‘entertainment rooms,’ visual aids for billing codes, and one-on-one physician dinners with a strong inference that Novartis used these tools, at least in part, to induce higher prescription-writing,” with the caveat that another FCA claim predicated on an AKS violation may in fact survive dismissal if similar facts were pleaded with greater particularity.[8]
Practical Takeaways
This case highlights the importance of drug manufacturers and other regulated entities’ duty to implement robust and ongoing health care compliance programs in order to continuously and thoroughly evaluate enforcement and whistleblower risk relative to marketing and other business activities.
This decision’s adoption of the “at least one purpose” rule lowers the bar for relators in the Second Circuit to plead FCA violations premised on noncompliance with the AKS. Indeed, the Second Circuit rejected arguments that remuneration is unlawful under the AKS only if the “sole purpose” or “primary purpose” of the payment is to induce health care purchases. As eight circuits across the country have now held, allegations involving a single improper purpose can allow a case to survive dismissal. In these circuits, a relator merely needs to allege that at least one purpose of the remuneration was to induce the purchase of federally reimbursable health care products or services.
The heightened Rule 9(b) pleading standard fully applies in FCA cases premised on AKS violations. While the “at least one purpose” rule broadens liability, the district court and Second Circuit made clear that FCA allegations will be scrutinized to ensure they comport with the heightened Rule 9(b) pleading requirements.
Epstein Becker Green Attorney Ann W. Parks contributed to the preparation of this post.
ENDNOTES
[1] 2024 WL 5230128 (2d Cir. Dec. 27, 2024).
[2] 42 U.S.C. § 1320a-7b(g).
[3] Id. at § 1320a-7b.
[4] Camburn, 2024 WL 5230128, at *2.
[5] Id. at *4.
[6] Id. at *6.
[7] Id. at *6 (cleaned up) (quoting Hart, 96 F.4th 145, 153 (2d Cir. 2024)).
[8] Id. at *19.
Rule 37 in Action – Case Dismissed
As stated in my previous blog, “A Rule 37 Refresher – As Applied to a Ransomware Attack,” Federal Rule of Civil Procedure 37(e) (“Rule 37”) was completely rewritten in 2015 to provide more clarity and guidance to the sanction process under the Rule.
In Jones v. Riot Hospitality Group, LLC, the Ninth Circuit makes very clear that, when the court faces a sanctions analysis based upon evidence that there is data that should have been preserved, that was lost because of failure to preserve, and that can’t be replicated, then the court has two additional decisions to make: (1) was there prejudice to another party from the loss or (2) was there an intent to deprive another party of the information. If the former, the court may only impose measures “no greater than necessary” to cure the prejudice. If the latter, the court may take a variety of extreme measures, including dismissal of the action. An important distinction was created in Rule 37 between negligence and intention.
Rule 37(e)(2) is clear that the court may impose a variety of extreme measures, including dismissal of a case if there is a violation of Rule 37 with an intent to deprive another party of the relevant information. The Jones case demonstrates this rule in action. The Jones case involves Alyssa Jones, a former waitress at a Scottsdale bar, who sued the bar’s owner-operator, Ryan Hibbert, and his company, Riot Hospitality Group, alleging Title VII violations and common law tort claims. During discovery, upon noticing an unusual pattern of time gaps in the text messages that Jones produced in discovery, along with deposition testimony that demonstrated that particular people had indeed texted with her during those gaps, the court ordered the parties to jointly retain a third-party forensic search specialist to review the phones of Jones and certain witnesses.
The court ultimately found that Jones intentionally deleted relevant text messages with co-workers from 2017 and 2018 and coordinated with her witnesses to delete messages from 2019 and 2020. The court used “reasonable inferences” to determine that it was done with the intent to deprive Riot of use of the messages in the lawsuit. The district court dismissed the case, using the five-factor test for terminating sanctions articulated in Anheuser-Busch, Inc. v. Nat. Beverage Distrib., 69 F.3d 337, 348 (9th Cir. 1995).
The 9th Circuit found that the use of the Anheuser-Busch test was not necessary and that, to dismiss a case under Rule 37(e (2), a district court need only find that:
Rule 37(e) prerequisites are met,
the spoliating party acted with the intent required under Rule 37(e)(2), and
lesser sanctions are insufficient to address the loss of the ESI.
Takeaways:
1. If you are in a spoliation dispute, make sure you have the experts and evidence to prove or defend your case.
2. When you are trying to prove spoliation, know the test. If intent to deprive is proven (with direct or circumstantial evidence), then proving prejudice is not a prerequisite to sanctions.
3. Be aware of, plan for, and enforce data preservation protocols early in your case.
2024 Title IX Regulations Vacated Nationwide
On January 9, 2025, the Sixth Circuit Court of Appeals decided the case of Tennessee v. Cardona, vacating the 2024 Title IX regulations nationwide. The court ruled that the issuance of the 2024 regulations exceeded the Department of Education’s authority and was unconstitutional on multiple grounds.
The ruling may be appealed, but for now, institutions covered by Title IX should revert to compliance with their policies in effect under the 2020 Title IX regulations.
The 2024 Title IX regulations, which took effect on August 1, 2024, had faced several challenges that led to injunctions with varying geographic scopes. As a result, prior to the Cardona decision, the Title IX regulations were only effective in about half of the states across the U.S.
D.C. Circuit Court Again Addresses NEPA’s Scope
On January 7, 2025, the U.S. Court of Appeals for the D.C. Circuit, in Citizens Action Coalition of Indiana v. FERC, rejected a National Environmental Protection Act (NEPA) and Natural Gas Act (NGA) challenge to FERC’s approval of a natural gas pipeline in Indiana after an Environmental Impact Statement was issued. Plaintiffs’ central challenge was that NEPA required FERC to analyze non-gas alternatives before approving the pipeline. The D.C. Circuit disagreed.
Expressing frustration with what have become regular NEPA challenges to critical energy infrastructure projects – challenges that follow federal permitting actions “as night follows day” – the Court found that NEPA does not require FERC to consider alternatives that are outside of FERC’s jurisdiction and would fail to serve the purpose of the project.
In other words, where a project’s purpose is to support new natural gas units, NEPA requires only that the permitting agency consider alternatives that would satisfy that purpose.
Further, in defining a project’s purpose, the Court concluded that FERC may give substantial weight to the siting and design of a private developer. Here, FERC properly refused to reconsider the mix of electricity generation chosen by Indiana that the approved pipeline would support. It was not required to do so under NEPA, nor could it do so under the NGA, which does not authorize FERC to choose between electricity generation sources – that decision is left to the states.
The Court also rejected the claim that FERC’s consideration of the greenhouse gas (GHG) emissions from the project and from the downstream power plant was insufficient because FERC failed to make a significance determination, but instead chose to report those emissions in quantitative terms. Citing its recent decision in Food & Water Watch v. FERC, the Court plainly concluded “NEPA contains no such mandate.”
Importantly, on the issue of GHGs, the Court also concluded that “while NEPA requires FERC to consider environmental effects of the projects it approves, it is far from clear what statutory authority FERC has, if any, to give determinative weight to the environmental effects of projects beyond its jurisdiction.” Indeed, nothing in the NGA suggests that FERC can prioritize environmental concerns over the primary objective of natural gas market development.
Citizens Action represents a marked shift from recent law out of the D.C. Circuit, particularly the Court’s expansive approach to NEPA that is currently under review by the Supreme Court in Seven County Infrastructure Coalition v. Eagle County, Colorado. In that case, the D.C. Circuit held that the Surface Transportation Board (STB) should have considered the effect of the proposed 88-mile-long railway in Utah on increased oil refining along the Gulf coast, notwithstanding the limited authority of the STB. In Citizens Action,by contrast, the D.C. Circuit curtailed the scope of NEPA review by renewing the emphasis on the project’s purpose:
Citizens Action in effect seeks a judicial directive exhorting FERC to promote general environmental concerns. But such a directive would far exceed our review under the APA as well as FERC’s authority under the NGA and NEPA. Congress charged FERC with the development of natural gas pipelines, not with making local energy decisions or setting national environmental policy.
The volatility of the D.C. Circuit when it comes to the proper scope of federal agency review under NEPA—specifically whether NEPA requires an agency to study environmental impacts beyond the proximate effects of the action over which the agency has authority—may very well be settled by the Supreme Court in Seven County. In the interim, however, the D.C. Circuit this week rejected using NEPA to delay critical development projects.
2024 Title IX Regulations: “Off the Books”
Yesterday, a federal district court in Kentucky issued a ruling in Tennessee v. Cardona, finding that the 2024 Title IX regulations are unconstitutional and violated the Administrative Procedures Act (APA) by being “arbitrary and capricious.” The court ordered vacatur, which “takes the unlawful agency action ‘off the books. . .’” and prevents application of the regulations “to all who would otherwise be subject to its operation.” (1)
The memorandum opinion of the court found that “expanding the meaning of ‘on the basis of sex’ to include ‘gender identity’ turns Title IX on its head.” (2) Further, the court determined that the First Amendment was violated by requiring Title IX recipients, specifically teachers, to use names and pronouns associated with a student’s asserted gender identity. (3) Furthermore, the court found that the regulations are overly broad and/or vague that schools have no way of predicting what conduct might violate the law. (4) For example, the court cited to the new regulation’s prohibition of “[u]nwelcome sex-based conduct that, based on the totality of circumstances, is subjectively and objectively offensive . . (5) As discussed in the training offered by SMGG on this topic, this portion of the regulation made determination of Title IX violations completely on a case-by-case basis, with no true guide as to offensive conduct. Due to the constitutional infirmity of the regulations, the court also found that the provisions violate the Spending Clause of the United States Constitution. (6)
In determining the appropriate remedy, the court found that all aspects of the new regulations were tainted with the provisions that the court deemed invalid, requiring the entirety of the regulations to be “jettison[ed].” (7) The court held that the “normal remedy” is vacatur when the challenged action of an administrative agency violates the law. (8) The court also granted plaintiffs’ declaratory relief, and characterized it as “Plaintiff States, their political subdivisions, and their recipient schools need not comply with the Rule to receive federal funding.” (9)
What this Means for Your School
The nationwide vacatur of the 2024 Title IX final rule means that the 2020 Title IX final rule as well as the prior Title IX regulations are in effect. It is anticipated that the Department of Education may issue guidance in the aftermath of yesterday’s ruling, which SMGG education attorneys will monitor.
(1) See, State of Tennessee v. Cardona, No., 2:24-00072 (Jan. 9, 2025), p. 13 (citations omitted).(2) Opinion, p. 7.(3) Id. at p. 8.(4) Id.(5) 34 C.F.R. §106.2 (emphasis added).(6) Opinion, p. 10.(7) Id. at p. 12.(8) Id.(9) Id. at p. 15.
MBTA Communities Act: Next Steps
Massachusetts SJC Upholds MBTA Communities Act on Constitutional Grounds, but Rules Ineffective on Procedural Grounds
Background
If you already have the background, please jump to the end of this article for a discussion of next steps.
The MBTA Communities Act (“§ 3A” or the “Act”) was established in response to the ongoing housing crisis in Massachusetts.[1] Among other things, the law requires cities and towns with access to MBTA services to implement zoning laws that allow for at least one district of multifamily housing “as of right” near local MBTA stations.[2] Under § 3A, each MBTA community[3] must maintain multifamily housing districts of “reasonable size,” in addition to other requirements set forth in the statute: such districts must meet a minimum gross density measurement of 15 units per acre; be located not more than 0.5 miles from an MBTA facility (commuter rail, subway, ferry, or bus station, as applicable); and must be suitable for families with children and must not contain age restrictions.[4]
MBTA communities that do not comply with § 3A are ineligible for certain State funding sources—such as the Housing Choice Initiative, the Local Capital Projects Fund, the MassWorks infrastructure program, and the HousingWorks infrastructure program—but notably, a municipality cannot simply choose not to comply with § 3A.[5] The plain language of the statute requires compliance: “municipalities shall have a zoning ordinance or by-law that provides for [multifamily housing as of right].”[6]
The town of Milton had initially taken steps to comply with § 3A: its planning board had discussed implementation, it received grant money to hire a design consultant to create a zoning plan, and submitted its “action plan” to the Executive Office of Housing and Livable Communities (HLC) seeking a determination of “interim compliance” with § 3A.[7] In February of 2024, however, Milton held a referendum, and the voters rejected the proposed zoning plan by a margin of 8%. Thereafter, the Attorney General filed its complaint against the town to enforce compliance with § 3A.
The Supreme Judicial Court’s January 8, 2025 Decision
In Attorney General v. Town of Milton, et al., the town’s position was threefold: that § 3A “provides for an unconstitutional delegation of legislative authority, that the Attorney General lacks the power to enforce the [A]ct, and that HLC’s guidelines were not promulgated in accordance with the [Administrative Procedure Act (APA)].”[8]
First, Milton argued that § 3A is legally ineffective because the HLC failed to implement the Act in accordance with the APA.[9] The Court agreed, citing the central function of the APA—G. L. c. 30A—which is to “establish a set of minimum standards of fair procedure below which no agency should be allowed to fall and to create uniformity in agency proceedings.”[10] In response, the Attorney General contended that HLC is exempt from the APA procedure because 30A “directs the agency to promulgate ‘guidelines’ rather than ‘regulations.’” Even if the APA applied, the Attorney General argued, the HLC nonetheless substantially complied with the statute and any omissions were therefore harmless.[11] The Court rejected both arguments: “Given the breadth, detail, substance, and mandatory requirements of the HLC guidelines . . . we reject the agency’s position that the ‘guidelines’ . . . are meant to be exempt from the APA[.]”[12] Here, the guidelines direct HLC to create compliance parameters for MBTA communities, such as detailing what is needed to achieve a “reasonably sized” zoning district. Moreover, the guidelines set forth the manner by which the HLC determines density requirements and whether all of a community’s multifamily housing must be situated within one-half mile of the designated § 3A MBTA facility. Finally, the guidelines define and establish the application process for “as of right” zoning of multifamily housing near MBTA facilities.[13] Taken together, the Act’s “guidelines” fall within the scope of 30A and must, therefore, be promulgated pursuant to the APA’s requirements. 30A, §5 requires agencies engaged in the rulemaking process to, among other requirements, file notice of proposed regulation—which includes a notice of public hearing—with the Secretary of the Commonwealth, along with a small business impact statement, both of which HLC admitted it did not do.[14] The APA leaves no room for “substantial compliance,” but rather strict compliance is required for agencies promulgating rules under 30A.[15] Notably, it also appeared that HLC failed to file a fiscal impact statement with the Secretary of the Commonwealth, which is also required by 30A. The Court, concluding, stated “because HLC failed to comply with the APA, HLC’s guidelines are legally ineffective and must be repromulgated in accordance with G. L. c. 30A, § 3, before they may be enforced.”[16]
Second, Milton argued the Legislature’s delegation of authority to the HLC violated the separation of powers doctrine because § 3A gives HLC the power to require “transformative zoning changes” in MBTA communities.[17] The Court rejected the town’s position based on three factors: first, the Legislature routinely assigns to others the implementation of a policy adopted by statute; second, the Act provided “intelligible” parameters to allow the HLC to make determinations as to whether an MBTA community was in compliance with the Act; and finally, under § 3A, the HLC was guided by principles of reasonableness as well as content limitations, and the Act required the HLC’s consultation with other State agencies in the promulgation of its guidelines, which “sufficiently demarcate[s] the boundaries of regulatory discretion.[18]
Finally, Milton argued the Attorney General could not enforce § 3A because there was no explicit grant of authority in the act, but the court rejected such reasoning, citing the Attorney General’s broad power to enforce the laws of the Commonwealth in addition to the Attorney General’s duty to “represent the public interest and enforce public rights.”[19] Moreover, the fact that § 3A already included consequences for noncompliance—e.g. lack of certain funding opportunities—does not foreclose the Attorney General’s power to enforce equitable relief particularly where, as here, “converting [the] legislative mandate into a matter of fiscal choice” would frustrate the Legislature’s purpose in adopting the statute.[20]
Next Steps
Multiple sources have reported on Governor Healey’s intention to have the HLC file new emergency regulations by the end of the week. While the emergency regulations would be effective immediately upon filing, it is unclear what alternate compliance deadline(s) might be established on municipalities or whether new emergency guidelines would face a court challenge for violating the APA, particularly if the filing by HLC is a perfunctory compliance with the APA procedural requirements only. The establishment of new compliance deadlines is politically sensitive: very near term deadlines could be deemed punitive, whereas distant deadlines could be viewed as accommodating the communities which have not been prompt to comply. Although 30A, § 2(5) states that emergency regulations shall not remain in effect for longer than three months, an agency may prolong such three-month period if during that time it gives notice and holds a public hearing, and files notice of compliance with the Office of the Secretary of State.
[1] See Multi-Family Zoning Requirement for MBTA Communities, Mass.gov (Nov. 22, 2024), https://www.mass.gov/info-details/multi-family-zoning-requirement-for-mbta-communities.
[2] See Compliance Guidelines for Multi-family Zoning Districts Under Section 3A of the Zoning Act, Commonwealth of Mass. Exec. Off. Hous. & Livable Cmtys. (revised Aug. 17, 2023), https://www.mass.gov/doc/compliance-guidelines-for-multi-family-zoning-districts-under-section-3a-of-the-zoning-act/download [hereinafter Compliance Guidelines].
[3] See id. at 4 (An “MBTA community” is “one of the ‘14 cities and towns’ that initially hosted MBTA service; one of the ‘51 cities and towns’ that also host MBTA service but joined later; other ‘served communities’ that abut a city or town that hosts MBTA service; or a municipality that has been added to the MBTA under G.L. c. 161A, sec. 6 or in accordance with any special law relative to the area constituting the authority.”).
[4] See id. at 1.
[5] See Attorney General v. Town of Milton, et al., SJC No. 13580, slip op. at 6, n.6 (Mass. Jan. 8, 2025).
[6] See Compliance Guidelines, supra note 2, at 1.
[7] See Milton, slip op. at 7.
[8] See id. at 9.
[9] See id. at 18.
[10] See id. (internal citations and quotations omitted).
[11] See Attorney General v. Town of Milton, et al., SJC No. 13580, slip op. at 19 (Mass. Jan. 8, 2025).
[12] See id. at 19-20.
[13] See id. at 19-20.
[14] See id. at 21.
[15] See Milton, slip op. at 21-22 (internal citations and quotations omitted).
[16] See id. at 22.
[17] See Attorney General v. Town of Milton, et al., SJC No. 13580, slip op. at 9 (Mass. Jan. 8, 2025).
[18] See id. at 10-13.
[19] See id. at 9, 14-16.
[20] See id. at 14-15.
Delaware Bankruptcy Court Denies Healthcare Debtors’ Request to Enter into Nonbinding Commitment Letter (US)
The goal of a sale process under section 363 of the United States Bankruptcy Code is for a debtor to maximize the value of estate property for the benefit of all parties-in-interest. But what happens when the only party that is interested in purchasing the estate property is a former insider who is unwilling to submit a binding offer without certain bid protections, such as a breakup fee and expense reimbursement? This is the predicament that the Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) recently faced, ultimately denying such protections without prejudice. The decision serves as a helpful reminder of how debtors should conduct a bidding process, evaluate bids, and what terms interested parties should expect a bankruptcy court to find improper.
Background
Between September 19, 2023, and October 20, 2023, UpHealth Holdings, Inc. and six of its affiliates (collectively, “UpHealth”) filed chapter 11 bankruptcy petitions in the Bankruptcy Court. On July 17, 2024, UpHealth filed a bidding procedures motion to market, auction, and sell its equity interests in a non-debtor subsidiary, TTC Healthcare, Inc. (“TTC”), which provides behavioral inpatient and outpatient treatment programs and was previously referred to as UpHealth’s “crown jewel.” However, UpHealth had no stalking horse bidder for TTC, so it enlisted the help of its investment banker to market TTC’s equity. The Bankruptcy Court approved the bidding procedures motion on August 6, 2024.
NewCo’s Commitment Letter
Unfortunately, despite contacting over 150 prospective buyers and executing 50 non-disclosure agreements, UpHealth only reported one meaningful indication of interest (the “Commitment Letter”) before the September 12, 2024, bid deadline. The Commitment Letter was from a newly organized special purpose acquisition entity (“NewCo”) formed by UpHealth’s former CEO and TTC’s former chairman, Martin S.A. Beck, and Freedom 3 Capital. NewCo proposed to purchase TTC’s equity for a cash purchase price of $11 million.
Unlike a traditional qualified bid to purchase a debtor’s marketed assets under section 363 of the Bankruptcy Code, NewCo’s Commitment Letter was not a binding commitment. Instead, the Commitment Letter stated that NewCo’s “goal is to execute a definitive share purchase agreement,” and contained the following terms:
Exclusivity Period: For up to four weeks after execution of the Commitment Letter, UpHealth and TTC shall not solicit, discuss, negotiate, facilitate any submission of a proposal, or consummate any agreement related to TTC’s equity with any other party other than with NewCo.
Right of First Refusal “ROFR”: NewCo has the right of first refusal related to any competing bid UpHealth receives for TTC’s equity during the Exclusivity Period.
Prior Approval: Before executing any definitive share purchase agreement, Freedom 3 Capital must first obtain final approval from its Investment Committee.
Breakup Fee: $750,000.
Expense Reimbursement: $500,000 cap.
On September 22, 2024, UpHealth filed a supplement to its bidding procedures motion requesting that the Bankruptcy Court authorize UpHealth to enter into, and perform under, the Commitment Letter and for the Commitment Letter to be binding on UpHealth (the “Private Sale Supplement”).
U.S. Trustee’s Objection to Private Sale Supplement
On October 7, 2024, the United States Trustee (the “U.S. Trustee”) objected to the Private Sale Supplement. In its objection, the U.S. Trustee argued that the breakup fee and expense reimbursement are (i) a “poison pill” meant to “chill the bidding process,” (ii) “value-destructive to the estates,” and (iii) “serve as a penalty against [UpHealth] for evaluating any other late materializing interest.” Moreover, the objection cited Third Circuit caselaw in support of the position that breakup fees are only allowable when such fees are “necessary to preserve the value of the estate” and an inducement for a party to negotiate an agreement, conduct due diligence, and submit a bid. In this case, the U.S. Trustee asserted that no such inducement was necessary because (i) the marketing process for TTC’s equity concluded with “no other actionable proposals identified” by UpHealth, and (ii) as TTC’s former chairman and UpHealth’s former CEO, Mr. Beck, “did not need to undertake any due diligence to make a bid, did not need an incentive to make a bid, and does not need expense reimbursement.”
Denial of Private Sale Supplement
At the October 9, 2024 hearing, the Bankruptcy Court denied UpHealth’s proposed Private Sale Supplement. Siding with the U.S. Trustee, the Bankruptcy Court found the breakup fee, expense reimbursement, Exclusivity Period, and ROFR “too rich” for an “uncommitted” indication of interest subject to further diligence.
Specifically, the Bankruptcy Court stated that it had not seen a “no shop” provision, i.e., the Exclusivity Period and ROFR, since the 1980s and did not understand why such provision was necessary. Moreover, the Bankruptcy Court noted that Mr. Beck’s Commitment Letter was “problematic” from a “bankruptcy court systemic perspective,” given Mr. Beck’s status as a former insider. Accordingly, the Bankruptcy Court concluded that UpHealth had not demonstrated that the Commitment Letter’s bid protections were necessary to preserve the value of the estates, declined to approve such protections, and noted that the parties could come back to seek approval of the bid protections after NewCo signs a definitive agreement or there is an alternative transaction.
On November 29, 2024, NewCo notified UpHealth that it was discontinuing its efforts to purchase TTC and no sale of TTC or any portion thereof was consummated, resulting in TTC’s operations being shut down.
Takeaways
This decision demonstrates the limitations of nonbinding bids to purchase estate property. Receiving no offers for assets that were formerly referenced as an estate’s “crown jewel” is disappointing to say the least. Although it is unclear why NewCo’s bid was not binding, it is possible that after a dismal marketing process, Mr. Beck, as TTC’s former chairman, agreed to publicly disclose an indication of interest in the hope of encouraging at least some of the 50 parties that executed non-disclosure agreements to reconsider whether to submit a bid. Not only would a binding bid liquidate one of UpHealth’s remaining assets, but it would also likely produce a public benefit by keeping a treatment facility open for its patients who may not have access to alternative healthcare services. Indeed, the continuation of TCC as a going concern is likely far superior to the alternative—liquidation and reduced healthcare services to the impacted community. As a court of equity, this is likely one factor the Bankruptcy Court considered before denying UpHealth’s requested relief.
Regardless of the parties’ intent, and notwithstanding potential public health benefits, future debtors can take heed that a court will not likely approve the entry of an order allowing a debtor to enter into a nonbinding commitment letter that (i) is contingent on further diligence and third-party approval, (ii) is from a former insider that does not need to conduct diligence, (iii) stems from a bidding process where no party submitted a bid for the assets, and (iv) when the case is over one year old, there is no conceivable need to rush the process, and the parties-in-interest can afford to grant a prospective bidder more time.
Moreover, even if the Commitment Letter had been binding, the Bankruptcy Court took issue with NewCo’s requested bid protections, the Exclusivity Period, and ROFR. First, when requesting bid protections, especially if the bidder is a former insider, the bidder should ensure that the breakup fee and expense reimbursements are arguably “necessary to preserve the value of the estate” and a percentage of the purchase price that aligns with recent comparable sales. Potential bidders and debtors should question whether the protections are necessary on account of the interested party’s diligence and negotiation expenses, or if the party will incur minimal expenses. Furthermore, bidders should be thoughtful before incorporating an Exclusivity Period or ROFR, as such provisions may be scrutinized by a court, especially in the context of a non‑binding bid.
INCARCERTATION STATION: Failing to Respond to TCPA Subpoenas Is Leading to Threats of Jail Time and It is a Little Scary
In Ford v. Glutality, 2025 WL 52850 (W.D. MO Jan. 8, 2024) a lead supplier was sent a subpoena seeking lead records and communications. The supplier apparently failed to adequately respond and the plaintiff moved to compel records.
The Court ordered the production to take place and added a chilling one liner that should be a reminder to everyone of the stakes involved with civil subpoenas:
If Mr. Weiss fails to fully comply with the subpoena, the Court may hold Mr. Weiss in contempt of Court. A finding of contempt may include sanctions, including an award of attorneys’ fees and incarceration.
Incarceration. Eesh.
TCPA is as dangerous as can be folks–even if you are just responding to a subpoena. But jail time is just one risk when responding to a subpoena. Failing to assert proper objections might lead to a needless deposition or an extremely burdensome production that turns your company inside out!
If you receive a subpoena be sure to retain qualified counsel right away to help walk you through the response, assert proper objections and negotiate to prevent making a bigger (and more burdensome) production than necessary.
U.S. Department of Education’s 2024 Title IX Final Rule Addressing Sex-Based Discrimination and Sexual Harassment Vacated
On January 9, 2025, in State of Tennessee v. Cardona, Civil Action No. 2:24-cv-072-DCR, the U.S. District Court for the Eastern District of Kentucky vacated the Title IX Final Rule that was issued by the U.S. Department of Education on April 29, 2024, and became effective August 1, 2024. The ruling appears to apply nationwide.
Quick Hits
The U.S. District Court for the Eastern District of Kentucky vacated the U.S. Department of Education’s 2024 Title IX Final Rule, which had expanded the definition of sex-based harassment to include sexual orientation, gender identity, sex stereotypes, and pregnancy.
The court found that the 2024 Title IX Final Rule violated the First Amendment and the Spending Clause of the United States Constitution, and it exceeded the U.S. Department of Education’s authority under Title IX of the Education Amendments of 1972, which traditionally prohibited only discrimination based on sex as male or female, not gender identity. The court also determined the rule was vague, overbroad, and arbitrary.
The decision concluded that while the plaintiff states and their schools were not required to comply with the 2024 Title IX Final Rule to receive federal funding, they potentially “could violate Title IX in ways unrelated to the Final Rule, which might render them ineligible for federal funding.” The 2020 Title IX Rule remains in place for federal enforcement and investigations by the U.S. Department of Education.
Among other changes, the 2024 Title IX Final Rule expanded the definition of “sex-based harassment” to include harassment based on sex characteristics, sexual orientation, gender identity, sex stereotypes, and pregnancy.
It also changed when a response was required. The Final Rule had already been halted in twenty-six states, as numerous legal actions were filed to enjoin the U.S. Department of Education from enforcing the Final Rule.
The district court’s decision granted summary judgment to six states (the Commonwealth of Kentucky, the Commonwealth of Virginia, the State of Indiana, the State of Ohio, the State of Tennessee, and the State of West Virginia) and two intervenors, who were the plaintiffs, and it denied summary judgment to the defendants, Secretary of Education Miguel Cardona and the U.S. Department of Education.
Each side had moved for summary judgment. The decision rejected the Department of Education’s reliance on Bostock v. Clayton County, Georgia, 590 U.S. 644 (2020), a Supreme Court of the United States decision in which the Court held that Title VII of the Civil Rights Act of 1964 protects employees against discrimination because of sexuality or gender identity. In its decision, the district court noted that Title VII has different language, goals, and defenses than Title IX and described inconsistencies the Final Rule created within Title IX, which allows sex-based separation in various circumstances. Notably, the new rules did not address transgender participation in sports.
The decision holds that the Final Rule and its corresponding regulations:
violated the United States Constitution, specifically the First Amendment and the Spending Clause;
exceeded the U.S. Department of Education’s statutory authority under Title IX, which prohibits discrimination based on sex as male or female, not gender identity;
infringed on the free speech rights of teachers and others by requiring them to use names and pronouns associated with a student’s asserted gender identity or face harassment claims;
were vague and overbroad and did not provide clear notice to the states of the conditions for receiving federal funds under Title IX; and
were arbitrary and capricious under the Administrative Procedure Act.
The decision concluded that the U.S. Department of Education did not provide a reasoned explanation for departing from its long-standing interpretation of Title IX and that it failed to account for the “glaring inconsistencies” and consequences of the Final Rule.
The court vacated the entire Final Rule and its corresponding regulations, and declared that they were unenforceable nationwide. The decision also granted declaratory relief to the plaintiffs, stating that they did not have to comply with the Final Rule to receive federal funding. The decision modified the fourth request for declaratory relief, holding that “it goes too far to affirmatively conclude that the plaintiff-states ‘are entitled to funding irrespective of their compliance with the Rule.’” After noting that “the plaintiff-States potentially could violate Title IX in ways unrelated to the Final Rule, which might render them ineligible for federal funding,” the court stated that “a more accurate way to characterize this declaratory relief is that the Plaintiff States, their political subdivisions, and their recipient schools need not comply with the Rule to receive federal funding.”
The U.S. Department of Education has not yet commented on the decision. For purposes of federal enforcement and investigative actions by the U.S. Department of Education, the 2020 Title IX Rule is still in place.