Investors in Infinity Q Capital Management’s (Infinity Q) funds filed a proposed class action against the firm last week after the fund’s founder was charged with securities fraud and obstruction of justice for allegedly inflating assets by over $1 billion and falsifying records.

The complaint, which was filed last Thursday in the U.S. District Court for the Eastern District of New York, alleges that the hedge fund and mutual fund “lost over 40% of their respective values after a forced liquidation by the SEC” in “one of the most egregious investment fund collapses in history.”[1]

The proposed class of investors accuses Infinity Q, the investment adviser that managed the funds, of manipulating the fund assets’ pricing methodology and overstating the funds’ net asset value (NAV) from 2017 to 2021.[2]  The investors allege that at the same time, Infinity Q intentionally misled investors by providing marketing materials that boasted of the funds’ robust valuation procedures, methodologies, oversight, and controls designed to ensure accurate NAV pricing.[3]

The investors further allege that Infinity Q halted investor redemptions in February 2021, when at least two whistleblowers reported concerns to the SEC about the funds, prompting a formal, ongoing SEC investigation and Infinity Q’s liquidation of the funds’ assets.[4]  “As a result of these egregious acts, the funds’ investors have been unable to withdraw their money from the funds, and investors are still waiting and wondering what amount they will receive from the wreckage as defendants continue to deplete available assets on legal defense costs,” the investors allege.[5]

The investors filed the complaint the day after James Velissaris, founder and former chief investment officer of Infinity Q, was criminally indicted for securities fraud and obstruction of justice.  According to the indictment, Velissaris manipulated the valuations for at least four years, creating results that were not only false but “mathematically impossible.”[6]  The indictment also states that Velissaris endeavored to mask the scheme by lying to auditors and altering term sheets and other documents from counterparties for over-the-counter (OTC) derivative positions so that they would appear to support the inflated values.[7]

On the same day as the indictment, both the SEC and the Commodity Futures Trading Commission (CFTC) charged Velissaris with fraud in parallel civil actions.  The SEC asserts that Velissaris and Infinity Q inflated the funds’ stated valuations by, among other things, manipulating computer code in the valuation models and knowingly entering incorrect inputs in what Velissaris had told investors was an independent third-party pricing service.[8]  Through this conduct, Velissaris materially inflated the mutual fund’s NAVs and the private fund’s total assets while pocketing over $26 million in management fees, according to the SEC.[9]

The SEC further alleges that in doing so, Velissaris deceived investors who likely would have requested redemptions had they known the funds’ actual performance, particularly given the volatility of the market during the COVID-19 pandemic.[10]  Echoing these claims, the CFTC additionally asserts that Velissaris’ “false record of success” allowed Infinity Q to charge inflated fees, induce existing pool participants to further invest, and lure in new investors.[11]

The foregoing court filings collectively seem to suggest that Velissaris and Infinity Q were able to carry out this scheme undetected for years due to the complexity of the “alternative strategies” investments Infinity Q offered.  For example, OTC derivatives, which made up a substantial portion of Infinity Q’s mutual and hedge funds, are contracts between private parties rather than trades effected on a public exchange.  As a result, even when market conditions were stable, investors had scarce opportunity to perform their own valuations or risk analysis, and were thus highly dependent on Infinity Q’s purported expertise and methodologies.  Undoubtedly, the market turmoil driven by the COVID-19 pandemic only increased the uncertainty surrounding these investments.  It thus comes as little surprise that Velissaris may have exploited the “unprecedented market volatility” caused by the pandemic, during which time “the scope and scale of the fraud increased,” according to the CFTC.[12]

The SEC and CFTC seek injunctions, civil monetary penalties, restitution, disgorgement, pre- and post-judgment interest, and bans on trading, registration, and service as an officer or director against Velissaris.  In the proposed class action, the investors seek, among other relief, compensatory damages and rescission for all proposed class members who purchased securities issued by the funds from December 2018 to February 2021.

[1] Schiavi + Company LLC dba Schiavi + Dattani et al. v. Trust for Advised Portfolios et al., No. 1:22-cv-00896 at ¶ 2 (E.D.N.Y. filed February 17, 2022).

[2] Id.

[3] Id. at ¶ 10.

[4] Id. at ¶ 12.

[5] Id. at ¶ 19.

[6] U.S. v. Velissaris, No. 1:22-cr-00105 at ¶ 3 (S.D.N.Y. February 17, 2022).

[7] Id. at ¶ 5.

[8] SEC v. Valissaris, No. 1:22-cv-01345 at ¶¶ 3, 85 (S.D.N.Y. filed February 17, 2022).

[9] Id. at ¶ 12.

[10] Id. at ¶ 6.

[11] CFTC v. Valissaris, No. 1:22-cv-01347 at ¶ 3 (S.D.N.Y. filed February 17, 2022).

[12] Id. at ¶ 1.

New York and Delaware each enjoy an excellent reputation in the business world and typically provide the governing laws and are the jurisdictions of choice in domestic (and many international) commercial contracts. But which law is more likely to uphold the freedom of contract? This blog post analyzes two New York Court of Appeals decisions that, while not newly decided, may shed light on this question.

In a landmark decision from 2015, the New York Court of Appeals in ACE Securities Corp. v. DB Structured Products, Inc., 25 N.Y.3d 581 (N.Y. 2015) (ACE), held that New York’s six-year statute of limitations for claims for breaches of representations and warranties (R&W) in a residential mortgage-backed securities (RMBS) contract accrue when the contractual representations are made (i.e., the closing date of the securitization if the R&Ws concern characteristics of the subject at the time of closing) and not when a sponsor refuses to cure or repurchase the underlying mortgages as was required in the parties’ contract. Id. at 589. Judge Susan Phillips Read, writing for a unanimous Court of Appeals, highlighted the “finality, certainty and predictability” that New York statutes of limitations are designed to foster, even when the result “may at times be harsh and manifestly unfair, and creates an obvious injustice.” Id. at 594 (internal citations and quotations omitted). In ruling in favor of the sponsor, the court found that the sponsor’s obligation to repurchase loans that breached R&Ws was not a substantive condition precedent to filing suit but a remedy that was necessarily “dependent on” and “derivative of” the R&Ws, which “did not survive the closing date” and were breached, if at all, on that date. Id. at 595.

The Court of Appeals was presented with a different, but related, question in 2018. Can commercial parties contractually define when a cause of action for breach of R&Ws accrues? The Court of Appeals answered this question in the negative in Deutsche Bank National Trust Co. v. Flagstar Capital Markets Corp., 32 N.Y.3d 139 (N.Y. 2018). Judge Eugene M. Fahey, writing for the majority, began the opinion by acknowledging that the case before the court “steps into an area of subtle interplay that exists between the freedom to contract and New York public policy.” Id. at 143. The parties had an “accrual clause” in their agreement; the clause conditioned the accrual of a cause of action on demand for compliance with the parties’ agreement. The Court of Appeals disagreed that the contractual language created a substantive condition precedent to suit, and further held that to the extent the parties intended to delay the commencement of the statute of limitations by agreeing when a cause of action “shall accrue,” their attempt to do so was prohibited by New York law and its public policy. Id.

However, not all the judges on the New York Court of Appeals agreed with that decision. Judge Jenny Rivera dissented, stating that she would enforce the accrual clause at issue. Judge Ronan D. Wilson took it a step further when he wrote his own dissent, stating that not only would he enforce the accrual clause at issue, but he would reverse the court’s decision in ACE, which predated his tenure on the court. He reasoned that the New York Court of Appeals in both cases had “fundamentally misinterpreted the structure of RMBS agreements and, as a result, . . . created bad law: bad because it neither hews to the intent of the contracting parties nor of the investors in securities issued thereby; bad because it serves no public policy; bad because it disserves a very important public policy–the preservation of New York’s role as the commercial center of the nation.” Id. at 165. To add insult to injury, he quipped that if he were advising a client, he would tell the client that “the law of Delaware is clear . . . , and the law of New York is not.”

Where does Delaware come into play? Based on a “long line of Delaware decisions follow[ing] hornbook law in treating a contractual accrual provision as a condition precedent to a plaintiff’s ability to sue such that the statute of limitations does not begin to run until the condition precedent is met,” the Delaware Chancery Court enforced an accrual provision in an RMBS contract. Bear Stearns Mortg. Funding Tr. 2006-SL1 v. EMC Mortg. LLC, No. CV 7701-VCL, 2015 WL 139731, at *10-12 (Del. Ch. Jan. 12, 2015). Delaware also amended its law in 2014 to allow parties to a written contract involving at least $100,000 to specify the limitations period for a claim in the contract “provided it is brought prior to the expiration of 20 years from the accruing of the cause of such action.” 10 Del. Code § 8106(c).

One cannot draw a sweeping conclusion about which state more strongly protects freedom of contract based on one narrow issue.  However, Delaware emerges from this particular battle the victor.

Arbitration clauses in commercial and consumer contracts can be an effective tool for limiting the time and expense associated with litigation. However, parties always may decide to litigate, assuming neither party seeks to arbitrate. When one party engages in litigation conduct and only later moves to compel arbitration, the other party may argue that the arbitration right has been waived.

Federal and state courts disagree, however, on the proper standard for determining when a party has waived its right to arbitrate. In particular, courts are divided over whether a party seeking to avoid arbitration must affirmatively show that it has been prejudiced by the opposing party’s delay. Most courts (including the Second and Third Circuits) make prejudice a prerequisite to finding waiver in the arbitration context (thereby furthering the federal policy in favor of arbitration).  However, the Seventh and D.C. Circuits apply a traditional contractual waiver test that looks at whether a party’s litigation conduct is inconsistent with an intent to arbitrate, without regard to prejudice; and the Tenth Circuit applies a less rigid multifactor test, that considers prejudice as one factor among many. As noted in the petition for certiorari filed by the plaintiff in Morgan v. Sundance, Inc., “[t]his question not only divides the federal courts of appeals, but divides federal courts from geographically co-located state courts of last resort … .” The question of what actually constitutes prejudice — in the jurisdictions that consider it — gives way to even greater differences in the standard’s application.

Clarity is on the way, as on Jan. 28, 2022, the Supreme Court scheduled oral argument for March 21, 2022, in Morgan v. Sundance, Inc., No. 21-328, a case that will squarely answer whether a party opposing arbitration on the ground of waiver must prove that it was prejudiced by the other party’s delay. Said another way, the Supreme Court will address whether “the arbitration-specific requirement that the proponent of a contractual waiver defense prove prejudice” violates the Supreme Court’s instruction in AT&T Mobility LLC v. Concepcion, 563 U.S. 333, 339 (2011) that lower courts must “place arbitration agreements on an equal footing with other contracts[.]”

In Morgan v. Sundance, the plaintiff filed a putative Fair Labor Standards Act class action against defendant Sundance, an owner of more than 150 Taco Bell franchise locations, for failure to pay overtime. Sundance initially moved to dismiss Morgan’s complaint, citing the first-to-file rule and claiming that a similar suit filed in another court barred the plaintiff’s action. Approximately four months later, the district court denied Sundance’s motion to dismiss, upon which Sundance answered Morgan’s complaint but did not assert its right to arbitrate. After Sundance answered, Morgan participated in a settlement mediation with plaintiffs from the related case. The mediation did not resolve Morgan’s claims, and nearly eight months after the filing of Morgan’s complaint, Sundance moved to compel arbitration. The district court denied the motion, concluding that by participating in the litigation, Sundance waived its right to arbitration. The Eighth Circuit Court of Appeals reversed, holding that Sundance’s conduct, even if inconsistent with an intent to arbitrate, did not “materially prejudice” Morgan, as Morgan was merely required to respond to a motion to dismiss on a “quasi-jurisdictional issue, not the merits of the case.” Morgan v. Sundance, Inc., 992 F.3d 711 (8th Cir. 2021) (available at

The Supreme Court’s upcoming ruling could make it easier for plaintiffs to argue that a defendant has waived its right to arbitration. For example, if the Court dispenses with the prejudice requirement entirely, a plaintiff will be able to argue a defendant has waived its arbitration right by inconsistent litigation conduct alone, regardless of any impact on the plaintiff. Alternatively, if the Court preserves the prejudice requirement, it could choose to address what litigation conduct actually constitutes prejudice, bringing greater uniformity to waiver analysis across jurisdictions.

Certain class action settlements—like employment and consumer settlements—will very often draw objections from absent class members. But other types of settlements with more sophisticated absent class members—like antitrust and securities—will often draw no objections at all.

Without any objectors, and thus no one contesting approval of the settlement, a district judge with busy docket will sometimes choose to dispense with the formality of a fairness hearing on an uncontested motion for settlement approval.  While more efficient for the court, this approach is problematic under Rule 23(e)(2), which states that “[i]f the proposal would bind class members, the court may approve it only after a hearing . . . .” This requirement originated in the 2003 amendments to Rule 23. The advisory committee note to that amendment explained that the provision “confirms and mandates the already common practice of holding hearings as a part of the process of approving settlement . . . that would bind members of a class.”

To be sure, district courts enjoy “wide latitude” on the scope of a hearing necessary to “reach[] an informed, just and reasoned decision.” UAW v. Gen. Motors Corp., 497 F.3d 615, 635 (6th Cir. 2007) (citation omitted). So if the class notice required written objection as a prerequisite to participation at the fairness hearing, and the court receives no written objections, then a fairness hearing could theoretically be a one-minute exercise in taking appearances, acknowledging the lack of objectors, and accepting the motion for approval for consideration on the papers. As empty as such an exercise may be, Rule 23(e)(2) does appear to require it.

For defense attorneys, a judge’s sua sponte cancellation of a fairness hearing for an uncontested settlement raises practical questions. The trigger for a mandatory fairness hearing is if the settlement “would bind class members.” Could the failure to hold a fairness hearing risk an appeal, a collateral attack on the settlement, or a new action from an absent class member? Or would the failure to object in writing waive such a challenge? And if a failure to object in writing would lead to waiver, then why does Rule 23 require a fairness hearing even when no class members have objected to the proposed settlement?

It does not appear that this issue has ever been litigated. Indeed, it is admittedly improbable that a non-objecting class member would seek to disturb a class settlement post-approval. But defense attorneys seeking to ensure the enforceability of a release may still want to avoid such risk altogether by pushing to ensure that a fairness hearing take place, even if just as a formality. At times, this may include pushing back (or at least making a record) when a judge sua sponte adjourns a fairness hearing over an uncontested application for final approval.

Cross-posted with permission from American Bar Association Class Actions & Derivative Suits Committee Practice Points.

The U.S. House Committee on Financial Services (Committee) met last Wednesday[1] to discuss the rapidly growing cryptocurrency market exchange and the regulatory landscape that currently governs it.

Executives from six major crypto asset companies, including Coinbase and Circle, testified at the hearing, calling for clearer standards and guidance from regulators. Among other things, the witnesses raised concerns about the current regulatory framework used to determine whether digital assets should be regulated as securities under the federal securities laws. They also discussed the need for oversight by a centralized body capable of taking a flexible approach to regulating the crypto assets industry in light of its complex, dynamic nature. Specifically, Coinbase CEO Alesia Haas expressed a need for regulation by “a nimble group that is constantly looking at the changes in crypto.”[2]

The Committee’s hearing memorandum reflects its concern that investments in digital assets are thus “vulnerable to fraud, manipulation, and abuse.”[3] As a result, and “[g]iven the digital asset sector’s growth and evolution, several questions have arisen as to how regulators can ensure investor protections, ensure consumer protections, and maintain market integrity.”[4] Some, but not all, digital market exchanges and issuers have obtained national charters and/or state money transmitter and sale of checks licenses from various states.[5]

The U.S. Securities and Exchange Commission (SEC) has sought to protect investors by requiring the registration and disclosure of any offerings of digital assets that fall under the definition of securities as set forth in the Securities Act of 1933,[6] which encompasses a variety of enumerated terms, including “investment contracts.” Securities are broadly defined under the statute, and courts liberally construe that definition.

To determine whether an offering, including one involving cryptocurrency, constitutes an “investment contract” under the federal securities statute, courts apply the U.S. Supreme Court’s “Howey test.”[7] Under the Howey test, courts analyze whether the offering is (a) an investment of money (b) in a common enterprise and (c) with an expectation of profits to be derived solely from the efforts of others.[8] As the SEC has explained, the Howey test not only requires a fact-specific analysis of “the form and terms of the instrument itself,” but also focuses “on the circumstances surrounding the digital asset [or other instrument or offering] and the manner in which it is offered, sold, or resold.”[9]

Howey, decided in 1946, focused on whether an offering of citrus groves, along with management services, constituted an “investment contract” under the statute.[10]

The SEC has offered some guidance on the application of Howey in the digital asset context but has acknowledged that the outcome of the test depends on the specific facts and circumstances in each case.[11] At Wednesday’s hearing, former U.S. banking regulator and current CEO of bitcoin mining company Bitfury Brian Brooks stated that the uncertain classification of digital assets was “the most important issue in the short-term for the industry.”[12] Brooks emphasized that the Howey test is a “balancing test” rather than a clear rule.[13]

The witnesses also answered questions from the Committee on a range of topics, such as the demographic differences between cryptocurrency investors and investors in traditional instruments and the extent to which the growth of digital assets and decentralized finance can drive financial inclusion and benefit underserved communities.[14] These questions reflect the Committee’s awareness of the potential benefits that the ever-evolving digital asset industry may offer–not only in the United States, but also on a global scale.

[1] Hearings, the U.S. House Committee on Financial Services, (last visited Dec. 10, 2021) (hereinafter, “Hearings”).
[2] Id.
[3] Memorandum: December 8, 2021, Digital Assets and the Future of Finance: Understanding the Challenges and Benefits of Financial Innovation in the United States, 3 (Dec. 3, 2021),
[4] Id. at 1.
[5] Id. at 3.
[6] 15 U.S.C. § 77a et seq.
[7] SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
[8] Id.
[9] Framework for “Investment Contract” Analysis of Digital Assets, SEC, (last modified Apr. 3, 2019) (hereinafter, “Framework”).
[10] 328 U.S. 293.
[11] See Framework.
[12] Hearings.
[13] Id.
[14] Id.

It is an old saw that partners, co-venturers, and insiders to closely held businesses owe fiduciary duties of loyalty and due care when dealing with one another. Importantly, these fiduciary duties modify the common law of fraud by imposing an affirmative duty upon the fiduciary to disclose material facts to the beneficiary, which, if breached, renders a material omission unlawful. But this assumes a commonality of interest in the operation of the business. How do these duties operate when a business partner is negotiating the terms of her exit from the business venture, and especially where the departing partner is asked to provide a general release of all known and unknown claims as part of her exit package? In that situation, the business and the remaining partners have interests at odds with those of the departing partner — the departing partner seeks to maximize her compensation, while the business’s interests are best served by minimizing the compensation paid and securing protection against any future potential liability through the general release. But does that mean the business can remain silent about facts that might have induced the departing partner to demand more money or refuse to sign the release, without violating a fiduciary duty and thereby voiding the release?

The answer is yes, provided that care is taken to be clear that the parties understand and agree that the parties’ interests are adverse and no fiduciary duties are owed in these circumstances.

The New York Court of Appeals has recognized that “[w]here a principal and fiduciary are sophisticated parties engaged in negotiations to terminate their relationship … the principal cannot blindly trust the fiduciary’s assertions” or rely on the fiduciary to disclose every particular fact about a transaction. Centro Empresarial Cempresa S.A. v. America Movil, S.A.B. de C.V.,17 N.Y.3d 269, 279 (2011). Rather, “[a] sophisticated principal is able to release its fiduciary from claims — at least where … the fiduciary relationship is no longer one of unquestioning trust — so long as the principal understands that the fiduciary is acting in its own interest and the release is knowingly entered into.” Id. at 278. As the First Department put it, to hold otherwise would effectively conclude that “a fiduciary can never obtain a valid release without first making a full confession of its sins to the releaser, a proposition that has never been the law.” Arfa v. Zamir, 76 A.D.3d 56, 60–61 (1st Dep’t 2010).

While nothing will preclude a departing partner from later seeking to renegotiate the terms of her separation or vitiate a complete release of claims on grounds that the business failed to disclose important facts in violation of its fiduciary duties, businesses can take steps to ensure maximum protection under Centro and its progeny. A business is well-advised to add provisions into the separation agreement with the departing partner to make clear (i) that everyone understands and agrees that the departing partner and the business are acting in their own separate interests with respect to the separation, (ii) the departing partner has had an opportunity to separately secure whatever legal, financial, or other counsel she feels necessary to advise her on the terms of separation, and that she is not looking to the business for such guidance or advice, and (iii) it is expressly understood and agreed that the business does not stand in fiduciary relationship to the departing partner with respect to the negotiation of the terms of separation or of the release.

Inspection rights in a partnership agreement are frequently ignored until a dispute arises. And by that time, a limited partner’s degree of access may make the difference as to whether a lawsuit is ultimately filed.

Section 17-305 of the Delaware Revised Uniform Limited Partnership Act , 6 Del. C. § 17-101, et seq. (“DRULPA” or the “Act”), grants a limited partner of a Delaware limited partnership the right to demand access to the partnership’s books and records in a summary proceeding analogous to a shareholder’s right to bring a § 220 action. See Del. C. § 220. While Delaware law is clear that a limited partner’s inspection right is not without bounds, it is less clear to what extent it may be contractually limited and, more importantly, whether a limited partner can contract away their information rights entirely.

Section 17-305(a) provides that a limited partner’s right to access information may be “subject to such reasonable standards (including standards governing what information (including books, records and other documents) is to be furnished, at what time and location, and at whose expense) as may be set forth in the partnership agreement.” Delaware courts have held that such reasonable standards should not be used to “deny completely a right granted in the Partnership Agreement,” Parkcentral Glob., L.P. v. Brown Inv. Mgmt., L.P., 1 A.3d 291, 296 (Del. 2010), and that a limited partnership’s adoption of “reasonable standards” should not “substantively reduce the [statutory] right itself.” Madison Ave. Inv. Partners, LLC v. Am. First Real Est. Inv. Partners, L.P., 806 A.2d 165, 171-72 (Del. Ch. 2002).

In 2001, subsection (f) was added to Section 17-305, providing a new avenue for limited partnerships to restrict information rights. That subsection provides: “The rights of a limited partner to obtain information as provided in this section may be expanded or restricted in an original partnership agreement . . .” The stated purpose for adding this subsection was “to permit a partnership agreement to further restrict the rights of a limited partner to obtain information.”  73 Del. Laws, c. 73, § 20 (2001). The legislative history does not address, however, whether a partnership agreement can waive entirely a limited partner’s information rights under the Act.

There are few Delaware cases interpreting Section 17-305 and even fewer that post-date the addition of subsection (f). And no case has considered whether the newly added section permits a wholesale elimination of a limited partner’s statutory information rights. However, there is support for the position that such rights cannot be completely disclaimed in a partnership agreement.

First, Delaware courts have defined the word “restrict” to mean “to restrain within bounds; to limit; to confine.” State ex rel. Lucey et al. v. Terry, 196 A. 163, 167 (Del. Super. 1937). Thus, a natural reading of the word restrict would suggest only limitation, not wholesale elimination of a right. Indeed, a different section of the DRULPA, dealing with fiduciary duties, expressly provides that limited partnership agreements may contractually “expand, restrict, or eliminate any fiduciary duties that a person may owe[,]” 6 Del. C. § 17-1101(d), suggesting that if the legislature intended to permit complete eradication of such information rights in a partnership agreement, they would have added the word “eliminate” to subsection (f). Additionally, the Delaware Chancery Court, in interpreting Section 18-305 of the Delaware Limited Liability Company Act (the analogue to § 17-305 for LLCs), which contains similar language to Section 17-305, determined that Section 18-305 “allows ‘reasonable’ modification of inspection rights[,]” as opposed to total waiver of such rights. Durham v. Grapetree, LLC, No. CV 2018-0174-SG, 2019 WL 413589, at *2 (Del. Ch. Jan. 31, 2019). On the flip side, there is also support for the notion that a partnership agreement can deny access to items to which a limited partner is specifically entitled by statute. See Parkcentral Global, L.P., 1 A.3d at 296 (suggesting that under § 17-305(f), parties can fully eliminate access to certain categories of information to which limited partners are statutorily entitled, such as the names and addresses of partners).

Given the uncertainty over whether, and to what extent, a limited partner can contractually waive their right to information in the partnership agreement, any analysis of a demand for information must include reference to the statute, as well as the relevant partnership agreement, to determine whether the agreement incorporates, expands upon, or disclaims (in whole or in part) the rights available under the Act. Moreover, because a limited partner’s inspection rights can be an important tool for conducting pre-suit discovery, extra consideration should be given to the language used in a limited partnership agreement to define the scope of such a right.

In a recent published decision, the United States Court of Appeals for the Third Circuit clarified the standards that district courts must apply when certifying discrete issues–rather than an entire action–for classwide adjudication under Rule 23(c)(4).

What Is Rule 23(c)(4)?

Rule 23(c)(4) is an obscure part of federal class action practice. It states, simply, “When appropriate, an action may be brought or maintained as a class action with respect to particular issues.”

Because the rule (and its commentary) provide so little guidance, courts have had to fill the gap with criteria for issue certification. The Fifth Circuit, for example, has adopted a narrow holding that issue-class certification is appropriate only when a plaintiff shows that a court should certify an entire action as a class, reasoning that Rule 23(c)(4) “is a housekeeping rule that allows courts to sever the common issues for a class trial.”

But most circuits have rejected this approach and found that issue certification may be appropriate even if full Rule 23(b) certification is impossible. For example, the Sixth Circuit has said that issue-class certification is proper “where common questions predominate within certain issues and where class treatment of those issues is the superior method of resolution.”

The Third Circuit’s Latest Rule 23(c)(4) Decision

The recent case before the Third Circuit–Russell v. Educational Commission for Foreign Medical Graduates–involved a Pennsylvania nonprofit organization that certifies foreign medical school graduates for United States medical-residency programs. The organization certified a particular doctor despite having suspicions that he had misrepresented his identity on his applications. Law enforcement eventually arrested the doctor for possessing fraudulent or altered immigration documents, medical diplomas, medical transcripts, letters of recommendation, and birth certificates. He pleaded guilty to using a fraudulent Social Security number to obtain a medical license.

Following the doctor’s guilty plea, two former patients of the doctor sued the organization that signed off on his participation in a residency program, alleging negligent infliction of emotional distress. The plaintiffs brought their claims as a putative class action on behalf of all the doctor’s former patients.

Because there were clear individualized issues of injury, causation, and damages, the district court could not certify the class for full adjudication. But it did find that issues of duty and breach could be decided as to the entire class under Rule 23(c)(4), with injury, causation, and damages reserved for individual proceedings.

Addressing the issue-class certification in the case before it, the Third Circuit (in an opinion written by Judge Restrepo and joined by Judges Bibas and Porter) held that the district court abused its discretion when certifying the duty-and-breach issue class.

The Circuit held that a court resolving a motion to certify an issue class must make three determinations:

(1) Whether the proposed issue class satisfies Rule 23(a)’s numerosity, commonality, typicality, and adequacy requirements;

(2) Whether the proposed issue class “fit[s] within one of Rule 23(b)’s categories”; and

(3) Whether it is “appropriate” to certify these issues as a class.

Applying this standard, the Third Circuit reversed for two reasons. First, the Circuit found that the district court abused its discretion by failing to analyze whether the duty and breach elements satisfied Rule 23(b)(3). Second, the Circuit also held that the district court abused its discretion by certifying a class without considering all nine issue certification factors that the Court had earlier announced in Gates v. Rohm and Haas Co.

Although the Third Circuit vacated the district court’s class certification order, it explicitly declined to adopt the Fifth Circuit’s rule that issue classes are appropriate only when an entire case is suitable for class certification.

Practical Considerations for Rule 23(c)(4)

Rule 23(c)(4) has been on the books for more than 50 years, but only recently have plaintiffs’ attorneys started paying attention to it as an alternative to traditional class certification. As more circuits weigh in, it is likely to garner more attention and attract putative class actions that attorneys might not have considered traditionally strong candidates for classwide adjudication. In particular, claims that have clear individualized injury, causation, and damages questions might now find new life as issue-class cases.

Because the question has never been before the Supreme Court, each circuit’s law has different and important variations in how to analyze motions for issue-class certification. Companies and practitioners should be familiar with their home Circuit’s requirements when assessing a putative class action’s changes at certification.

In the wake of COVID-19, litigants have increasingly sought to excuse contractual performance by invoking force majeure clauses. In the early stages of the pandemic, there were few reported decisions on these matters, and the substance of these rulings echoed the principles that were applied in the pre-COVID era: force majeure clauses are strictly and narrowly construed. See, e.g., Lantino v. Clay LLC, 2020 WL 2239957, (S.D.N.Y. May 8, 2020) (rejecting a gym owner’s force majeure/impossibility argument that COVID-19 and the state’s shutdown order destroyed his business and ability to pay because the gym owner established financial difficulty but not a set of circumstances that made performance genuinely impossible).

Other recent opinions, however, have trended toward a more lenient standard. See, e.g., In re Hitz Restaurant Group, No. BR 20 B 05012, 2020 WL 2924523 (Bankr. N.D. Ill. June 3, 2020) (excusing a restaurant owner and tenant’s performance under a lease due to force majeure where the owner argued that Illinois’ stay-at-home order precluded performance and the language in the lease’s force majeure clause that explicitly mentioned “laws and other government action”); Richards Clearview, LLC. v. Bed Bath & Beyond, Inc., 2020 WL 5229494 (E.D. La. September 2, 2020) (excusing a tenant’s failure to pay rent on force majeure grounds, even though the operative force majeure clause did not mention pandemics, COVID-19, or related government shutdowns).

Still, the varying authority on this topic has left litigants uncertain regarding whether they have a viable force majeure argument. But a recent opinion from the Eastern District of New York — Banco Santander (Brasil), S.A. v. American Airlines Inc., No. 20CV3098RPKRER, 2021 WL 4820646, at *3 (E.D.N.Y. October 15, 2021) — suggests that a related argument, “frustration of purpose,” may carry the day, even though it is based on the same facts and circumstances as an unsuccessful force majeure argument.

In Banco Santander, when the COVID-19 pandemic struck, American Airlines (“American”) suspended flights between Brazil and the United States. Prior to the pandemic, however, Banco Santander (“the Bank”) contracted with American to offer a credit card program, co-branded with American. Under the terms of the contract, cardholders would earn miles with their purchases, and the Bank would, in turn, pay American for those miles. But the Bank was required to purchase a minimum number of miles each year — regardless of how many miles cardholders would earn through their spending.

Because of the pandemic, the Bank sought to terminate the contract due to a force majeure event, and, in the alternative, the Bank argued that it should be excused from performance based on the common-law doctrine of frustration of purpose. The Court gave short shrift to the Bank’s force majeure argument. Particularly, it held that while the pandemic could, in theory, qualify as a force majeure event, the parties’ contract foreclosed the application of the doctrine to American because the force majeure provision applied only if American “delays performance or fails to perform due to a Force Majeure Event” for at least 90 days. However, the contract did not state that flying between Brazil and the United States was among the duties expressly assumed by American. Thus, the Bank’s force majeure argument was rejected.

Nonetheless, the Court refused to dismiss the Bank’s claim for frustration of purpose. The Court explained that under New York law, the frustration-of-purpose doctrine permits a party to stop performing under a contract when a “wholly unforeseeable event renders the contract valueless” to that party. Axginc Corp. v. Plaza Automall, Ltd., 759 F. App’x 26, 29 (2d Cir. 2018); cf. PPF Safeguard, LLC v. BCR Safeguard Holding, LLC, 85 A.D.3d 506, 508 (N.Y. App. Div. 2011) (frustration of purpose applies when “a change in circumstances makes one party’s performance virtually worthless to the other, frustrating his purpose in making the contract”). To that end, the Bank essentially realleged its force majeure argument — that the COVID-19 pandemic was an event unforeseen by the parties that both disrupted all air travel worldwide and led American to cease all air travel between the United States and Brazil. The Bank further claimed that the pandemic had a “fundamental” impact on the desirability of air travel between the United States and Brazil because it led to government travel restrictions, reductions in airline capacity, and a general reluctance to travel. Thus, the Bank concluded that the consequences of the unforeseeable global pandemic rendered the contract valueless to the Bank.

Notably, in refusing to dismiss the Bank’s claim, the Court explained that:

[F]airly read, the complaint argues that a confluence of factors stemming from the COVID-19 pandemic rendered the contract valueless — including not just the suspension of flights, Compl. ¶¶ 47-48, but also a broader decimation of air-travel demand, id. ¶ 49. Even if one link in the chain of events on which the bank relies was foreseen by the parties — the suspension of flights — it would be inappropriate to dismiss a frustration-of-purpose claim that also relies in substantial inm part on other, assertedly [sic] unprecedented events.

2021 WL 4820646, at *5. The Court then held that these are plausible factual issues that were not appropriate to resolve on a motion to dismiss.

There are several takeaways from this holding and the evolution of force majeure litigation in a post-pandemic era:

  • Careful attention should be paid to the evolving force majeure/COVID jurisprudence in the relevant jurisdiction.
  • Practitioners should be mindful of both (i) a contract’s force majeure language (namely, whether it identifies COVID-19, pandemics, or government shutdown orders as force majeure events) and (ii) the particular facts and circumstances that led to a client’s frustrated performance, with the understanding that some courts may require a thorough argument demonstrating that performance was not merely frustrated but impossible.
  • Despite the uncertainty of successful force majeure arguments, however, practitioners should consider arguing the common law doctrine of frustration of purpose as an alternative form of relief, as the same facts that constitute an unsuccessful force majeure argument may nonetheless state a viable frustration-of-purpose claim.

The common train of thought when litigating as an out-of-state defendant is that it is best to be venued in federal court so as to eliminate any advantage an in-state plaintiff might have with a local jury. Typically, foreign companies will seek to remove state court actions filed by local plaintiffs to federal court under 28 U.S.C. § 1332 on the basis that there is diversity of citizenship between the parties–i.e., the parties on opposite sides of the lawsuit are citizens of different states. But what happens when a local stakeholder sues a limited liability company (LLC) in which he or she has an interest that neither was formed nor operates in the forum?

While at first glance there would appear to be diversity of citizenship between the parties, the unique character of LLCs necessitates further analysis. Unlike corporations, which are considered citizens of the state where they are incorporated and the state where they maintain their principal place of business, LLCs, and other unincorporated entities, are considered citizens of every state where their members reside. Thus, when an LLC member names the company itself as one of several defendants in a lawsuit, there may not be grounds for removal because “diversity jurisdiction in a suit by or against [an unincorporated] entity depends on the citizenship of all the members.” Carden v. Arkoma Assocs., 494 U.S. 185, 195 (1990) (internal quotation mark omitted).  The plaintiff member’s residence would supply the state of citizenship for both him/herself and the company.

At present, the U.S. Supreme Court has not weighed in on the analysis to be applied when an LLC member and the company are on opposite sides of a lawsuit and diversity jurisdiction is challenged. District courts, however, have applied a “nominal defendant” test when evaluating whether complete diversity exists. That is, a court will decide whether the LLC’s presence impacts the jurisdictional analysis by examining whether the company is essential to the lawsuit. Under this test, the company’s citizenship will be evaluated if the plaintiff member has an independent cause of action against the company. If, on the other hand, the member is really asserting claims against the LLC’s other interest holders and the company was named in the lawsuit purely for the purpose of affecting any remedy granted to the plaintiff member, the company’s presence does not factor into the citizenship analysis. See, e.g., S. Lavon Evans, Jr. Drilling Venture, LLC v. Laredo Energy Holdings, LLC, No. 2:11-CV-12, 2011 WL 1104150 (S.D. Miss. Mar. 23, 2011); J2 Enterprises, LLC v. Fields, No. CIV-14-781, 2014 WL 4957300 (W.D. Okla. Oct. 3, 2014); Kroupa v. Garbus, 583 F. Supp. 2d 949 (N.D. Ill. 2008).

Rather than risk ending up locked in an unfavorable state court due to the absence of federal jurisdiction, LLCs can, to a certain degree, preempt the issue by including broad forum selection clauses in their operating agreements. Thus, by contract, an LLC can control where its members file lawsuits relating to company operations.  Li v., LLC, No. CV 2019-0026-JTL, 2019 WL 1792307 (Del. Ch. Apr. 24, 2019); KTV Media Int’l, Inc. v. Galaxy Grp., LA LLC, 812 F. Supp. 2d 377 (S.D.N.Y. 2011); Marth v. Innomark Commc’ns LLC, No. CV 16-8136, 2017 WL 3081684 (C.D. Cal. Apr. 19, 2017).  And even though the forum selection clause itself will not create diversity jurisdiction to provide an avenue into federal court (which depends on the citizenship of the company’s members), the company can use the clause to select a favorable or neutral state for resolving company disputes—for example, the state under whose laws the LLC was formed.