Banking and Financial Services Update, Vol. 8, Winter 2011


In this issue:

  • As Sure as Death and Taxes: Litigation Holds in the Modern Era
  • In the Wake of Dodd-Frank, Lenders Modifying Credit Agreement Language to Pass Compliance Costs to Corporate Borrowers
  • Protect Yourself: Lessons for Lenders from the Tennessee Supreme Court
  • Save the Date: Seventh Annual Southeastern Banking Seminar

As Sure as Death and Taxes: Litigation Holds in the Modern Era

By: Carol Owen

Modern technology has blessed today's financial services institutions with the ability to store vast amounts of detailed information at low cost. It has also cursed them with burdens of document retention and production that make one long for the days of carbon paper, short-hand dictation, and the IBM Selectric. Four years ago, amendments to the Federal Rules of Civil Procedure brought "litigation holds" out of obscurity and onto center stage for every piece of litigation – as well as threatened  or anticipated litigation – for every financial services institution. Many institutions have noted that litigation holds, which include corporate documents, email, voicemail and backup systems among others, are so expensive and onerous that they materially impact budgets and create uncertainty and unrest among those charged with implementing them. These concerns are valid and have been keenly felt in this era when the public's impression, fueled by the plaintiff's bar, is that the retention and production of electronic documents can occur "with the push of a button."

Corporate counsel, however, know that financial and human resources can be drained by the implementation of litigation holds, which are required frequently and expansively in large institutions. We also know that these concerns can be allayed with proper proactive measures. Accordingly, we have focused recent efforts on how to reduce the initial burden of implementing a document hold, as well as on how to protect our clients from suffering the consequences of failing to do so. Meeting these challenges requires an understanding of both the public policy goals and the pragmatic concerns involved.

As for the policy goals, courts became concerned, as inexpensive electronic storage capacity grew (and came to replace hard-copy records), that corporate defendants would engage in wholesale destruction of troublesome documents and thus eviscerate plaintiffs' ability to prove meritorious cases. For that reason, the Federal Rules evolved to require such defendants to affirmatively anticipate disputes, to identify the locations and custodians of electronic records related to such disputes (which can include corporate email accounts, personal email accounts, voicemail records, accessible back-up systems, and legacy systems); to send a specifically tailored hold notice to employees with such records; and to suspend routine destruction policies, including auto-delete features. These steps were viewed as a reasonable burden to impose upon corporate litigants, in order to promote the ends of justice.

On the pragmatic side, courts measure defendants' adherence to this goal by determining whether a plaintiff can prove that: (1) documents responsive to a valid discovery request were destroyed or altered; (2) the defendant was under a duty to preserve them at the time they were destroyed or altered; (3) the defendant had a "culpable state of mind" in failing to preserve the documents; and (4) the documents in question were "relevant" to the claims or defenses of the parties. This test typically arises when a plaintiff asks the court to sanction a defendant because the defendant has failed to meet its obligations to preserve documents and thus has "spoliated" them.

If the court finds a defendant has done so, the court may penalize the defendant by excluding some of the defendant's evidence or by instructing the jury to draw an adverse inference based on the spoliation. Where a court finds that a defendant willfully destroyed key documents or was grossly negligent in failing to preserve them, the plaintiff may win a default judgment. Emboldened by this express lane to victory, the plaintiff's bar now actively uses spoliation motions to extract settlement concessions and to place defendants in a bad light with courts, hoping to affect the outcome of the case. In light of this trend, corporate citizens must become familiar with how to craft, issue, and maintain an effective litigation hold in a cost-effective manner. Our guidance on this includes these steps:

  • Adopt a written retention policy and educate all employees about it. For each category of documents that would predictably exist within your company, the policy should explain what records are to be retained, by whom, and for how long. To capture documents outside these categories, the policy should include a catch-all provision setting forth the decision-making process or principles for retention. Existence of such a policy is a factor showing reasonableness and good faith in meeting preservation obligations.
  • Be sure your electronic controls conform to this policy. Sophisticated software providers are aware of the demands of modern litigation, and they have created systems that allow for the automatic retention or deletion of electronic records. Work with your IT professionals to be sure they understand the written retention policy and can implement a litigation hold that complies with the policy when a hold is issued. Email accounts are now routinely the subject of discovery requests, and defendants must anticipate this. This means that the "auto-delete" feature that may routinely be running on your system may need to be suspended for certain users – or that you may need to "ghost" their email accounts in order to preserve their email accounts as they existed at a certain date.
  • Know when to issue a hold. The Rules require defendants to do so when they "reasonably anticipate" litigation. "Reasonable anticipation" occurs when the organization is on notice of a credible threat that it may be sued or when it anticipates it will initiate litigation. Plan to issue the hold as soon as the dispute has been identified and described with particularity (by counsel in conjunction with a corporate representative knowledgeable of the facts), and as soon as an initial list of persons subject to the hold can be developed.
  • Know to whom a hold should be issued. When the appropriate decision-maker becomes aware of potential litigation, he or she should immediately seek to identify those persons likely to have relevant information. They will need to receive a written litigation hold as soon as one of the appropriate scope can be drafted. Some courts require that notices be given to third-parties in possession of documents that are likely to be relevant; the best practice based on recent court decisions is to send a hold notice to those third-parties so that you have taken steps to ensure preservation of documents in their possession that would otherwise be subject to auto-delete processes or document destruction policies.
  • Establish a reporting procedure. To ensure that budding disputes come to the attention of the appropriate decision-makers, establish a procedure so that employees can report information they may have about a potential dispute. This too is a factor courts consider when determining whether a litigant took reasonable measures to preserve documents.
  • Understand the proper scope of a hold. A well-crafted hold clearly defines the nature of the information to be preserved and the steps required to preserve it. "Information to be preserved" means, broadly, information that may be "relevant" to the facts underlying the dispute. Accordingly, the litigation hold should describe the dispute with enough specificity so that its recipients can readily identify the information in question or know to seek clarification. Thus, the hold is likely to include the date range of relevant events, key players involved, and a description of the nature of the dispute (employment discrimination? loan agreement? slip and fall?). It should be tailored narrowly enough to be specific, yet broad enough so that a court would find it calculated to preserve documents that an opposing party would expect to obtain in discovery.
  • Conduct a reasonable investigation when a dispute emerges. It is impossible to know what information might be relevant to a dispute if you have not explored its parameters. You must take steps to determine who has likely been involved in the situation and what they know about it. If resources permit, this investigation should be conducted by counsel so that written reports of it are protected by attorney-client privilege and the work product doctrine.
  • Review, revise, and re-circulate the hold as the dispute evolves. Few lawsuits look, at their conclusion, exactly as they looked at the outset. Surprise witnesses surface, complaints are amended, new allegations emerge in the course of discovery. To address this, the best practice requires adopting a policy that provides for the review of all litigation holds a company has in place, both periodically and upon key events such as the addition of a party or claim. If the facts have changed, the original hold may need to be modified, and the list of recipients may need to be revised.
  • Prepare to resume normal destruction procedures. Once a dispute is resolved or the threat of litigation dissipates, the duty to retain documents ends. Your litigation hold policy should provide for informing hold recipients that they no longer need to retain documents – and it should also inform them of any duty to destroy documents that results from the end of the hold. IT personnel should be informed that the dispute has ended so that they can reinstitute auto-delete features or other destruction procedures. It is important to act promptly to accomplish these ends, as litigation sometimes reemerges. If the documents have not been destroyed, then a new hold must be instituted.

In an ideal world, none of these steps would be necessary. Borrowers would never default, employees would never be terminated, and shareholders would never complain about officers and directors. That world is not our world. On the contrary, today's financial services industry faces ongoing litigation threats ranging from the trivial to the profound, and industry practices must evolve to reflect courts' expectations. By taking proactive measures such as those outlined above, corporate defendants can avoid severe sanctions such as default judgment, and they can diminish the possibility of lesser sanctions. These measures will not eliminate the costs associated with litigation, but they will minimize them. And sometimes minimizing risk while avoiding cost is all that one can ask in the modern era. There's just no going back to the Selectric.

In the Wake of Dodd-Frank, Lenders Modifying Credit Agreement Language to Pass Compliance Costs to Corporate Borrowers

By: Jason Shields

Following the July 2010 enactment of the Dodd-Frank financial services reform legislation, corporate lenders have begun modifying their credit agreements in an effort to pass the increased costs associated with regulatory compliance to corporate borrowers. The Loan Syndications and Trading Association, a nonprofit industry group that develops loan market practice standards, plans to issue guidelines under which lenders can require borrowers to pay for costs incurred as a result of the Dodd-Frank legislation (or other rules or guidelines issued in connection with the financial services reform law) regardless of the date when the change in law occurs. This move reflects banks' general uncertainty of the impact of the implementation of Dodd-Frank and how it will affect the costs of lending. Traditionally, lenders have included an "increased-cost" provision in credit agreements for situations in which laws or rules changed after a loan agreement was signed. The most recent "increased-cost" language in recent publicly filed credit agreements provides, expressly, that the Dodd-Frank law and all laws issued in connection with the reform legislation are deemed a "change of law" regardless of the date enacted. The modified credit agreement language makes it the responsibility of the borrower to pay any additional costs that result from the legislation. While some borrowers have recently accepted the inclusion of the modified language, not all borrowers have been willing to accept these provisions. Industry observers warn that lenders in certain situations could risk losing commercial loan business to competitors by pushing the modified language too aggressively.

Protect Yourself: Lessons for Lenders from the Tennessee Supreme Court

By: Michael Harmon

No one is sure how much of a crunch small business lending saw in the past two-and-a-half years. Different definitions of "small business" give us different numbers. The one thing we do know is that small business lending has changed, and in fundamental ways. Lenders are requiring more capital, more assurances and more protection. In a moment of truth, most lenders will admit that this is not best for the economy because the more restrictive small business' access to capital, the less the economy will grow. There must be a balance, but this balance is difficult to strike as lenders struggle with what protections are available and what protections they should seek.

Although it does not provide all of the answers, a recent Tennessee Supreme Court case, Sanford v. Waugh, 2010 WL 5139496 (Tenn. Dec. 17, 2010), provides lenders with good information about the protections Tennessee law provides in the event of the insolvency of a small business. The Sanford case dealt with the narrow question of whether an individual creditor of a closely held corporation could assert a direct, as opposed to derivative, cause of action for breach of fiduciary duty against a member of the board of directors of a closely-held corporation when the corporation became insolvent. In reaching its decision that no direct cause of action was available, the Court outlined for lenders the protections they can expect in the event of insolvency and emphasized the need to address the protections sought at the beginning of a relationship with a borrower.

Factual Background of the Sanford case

In the mid-nineties, Michael Sanford and Bruce Prow formed a company called SecureOne that sold and serviced security systems. A dispute developed between the two, and Mr. Sanford sold his interest in the company to Mr. Prow and his wife. Under the terms of the sale, Mr. Sanford received a note for $2 million. With this note, which was at the center of the Sanford decision, Mr. Sanford become a creditor of SecureOne.

In early 2004, SecureOne began to wind down its operations. The company ultimately defaulted on Mr. Sanford's note. Mr. Sanford sued Troy and Carol Waugh, Mr. Prow's in-laws who were also directors and creditors of SecureOne. In his suit against the Waughs, Mr. Sanford brought multiple claims including a "direct" claim against the Waughs in their capacity as directors of SecureOne for purported breach of fiduciary duties. Any recovery under a direct claim would have gone directly to Mr. Sanford whereas recovery under a derivative claim would have gone to the corporation, SecureOne, and may not have ultimately inured to Mr. Sanford. Although Tennessee law recognizes a derivative cause of action for breach of fiduciary duty brought by a creditor against a director of an insolvent corporation, Tennessee law had not recognized any direct cause of action in a similar situation.

The Tennessee Supreme Court's Decision

The Tennessee Supreme Court determined that allowing direct causes of action like the one Mr. Sanford sought would cause more harm than good, especially given the protections that individual creditors already have under Tennessee law. The Tennessee Supreme Court noted that creditors are: (1) able to protect their interest through loan and security agreements before lending money to any firm, (2) protected by federal bankruptcy law in the case of an insolvent corporation, (3) protected by the "trust fund doctrine," (4) have a right to bring a derivative claim in certain instances and (5) can bring certain direct claims against a director, just not a claim for breach of fiduciary duty.

The first two protections are well known to most, but it is worth noting that the Tennessee Supreme Court emphasized that loan contracts provide the lion share of the protection needed by any lender, so long as the contracts are properly drafted. Many lenders take their loan contracts for granted because form contracts provide the protection needed in most instances. Each loan is a unique agreement between a borrower and a lender that has it own idiosyncrasies. It never hurts to look at the contracts for each substantial loan because it is the idiosyncrasies of a borrower that can make a difference. As the Tennessee Supreme Court noted, the time to address the complete relationship between a lender and a borrower, including what will happen in the event of insolvency, is during the creation of the loan contract, not when insolvency rears its head. Federal bankruptcy law provides the framework for distributions of assets, and any distribution is influenced by the protections a lender receives in its loan contracts.

The last three protections are designed to protect a lender from actions taken at the end of a company's life. The trust fund doctrine holds that any shareholders to whom assets of an insolvent corporation were transferred can be liable to creditors when the corporation is dissolved. If a director harms the corporation by breaching his or her fiduciary duties, a creditor of an insolvent corporation may attempt to step into the shoes of the corporation and seek recovery on behalf of the corporation through a derivative cause of action. And of course, if a director of a corporation commits a tort directly against a creditor, then the creditor may seek recovery directly from the director. These three protections, though rarely used, can be powerful when available.

At first blush, a case about whether a creditor can be bring a direct action for breach of fiduciary duty may not seem that important to a lender. But in reaching its decision, the Sanford Court laid out the five protections every lender should remember when entering into a loan agreement. The role these five protections play in how a loan agreement should be structured depends on the circumstances of each loan relationship, and each loan relationship should be developed with these protections in mind.

Save the Date: Seventh Annual Southeastern Banking Seminar

Mark your calendar now for Friday, August 19, 2011, when Waller Lansden hosts the Seventh Annual Southeastern Banking Seminar. This complimentary program will once again feature insightful presentations on timely topics and emerging issues for banks and financial institutions. A detailed agenda will be published soon, but please make plans now to join us on August 19th. For additional information or to register for the Southeastern Banking Seminar, please contact Ruth Freeland at Waller Lansden via email or by calling 615-850-8502.