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Aug. 2013

August 2013
From the Colorado Bar Association
Business Law Section

Ed Naylor, Editor
In this issue...

Vicarious Liability for Fraud and Embezzlement and Imputed Non-Dischargeable Debt

Michael J. Guyerson, Esq., Onsager, Staelin & Guyerson, LLC

In her recent to-be-published decision in Chenaille v. Palilla, (In Re Palilla), Adv. Proc. No. 12-1092-EEB, 2013 WL 3327327 (Bkrtcy. D. Colo. May 28, 2013), the Honorable Elizabeth E. Brown of the United States Bankruptcy Court for the District of Colorado ruled that one partner’s embezzlement conduct and the damages caused thereby can be imputed to his innocent partner, resulting in a non-dischargeable debt in the subsequently filed innocent partner’s bankruptcy proceeding.

Relying upon the Colorado Uniform Partnership Act’s C.R.S. §7-64-305(1), which in her view codifies a partner’s vicarious liability for the misapplication or theft of funds committed by another, and the United States Supreme Court decision in Strang v. Bradner, 114 U.S. 55, 561 (1885), Judge Brown found ample support for the proposition that vicarious liability for embezzlement of funds by one partner creates a non-dischargeable debt under 11 U.S.C. § 523(a)(4) in the innocent partner’s subsequent bankruptcy proceeding. (Slip opinion at p.4–6.) The case is also of note in that the partnership was found to exist even though no written partnership agreement existed. Judge Brown relied upon In Re S & D Foods, Inc. 144 B.R. 121, 158 (Bankr. D. Colo. 1992), a case also notable because of the $11.4 million dollar fraud and breach of partnership agreement verdict returned by the Bankruptcy Court in that adversary proceeding, one of the largest ever returned by a Colorado Bankruptcy Court.

The Palilla case involves a rather infamous business called Autohut which was a consignment auto sales business located in Englewood. Autohut was to charge a $500 commission on each consigned car sold, and deliver title to the buyer on behalf of the seller and the cash sales proceeds to the seller. The Plaintiff in the adversary case had made a $6,400.00 down payment on a vehicle but never received the title. A police investigation found multiple instances of parties either not receiving clear title or the sales payments to which they were entitled. In the end, an investigation concluded that one of the partners, Andrews, was engaged in fraud and embezzlement, among other crimes. As one might expect, Andrews disappeared, leaving his innocent partner, Palilla, alone to face angry customers and lawsuits. Ultimately the innocent partner filed a Chapter 7 bankruptcy.

As to vicarious liability under the Colorado Uniform Partnership Act, Judge Brown noted that it provides that a partnership is liable for any loss or injury caused “as a result of a wrongful act or omission, or other actionable conduct, of a partner acting in the ordinary course of business of the partnership or with authority of the partnership.” (Slip opinion at p.6–7; Colo. Rev. Stat. § 7-64-305(1)). The Act also contains a specific provision concerning misappropriated funds:

If, in the course of the partnership’s business or while acting with authority of the partnership, a partner receives or causes the partnership to receive money or property of a person not a partner, and the money or property is misapplied by a partner, the partnership is liable for the loss. Colo. Rev. Stat. § 7-64-305(2).

While § 7-64-305(2) imposes strict liability on the partnership for the misapplication of money or property received by a partner in the course of the partnership’s business or otherwise within the scope of the partner’s actual authority, Judge Brown went further by holding an individual partner liable for such acts, not just the partnership, noting that all partners are jointly and severally liable for all partnership obligations under Colo. Rev. Stat. § 7-64-306(1), and thus the defalcation by one partner ultimately becomes the liability of the others, at least in a general partnership. Thus in her view, a partner may be held liable for another partner’s embezzlement of funds, despite the fact that the innocent partner had no knowledge of or participation in the guilty partner’s activities. One rebuttal to the Judge’s conclusion of vicarious personal liability is that the legislature could have easily added the words “partners” to Colo. Rev. Stat. § 7-64-305(2) but chose not to do so; but it is then hard to ignore the catch-all language of § 7-64-306(1).

Judge Brown noted there is no applicable Tenth Circuit precedent on the non-dischargeability of vicarious liability for embezzlement under 11 U.S.C. 523(a)(4), but the precedents from other jurisdictions are greatly in favor of holding such debts non-dischargeable. Both 11 U.S.C. § 523(a)(2) and (a)(4) refer generally to the nondischargeability of a “debt” for fraud (in the case of § 523 (a)(2)) or a “debt” for embezzlement (in the case of § 523(a)(4)). Contrast this with § 523(a)(6), which excepts from discharge debts “for willful and malicious injury by the debtor.” As Judge Brown held:

Neither § 523(a)(2) nor § 523(a)(4) explicitly require the fraud or embezzlement which caused the debt be committed by the debtor. This change in language offers additional support for imposing vicarious liability in connection with certain discharge exceptions. See Securities Investor Protection Corp. v. Rounds (In re Rounds), Ch. 7 Case No. 09-10676 ABC, Adv. No. 09-1220 ABC, slip op. at 24 (Bankr. D. Colo. Aug. 6, 2010). (Slip opinion at p. 5)

In her decision, Judge Brown restated the strong public policy behind denying discharge of debts created by fraud, embezzlement, and other similar acts and to make the victims of such acts whole again to the extent possible. (Slip opinion at p. 8.)

The lessons to be learned from Pallila are many, but the primary one is that there is no such thing as an “innocent” partner when it comes to embezzlement and damage claims resulting from fraud by a general partner. This type of potential liability sweeps across all types of businesses and industries. It is difficult to see how skilled drafting of a general partnership agreement or other document could insulate one from this type of debt obligation.

The non-dischargeability result in Pallila may have been different had the partnership been a limited liability partnership (LLP). Partners in LLPs are generally not liable for partnership obligations. See Colo. Rev. Stat. § 7-60-115(2)(a) and § 7-64-306(3). The underlying premise of Pallila was that the statutory scheme for general partnerships imposed vicarious liability on the individual partners, not the situation with LLPs.

In the final analysis, better operational, accounting, and institutional controls may have prevented the fraud. Ultimately, trust in one’s partner may not be enough.

Invalidating and Fixing Patents

Henry L. Smith, Jr., Registered Patent Attorney

If a defendant is sued for patent infringement, the main defenses are that the exact wording of the patent claims does not cover what the defendant is doing, or that the patent is invalid. The main ways to invalidate a patent are to show (a) that the inventor went public with the invention more than a year before the patent application was filed, (b) that the invention was the same as something invented or disclosed earlier by someone else (“prior art”), or (c) that the invention is an “obvious” combination of two or more pieces of prior art, or is an “obvious design change” of some piece of prior art.

Going “public” mentioned above generally includes selling, offering for sale, describing in a printed publication or on a website, disclosing to persons or groups without a confidentiality agreement, or public use or test. “Prior art” can include patents, published patent applications, books, articles, products or services publicly sold or used, material on websites, etc.

Infringement Actions

In an infringement situation, patents can be invalidated in federal court or in the U. S. Patent and Trademark Office (PTO). The former tends to be slow and expensive, but the latter is often less expensive and faster. For a number of reasons, federal judges often suspend an infringement suit in federal court while the plaintiff and defendant fight it out in the PTO where the patent owner (plaintiff) will try to show that the patent is valid, while the defendant (accused infringer) will try to show that the patent is invalid for reasons (a) through (c) above or for some more technical reasons such as (d) the patent did not indicate that the inventor had actual “possession” of the invention (that is, that the invention was shown to actually work), or (e) the patent had insufficient disclosure of the invention to enable a person of ordinary skill in the art to make and use the invention when the patent expires, without undue experimentation or need for additional information.

Using the PTO under the AIA

After the Patent Reform Act of 2011 (“America Invents Act” or “AIA”), there are now several ways in the PTO to review an issued patent. Some of the processes can be initiated by the patent owner to remove any “cloud” or doubts about the patent’s validity; and some of the processes can be used by an accused infringer, or someone wanting to use the patented invention, to show that the patent is invalid. Each of the processes has a number of specific requirements, and there are very complex cost, timing, and strategy factors which determine which process is the best to use in various situations. The PTO processes can be faster than actions in federal court, but the PTO filing fees can be large—$25,000 to $50,000 or more, and the PTO has discretion to disallow the use of some processes.

The following are very brief descriptions of the processes:

Inter Partes Review is a process initiated by a patent challenger, in which a patent can be invalidated by a mere “preponderance of the evidence”.

Post Grant Review is a process filed by a patent challenger, and again the standard for invalidating the patent is “preponderance of the evidence”, but this process is available only for patents resulting from applications filed after March 16, 2013.

Ex Parte Re-examination is a process initiated by the patent owner to shore up the validity of the patent, or by a patent challenger (who could remain anonymous).

The patent owner has the following processes to “fix” problems with a patent.

Patent Re-Issue can be used by a patent owner to correct fairly minor problems with a patent.

Supplemental Examination is initiated by a patent owner regarding a patent in litigation to “cure” problems of inadequate disclosure of prior art, etc. to the PTO.

Generally there is a legal presumption that a patent is valid, but the presumption is stronger in federal court than in the PTO, which is a reason to take action in the PTO in some situations. In court, invalidation of a patent must generally be by “clear and convincing evidence”, but in the PTO a patent can be invalidated by a “preponderance of the evidence”.

Amazingly, some of the PTO processes have estoppel effects in later actions in federal court or in the PTO, but some do not.

Archive.org

As an interesting note, if you have not seen it before, take a look at archive.org. This is a giant website which shows what most websites in the world looked like at various times in the past every few months, in some cases to the late 1990’s. This is a favorite website for patent attorneys to use to invalidate a patent on the basis that the inventor went public more than a year before the patent application was filed, as mentioned above. The website can be very useful to other attorneys in many kinds of litigation. Because of archive.org, websites and their previous versions do not disappear into cyberspace without a trace.

 

Severability—Do You Want the Contract in One Piece or Many?

By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C.

Many contracts contain a term which provides generally that, if a provision of a contract is determined to be unenforceable, the unenforceability of that provision does not impact other provisions of the contract. The following is an example of a severability clause:

If a provision of this Agreement is or becomes illegal, invalid or unenforceable in any jurisdiction, that shall not affect: (a) the validity or enforceability in that jurisdiction of any other provision of this Agreement; or (b) the validity or enforceability in other jurisdictions of that or any other provision of this Agreement.

Alternatively, the contract may provide that if any material provision of the contract is or becomes invalid, the contract as a whole is invalid. In many cases, the severability clause is included without real thought whether the parties want a contract to survive if a material provision is voided. It is frequently just part of the “boilerplate” in a contract, and usually does not engender much discussion.

Sometimes, severability clauses will state that some provisions of the contract are so essential to the contract's purpose that if they are illegal or unenforceable, the contract as a whole will be voided. Occasionally, a contract does not address severability. In Colorado, as discussed in the Court of Appeals decision in CapitalValue Advisors, LLC v. K2D, Inc., 2013 COA 125 (Colo. App. 8/15/2013), this leaves the question of severability of the contract to the court’s determination of the intention of the parties.

In this case, CapitalValue entered into an agreement to provide services to K2D by which CapitalValue would earn: (1) a 4.5% commission for a sale of less than a majority interest in K2D; (2) a 4.0% commission for a sale of more than a majority interest in K2D; or (3) a 4.5% commission for obtaining debt financing for K2D. The agreement had a 24 month “tail” by which CapitalValue would earn its commission should K2D complete a transaction within that period.

K2D terminated the agreement with CapitalValue and entered into another agreement with another entity which assisted K2D in obtaining a $57 million debt financing package within the tail period. CapitalValue claimed its commission. The litigation followed K2D’s refusal to pay CapitalValue.

The Weld County District Court granted summary judgment to the defendants, finding that the first two promises (the “sale of a business provisions”) were illegal in that they violated the real estate licensing requirements of C.R.S. § 12-61-101(2) and the broker-dealer licensing provisions of § 15(a) of the federal Securities Exchange Act of 1934 and C.R.S. § 11-51-401. The District Court concluded that, as a result, the contract, which did not have a severability provision, was void and unenforceable as a whole.

On appeal, CapitalValue did not challenge the District Court’s conclusion that the sale of a business provisions were illegal in light of the real estate and securities broker-dealer licensing requirements. CapitalValue did challenge that the illegality of those provisions would necessarily void the entire contract. CapitalValue also pointed out that there are no licensing requirements for entities assisting in procuring a business loan, as CapitalValue had agreed to do, and as the successor advisor accomplished.

The Court of Appeals recited black-letter contract law when it said that “[i]n interpreting a contract, our primary goal is to determine and give effect to the intent of the parties.” Citing Reilly v. Korholz, 137 Colo. 20, 27, 320 P.2d 756, 760 (1958), the Court noted that “[w]here an agreement founded on a legal consideration contains several promises, or a promise to do several things, and a part only of the things to be done are illegal, the promises which can be separated, or the promise, so far as it can be separated, from the illegality, may be valid.”

Quoting a Tennessee case (Penske Truck Leasing Co. v. Huddleston, 795 S.W.2d 669, 671 (Tenn. 1990)), the Court said:

An agreement can be either an entire contract or a severable contract according to the intention of the parties, and the fact that divisible parts are included within the same document does not preclude them from being considered and enforced as separate contracts.

In determining whether a contract is severable, the Court said “[t]he primary objective is to ascertain the intent of the contracting parties, as such intent is manifested by not only the several terms and provisions of the contract itself, but also as such are viewed in the light of all the surrounding circumstances, including the conduct of the parties before any dispute has arisen.” John v. United Adver., Inc., 165Colo. 193, 198-199, 439 P.2d 53, 55-56 (1968).

In the end, “[b]ecause the parties’ intent as to whether the Agreement was severable presents a disputed issue of material fact, the court should not have entered summary judgment.” “Here, the single document—the Agreement—contains multiple promises, each of which may constitute a separate agreement or contract.” The Court of Appeals remanded the case to the trial court to ascertain the intent of the parties as to severability.

In one Colorado case (Lundwell Communications, Inc. v. Batte, 2006 WL 3933863 (Colo. D.Ct. Arap. Cty. 12/5/2006)), a plaintiff attempted to enforce a non-competition agreement against a former employee which the court found to be unenforceable under C.R.S. § 8-2-113 and common law because it was neither reasonable in time nor scope. The plaintiff asked the court to use its “blue pencil” to amend the agreement to impose a reasonable geographical limitation. In denying the plaintiff’s request, the District Court said:

Unlike some contracts, the Agreement does not expressly provide the Court the right to blue pencil the Agreement. In any event, the Court is not willing to amend the Agreement, which is unenforceable.

A Nebraska law review article (Pivateau, Putting the Blue Pencil Down: An Argument for Specificity in Non-Compete Agreements, 86 Neb. L. Rev. 672 (2008)) argues that courts, even when authorized by the agreement, should not reform non-competition agreements. Such a contractual provision allows the employer to seek significant concessions from the employee when the employer has the negotiating advantage, with the only risk being that some provisions may be cut back. The agreement and the unreasonable provisions, however, have an in terrorem effect on the employee.

The CapitalValue case points out the importance of recognizing that even the boilerplate provisions can be important and should be considered when negotiating contracts. The contract negotiators should consider how these provisions, like the severability provision, fit into the overall scope of the contract and whether the parties really intend that the contract survive if a material provision is invalidated. It is much easier for a court to determine the intent of the parties (as the district court will now have to do in the CapitalValue case) if it is expressed in the contract. Do not count on blue pencil provisions to allow the court to reform the contract. The court may choose not to exercise that right.

Business Law Section Activities
Bankruptcy Subsection

The new Bankruptcy Subsection Co-Chairs, Leigh Flanagan (laf@kutnerlaw.com) and Andrew Johnson (ajohnson@osglaw.com), are now planning meetings and presentations for 2013-2014. A Case Law Update is expected near the end of September. An email will be sent to Bankruptcy Subsection members with the date and time. If you want to provide suggested topics for future CLEs and events or are interested in presenting at a Case Law Update or CLE, please contact the co-chairs.

Financial Institutions Subsection

The New Consumer Financial Protection Bureau Regulations: CFPB—What Does it Mean for Your Clients? —Friday, Sept. 27

Co-sponsored by the CBA Real Estate Section and the Business Section’s Financial Institutions Subsection

The regular September meeting will not be held this month. Instead, the Financial Institutions Subsection will be co-sponsoring this event.

An overview of the new rules and regulations implemented by the Consumer Financial Protection Bureau in accordance with the Dodd-Frank Act and a discussion of the potentially significant implications for real estate lawyers, brokers and mortgage lenders. Topics include:

  • An Overview of the CFPB—There is a New Sheriff in Town
  • The Changing Regulatory Landscape—An Overview of the CFPB’s New Rules Affecting Residential Mortgage Lending
  • What Should an Attorney Do When Approached by a Broker in a Seller Financed Transaction?
  • Ability to Repay Rule
  • Take-Away Points—Q&A with the Faculty

The program is from 9 to 11:30 a.m. live or via webcast. Available for three general CLE credits. Learn more and register online, or call 303-860-0608 (toll free 888-860-2531).

Mergers and Acquisitions Subsection

Delaware LLC Fiduciary Duties to Members—Opting Out and Applications in M&A Transactions—Tuesday, Sept. 10

Co-sponsored by the M&A Subsection of the CBA Business Law Section

This presentation will focus on the application of fiduciary duties to members of Delaware limited liability companies, including “opting out” of certain duties and application in connection with M&A transactions. The program will also cover relevant pending Delaware legislation and how that might affect the landscape for LLC’s.

The program is from 8 to 9 a.m. live or via webcast. Available for one general CLE credit. Learn more and register online, or call 303-860-0608 (toll free 888-860-2531).

CBA-CLE Information

Unless otherwise noted, all programs are at the CBA-CLE offices, 1900 Grant St., Ste. 300, Denver

Annual Tort Law Update 2013—Friday, Sept. 20

Learn from some of Colorado’s leading practitioners the new case law, important pending and settled cases, recently enacted and pending legislation, new fact patterns, legal theories and defenses, judicial and discovery trends, and recent developments in courtroom strategy. 5 general CLE credits are available.

Learn more and register online, or call 303-860-0608 (toll free 888-860-2531).

Transactions—The Art and Skill of Lawyering—Tuesday, Oct. 1

Learn in a short interview session what it took four experienced business lawyers decades to acquire. We will find out how they confronted the challenges of putting together sophisticated transactions in complex environments, at times with challenging clients. Our panel will share their experiences and how their perspectives changed over decades of representing business clients. 2 general CLE credits available.

Learn more and register online, or call 303-860-0608 (toll free 888-860-2531).

2013 Business Law Institute—Oct. 16–17

Live at the Grand Hyatt Pinnacle Club, 1750 Welton Street, 38th Floor, Denver

This is an exceptional program if you are in private practice or in-house counsel—and if you’re new to business law or have many years of experience. This blend of dynamic topics and talented professionals can provide important lessons that directly affect your business practice. Plenary sessions include Colorado Business Case Law and Legislative Update; Exploring Current Corporate Transactional Issues Through Recent Delaware Case Law; What Business Lawyers Do that Litigators Love; and Legal Ethics for Corporate and Transactional Attorneys. 12 general CLE credits available, including 1.9 ethics.

Learn more and register online, or call 303-860-0608 (toll free 888-860-2531).

Recent Homestudies

CBA-CLE Featured Publication

Practitioner’s Guide to CO Business Organizations, Second Edition

The Guide begins with basic topics that a Colorado practitioner should consider in the choice-of-entity process. The book then presents detailed discussions of the numerous types of Colorado entities. Finally, chapters from authors from a wide range of practice areas and expertise address the various aspects of their practice areas that relate to Colorado business organizations.
Managing Editors: Lee Reichert and Allen E.F. Rozansky

For more information or to order books, call 303.860.0608 or 800.860.2531 or click here.

Contributions for future newsletters are welcome —
Contact Ed Naylor at ed.naylor@moyewhite.com or 303-292-2900

This newsletter is for information only and does not provide legal advice.

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